What is causing the falling dollar?
Gerard Jackson
The falling dollar has been causing consternation and confusion while giving rise to various explanations, none of which are right. Buffett apparently believes that debt has been widening the trade deficit and so driving down the dollar. Soros argues that it is the result of Russian and Middle East oil exporters switching from dollars to euros.
On the other hand, members of the Federal Reserve Board and a number of Wall Street economists have been focussing for sometime on the current account deficit as a source of an impending financial crisis. Their solution is to eliminate or drastically reduce the trade deficit by allowing the dollar to fall. This, they hope, will boost exports and domestic production while reducing the flow of imports.
The counterargument has it that these are primary effects and only temporary ones at that. Eventually devaluation would generate inflation which would undermine exports by raising domestic prices which would cause the Fed to raise interest rates.
The economic commentariat has once again missed the mark. It is axiomatic in economics that, all things being equal, if you increase the supply of a commodity its price will fall.
Money is not only a medium of exchange it is also a commodity, the supply of which the Fed has been rapidly increasing. Since the beginning of 2001 M1 has grown by more than 30 per cent. Therefore the Fed’s loose monetary policy drove the dollar down and generated the current account deficit, irrespective of what Buffett or Soros think.
When discussing economic problems it should never be forgotten that changes require time, and all things do not remain equal. Unlike the nineteenth century where the gold standard reigned supreme our world is one of continuously changing money stocks. Under these inflationary conditions all currencies are continually declining.
But this reality is usually concealed from us by the fact that some currencies fall faster than others. This can sometimes give the impression that some currencies are holding their values or even rising against other currencies.
But if the monetary expansion is big enough this must eventually make itself felt through a significant depreciation, which is what is happening to the US dollar. It would have happened sooner, I believe, if the Japanese and Chinese had not moved to prevent a dollar fall against their own currencies by buying huge amounts of Treasury securities.
They did this in the hope of keeping their export prices low in dollar terms. It should be clear, however, that this process cannot continue indefinitely. Some argue that these monetary shenanigans are limited in scope because they threaten these central banks with massive capital losses if the Fed raises interest rates.
True but irrelevant. The real threat does not come from foreign dollar balances but from the Fed’s monetary policy. Where else do these dollars come from? Foreigners could not have accumulated masses of dollars unless the Fed had printed them.
Looking at the problem in monetary terms instead of accounting terms we find that those who argue that the problem is one of imbalances that must eventually bring about a crisis are only partly right.
If they had used economics to examine the situation more thoroughly they would have had to conclude that loose money monetary policies are the source of the imbalances that cause them so much worry. By ignoring the role of money, without which these crises would not appear, commentators are in danger of seeing imbalance where none exist.
For example, from the 1784 right up to 1914 America was a debtor nation. From 1784 to 1870 it ran an annual trade deficit. These debts and deficits were not dangerous imbalances because they were incurred while the country was on a gold standard.
However, once the gold standard was abandoned and Keynesianism took hold it was guaranteed that the world would be subjected to volatile exchange rates, depreciating currencies and recurring international financial crises.
And to think that this very problem had been thoroughly debated in the 1800s in what was known as the bullion controversy. Thanks to Keynesians it is as if the classical economists and their illuminating discoveries and exchanges had never been.
American economy: deficits are not a “force for economic good”
The American economy: is the current account deficit a problem?
US trade deficits and foreign debt: problems or symptoms?
Gerard Jackson is Brookes’ economics editor
BrookesNews.Com
Monday 28 February 2005