Dereliction of the Dollar
Release 4.8 March 2008
by Bret Swanson*
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The dollar slid yet again Friday afternoon to another all-time low versus the euro, at $1.57. Gold hovers around $1,000 per ounce. As inflation expectations explode and the term "bank run" re-enters the vocabulary after a decades-long hiatus, the panic continues in global markets and on Wall Street. Is this what the weak-dollar advocates had in mind?
At Thursday's U.S. Chamber of Commerce "Declining Dollar" event, economist David Malpass made the cogent case for a stable currency. Businesses and investors, he insisted, must have a predictable foundation and unit of account on which to base their important long-run decisions. To calm the financial markets and reignite growth, America must restore confidence in the world's reserve currency, the dollar.
Free trade is also in the balance, Malpass warns:
There's more at stake in the dollar debate than a recession, inflation and a bear market. In the economic confusion created by the weak-dollar policy, presidential campaigners are blaming Nafta and free trade, not the weak-and-weaker dollar, for hard times.
But the level of misunderstanding about the dollar, the trade deficit, and the financial markets is almost as bad as ever. The demand-side worldview still dominates, even among conservative economists. Eminent scholars like Martin Feldstein ,  and John Taylor  have been arguing for a "more competitive" - read, weak - dollar. Taylor calls the weak dollar the "silver lining" of the subprime mortgage crisis, instead of the cause of the crisis that it really is. Feldstein, meanwhile, misses the inflationary impact of a weak dollar by ignoring the time lags of monetary policy and currency changes.
The demand-side economy is a machine, where changes in big accounting aggregates cause other variables, like the dollar, to move in predictable fashion. The trade deficit thus forces the dollar to decline and "adjust" to mercifully relieve "imbalances." Why the imbalances are bad they never quite say. Nor can they even define an "imbalance" in a highly integrated global economy. But in this view, currencies must shift so that every nation's imports and exports more or less match. Relatively cheaper and rising exports can then compensate for more expensive and falling consumption of imports. The trade deficit goes poof.
Never mind the accuracy of this theory: As the dollar weakened these last half-dozen years, the trade deficit didn't shrink. It boomed. Mostly because of surging imports of weak-dollar high-cost petroleum.
But even if the trade-deficit-is-bad-and-can-be-relieved-by-a-weak-dollar theory were correct, what do we get for it? Usually a recession. The U.S. last briefly "achieved" a trade surplus in the glorious recessions of 1990-91 and 1981-82. Consumption and business investment - and therefore imports - all plunged during these bad times, so the trade deficit very temporarily vanished. Unemployment and inflation were way up, and asset values and GDP were way down, but at least we vanquished the trade deficit. Congratulations.
Despite ubiquitous fear of the trade deficit, ask yourself: Have you ever heard a coherent, let alone convincing, case for why the trade deficit matters at all? Or why killing the economy in order to relieve this phantom burden is even remotely worth it? When monetary and fiscal policy got back on track and the economy rebounded after the '81-82 and '90-91 recessions, the trade deficit came back, and with a vengeance. When our economic prospects are bright, we import lots of capital—remember, foreign investment in America is a good thing—and when the economy is growing we buy lots of goods and energy, much of it imported.
That's all the trade deficit has meant for 350 out of the last 400 years. The U.S. will continue to have a trade deficit as long as our wealth, growth, and demographic differentials vis-à-vis other nations persist. The trade gap is a good reflection of our prosperity gap.
Another point about the supposed need for currencies to adjust to effect a trade balance: Trade happens because each side wants what the other has. I'll trade you the fruit of my labor for the fruit of yours. It's a win-win transaction. I value what you have produced more than what I have produced. Let's trade. But if all currencies adjusted to relieve the "imbalances," to unwind the "pressures," to compensate for the differences and "disequilibria," then there would be no trade at all. Movements, transactions - trade - only happens because there is a disequilibrium in the first place. But if it is the currencies that move, rather than the goods, services, assets, and information changing hands, then the transactions themselves become superfluous. If the value of money adjusts to wipe out the value of the good or asset, then why would I want what you have, and vice-versa? If the value of the transaction - and all the information - is consumed by the change in currency values, then there is no value in the exchange of the original good, service, asset, or idea.
Ignored in the overly formulaic effort to balance the books across contrived national borders is the damaging effect a weak dollar (or any quick change in the value of money) has on the price of every good, service, commodity, and asset across the world economy. And - on every decision of every investor, business, and entrepreneur. The trade-deficit hawks think mechanically. But the economy is about information - prices, uncertainty, forward-looking decisions, and surprising news and innovations, or what we call entropy. In Friday's Wall Street Journal, Nobel economist Ned Phelps nicely summarized this information-not-mechanics worldview:
In recent times, most economists have pretended that the economy is essentially predictable and understandable. Economic decision- and policy-making in the private and public sectors, the thinking goes, can be reduced to a science. Today we are seeing consequences of this conceit in the financial industries and central banking. "Financial engineering" and "rule-based" monetary policy, by considering uncertain knowledge to be certain knowledge, are taking us in a hazardous direction.
Predictability was not always the economic fashion. In the 1920s, Frank Knight at the University of Chicago viewed the capitalist economy as shot through with "unmeasurable" risks, which he called "uncertainty." John Maynard Keynes wrote of the consequences of Knightian uncertainty for rational action.
Friedrich Hayek began a movement to bring key points of uncertainty theory into the macroeconomics of employment - a modernist movement later resumed when Milton Friedman and I started the "micro foundations of macro" in the 1960s.
In the 1970s, though, a new school of neo-neoclassical economists proposed that the market economy, though noisy, was basically predictable. All the risks in the economy, it was claimed, are driven by purely random shocks - like coin throws - subject to known probabilities, and not by innovations whose uncertain effects cannot be predicted.
Recently, many others, like the trader-turned-academician Nassim Nicholas Taleb and the insightful writer Michael Lewis, have also exposed the fallacies of mechanical economics and statistically modeled finance. As Lewis writes, something is wrong with financial models when once-in-a-million-year-events - "black swans" in Taleb's phrase - happen every year.
Some of the weak-dollar inflation story is beginning to poke through, and news articles and even the President are now mentioning the dollar-oil-commodity link. Europe, Japan, the Mideast, and China are all consumed with weak-dollar worry and are urging the U.S. behind the scenes to take action. Yet the dollar continues its fall.
Wednesday night, in a little noticed interview with the "Nightly Business Report," President Bush finally called for a stronger dollar:
Q: You mentioned that one of the reasons that's driving up the price of oil is the dollar. You have said that you are for a strong dollar. Do we have a strong dollar now?
Bush: We have a dollar that's adjusting, and I am for a strong dollar. One reason I am for a strong dollar is because I want, you know, people to - I think it helps deal with inflation. And you're right, the weakening dollar has affected our capacity to be able to purchase energy. I mean, we're dependent on energy from overseas. Our dollar doesn't buy as many barrels of oil as it used to, and so therefore it's more expensive for the American people. And that's why I'm for a strong dollar; one reason.
But it was not clear just how firm or premeditated Bush's statement was. Then any hope his statement would get some attention was swamped by the announcement on Thursday of Treasury Secretary Paulson's new mortgage and credit crackdown. The crisis at Bear Stearns dominated Friday's news, and in an interview with Lawrence Kudlow the President himself seemed to backtrack from his fleeting strong-dollar statement.
Nevertheless, Morgan Stanley on Friday said the odds of a currency intervention are rising fast. The Real Time Economics blog summarized the view of Morgan's Stephen Jen:
First, the lower dollar is driving up commodity prices. "There is a vicious circle between (i) the falling dollar, (ii) rising commodity prices, (iii) the impression that inflation is high and rising in the world, (iv) the world having to remain vigilant on inflation by keeping interest rates high and currencies strong, and (v) the dollar falling as a result of this and a hyper-proactive Fed," Mr. Jen writes. Perceptions of high inflation because of rising energy and food prices "also undermine the credibility of the Fed ... further hurting the dollar."
Second, at "these extreme levels," the lower dollar is "starting to inflict serious damage to investor confidence ... The excessive weakness of the dollar is starting to hurt the global equity markets and, more importantly, it is accelerating the quiet erosion of investor confidence in the dollar and dollar assets." The U.S. is perceived to be devaluing its way to prosperity and the Treasury's "strong dollar" mantra is no longer "taken seriously." If a member country of the Gulf Cooperation Council decides to abandon its currency peg to the dollar, it could aggravate a "negative feedback loop" between the dollar and U.S. assets.
Inflation, capital outflows, huge asset price swings, modern-day bank runs, psychological impacts on investors and entrepreneurs - these effects of the weak dollar cannot be modeled in mechanical fashion.
This is why the value of money is not like any other product, whose value is set in the marketplace. The value of money in a floating rate environment where fine-tuning central banks print money cannot be "set by the market." This is an illusion, and a dangerous one. Money is not a product or commodity. Money is an abstract concept - a measuring rod, a standard of value, a unit of account that must remain constant over time. Only then can workers and businesses, entrepreneurs and investors engage in meaningful trade, risk new money in forward-looking ventures, and lend and borrow money on reasonable terms. Movement in the value of money is not a helpful "adjustment" but harmful noise that impairs the transmission of all-important information. To achieve a dynamic and growing economy, you need an utterly undynamic, stone-cold unit of money. It is the information-rich creative spikes of entrepreneurship and profit that comprise all economic growth. Economic entropy thus requires a zero-entropy foundation. A high-entropy message requires a low-entropy carrier.
In this model, money is the carrier - the transmitter of information. The information itself - the positive entropy of economic growth - is the new ideas, ventures, products, services, technology, and profits that yield both steadily rising living standards and the occasional quantum leap to higher levels of economic life and lifespan.
Thus theory as well as experience argues not only for stable currencies at home but also for stable exchange rates among nations.
The dollar derelicts have it backwards. In the end, high-entropy money yields a low-entropy, stone-cold economy.