The U.S. dollar last week appeared mercifully to end its plunge. World markets cheered, and the immediate financial crisis in the U.S. abated. But this week the dollar is retesting all-time lows versus the euro and yen, and commodity prices, capital flows, and trade remain vulnerable to its movements. Inflation in dollar-linked China is rising fast, and an over-strong yen could thwart Japan's recent recovery after its painful 1990s deflation. In the U.S., currency swings are destabilizing the economy and fueling anti-trade populism. After a decade of wild instability, it's time to rethink global currency markets and monetary policies.
How did we get here? After the global inflation of the 1970s, the currency interventions of the late 1980s helped push the value of the yen ever higher, and Japan slid into a long deflation. With Fed Chairman Alan Greenspan's high real interest rates, the dollar-linked world then stumbled into its own deflation in the late 1990s.
As the dollar strengthened dramatically in the late '90s, it exerted enormous pressure on all dollar debtors, rumbling through Asia in 1997-98, then on to Russia, Turkey, and Argentina. The world's capital fled these crashed economies and the new euro area and poured into the U.S. Foreign reserve accumulation slowed or even sank. Capital shunned hard tangible assets like oil and gold, and profits at old-economy companies shriveled. U.S. farmers and manufacturers suffered. Money went into soft abstract assets like Microsoft, Cisco, and Silicon Valley dot-coms. U.S. stock markets rose to half the world's equity wealth.
But eventually the strong dollar overwhelmed the U.S. economy, too, where longer contracts and debt structures, more services and less manufacturing, and profitless dot-coms could save America from the effects of deflation only for so long. Dollar debtors in the U.S. finally succumbed to squeezed profit margins and very tight credit, with corporate defaults hitting records in 2001 and again in 2002. After 9/11, everything changed, as the Fed turned up the dollar spigots and liquefied the world economy with 1% interest rates.
The last five years were thus a mirror image of the late '90s. With negative real interest rates in the U.S, the dollar weakened substantially. Capital poured into Asia, and Europe revived. Money flowed away from soft intellectual ventures and into dollar-sensitive hard assets. Oil, gold, and all other commodities skyrocketed, as did the equity of old-economy industrial companies. Dollar-linked real estate soared. Foreign dollar reserves boomed. The world share of equity wealth rose toward 70% as the U.S. share shrank toward 30%. In 2003, despite the U.S. technology crash, 13 of the 20 richest people in the world were Americans. Today, according to Forbes, that number has dropped to four.
Rising global wealth is a welcome trend and is driven in large part by greater freedom and thus productivity and growth in booming Asia. But it is also driven by the weak dollar, which shifts money to the oil-rich Middle East and Russia, and by stronger global currencies, which attract investment to Europe and Asia. Just as the U.S. could not forever sustain a stronger dollar, however, no country can prosper for long with a currency that is excessively weak or strong.
Since 1994, China's peg to the dollar was a key to its growth and the long but relatively smooth modernization of its financial system. Although it endured falling prices from the strong dollar of the late ’90s, it valiantly held its dollar link and avoided the fate of its Asian neighbors. Overall, the dollar peg has been a very good deal for both China and the U.S. It created a seamless trading partnership that brought the nations together economically and politically. But many wonder what U.S. politicians are thinking when they charge China with "currency manipulation." With the dollar swinging wildly from super-strength to destructive depreciation inside of 10 years, the Chinese might ask, "Who’s the real manipulator?"
For all the benefits of the dollar-yuan peg, the dollar's recent depreciation is simply too much for some. Inflation of 6% in China has been matched by rising prices of around 7% in Indonesia, Singapore and Saudi Arabia, and 15% in Vietnam. Kuwait abandoned its dollar peg, and other Middle Eastern nations are considering it, too. China, which long resisted Washington’s badgering, now sees yuan appreciation as a necessary tool to fight inflation.
China is in the crucial process of more fully opening its capital account and, hopefully, making its currency convertible. Ideally, dollar-yuan stability would allow China to more rapidly modernize and open up. But when the dollar itself is unsteady, China must constantly adjust to ward off hot money inflows and dollar-induced inflation. Domestic tensions rise and important reforms are delayed.
Although currency swings of 30%, 40%, or 50% seem arbitrary and harmful to many, most economists believe in hyperflexible exchange rates. Eminent scholars like Martin Feldstein and John Taylor believe a weaker, more "competitive" dollar helps attenuate the U.S. trade deficit with Asia. Never mind the conceptual argument. (Many of us think the trade deficit means a beneficent capital surplus; the trade gap, in other words, reflects our prosperity gap.) But does the weak dollar theory even work in practice? In fact, as the dollar weakened these last half-dozen years, the U.S. trade deficit didn’t shrink, it boomed, mostly because of surging imports of weak-dollar high-cost petroleum.
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. 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. How can one determine the price of a house, or a complex mortgage security, for example, when the value of money itself is under suspicion?
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—or economic entropy—that comprise all economic growth. A high-entropy message requires a low-entropy carrier.
The great events of the globe increasingly are governed by the movements of world currencies. We need a return to currency stability. But that requires a return to dollar stability. And the dollar is the responsibility of the Federal Reserve.