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Too Much Money Chasing Too Few Goods

Wednesday, August 1, 2007

A weakening dollar may seem like trouble, but exchange rates don’t tell the whole story.

Much ink has been spilled of late about the strength of foreign currencies versus the dollar, but in truth, many of the major currencies have been weakening too; just not as much as the dollar. The problem with measuring the paper concepts that are currencies against each other is that they can all move in tandem relative to the value of real things.

When we factor in the constant that is gold, a different story emerges. While gold has risen 145 percent in U.S. dollars since June of 2001, it has also risen 45 percent in Australian dollars, 52 percent in Euros, 65 percent in Canadian dollars, and 73 percent in British pounds. When H.C. Wainwright principals David Ranson and Penny Russell wrote in a recent Wall Street Journal op-ed of “another classic ‘run’ on paper currencies,” they were talking about the gold price of currencies.

Some would point to the low Fed funds rate as an explanation for the dollar’s weakness, but the euro continues to test all-time highs against the dollar despite a cash rate 125 basis points lower than ours, while the Canadian dollar threatens parity with its U.S. counterpart despite a short-term rate that is 75 basis points less than the one the Fed sets. More realistically, as the dollar began its fall in 2001 amidst terrorist threats, tariffs, and Sarbanes-Oxley, foreign central banks aggressively sold their currencies for dollars to slow the latter’s fall. Though not as substantial as the great inflation of the ‘70s, dollar weakness has begotten worldwide currency weakness given the understandable desire among countries around the world to maintain some semblance of stability against what remains the world’s reserve currency.

Amidst this broad currency weakness, a debate has begun as to whether the liquidity is a function of the Fed and other central banks printing too much money, or instead, rapidly rising prosperity around the world adding to the total stock of money through increased demand for goods. While the latter is certainly a fact, and is something that should be embraced, it can’t serve as an explanation for all the excess liquidity. 

With government measures of growth uncertain and volatile, investors necessarily hold back on committing capital given the well-founded fear that the Fed will use its rate mechanism under the misbegotten view that growth causes inflation.

Prosperity and economic productivity don’t create liquidity, they work against it. Growing economies require more money, meaning rising employment and production by definition sop up excess liquidity. While the major business media continue to wring their hands over a global boom that will in their view cause inflation, they misunderstand its true nature. The better question to ask would be how liquid and inflationary the world economy would be absent the expansion they speak of. 

Somewhat scarily for the excess liquidity picture, the Fed continues to view inflation as the result of strong resource utilization and too many people working. U.S. shares frequently sell off on good economic news given the understandable investor fear that the Fed will use its funds rate to slow the very growth that has kept the dollar’s weakness from turning into a rout. 

AEI economist Kevin Hassett wrote an excellent piece recently which discussed how inconsistent tax policy exerts a “chilling” effect on investment. Not knowing what to expect from Congress in the future, investors hold back on committing capital for the long-term out of fear that the rules will change in such a way that potential profits will be seized.

This chilling effect similarly applies to monetary policy today. With government measures of growth very uncertain and volatile (see GDP), investors necessarily hold back on committing capital given the well-founded fear that the Fed will use its rate mechanism to leaven growth under the misbegotten view that it causes inflation. That the Fed at times seeks to lean on growth through rate hikes helps to explain why the dollar’s weakness versus gold and other currencies accelerated once it began raising rates in June of 2004. 

Judging by stock rallies around the world, the global economy continues to expand despite money creation that outpaces demand. But with the Fed in the clear lead when it comes to excess money creation, it should be remembered that the more credible the monetary policy standard, the greater the demand for money issued. 

However well intentioned they might be, rate hikes meant to cool the economy work against efforts to reduce overall liquidity. Conversely, if the Fed singularly targeted dollar-price stability, there would be no need for higher rates given the rising dollar demand that would result from the Fed offering investors a clearer and more credible policy. 

John Tamny is editor of RealClearMarkets. He can be reached at

Image credit: Photo by flickr user pinkiwinkitinki.

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