A Sound Dollar is the Key to Recovery
Monday, October 27, 2008
Without it, we will be facing stagflation.
“Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch its currency,” John Maynard Keynes once wrote. “Lenin was surely right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose.”
Those words seem especially relevant today. The Wall Street meltdown has provoked a frenzy of finger-pointing among politicians and pundits. Yet few commentators have identified the root cause of the crisis: the Federal Reserve’s weak-dollar policy. Instead, they have blamed deregulation, “Wall Street greed,” a global savings glut, and the sharp decline in U.S. housing prices. Some have mentioned the rank corruption of Fannie Mae and Freddie Mac, which indeed played a significant role in triggering the crisis. But Fannie and Freddie’s high leverage and asset growth were ultimately a result of easy money. Their abuses would have been far fewer in a sound money regime.
Just how loose was the Fed’s monetary policy? One broad measure of the money supply, MZM (Money with Zero Maturity), grew from $3.2 trillion to $7.8 trillion between 1998 and 2007. This monetary expansion enabled many of the excesses that fueled the housing boom. Growing bank assets went searching for more loans; misguided federal policies promoted lax lending practices; and securitization ratified both the process and intermediaries’ profit streams. Government-certified ratings agencies were encouraged to keep the party going, and international investors awash in dollar liquidity were happy to snap up the ceaseless supply of ostensibly safe but high-yielding mortgage-backed securities. The endless monetary injections into the banking system also engendered moral hazard and led to imprudent leverage levels.
Monetary expansion enabled many of the excesses that fueled the housing boom.
It is crucial to understand that without a sound dollar, there will be no sustained economic recovery, only stagflation. “Sound” money means a stable-valued currency and a price system that reflects true scarcities. When the dollar is strong, it retains purchasing power over time against goods and other currencies.
Why does this matter? First, sound money supports prosperity by facilitating trade through specialization and the division of labor, which radically improves productivity and output. Second, by reducing variability in purchasing power, sound money stimulates better entrepreneurial decision-making and capital investment.
When the U.S. dollar in unstable, that often means its value is depreciating, investment in the United States is declining, resources are being misallocated, and the country is losing wealth. Over time, societies with weak or fluctuating currencies are unambiguously poorer.
Why, then, does the Federal Reserve ever tolerate dollar weakness? The Fed has two statutory tasks: 1) promote stable money and 2) induce economic growth. In the long run, the former begets the latter. But in the short run, there are winners from currency depreciation. For example, a weak dollar tends to boost exports, which helped to buoy U.S. economic growth in recent years. As the world’s largest borrower, the U.S. government benefits from a weak dollar, too, since it can repay its debts in a depreciated currency.
Monetary policy is thus driven by short-term goals, and keeping interest rates artificially low can temporarily increase lending and economic activity. This means ignoring the money supply, which the Fed felt justified in doing as long as inflation remained acceptably low.
In the long run, societies with weak or fluctuating currencies are unambiguously poorer.
Over the long term, however, interest rate management is a questionable policy instrument. Data going back to 1971 show little correlation between the federal funds rate and GDP growth. And while exports have boomed during this weak-dollar decade, currency decline is not a necessary condition for growth.
The costs of the Fed’s continuous monetary expansion are now obvious. Easy money created a classic asset bubble in the U.S. housing market. Money supply increases distorted the structure of relative prices, and many of the capital projects subsequently undertaken were not justified by real demand and real savings. Fed policy guaranteed such errant capital allocation through false interest rate signals.
How severe will the correction be? Despite the dollar’s recent surge due to a flight to safety, a period of 1970s-style stagflation is possible, because the Fed plans to monetize the debt incurred by Treasury as part of the financial bailout. Such an action is inherently inflationary, and it will weaken the dollar, which over the past eight years has seen its share of official foreign exchange reserve holdings drop from 71 percent to 63 percent.
What should be done? The fundamental problem in the banking system—and in the broader U.S. economy—is a shortage of capital. According to the Fed, the fourth quarter of 2008 will mark the fifth consecutive quarter in which U.S. household net worth declined. U.S. market capitalization is down by $8 trillion since last summer. The banking sector is now earning collective losses for the first time in 18 years.
In the years ahead, U.S. policymakers should seek to make the United States more capital-friendly. Their immediate priorities should include the following:
An early recovery will occur only if the United States becomes a magnet for capital.
(1). Consider the “Sound Dollar and Economic Stimulus Act of 2008.” Introduced by Congressman Ted Poe (R-TX), this bill would define the U.S. dollar in terms of gold. As former Republican presidential candidate Steve Forbes points out, if the Fed abandoned interest rate targeting and instead targeted the price of gold, it would have an electrifying effect on global markets. All dollar-denominated assets would rally, currency speculation would decelerate, most interest rates would fall, and consumer prices would stabilize. Maintenance of a gold-tracking dollar would require fiscal and monetary discipline, but it would guarantee a huge inflow of needed capital.
(2). Make the 2001 and 2003 tax cuts permanent—this would cancel a $280 billion tax increase scheduled to arrive in 2011, when those tax cuts expire—and pursue pro-growth capital gains and corporate tax cuts. Investment-friendly tax cuts would lead to an immediate stock market rally, job growth, and recapitalization of the U.S. economy.
(3). Restrain government spending. Lower spending will hasten an economic recovery by encouraging job-creating investment, reducing interest rates, and spurring recapitalization.
The United States is facing a painful economic downturn, and some experts argue that monetary expansion and fiscal loosening will be needed to soften the blow in 2009. But these are the policies that led to this disaster. An early recovery will occur only if the United States becomes a magnet for capital.
To that end, we should be pursuing a sound dollar, pro-growth tax cuts, and spending restraint. Such policies would help to sustain the dollar’s recent rally. They would also hasten an economic recovery, promote sound banking practices, and provide an enormous boost to capital accumulation worldwide.
John L. Chapman is a researcher in economics at the American Enterprise Institute.
Image by Darren Wamboldt/The Bergman Group.