The US Dollar - Don’t just do something, stand there!

Wednesday, 10/14/2009 - 5:04 pm by Marshall Auerback | 8 Comments

Fears about the falling dollar are stoked by neo-liberal money myths that harken back to the gold standard system, argues Marshall Auerback.

It seems there isn’t a day that goes by without more commentary on the demise of the dollar and the concomitant risk of a collapse of the world’s reserve currency. Again, the reasoning here appears largely to be based on the tyranny of orthodox neo-liberal economics. Orthodox economists view dollar depreciation as an imminent danger which raises the relative costs of imports, and imparts an inflationary bias to the economy. Moreover, they argue that depreciation leads to expectations of further depreciation and fuels the run out of the currency.

So, in the logic of this view, there may be no interest rate that is high enough to counter expectations of losses due to depreciation and possible default, which means that there will be no alternative but to urgently restore reserves of foreign currency either through renegotiation of foreign debt obligations, international donor assistance or default, especially given our supposedly “reckless” and “irresponsible” government spending, which is supposedly robbing future generations of growth and prosperity.

Large deficits are not the problem

Let’s all take a deep breath here: Whilst the dollar index has fallen some 15% from the high sustained earlier this year, it is still above the lows sustained at the height of the credit crisis reached about a year ago. Secondly, there seems to be a fear that the current fall in the dollar could well engender inflation, and create a panicked response from policy makers where the Fed actually does raise rates and the Treasury begins to reduce government spending. Given high prevailing debt levels and the weak state of the consumer’s personal balance sheet, this would be an unmitigated disaster.

It is true that excessive government deficit spending can be inflationary, and could therefore cause some impact on exchange value of dollar. But this can’t be viewed in some sort of vacuum. The size of the deficit is irrelevant in itself. There is no meaning in the terms ‘large deficit’ or ’small deficit.’ You have to relate them to the extent of labor and capital underutilization, which is a human measure of the aggregate demand deficiency. The fact that labor underutilization is now in excess of 16 per cent in the US (combined unemployment, underemployment and hidden unemployment) and capacity utilization is in the 60-65 per cent range rather than 90 per cent range sends one very clear message - the deficit is not large enough.

So the correct policy response is to spend until we get to full employment. That is the only consequence of excessive deficits — insolvency is not possible. Your social security check will never bounce in a country issuing debt in its own freely floating non-convertible currency.

The size of our government deficit is endogenously determined, which is to say that it has no external cause; it is a function of internal, domestic phenomena. Today, the deficit is largely a function of weaker spending power and concomitantly lower economic growth. (”Good government spending” more or less seeks to fill private output gaps; “bad government spending” is a consequence of government not taking responsibility for filling the spending gap and instead letting this occur via the automatic stabilisers). So the scenario of ever-increasing deficits is unlikely because as economy heats up, deficit shrinks and turns to surplus (as during the Clinton years and also the 1920s).

The orthodox interpretation of a nation with a declining currency and a large current account deficit appears to indicate that the nation concerned is “living beyond its means” — with excessive domestic demand that boosts imports; the excessive demand also fuels inflation that restricts exports. The presumption is that the resultantly large deficit must be “financed” by flows of foreign reserves, which, for the most part, must be attracted by high returns and a stable political, economic, and social environment.

From the US perspective, this means that if America cannot continue to attract these needed reserves, it must raise rates to attract new foreign capital, which in turn will slow its growth to reduce imports; lower prices and wages could also encourage exports. The obvious portent of the default on foreign debt obligations is then used to argue in favour of restricting government spending. Thus, both monetary and fiscal policy ought to be tightened to encourage such capital flows even as this reduces the need for them. In other words, an emerging markets’ crisis writ large.

Deflation or inflation?

But the reality is not so much that the US is inflating, so much as that the rest of the world is deflating relative to the dollar. Import prices are still generally falling, inflation remains quiescent and private credit growth is now contracting. These are hallmarks of deflation, not inflation. Additionally, the US is not borrowing in a foreign currency (in contrast to Iceland or Latvia or the Asian countries during the 1997/98 emerging markets’ crisis), so it does not face an external funding constraint.

What about China? True, there may be some indications that there is some shifts in terms of private portfolio preferences. Perhaps the Chinese don’t want to buy as many dollars as they did before. Perhaps hedge funds are now laying on a big “short dollar” trade in the markets. These are one-off portfolio preference shifts and it seems inadvisable for US policy makers to respond to every single vicissitude of changing market sentiment. That way leads to Latvia and economic implosion.

It’s hard to believe that a nation with 10% official unemployment and likely double that when one factors in underemployment is actually “living beyond its means.” It is even crazier to suggest that we should scale back government spending and private consumption, when there is substantial unused capacity and under-utilised resources (particularly labour). In those circumstances, the nation could not possibly be living beyond its means.

What about those terrible “global imbalances” that we are told must be rectified, what I call “the cult of zero imbalances”?

Well, let’s consider that as a possible policy response.

Policy fables

According to the G20 communiqué, those countries running current account deficits, most notably the U.S., would have to define ways to boost savings. Nations running surpluses - China, Germany and Japan, among others - would detail how they propose to reduce any reliance on exports. The U.S. would likely need to commit to a sharp deficit reduction by government. Europe would need to commit to improving competitiveness. That could mean introducing “labour market reforms” (an interesting choice of language here), which generally is code for being able to sack workers and destroy the power of trade unions.

The collective impact of these measures? We want more domestic led consumption in Asia and the EU (especially Germany), but then the two largest economic areas (the US and Europe) would have to deflate their economies. The former, by reducing the public net spending which would thwart the goal of “boosting” saving, and the latter, by widespread shedding of workers and the resulting collapse in consumption (and rising deficits via the automatic stabilizers as welfare payments and crime rose).

These, of course, are the traditional “remedies” proposed by the IMF — and we can see what a great job this organisation has done. Just ask any Argentinean. Neo-liberal-based policy recommendations almost invariably make things worse. We have ample examples of this in Asia, Russia and Brazil during the 1997/98 emerging markets and more recently in Iceland and the emerging market economies of Eastern Europe.

Goldbug mentality still dominates

It is important to understand that much of the economic orthodoxy is still dominated by the “gold standard paradigm”.
Under the Gold Standard, the leading economies of the world, through their monetary authorities, agreed to maintain the “mint price” of gold fixed by standing ready to buy or sell gold to meet any supply or demand imbalance. Further, the central bank (or equivalent in those days) had to maintain stores of gold sufficient to back the circulating currency (at the agreed convertibility rate). The currency was strictly convertible into gold at the fixed parity. So this was a convertible, fixed exchange rate system.

Gold was also considered to be the principle method of making international payments. Accordingly, as trade unfolded, imbalances in trade (imports and exports) arose and this necessitated that gold be transferred between nations (in boats) to fund these imbalances. Trade deficit countries had to ship gold to trade surplus countries. Money literally did “flow” between countries (which is why we still speak in terms of “capital inflows” and “capital outflows” even though the reality of current modern monetary operations is that we electronically credit and debit bank accounts).

This inflow of gold into surplus countries allowed them to expand their money supply (issue more notes) because they had more gold to back the currency. This expansion was in strict proportion to the gold-currency parity. The rising money supply would push against the inflation barrier (given no increase in the real capacity of the economy) which would ultimately render exports less attractive to foreigners and the external deficit would decline. The trade deficit country would lose gold reserves and this would force their government to withdraw paper currency which drove up unemployment and drove down the price level. The latter improved the competitiveness of that economy. The two adjustments - for the surplus and deficit countries — helped to resolve the trade imbalance. But it remains that the deficit nations were forced to bear rising unemployment and vice versa as the trade imbalances resolved.

So under the Gold Standard, the government could not expand base money if the economy was in trade deficit. It was considered that this constraint acted as a means to control the money supply and generate price levels in different trading countries which were consistent with trade balances. The domestic economy, however, was forced to make the adjustments to the trade imbalances.Monetary policy became captive to the amount of gold that a country possessed (principally derived from trade).

In practical terms, the adjustments to trade that were necessary to resolve imbalances were slow. In the meantime, deficit nations had to endure domestic recessions and entrenched unemployment. So a gold standard introduces a recessionary bias to economies with the burden always falling on countries with weaker currencies (typically as a consequence of trade deficits). This inflexibility prevented governments from introducing policies that generated the best outcomes for their domestic economies (high employment). Ultimately the monetary authority would not be able to resist the demands of the population for higher employment.

We no longer have this currency system, but traditional economic thinking and modelling is still based on it, which is why notions of “affordability” and “sustainability” still dominate our economic discourse. But given that we operate under a fiat currency system (where government declares money to be legal tender), we face no operational constraint per se, or issues of national solvency.

So, in regard to the dollar, what is our advice to Lawrence Summers, Tim Geithner, and Ben Bernanke? Do nothing. In the words of the English poet, John Milton, “They also serve, who only stand and wait”.

Roosevelt Institute Braintruster Marshall Auerback is a market analyst and commentator.