A Reliable Dollar, Not A Strong One

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This column was written by John Tamny.

While stock markets continue to gyrate amidst domestic and world uncertainty, the dollar's fall has become an even more pressing issue. Rate hikes initiated in 2004 didn't arrest its downdraft, just as rate cuts of more recent vintage have occurred alongside further dollar weakness.

Much of the recent talk about the need to prop up the dollar has centered on the money supply and the Federal Reserve's interest-rate lever. But very little has been said about the demand side of the money equation, whereby we get the principle: The more credible the currency regime, the greater the demand for the money issued.

The U.S. learned this lesson the hard way in the aftermath of President Nixon's decision to close the gold window in August 1971. When currencies around the world fell in response to Nixon's move, a system of fixed exchange rates was quickly put together. Unfortunately, the dollar's new position wasn't taken seriously by the markets, resulting in a substantial flight away from dollars and into the more credible currencies offered by Japan and Germany. The era of floating currencies had begun.

By 1975 floating currencies had created short-term trade advantages at the expense of long-term economic health for the devaluing countries, with the U.S. a frequent miscreant when it came to using devaluation as an export tool. When Carter Treasury secretary Michael Blumenthal communicated his desire for a weaker dollar against the yen in 1977 -- despite a Fed that was raising its funds rate in large chunks -- the markets eagerly complied.

At the time, worried investors sought to move into the most credible currencies available. And with the U.S. not offering up a reliable dollar, other countries would fill the void. For instance, Switzerland's monetary base grew only 1 percent in 1977. In 1978, however, after making clear its desire to maintain a strong, stable franc, the Swiss money base grew 19.7 percent. The dollar's base grew 8.2 percent over the same timeframe, yet the U.S. experienced a 13 percent price inflation between 1979 and 1980 compared with Switzerland's 4.5 percent rate.

Another seeming paradox emerges when comparing the direction of the dollar in the 1970s and 1980s. It is often said that the Fed's expansion of the monetary base gave us the inflationary 1970s. But measured in supply terms, the story is much more nuanced. The monetary base did grow 111 percent in the 1970s, but the Fed oversaw nearly identical money growth of 109 percent in the 1980s, the decade in which inflation was tamed. The difference in the latter decade was that a president offered tax cuts and deregulation as a tonic for the growth that was meant to restore the value of the dollar.

And now back to 2007. Portfolio manager Stephen Shipman noted recently that the amount of high-powered money being created by the Fed is actually lower today than it was in May, a situation one would think would equate with a strong greenback. Yet despite this fact, the dollar almost daily tests new all-time lows with no end in sight. What to do? Though Treasury secretary Henry Paulson is on record saying markets should set the dollar's value, this form of "benign neglect" seems a bit wanting given the dollar's direction.

Faced with a falling pound in the 1980s, Margaret Thatcher's Chancellor of the Exchequer Nigel Lawson communicated to the markets his desire for an exchange rate of one pound to three deutschemarks. The markets matched his desires almost instantaneously. While it's unrealistic to assume Paulson will seek a direct currency link with the euro, a strongly worded communiqué from the secretary that makes plain his unhappiness with the dollar's fall will at least give traders a story to support resumed dollar buying. It also could present a way out of what could be a painful inflationary episode.

By John Tamny
Reprinted with permission from National Review Online