Dollar Alarm

THE WALL STREET JOURNAL: Dollar Alarm

April 14, 2008; Page A14

Awakening from their long slumber, the G-7 finance ministers have finally admitted that a global run on the dollar is a bad idea. The currency markets will no doubt begin testing immediately to see if they mean it.

At their weekend meetings in Washington, the G-7 ministers dropped their long neglect of the dollar and noted that “Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange rates closely, and cooperate as appropriate.” Translation: We don’t want the dollar to keep falling, and speculators might get burned if they bet on further dollar declines.

This is progress. For years the G-7 countries have welcomed a falling greenback as they fretted about the U.S. trade deficit and the non-problem of “global imbalances.” The Bush Treasury has been as guilty as anyone, pushing China to revalue the yuan and hoping that a falling dollar would get U.S. manufacturers off its back. The ministers have now got their wish, but the consequences aren’t so benign.

Inflation is rising throughout the world due to dollar weakness, and the prices of such commodities as oil and corn have soared. The dollar has fallen 25% since 2002, and nearly 8% against the euro so far this year. As former Federal Reserve Chairman Paul Volcker noted last week, we are already in a “dollar crisis.” Even the International Monetary Fund – typically the temple of devaluationists – is alarmed by the dollar’s fall.

The new G-7 language is also a welcome break from its boilerplate about exchange rates being set by “market forces.” This is one of the larger misunderstandings in modern economics, and has been especially hard for the Bush Treasury to comprehend. Currencies are not a typical commodity, like wheat or platinum. They are a medium of exchange. While currencies are freely traded in a world of floating exchange rates, the supply of dollars, euros or yen is set by a cartel of central banks. Those banks can influence exchange rates by signaling a change in their respective monetary policies.

This is where the currency traders will test the G-7’s sincerity. The hint that the countries might “cooperate” to influence exchange rates is a warning that central banks could intervene in currency markets and catch some traders on the wrong side of a bet. However, such interventions are typically “sterilized,” which means that the banks quickly mop up whatever dollars or euros they use to intervene in markets. If central banks really want to put a floor under the buck, the Federal Reserve will have to change its weak-dollar policy.

Such a change will run into enormous opposition in Congress, among homebuilders and on Wall Street – all of which want the Fed to inflate its way out of their current credit woes. (John Makin makes the case for the inflation solution here.) We only wish life were that easy. The Fed’s aggressive easing in the last year may already have done more harm than good.

Dollar weakness has contributed to soaring commodity prices that have walloped U.S. consumers just when their spending is most needed to offset the housing slump. Oil alone has climbed to $110 a barrel, from $70 in August, even as the International Energy Agency has slashed its predictions for global oil demand. The commodity boom is the result in large part of the Fed’s weak-dollar policy, and it may have tipped the U.S. into a recession that could have been avoided.

As Stanford’s Ronald McKinnon noted on March 31 on these pages, the Fed’s easing has also driven private capital away from the U.S. Money has flowed instead to those countries with rising currencies, such as China. To prevent the too-rapid revaluation of their currencies, these central banks are buying up dollars, which they then invest in safe U.S. Treasurys. This explains the paradox of low U.S. Treasury rates even amid a weakening dollar.

In a double irony, China is now revaluing the yuan of its own accord to avoid importing inflation from the U.S. Other countries that have pegged their currencies to the greenback are now de-linking. The U.S. devaluationists are getting their way, but in the most painful way possible for the U.S. and world economy.

Because the weak-dollar policy hasn’t ended the credit turmoil, maybe the Fed should try Plan B. Specifically, it could signal the end to its easing to stop flight from the dollar. Meanwhile, the Fed can use its various discount-window facilities to address bank liquidity problems, as it is finally doing in earnest since the Bear Stearns collapse.

In a better world, Congress and the White House would also help with a fiscal growth agenda, such as a marginal rate tax cut. Instead, they passed a demand-side tax rebate that will goose consumption a bit later this year without changing investment or work incentives. That was a big lost opportunity. Amid so much intellectual confusion, at least the G-7 has signaled an alarm over dollar weakness. These days we’ll take the good news wherever we can get it.

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