Dr. Paul Krugman, one of my favorite economists (if “favorite” now means something completely different than it used to) put up a spirited defense of the precipitous decline of the dollar in his Oct 10th piece Misguided Money Mentalities as published in the print media organ of the Obama Administration, The New York Times.
I take issue with two fundamental points of his thesis that a falling dollar is a good thing. The first, that the falling dollar is a reflection of renewed confidence of investors who no longer see the need to take safe haven in the dollar, is flawed. Other safe haven assets – gold and short term treasuries – are at crisis pricing levels. Gold has broken above $1000/oz. (in no small part due to eroding confidence over the value of the dollar) while the three month treasury remains (as of the time of this piece being written) at a yield of 5 basis points (0.05%).
Secondly, he asserts that the falling dollar is good for US exporters. This glib statement a) ignores some basic assumptions about the environment into which US exports are sold and b) is a overly simplistic application of the Marshall-Lerner Principle which governs the relationship between exchange rates and the trade balance. It is true that devaluing the dollar will make goods whose price is denominated in dollars less expensive for those who are directly purchasing those goods from an American source using a foreign currency; however, that price is not necessarily passed along to the end consumer if the foreign entity reselling those goods is subject to trade restrictions such as high tariffs (priced in the local currency) on American products. Furthermore, even in the absence of tariffs, the effects of a price reduction will be mitigated by an inelastic demand for the American made goods in question, such as in the case in which a third country can produce and sell its goods even more cheaply (China comes to mind immediately). Additionally, the trade balance has two parts – exports and imports. Improving the trade balance by reducing the American demand for foreign made goods by making them more expensive here is not a positive development.
So how did we get into this predicament? The simplistic answer is that the supply of dollars in the international currency marketplace exceeds its demand and thus the value (price) of the dollar is depressed. The underlying principle behind the supply and demand of dollars is interest rate parity. In essence, when one nation’s aggregate interest rate is higher with respect to that of another, there will be a net inflow of money into the nation with the higher rate from that with the lower to take advantage of the better return. This increases the demand on the currency associated with the higher rate and conversely reduces the demand for that associated with the lower rate. The interest rate parity effect was clearly observed recently when the Australian central bank raised its target rate and the Australian Dollar immediately appreciated in value.
Where do we stand with respect to this effect? We are at essentially a zero interest rate policy – both by Fed fiat (the Fed Funds target range of 0-0.25%) and by the dynamics of the market (for instance, the previously mentioned 5 basis point 3 month Treasury yield). The marketplace effects are further magnified by the Quantitative Easing policy in which the Fed electronically prints money by taking government bonds onto its balance sheet, thereby a) inflating the supply of dollars by providing money for government spending and b) keeping interest rates artificially low by reducing the supply of government paper on the open market. Thus the falling dollar.
The inflationary effects are apparent and are upon us. In addition to making imported goods more expensive to the consumer, there is also an effect to the supply side which could be catastrophic. When investors who are holding dollars see (or expect) a decline in the dollar’s value, their inclination is to purchase an asset which is denominated in those dollars and whose value is not likely to decline in the declining dollar environment. One such commodity is crude oil (and it’s kind of an important one). This currency-driven demand for crude oil (or, more specifically, crude oil futures, not necessarily spot crude for delivery) is behind the recent run-up in the price of a barrel of oil past $80/bbl – not any supply shock, not demand, and not the “evil speculators” who “manipulate the market” (and my use of quotes should indicate my thoughts on those notions). As we saw in the 1970s, the run-up in cost of basic materials (oil based energy products) needed by the supply side increases the aggregate cost of production, pushing the aggregate supply curve up/left. This is classic cost-push inflation and results in a market clearing point at a higher aggregate price and lower aggregate output – or, to use the more common term, stagflation. Prevention of stagflation is the fundamental reason to defend the dollar.
So what do we do to defend the dollar? Given the current weak state of the economy, a step up in the Fed Funds target rate is probably a bad idea. Quantitative Easing, on the other hand, can go away if accompanied by spending restraint on the part of the elected government. The “stimulus” which the runaway spending was supposed to accomplish (you know, the spending that was supposed to keep unemployment under 8%, and that Christina Romer stated whose best effects were behind us) is better accomplished by way of a reduction in marginal tax rates, specifically aimed at the supply side of the economy. A supply side tax cut has the opposite effect of increasing oil prices – reduce costs to suppliers, move the aggregate supply curve down/right, and produces a market clearing point at a lower aggregate price and higher aggregate output.
Now, by show of hands, who sees Paul Krugman recommending this course of action, or the Obama Administration doing this? Didn’t think so. Our economy is a short ride away from being known as “That 70s Show”.