My major point in “The Bear and the U S Dollar” (http://seekingalpha.com/article/255989-the-bear-and-the-u-s-dollar) is that the United States government has actively pursued a policy of “credit inflation” for the past fifty years and shows no signs of altering this policy stance in the future.
The federal government is projecting a budget deficit of $1.5 trillion for the current fiscal year and my estimate is that cumulative budget deficits for the next ten years will be at least $15 trillion. This is the foundation for the continuation of a governmental economic policy stance that is no different from what existed during the last fifty years.
Many in Washington are now saying that the budget deficit needs to be brought under control and there is a substantial amount of discussion about how much needs to be cut from expenditures.
How credible is this ranting and raving?
Not very says the foreign exchange market! The value of the United States dollar is under pressure and continues to decline and traders in this market seem to be ignoring all the “fuss and bother” going on.
Why focus on the value of the United States dollar?
To me, “a nation’s exchange rate is the single most important price in (the) economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity. So it is hard for any government to ignore large swings in its exchange rate.” This quote is from Paul Volcker (“Changing Fortunes: the World’s Money and the Threat to American Leadership,” by Paul Volcker and Toyoo Gyohten, Times Books, 1992, page 232.)
The problem is that the United States government has given vocal support to “a strong dollar” over the past fifty years and then inflated the economy and been surprised that the value of the dollar has declined and has continued to decline.
The question should be: “Why should anyone think that the United States government has any credibility when it comes to attempting to control the federal deficit?”
And, the gross federal debt has risen at a compound rate in excess of 7% from 1961 to 2009. The currency that could buy $1.00 worth of goods and services in 1960 can only buy $0.15 worth of goods and services now. The purchasing power of the dollar has declined by about 85% in this time period!
The United States government believes in a strong dollar? Have I got a bridge to sell you!
The reason for this abysmal performance? The United States government has an objective, written into law, that says that it should focus on achieving high levels of employment, low levels of unemployment, in crafting its economic policy.
And, has the United States achieved this objective? Not unless you believe that having roughly one in five working age adults under-employed as meeting this objective. Oh, and by-the-way, this policy has resulted in the income distribution in the United States being the most skewed toward higher incomes ever. Good work, government!
The problem with this economic philosophy is that it was constructed in the 1930s and 1940s when “things” were different. There are three basic assumptions that lie behind the philosophy that are not applicable in today’s environment. The first had to do with the lurking fear of a Bolshevik revolution resulting high levels of unemployment in England and on the European continent. The second had to do with the international flow of capital: there was little or no flow of financial capital in the world. The third assumed fixed exchange rates. (See http://seekingalpha.com/article/167893-john-maynard-keynes-and-international-relations-economic-paths-to-war-and-peace-by-donald-markwell.)
The presence of the second and third assumption allowed a government to construct an economic policy that was independent of every other nation in the world. And, this economic policy could be designed to achieve high levels of employment thereby thwarting the possibility that there would be a successful revolution. The economic philosophy relied on the creation of governmental budget deficits and the underwriting of the credit inflation that was needed to achieve the government’s employment goals.
What happened? Well, by the time the 1960s got going, the new policy of fiscal deficits and credit inflation was in place while, at the same time, international capital flows became quite fluid. For example, by the end of the 1960s, Eurodollar deposits, dollar deposits at London banks, became a major factor in international money markets and a real problem for the conduct of the Fed’s monetary policy. So, one assumption “bit the dust.”
On August 15, 1971, President Nixon took the United States off of the gold standard and allowed the price of the United States dollar to float in foreign exchange markets. The flow of capital throughout the world was so fluid that the United States could not continue to “fix” the value of the dollar and continue to conduct an inflationary economic policy that was independent of other nations.
Now, politicians could focus on getting re-elected by promising high levels of employment for everyone!
However, conducting an “independent” economic policy based on credit inflation when your currency floats and capital flows are relatively fluid internationally can result in a falling value for your currency and a weakening of your economic and political power. As Volcker suggested, that is exactly what happened.
There were two periods in which the policy of the government counter-acted this policy of credit inflation. The first came when Paul Volcker was the Chairman of the Board of Governors of the Federal Reserve System (1979-1987) and the second came when Robert Rubin was the Secretary of the Treasury (1995-1999). Volcker, in an effort to fight a robust spurt in inflation, oversaw a massive tightening of monetary policy. As a consequence, the value of the dollar soared when he was chairman by 55% from early in 1980 to the middle of 1985. Rubin oversaw the efforts to balance the federal budget. During this effort the value of the dollar rose by almost 30% from the middle of 1995 to the end of 1998.
So, if the foreign exchange markets believe that you are serious about establishing some discipline over your economic policy, you can achieve a rise in the value of your currency. And, this policy stance can accompany economic growth: after the double-dip recessions which ended in November 1982, the Reagan expansion continued through the rest of the decade; and the Clinton expansion continued into 2000 without the balancing of the budge affecting economic growth.
Thus, it would seem as if the first task of the current government would be to honestly commit to achieving a strong dollar and assign a lesser priority to achieving low levels of unemployment. Then the Congress needs to construct a budget that will earn a positive response from the foreign exchange markets. People in the foreign exchange markets realize that the deficit gap is not going to be closed immediately. But, the government must earn its credibility with respect to its support for a strong dollar. And, the government must continue to prove this commitment every day, from the President on down.