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October 25, 2009

Will Obama's Economic Policies Destroy the US Dollar?
by Gerard Jackson

One doesn't need to be an economic genius to see that the US dollar is in trouble. That Americans are hopelessly confused about what is happening to their currency is no surprise. However, before we get to the point of whether Obama's economics will do the dollar in I think it is important to provide a brief outline of the history behind the economic thinking that is sometimes used to explain exchange rate movements in the hope that this will give readers a better understanding of the current situation.

Economics is not as easy as some people think, particularly those political activists who are passing themselves off as honest journalists. Unfortunately, most of the economic commentariat are not much better informed. Regardless of what some commentators assert a weak currency does not necessarily reflect a weak economy. More than 80 years ago Mises pointed that those who argue that a strong economy must always mean a strong currency

...do not understand that the valuation of a monetary unit depends not on the wealth of a country, but rather on the relationship between the quantity of, and the demand for, money. Thus, even the richest country can have a bad currency and the poorest country a good one. (On the Manipulation of Money and Credit, Free Market Books, 1978. The article was first published in 1923).

In other words, the supply of and the demand for money determines its purchasing power irrespective of the country's productive capacity. It naturally follows that if a currency's domestic purchasing power is falling then its exchange rate (its price in terms of other currencies) should also fall. This is called the purchasing power parity theory of exchange rates. Sixteenth and seventeenth century Spain provides us with an excellent case study of a what happens when a country rapidly expands its money supply while its trading partners' money stocks remain comparatively stable.

Importing massive quantities gold from her South American colonies, which in turn triggered the "price revolution", caused Spanish prices to rise relative to those of her trading partners causing the escudo to depreciate against other currencies. Fortunately for us Spanish economists of the time were a lot better than most of the present bunch. In 1553 the Dominican Domingo de Soto, a Salamancan theologian and a prominent Spanish Scholastic, rigorously applied supply-and-demand analysis to the problem of Spanish exchange rates, observing that

the more plentiful money is in Medina the more unfavourable are the terms of exchange and the higher the price must be paid by whoever wishes to send money from Spain to Flanders....And the scarcer the money is in Medina [i.e., the greater its purchasing power] the less he need pay there, because more people want money there than are sending it to Flanders. (Alejandro A. Chafuen, Christians for Freedom: Late-Scholastic Economics, Ignatius Press, 1986, pp. 78-9).

De Soto was using the theory of purchasing power parity to explain Spanish exchange rates in terms of the relative purchasing power of other moneys. This theory became the standard orthodoxy and was largely explained in terms of relative price levels. However, after the gold standard was abandoned it seemed that the theory no longer held as exchange rates appeared to move regardless of changes in relative price levels.

The problem here is that the theory was usually interpreted as stating that the exchange rate between one currency and another is in equilibrium when their domestic purchasing powers at that rate are equalised. This definition led economists to commit the error that purchasing power parity is found by dividing the relevant price levels. The much neglected Chinese Chi-Yuen Wu exposed this approach as fallacious.

If the term purchasing power refers to the power of purchasing commodities, which are not only similar in technological composition, but also in the same geographical situation, the theory becomes the classical doctrine of comparative values of moneys in different countries and is a sound doctrine. But unfortunately the term purchasing power in connection with the theory sometimes implies the reciprocal of the general price level in a country. While so interpreted the theory becomes that the equilibrium point for the foreign exchanges is to be found at the quotient between the price levels of the different countries. That is, as we shall see, an erroneous version of the purchasing power parity theory. (Chi-Yuen Wu, An Outline of International Price Theories, George Routledge & Sons LTD, 1939, p. 250).

All of this leads to the conclusion that if a currency becomes overvalued it will run a persistent current account deficit. The more a currency diverges from its purchasing power parity the worse the deficit will get. This did not present a problem under the gold standard because corrective measures quickly reversed any gold outflow. But under a regime of paper moneys this is no longer the case. Hence a prolonged overvaluation can have serious consequences for a country's manufacturing base.

Floating exchange rates were supposed to eliminate this problem. It was argued that irrespective of whether or not exchange rates were determined by domestic purchasing power a floating rate would always equate supply with demand. It is obviously being assumed that a currency can never be overvalued or undervalued so long as supply and demand are equalised. This is a very shallow and dangerous assumption.

Those who push this line do not grasp that the equilibrium exchange rate is not the one where supply and demand are equalised but where the currencies respective purchasing powers are equalised. In other words, the latter ratio is the real equilibrium rate. What this boils down to is that the process of "hollowing out" needs to be examined within the framework of monetary policy and its effects on the exchange rate.

Critics can claim that this is all well and good but the fact remains that at the very least inflation is subdued so why is the dollar falling if its domestic purchasing power is not falling? These critics are overlooking the fact that a great deal of money has already been injected into the economy which in itself could be enough to have a detrimental effect on the dollar's exchange rate. At this point it needs to be stated that the theory does not assume that domestic prices have to rise before the exchange rate is affected, only that the money supply has to expand at a faster rate than that of the country's trading partners (strictly speaking, the supply of money must increase at a faster rate than demand) which now brings us to Obama's economic policies.

Markets anticipate changes in prices. And this is exactly what is happening now. They are expecting the Fed to monetise Obama's horribly irresponsible program of massive deficits, spending and borrowing. (In fact, the Fed has already started the process by buying securities). As there is no indication that the Democrats intend to drop this ruinous policy the markets are acting accordingly.

As a good Keynesian Bernanke knows that his criminally loose monetary policy will drive down the exchange rate. But he can argue -- at least in private -- that the effect will be to promote growth by encouraging exports. This is banana republic economics and amounts to a devious tariff policy. Assuming that the rest of world sits idly by while Bernanke tries to price them out of world markets as well as US markets all that this policy will achieve is to further distort the pattern of international trade.

Moreover, expanding exports by destroying the dollar's purchasing power will not raise aggregate investment, it will simply direct more production to exports while causing import prices to rise. An honest economist would call this a cut in living standards. Naturally, the economic commentariat -- being what it is -- will blame the the dollar's depreciation for the inevitable increase in domestic prices instead of Bernanke's monetary policy. They will also overlook the fact that Obama's spending program will suck huge amounts of savings out of the economy in favour of government consumption -- a thoroughly destructive process that he intends to make permanent.

One is left wondering whether Obama and his leftwing crew are just incredibly ignorant or incredibly malevolent. Whichever one it is, don't be fooled by accusations that evil Republicans, greedy banks and incompetent capitalists are responsible for the diving dollar and the consequences of his ideologically-driven spending program. Look no further than the Obama White House.

Gerard Jackson
BrookesNews.Com

Gerard Jackson is Brookes economics editor.

Copyright © 2005-2009 Gerard Jackson

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