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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
Also
by Gerard Jackson
Gerard Jackson is Brookesnews Economics
Editor
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