Thursday, February 5, 2009

The Leading Concern: Q & A (02.05.2009)

We've seen many ways, over the years, to weaken the dollar. What would you have to do to strengthen the dollar and affect an increase in its buying power? --Edmund Fos, III, Felix’s Restaurant, New Orleans, La.

My immediate response is to answer this question with a question: how strong should the dollar be?

No one should ever want to see the day when the dollar gets diminished, particularly in the way that the British pound and the Russian ruble are being hammered. If investors suddenly lost faith in our currency, the consequences could be globally disastrous. In the U.S., the prices for imports—everything from Japanese electronics to Middle Eastern oil—would skyrocket, and our government would no longer be able to depend on borrowing to sustain public services. The federal government would essentially go out of business. Meanwhile, holders of U.S. debt and equities would see their wealth drastically reduced, and a prolonged and even very painful downturn would ensue around the world. Hence, the slaughter of the dollar is good for no one.

Even still, a weak dollar, one that is based on trust and confidence—and not on any tangible commodity or resource—has both positive and negative consequences. For example, when times are good and people are working, prosperity is broadened, right? A richer populace means that more people have the means to buy things. Hence, demand for those things will rise, and a rise in demand translates into a rise in the prices of those things. That is one way that prosperity helps to actually weaken a currency; it is how inflation creates a purchasing power disparity that does not benefit some market participants, particularly those on fixed incomes and lower-income wage earners.

That said, though, a comparatively weak dollar can be beneficial for businesses, particularly from the standpoint of trade. When our dollar is cheap, relative to other currencies like the yen or the Euro, businesses exporting goods and services abroad can be more competitive. More importantly, the weak dollar also gives them a competitive edge at home, as well, where cheap imports have a long history of siphoning away market share from domestic manufacturers. (This is not true for China, but that is another subject.) Therefore, if you allow a currency like the dollar to get too strong, it will not necessarily be good for domestic businesses.

Now the question becomes one of balance: how do we appropriately strengthen the greenback, while also giving people consistent purchasing parity, and keeping our own goods and services competitive in the global marketplace?

To the new question, I can only give you the perfunctory, macroeconomic answer. That is, to build a stronger dollar, you have to have scarcity; there have to be fewer dollars qua less demand chasing goods and services. How do you do that? Well, assuming you were politically suicidal, there are a number of approaches that can be taken to impact dollar availability. For starters, you could impose an excessive tax regime, or you could raise interests. You also could reign in any capital outflows from your country, or you could try to limit the trading of your currency—though neither of these practices ever really works. And if all else fails, you could hinder finance, thereby putting the brakes on borrowing for new production, new economic development, and new job creation.

The only problem with the idea of a stronger currency and the approaches to get there—as if the approaches, themselves, aren’t bad enough—is that fewer dollars in the economy would literally constrain the ability of many to partake in any level of growth. Broad-reaching prosperity would not exist in an economic climate where there was such a proclivity for the persistent monetary manipulation needed to achieve this goal, and as a result, a majority of people would inherently be deprived of the resources needed to acquire and/or create wealth. And we all know happens when people cannot participate in prosperity, right? The sociopolitical ramifications can be catastrophic. Think of the grey economies that develop in shantytowns from Lagos to Sao Paolo—no real jobs, no real taxable commerce. Think of the underground criminal networks that flourish in many poorer communities in our own country. Worse still, think of the events that occur when the desperate and impoverished rise up against those who do have—events that have played our in revolution after revolution.

It is worth mentioning here that, for a long time, our dollar was backed by gold, any thought of a weak currency was not on the table for the United States. Under the Bretton Woods Agreement, most of Europe’s war-ravaged democracies pegged their own currencies to the dollars, which, itself, was supposed to hold true to a fixed gold value. At the time, that sure seemed like a nice idea, but it did not last long. The dollar became inherently too strong against currencies like the Japanese yen and those of its European trading partners, and soon our goods and services were just not competitive against those exported by these countries. The situation was worsened at home when America started appropriating massive amounts of money for a war in Vietnam and an unprecedented welfare state. With the printing presses humming and dollars steadily flowing out of the country, the fixed valuation just could not hold. Consequently, we nixed the gold standard for a fiat currency, which is, of course, now rooted only in the trust and confidence of all those participating in its use and, therefore, is subject to perpetual shifts in value.

A stronger, fiat dollar seems like a nice idea, at least on the surface, but it can have troubling consequences. Instead, it is better that the strength of the dollar be balanced in a way that allows for businesses to remain competitive and for the people to participate in economic growth.

3 comments:

efos said...

I've got to admit, the first time I read your response, I was more unsure of the answer than when I first asked the question (I can be a bit dense sometimes). However, upon reading it for the second time, everything seemed to make sense. If the global economy is like a boat on rough waters, the strength of the dollar is like leaning to one side or the other to keep yourself upright on the boat. Lean too much to either side and you fall down, right? I posed this question because each night on the financial news, you hear the anchor person state that the dollar has weakened (or strengthened) against the yen, or whatever other currency, and I've always assumed that weakening was bad, and strengthening was good. Now I see that to an extent I was wrong, it was simply a statement of the fluctuation of the dollar's value, which is neither inherently good nor bad, but necessary to maintain balance. Thanks for clarifying that for me.

Digger in LV said...

Okay so now I have something like five questions for this one answer. Are you sure you want to head down this path? ;-)

I like this idea for the blog. I know everybody asks you a ton of stuff, and it's smart how you find a way to bring that to everyone else. Thanks for looking out and keep up the good work.

Jonathan B. Melancon said...

Efos,

Gary makes some good points about how a weak dollar is not necessarily a bad thing in regards to foreign trade. And I like the analogy of a boat on rough waters. But here is the problem. If the strength and weakness of the dollar had an ebb and flow characteristic of an ocean wave with a flat trendline consistent with sea-level than I'd agree, but unfortunately this is not the case at all.

The dollar has been on a path of ever increasing weakness ever since 1971 when Nixon permanently and completely severed the dollar's ties to the gold standard (a process started in 1913 with the creation of the Fed Reserve). There has not been any significant strengthening of the dollar over any long term measure. What this does is inherently punish savers because it decrease the value of their saving over time and it promotes (actually demands) a culture of spending and speculating in order to compete with and hopefully beat out inflation over time. Just look at the problem here in the US today. We don't save because it doesn't pay, so what we would otherwise save we send over to financial institutions for them to speculate with, we spend what we have and borrow what we don't to get things we probably can't afford.

Yes, a weak dollar can be beneficial to foreign trade under the right conditions and that's one reason it's done, but the problem is that its unsustainable, punishes savers and promotes unbalanced spending and consumption. Its a house of cards, plain and simple.

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