It's Time to Rescue the Dollar

People are telling pollsters that they are frightened about the future. Some pundits are saying that a recession is already underway. The stock, bond, and commodities markets are gyrating wildly. And with the dollar's floor nowhere in sight, the price of gold has reached all-time highs.

The explanation for today’s turmoil in the economy and the financial markets was given more than 70 years ago by John Maynard Keynes. Here is what he said:

“There is no subtler, surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and it does it in a manner which not one man in a million is able to diagnose.”

At this point, we must all hope that Ben Bernanke is Lord Keynes’ “one man in a million”. The markets have lost confidence in the dollar, and the resulting fears about the future are causing economic decision-makers to pull back with respect to production, hiring, and investment.

If you want to understand how concern about an unstable dollar could cause a recession, imagine if tomorrow the U.S. Bureau of Standards announced that it was “floating” the foot. Instead of being fixed at 0.3048 meters, the length of the foot would henceforth be set by “the market”. This would impact not only economic arrangements based upon length (property lines, lumber sold by the foot), but also every transaction involving area (flooring is sold by the square foot) and volume (“the gallon” is legally defined as 231 cubic inches).

Even before there was any change in the market length of the foot, there would be a massive redirection of economic energies and focus. Executives would turn their attention from production, trade, and investment to protecting their interests from possible changes in the value of the foot. Transactions would be delayed or cancelled. Just the existence of the possibility that the foot could change in length would cause economic chaos.

Just as “the foot” is our basic unit of length, “the dollar” is our fundamental unit of market value. The smooth, efficient operation of the economy depends upon stable units of measure. Unfortunately, the dollar has become highly unstable.

This is a very strange situation. Because the Federal Reserve has the power to set the size of the monetary base (i.e., the number of “dollars” in the world) anywhere between zero and infinity, the Fed has total control over the value of the dollar. Unfortunately, the Fed seems to lack the understanding necessary to use its power wisely.

The underlying problem appears to be intellectual confusion between “money” and “capital”. Because the Fed is both the monetary authority and a bank (“the lender of last resort”), it deals with both. Unfortunately, right now there seems to be considerable confusion between the Fed’s two roles.

In its role as the monetary authority, the Fed’s job is to meet the market demand for the monetary base while keeping the value of “the dollar” stable. In its role as a bank (the lender of last resort), its job is to keep the banking system operating smoothly. The Fed has the necessary tools to do both of these important tasks, but lately the Fed has been doing the equivalent of using a hammer to change a light bulb.

The confusion between “money” and “capital” is embedded in the Fed’s practice of targeting the interest rate on Fed Funds to control the size of the monetary base. The monetary base is “money” and every interest rate is the price of some form of “capital”.

Monetary control based upon intellectual confusion yields an unstable dollar. Here is how it works. What it means for the Fed to have a Fed Funds target of 4.25% is that the Fed adjusts the size of the monetary base to keep the interest rate on overnight loans among the 1000 or so Federal Reserve member banks at 4.25%. In turn, what this means is that the Fed is keeping the value of “the dollar” equal to the value (in the Fed Funds market) of a promise by a Fed member bank to pay $1.00011644 tomorrow. By targeting the Fed Funds rate, the Fed literally defines the value of “the dollar” in terms of itself. This practice makes the value of “the dollar” indeterminate, and therefore inherently unstable.

Monetary control based upon targeting an interest rate can work if there is high market confidence in the value of the dollar. Once that confidence is lost, however, the fatal flaw in this approach is exposed and the costs to the economy begin to escalate.

Can the dollar be saved? Of course it can.

The Fed should announce that it is abandoning the targeting of the Fed Funds rate and will henceforth express its monetary policy in the form of a target range for the COMEX price of gold. It should further announce that it will use Open Market operations to force the price of gold down until it is trading in a range of $505 maximum, $500 minimum.

While the dollar is being stabilized, the Fed can use its capabilities as a bank to relieve any strains that might appear in the banking system. It would do this by selling government bonds and buying other types of financial assets from whatever institutions needed liquidity. The Fed is already doing this to help deal with the fallout from the “sub-prime” debacle.

I humbly predict that this approach would cause gold prices to plummet, the dollar to soar, interest rates to plunge, talk of recession to vanish, the monetary base to expand, and speculators to file for bankruptcy. It would be fun to watch.