Sins and Wages of Mercantilist Monetary Policy

Dollar woes are well known although not well understood in financial circles. The dollar’s value has declined so much in the last three years that producers and investors search for an alternative currency. U. S. equity markets are unusually volatile and moving towards the downside, partly due to investors’ desire to move out of assets denominated in dollars. If an investor buys U. S. equity shares that appreciate 45% but the dollar loses 45% relative to the investor’s domestic currency (as the dollar has fallen against the euro in recent years), the investor has gained nothing despite risk to his funds and passage of time.

But investment assets have not moved wholesale from the U. S. to Europe. Some assets have moved into U. S. bonds and treasuries, seeking greater safety and moving interest rates lower. Equity markets have not crashed and the dollar has not experienced a full-fledged “run.” The dollar experienced such a “run” in October, 1987, causing a sharp drop in share prices, when the dollar showed much better strength than now. Why no run in 2007 or, so far, in 2008?

Strangely, the credit is likely due primarily to the U. S. armed services, since no other currency is defended adequately to qualify as the world’s reserve currency. If the trading nations of the world place large amounts of wealth reserves in a currency whose issuer is then placed under siege by international terrorism, which currency other than the dollar will be secure? None readily comes to mind.

Crisis in the European Monetary Union

The euro is the best alternative candidate, but it has additional problems, some of its own making and others that derive from U. S. policy. Euro strength relative to the dollar aside, the European Monetary Union is in danger of coming apart. The reason is not cultural or nationalist disunity. Economic growth in the northern tier of member nations is outstripping growth in the southern tier. Interest rates on government bonds in Spain, Italy and Greece are rising to historic highs relative to German bond rates. This leads to higher government deficits, higher tax rates, lower real wages and lower growth in the southern tier. The economic spiral is moving dangerously in the wrong direction, and southern EMU members may withdraw.

The EMU dilemma appears complex, perhaps beyond satisfactory resolution, because conventional economic wisdom advises higher tax rates and higher interest rates when budget deficits and inflation are problematic. That advice, if followed, means more unemployment and lower wages. The crisis is deplorable, partly because such disunity among neighboring nations is not good for global progress, but also because it results partly from U. S. monetary policy.

Bad Vibes from the Federal Reserve

The Federal Reserve is the most important central bank in the world due to the size and strength of the U. S. market and to the U. S. role in global security. In this context, every other central bank must follow the Fed’s lead in theory and policy. Since 1971, the Fed’s lead has at times been ill-advised and unsuccessful in the extreme. At this writing, the dollar is trading at its historic low value relative to gold, not reached previously even in the monetary debacle of 1980. Will the Fed reverse course, as it did in 1980-1982, and drive the dollar’s value upwards again? By present Fed practices, only time will tell. Yet the answer is all-important in forecasting profits and commodity prices.

The Fed’s moves with the dollar are also highly important to the ECB and to EMU members. As the Fed manages the dollar, the ECB manipulates domestic interest rates and liquidity to position the euro’s value relative to the dollar, while EMU member governments manage government spending and tax rates. Orchestrating these variables successfully is almost impossible, particularly with the dollar value changing so drastically. This is so even if their economic theories are correct.

Invalid Keynesian Monetary Theory

Complicating the EMU problem is the reality that the economic theories of the Fed and the EMU are invalid. Raising interest rates to slow production, cut employment and slow economic growth does reduce wage growth and economic growth, but it does not reduce monetary inflation. Higher interest rates reduce demand for dollars, thus actually creating greater excess liquidity and inflation. The Fed does this with the dollar, and the ECB and EMU attempt to emulate the conduct among the nations of Europe. Little wonder individual nations cannot uniformly trace the course the EMU wishes to follow.

Fed governors and staff must know their actions actually weaken the currency. Indeed, they are praised by their Keynesian brethren for doing so. As it happens, academic Keynesians welcome dollar devaluations engineered by the Fed, even at the cost of collapsing U. S. corporate equity share prices, in order to relieve their angst over the current account deficit. In the Keynesian model, “managing” the dollar’s value is all about trade war: winning through currency manipulation.

Funds Rate Manipulation

The Fed’s handling of the funds rate is about something different. As I concluded back in 2007, the dollar’s weakness is determined by the Fed’s handling of liquidity, which is not dependent on the funds rate. Now a new study at the St. Louis Fed confirms by statistical analysis essentially what I saw in macro-analysis: “Contrary to conventional wisdom – that the Fed controls the federal funds rate through open market operations – [the data show] little support of an important liquidity effect….” The data cover 1986-1996, but bolster the essential point previously made. The funds rate target is not the valve governing flow of Fed liquidity to and from the economy. The Fed’s continuing use of it is indefensible, as the funds rate serves only to set anti-competitive prices for bank credit costs and to manipulate asset prices.

The Fed should allow the funds rate to be set by market forces and manage liquidity to achieve dollar stability at a stated gold price. The overnight funds rate would decline to a normal yield curve, meaning lower than short-term Treasuries (the 2-year note is about 2.65%, the low point on the existing yield curve). Financial intermediaries could then relieve the “crunch” affecting credit markets. The cost of credit to small business and consumers would drop by another 2%, permitting the U. S. economy much better prospects of growing rather than receding.

Best Chance for EMU and the U. S.

More importantly for the EMU, a stable dollar and market-set interest rates would make EMU issues considerably more manageable. The ECB could stabilize the euro using the same policy recommended to the Fed, allowing market-set interest rates and managing liquidity to a gold price in euros. EMU member states could then concentrate solely on fiscal policy, cutting marginal tax rates in the southern tier to achieve economic growth comparable to what is presently being experienced in the north. Europe would welcome this, as its pre-eminent economist Martin Wolf has proposed returning to a Bretton Woods system of fixed exchange rates. Wolf, as is well known, rightly deplores mercantilist monetary practices.

Reform of Fed policy is important and urgent. Public policy of this scope, when demonstrably so counter-productive, is fully capable of causing serious dislocation and breakdown in the global economy. U. S. elections and equity markets, and far more, are at risk. Regardless of claimed Fed independence, the people hold the president and his party responsible for the economy and the dollar. The culprit is the Fed. If the Fed won’t reform its practices, the president must act. ~