The Cart-Horse Problem of the Currency Debate

The blogosphere and op ed pages are filling up with calls to arms over the recent decline of the dollar. Predictions of the imminent collapse of American civilization abound. Gold sales boom.

Although the value of the dollar is very important, it is the result, not the cause, of our economic problems. A currency becomes strong when the nation issuing it is economically strong. A currency weakens when the issuing nation's economy weakens. The strong currencies today--the Japanese yen and the Chinese yuan--got that way because Japan and China became manufacturing powerhouses. Both nations try like heck to keep their currencies weak in order to bolster exports. Over the long course of time, they have failed. Their currencies have inexorably strengthened as their economies have strengthened. The Japanese yen has tripled its value in the last 30 years. The Chinese yuan probably would be considerably higher than its current value, as well, if it were freely tradeable--the Chinese government does not allow full convertibility of the yuan in order to constrain the outflow of capital from China.

Conversely, the dollar has fallen as the U.S. has shifted from being a manufacturing powerhouse to a binge consumer living off the equity of its real estate. The American way of life in recent years was possible only because foreigners were willing to buy dollar-denominated debt, in effect lending us the money for $5 lattes, $3,000 wide-screen TVs, luxury nameplates on all three cars in the driveway, and a house twice as large as the one we grew up in. When things fell apart, the entire nation became like a person with 22 credit cards and $230,000 of consumer debt, looking for a bailout.

A weakening nation cannot, through government intervention, preserve or increase the value of its currency. Calls to the Treasury or the Fed to intervene in currency markets or raise interest rates in order to support the dollar are misguided. The last major economic power to try something like that--Great Britain in September 1992--was blown up by a wolf pack of hedge funds that shorted the pound in the direction it would have eventually gone anyway. It's doubtful that any collection of hedge funds, however large and well-leveraged, could blow up the dollar. But the other major economic powers of the world can. And, gradually, they are, with talk of repricing oil in a basket of other currencies and gradual reallocation of central bank bond portfolios away from the dollar.

There is a way to save the dollar. That would be to institute government policies to bolster the manufacturing capabilities of the U.S. economy. America has a long and illustrious history as a manufacturing powerhouse, and does not inevitably have a dark future in that regard. It also does not have to rely on exports to support a manufacturing sector, since the American consumer, although currently down in the dumps, will probably rise from the ashes if given half a chance (i.e., a full-time job) and a little more reasonably priced credit. But the Federal Reserve, with its all for the banks and none for anyone else distortion of the Robin Hood tale, offers only sermons but not solutions. And the Obama administration's stimulus package has been unfocused and diffuse. A nation cannot spend or consume its way to economic health. It must be able to make things that other people will pay good money for. This should be the goal of government economic policy.