December 01, 2004,
Key members of the Federal Reserve Board and a cadre of Wall Street economists have become fixated on the current account deficit as a worrying symptom of economic distress and a sign of impending crisis. This has led a host of Reserve Bank presidents and Fed governors to imply that the dollar should fall in order to rectify imbalances before a crisis becomes inevitable.
Since the theory of imbalances holds that a crisis eventually will ensue, destructive policy actions that surely would trigger a crisis are being advanced as “solutions” to a non-problem. Steep tax increases to augment “savings,” a depreciated dollar to boost exports, and higher tariffs or a sharp domestic-growth slowdown to discourage imports have all been floated as “solutions” to our current account deficit.
In other words, precipitating a crisis to solve a non-crisis only can reduce the severity of a crisis that would have happened anyway. Lord Keynes captured this kind of logic in the general theory when he said that “Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.”
Those advocating a weak dollar to redirect trade flows do not have history on their side. While a depreciating currency is assumed to boost exports and shut off the demand for imports, this is only the first effect. Eventually a weak currency invites inflation, which neutralizes the effect of the lower exchange rate. This was proven by economist Michael Salant, who conducted an exhaustive study of 101 devaluations in 1977 by both developed and emerging countries. In total, the study found that the balance of trade improved in 46 instances of devaluation, deteriorated in 54 cases, and remained unchanged in one episode.
Weak-dollar advocates assert that the dollar can fall without aggravating inflation as long as capacity utilization rates are depressed. This is a dangerous assumption. It is rooted in illusory Phillips Curve tradeoffs between growth and inflation that have been discredited empirically and refuted by history. The data show that capacity utilization rates and employment levels are usually inversely related to inflation. This should not be surprising since the demand for money is positively related to the use for it (i.e., real activity). Inflation occurs when money supply exceeds money demand. Inflation is a monetary phenomenon.
Persistent currency depreciation has never brought lasting prosperity to any government in the history of the world. If the dollar continues to depreciate it will bring higher inflation, higher interest rates, lower real growth rates, and a reduced standard of living for most wage earners. There is zero evidence to support the notion that moving to fiscal surplus from fiscal deficit will have an influence on trade flows or the current account. Japan and Germany both have “strong currencies,” huge fiscal deficits, and capital outflows (current account surpluses). Conversely, the U.S. experienced a dramatic rise in the value of the dollar against a surge in capital inflows (current account deficits) and large fiscal surpluses during the late 1990s. The economics of imbalances and the theory of the twin deficits are thus theoretical constructs in search of empirical evidence that does not exist.
Empirical testing reveals that economic growth differentials explain more than 50 percent of the change in the current account as a percent of gross domestic product, while changes in the dollar’s broad foreign-exchange value explain a scant 9 percent of the same variation. In other words, capital flows to countries where the perceived real, after-tax rates of returns are the highest (i.e., those countries with the fastest growth rates).
Fed Chairman Alan Greenspan spoke eloquently on trade and capital flows earlier in the year only to lapse into a zero-sum neo-mercantilist model in Frankfurt, Germany, on November 19 when he suggested that foreigners may flee U.S. assets (precipitating a further dollar decline) because of the U.S. budget deficit. The fact of the matter is that the Fed, and only the Fed, has monopoly control over the U.S. money stock. The Treasury and foreign governments have nothing to do with it.
It is the Fed’s job to adjust money supply to meet money demand (through the use of its overnight rate target), not to impersonate a trade czar or to stand in as resident deficit hawk. Chairman Greenspan would be well advised to revert back to real time, auction-market indicators gold, commodities, currency cross rates, and the yield curve as leading proxies for excess money creation and incipient inflation. Virtually all of these indicators are sending an excess money signal that should not be ignored.
Michael T. Darda is the chief economist and director of research for MKM Partners, an equity execution and research boutique located in Greenwich, Conn. He welcomes your comments here.