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New Voodoo Economics

The value of a falling dollar.

By 3.3.05

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"The world economy is out of whack," says David Wessel on the front page of the Wall Street Journal. "There's a financial grinch lurking," says William Niekirk of the Chicago Tribune. "In my lifetime we will have gone from the Greatest Generation to the Profligate Generation to the Bankrupt Generation," says Thomas Friedman in the New York Times.

These are but a few of the public panic attacks making headlines these days. The thought process behind these shrill warnings is straightforward. President Bush cut taxes in the middle of a war, federal budget deficits are soaring, and U.S. consumers are living beyond their means. Worse: foreigners are financing all of this profligate waste.

Robert Reischauer, president of the Urban Institute and former director of the Congressional Budget Office, compared America to"a rich family that is selling off its furniture and silverware, and still living in the big house, while taking vacations every year." Stephen Roach, economist at Morgan Stanley, has nicknamed foreign investors "the global enablers."

Wow. It sounds like the apocalypse. "Simply put," writes David Wessel, "the U.S. -- either voluntarily or forced by the markets and the rest of the world -- has to save more and buy less, particularly from other countries."

It must be the mid-1980s all over again. During Ronald Reagan's presidency the same arguments were heard over and over, and in the same shrill tones. In the 1980s, the tax cuts supposedly led to over-consumption and since we needed foreigners to finance the budget deficit, the trade deficit grew. The twin deficits were supposedly a sign that the U.S. was destined for ruin.

OBVIOUSLY, THE ECONOMY DID NOT COLLAPSE in the 1980s or 1990s, despite large trade and budget deficits. In fact, the tax cuts moved the U.S. from a stagflationary malaise in the late 1970s to the dominant economic force in the world (and unsurpassed technological leader).

And many seem to forget that the stock market collapsed in 2000 and the recession began in early 2001, despite a federal budget surplus and rising net national savings. If surpluses truly are the Holy Grail, why did the economy have so many problems?

None of this evidence seems to dampen the dire warnings of the economic doomsayers. They see a world that is about to spin out of control if U.S. saving does not rise. The recipe to fix this problem is a devalued dollar to make imports more expensive and a tax hike to reduce the deficit. In an honest moment, some of those who advocate these positions might even let slip that they want tax hikes to slow consumption.

All of this smacks of the Keynesian notion that the economy is a machine that can be managed by a few turns of the right screws. But the economy does not work this way. Truth be told, all of this talk of doom is just a way to get the government more involved in managing the economy, taking away freedom from individuals.

Trade deficits are the result of millions of individual decisions made by consumers and businesses. Unless you own a grocery store, every reader of this magazine runs a trade deficit with the local food purveyor. Chicago runs a trade deficit with the rest of Illinois. Consumers buy goods made in China because they cost less. Trade increases our standard of living. There is nothing wrong with buying goods that you, your city, or your country do not produce.

Adam Smith talked of an "invisible hand." To assume that a perfectly rational decision for the individual is somehow an irrational decision for the nation is socialistic. And manipulating currency values, monetary policy, or taxes to alter these decisions is a recipe for disaster.

THE SAME RATIONAL DECISION-MAKING also takes place on the other side of the transaction. Foreigners make rational decisions about what to do with their earnings from exports. And this is where so many analysts make a mistake. The world is a closed system. It should be analyzed like a balance sheet. For every debit there must be a credit.

Dollars sent overseas must come back into the U.S. system. The only way to hold dollars outside of the country is to convert them into currency. Foreigners who receive dollars as payment for exports to the U.S. have just two choices -- they can either buy goods and services or invest them back into the U.S. If they trade them for another currency, the new holder faces the same two choices.

The reason for this is simple. As long as U.S. interest rates are above zero, it would be irrational to hold dollars in a non-interest bearing form. Japanese corporations and the Chinese central bank do not store dollars on pallets in a warehouse. They invest them, immediately, even if that means leaving them in a dollar-denominated bank account. To ignore this is to assume that for every credit there is not an offsetting debit.

Once we realize that the world economy is a closed system, the trade deficit and the resulting capital inflows become more understandable. American consumers and businesses send dollars overseas for imports, while foreigners are making a conscious decision to invest those dollars back into the U.S.

If, by some strange coincidence, every foreigner who has a trade surplus with the U.S. decided to stop investing in the U.S., they would face a huge dilemma. They would still earn dollars by selling goods to U.S. consumers, but now they would be forced to buy goods and services from America. The trade deficit would disappear overnight. All of this talk about how our country is at the mercy of foreigners and that the dollar is falling because of the trade deficit is pure voodoo.

The real reason the dollar is falling is that the Federal Reserve is supplying more dollars to the world than the world demands. The value of the dollar is also falling versus gold, oil, and other key commodities. Consumer and producer price indices, even after removing oil and food, have accelerated. And they will continue to do so as long as the Fed holds short-term interest rates artificially low. The value of the dollar is a function of monetary policy, not trade deficits, statements by the treasury secretary, or foreign investment decisions.

Because China pegs its currency to the dollar, its inflation rate is also accelerating (its CPI is up 6 percent in the past year). If China were to continue to hold its currency peg, inflation would eventually erode its low-cost advantage. China should revalue its currency upward, but not to appease U.S. lobbyists. It should do so to stop importing inflation from the U.S.

TRADE AND BUDGET DEFICITS are not things that U.S. citizens should celebrate. But to panic about them is dangerous. Inflating the economy to reduce the value of the dollar, increasing taxes to slow consumption and reduce the deficit, or to become protectionist in order to stem the flow of imports are all damaging to the economy.

When the dollar declines, U.S. purchasing power on world markets is reduced and the American share of total world output falls. Tax hikes obviously reduce the incentives to invest and inflation undermines business decision-making. None of these policies are good for growth.

"Out of whack," or not, the trade deficit is a result of individual decisions. Attempting to fight it using ham-handed, mercantilist macroeconomic tools is wrong. If pessimists are intent on boosting saving in the U.S., the appropriate tool is to reduce tax penalties on savings. Whether or not this shrinks the trade deficit is anyone'-s guess.

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About the Author

Brian Wesbury is chief economist for First Trust Portfolios, L.P.