Adam Smith Growls

November 9, 2007

"The U.S. dollar is the linchpin of not only the American economy but also the world monetary system." Those words were the lead of an editorial in this newspaper on August 21, 1978, amid the inflation of the 1970s and the world's last great dollar crisis. Are we watching another such period today? It's not inevitable, but this week we all got a reminder of what such a thing looks like, and it isn't pretty.

The dollar is "losing its status as the world currency," declared Xu Jian, a middling official at China's central bank, on Wednesday. "We will favor stronger currencies over weaker ones, and will readjust accordingly." That was perceived as a threat by China's central bank to diversify its foreign exchange reserves out of dollars and into other currencies, especially euros. While China later qualified those remarks, the dollar nonetheless fell again around the globe, stocks plunged, and gold and other traditional inflation hedges rose to fresh heights.


Meanwhile, French President Nicolas Sarkozy visited Washington and brought a dollar warning of his own. "The dollar cannot remain someone else's problem," he told Congress. "If we are not careful, monetary disarray could morph into economic war. We would all be its victims." The Frenchman was referring to the damage that the dollar's record lows against the euro are doing to Europe's exports, and the potential for a return to so-called "competitive devaluation," or what used to be called "beggar-thy-neighbor" currency policies.

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Coming from opposite sides of the world, these are warnings worth heeding. For as our editorial explained 30 years ago, the dollar is far more than a medium of American exchange. It is a reserve currency, held by central banks the world over, and the core of the monetary system that underpins what has been a remarkable period of global economic growth. By toying recklessly with dollar devaluation, our policy makers are also toying with a far larger economic crisis than the current credit problems.

Yet the striking and dangerous fact is that the conventional wisdom in U.S. financial circles has been that the dollar's fall is in fact beneficial. Wall Street wants easier money to rescue the banks caught in the subprime crisis, never mind the risks of future inflation and how damaging that can be to stocks. Manufacturers favor a lower dollar to boost their own exports, never mind how exchange-rate volatility makes a hash of business planning.

Worst of all are the economists, who should know better but have convinced themselves that the dollar must fall so that the "trade deficit" can adjust. Some want to give a short-term boost to exports, which they hope will keep the economy out of recession while housing dips. Others have been preaching trade-deficit doom for so long that they view a dollar rout as a kind of policy wish fulfillment.

What all of this ignores is why the dollar should fall so precipitously now. The trade deficit is, by accounting definition, merely the reverse of a capital surplus. To buy something abroad you must get foreign currency. So the national accounts will show some offsetting transaction, whether borrowing or the sale of assets or goods. The trade balance isn't a moral verdict on the strength of an economy, but is merely one snapshot in a constant series of global transactions.

The U.S. has run trade deficits for years and decades when the dollar was strong, most recently in the late 1990s -- a period of legendary prosperity. As long as foreigners want to invest in the U.S., a strong economy and a trade deficit can co-exist for long periods. It's preposterous to think that millions of foreigners awoke in the last week and suddenly discovered that the U.S. trade deficit they'd tolerated for years is a crisis.

To understand the dollar's current woes, you have to look elsewhere -- to monetary policy and economic management. The supply of dollars in the world is ultimately controlled by a single source, the Federal Reserve. With its aggressive easing in September, and again in late October, the Fed has signaled to the world that it cares more about creating dollars in the hope of limiting U.S. credit problems than it does about the dollar's value. Investors can see this, and so they are dumping dollars and looking for other assets to hold. This includes commodities such as gold, which is now at $835 an ounce. The nearby chart from economist Michael Darda gives a sense of how far the dollar has fallen this year.

The world can also hear the silence from U.S. economic officials, whom they have come to believe are content with the dollar's decline. Treasury Secretary Hank Paulson mouths the ritual lines about a strong dollar, even as he keeps pressuring China to revalue the yuan. Fed Chairman Ben Bernanke yesterday told Congress that inflation remains a risk, which shows that he at least has noted this week's dollar rout. But his previous actions have left him and the Fed with a growing credibility problem that is perilous for any central banker.

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Our current financial woes are in large part the result of previous monetary excess, which fueled a debt and asset boom that has become a banking bust. The way to emerge from the mess is to slowly but honestly work off the bad debt and write down the losses. The one sure way to make things worse is with more monetary excess. That could trigger a run on the dollar and the necessity for far higher interest rates to stem it.

But don't take our word for it. Listen to Adam Smith, who this week has been growling in the distance, ready to enforce his own very rough form of market discipline if the Fed doesn't listen.