Monday, June 16, 2008

Defend the Dollar: Make the Federal Reserve's Job Simpler

The declining dollar has hit Main Street in a big way. Commodity prices are rising faster in dollar denominated terms than Euro denominated terms because the dollar is falling against the Euro. In particular, oil prices denominated in dollars have risen much faster than oil prices denominated in Euros. If oil prices in America had risen in relative terms only as much as they have in Europe, oil would be about $80 a barrel instead of $135. Stabilizing the dollar would help to keep inflation under control.

How to stabilize the dollar? Let’s begin by understanding that inflation primarily results from governments increasing the amount of currency they issue. If they did not increase the amount of currency, price increases in some things (like gasoline and food) would leave comparatively less money for other things, and the prices of the latter would face downward pressure. Inflation would be constrained because a transfer of wealth to energy and food producers would mean a loss of wealth for others.

Ideologues on the right advocate a return to the gold standard as a means of controlling inflation. The dollar would be redeemable for a fixed amount of gold. You’d just take your cash to a Federal Reserve bank and exchange it for gleaming bullion. This idea has superficial appeal; if the paper currency becomes inflated, protect your wealth by converting it to gold. But there isn’t enough gold in the government’s hands to begin to cover the quantity of dollars outstanding at current market prices for gold. (It would be important to set the redemption rate at current market prices; a higher benchmark would automatically inflate the dollar.) The gold standard prevailed in the U.S. until 1971, a fact that didn’t prevent significant inflation in the years immediately following World War II or in the 1960s. The gold standard became symbolic, because everyone knew that they couldn’t realistically redeem their dollars for gold.

A better way would be to simplify the Fed’s responsibilities. The Fed is expected not only to keep prices stable, but also to maintain maximum employment and keep long term interest rates moderate. This is a complex set of responsibilities that can’t always be fulfilled simultaneously. Keeping employment up requires low interest rates to stimulate consumer spending and business investment. But low interest rates diminish the value of the dollar and facilitate inflation. The Fed can’t have it both ways, and must dance over slippery rocks in the rapids in order to keep the economy going and the dollar steady. It can’t always keep a firm footing.

By contrast, the European Central Bank, which issues the Euro, is principally responsible for maintaining price stability (i.e., combating inflation). The ECB is independent of any particular nation, and is expected to give preference to price stability over economic growth or unemployment levels. The Euro isn’t hurting right now.

The differences between the Fed’s responsibilities and the ECB’s responsibilities do much to explain why the ECB sometimes zigs when the Fed zags. For example, the ECB has held interest rates in the Euro-zone steady during the last ten months, while the Fed has been lowering them. The ECB even recently hinted at raising rates, which flummoxed the dollar when it was just barely stabilizing.

Reducing the Fed’s responsibilities so that its primary job is protecting the stability of the dollar and the safety and soundness of the financial system still leaves it with a full plate. Then, however, it could concentrate on something it probably could do effectively, especially since it could more easily coordinate policies with the ECB. If the Fed has to prop up the economy with cheap credit, and then clean up the mess left by credit-induced bubbles, it always be caught between a conflicting web of priorities that it cannot fully serve.

Much of the problem is that neither Congress nor the White House has stepped up to the plate to adequately deal with the economy’s problems. One could argue that the Fed can react to economic ills much more quickly—and there’s no doubt that the legislative process closely resembles an aircraft carrier turning. But the Fed’s interest rate policies are blunt and easily misdirected tools that can have only short term impact on the direction of the economy with serious risk of asset bubbles and other unpleasant side effects. The Fed’s discount rate and fed fund rate target are government-prescribed prices for credit; and government price controls always distort markets. If government prescribed interest rates are used primarily to protect the value of the one government asset that is central to the economy—the currency—then the government serves the vital economic function of providing a reliable medium of exchange.

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