Executive Summary: The worldwide focus on the soaring dollar is distorted by general failure to connect the problem to the Federal Reserve's domestic monetary policy. Longstanding tacit agreement between Monetarists and Keynesians create two theoretical dollars, one domestic, one international. Volcker slips responsibility, suggests tax cuts in Europe, which won't affect exchange rates unless central banks also deflate. Political power of U.S. farmers a welcome counterweight to the monetary squeeze. Volcker stuns the farm bloc by suggesting a balanced budget will strengthen the dollar further, not ease as some suggest. "Massive intervention" of Feb. 27 has little effect; without Fed monetizing of debt, capital flows across the Atlantic are circular. President Reagan almost gets it, but monetarists still dominate the White House. Maybe, thinks Robert Mundell, the breakup of the floating exchange-rate system, cause for continued optimism, opportunity in chaos.
Monetary Chaos and Farm Crisis
It probably isn't possible to understand the current monetary chaos in the world economy unless you are aware of the jurisdictional agreement among Washington's economists. Like unionized carpenters and electricians, who will not do each other's work, American economists have divided the monetary turf between monetarists and Keynesians. Monetarists watch over the domestic dollar by making sure the Federal Reserve keeps the money supply under control. Keynesians watch over the international dollar and devise policies — usually fiscal — to keep it in a "competitive" relationship with the currencies of U.S. trading partners.
Monetarists care nothing about the value of the international dollar. They are especially jealous of their turf and are vehement against the use of monetary policy to try to alter the value of U.S. money abroad. Keynesians sometimes urge that the U.S. use some of its domestic dollars to buy foreign currencies; they think this weakens the dollar against foreign currencies and makes it more competitive. Monetarists abhor such "intervention" because they believe it makes it harder for them to manage the domestic dollar.
Because the Washington press corps accepts this long-accepted notion of two different dollars, the current monetary chaos is being reported with an unusual degree of befuddlement. On the one hand the "money supply" is exceeding its planned target range at the Federal Reserve. This suggests there are too many domestic dollars around and the Fed should tighten up. The international dollar, though, is setting new records in the foreign-exchange markets. Keynesians take this as meaning the Fed should sell dollars for foreign currencies.
In addition, the Keynesian model isn't working according to long-held beliefs. For a generation, the neo-Keynesian experts advised that a country exporting less than it imported — running a trade deficit — would see its currency weaken. Foreign exporters would dump their surplus dollars in the exchange markets, driving the dollar down. But today we see the dollar soaring amidst a colossal U.S. trade deficit.
Confusion is reinforced because the reporters assigned to cover international economic matters in Washington have either been trained as Keynesians (Peter Kilborn of The New York Times) or talk only to Keynesians (Art Pine of The Wall Street Journal, Clyde Farnsworth of The New York Times, Robert Samuelson of Newsweek, to name a few).
The Journal's Art Pine, for example, reported on the strong dollar on the front page of February 12. "Demands for Import Relief Flood Washington, Raise Chance of Protectionism," his report is headlined, "But No One Has an Answer." His sources offer a number of fiscal reasons for the soaring dollar. But in the few thousand words, monetary policy is never cited as having anything to do with the dollar. Similarly, Kilborn of the Times, in the lead article of the March 3 Sunday business section, writes of "Reagan's New Dollar Strategy" and the convulsions in the currency markets without ever mentioning the Fed's role.
But Pine does report that Fed Chairman Paul Volcker "last week called the greenback's latest jump 'unfortunate.'" Why unfortunate? Volcker knows there is only one dollar and that he alone manages its value. But because almost everyone in Washington has come to think of separate domestic and international dollars, the Fed chairman manages to escape any responsibility for the dollar's global fluctuations.
Unfortunately, President Reagan is also confused. At his February 21 press conference, the President said he thought "the problem of the dollar today is that our trading partners in the world have not caught up with us in economic recovery." The policy implication is that the Europeans should cut taxes, something Volcker has recently been urging for this same reason — to increase the demand for their currencies and thus "weaken" the dollar.
The tax-cutting idea is a good one. But it wouldn't lead to stronger currencies in Europe unless the European central banks refused to accommodate the demand for their currencies spurred by the economic growth. That is, they would have to deflate along with the U.S., dampening the stimulative effects of the tax cuts. It's doubtful the debtor classes of Europe would stand still for a commodity deflation; they have too many farmers.
Volcker has gotten away with his deflation here partly because the connection with the farm crisis has been kept a secret. Time and Newsweek have done cover stories on the farmers without ever mentioning the Fed. The networks report the farmers' pleas for lower interest rates and higher prices to avoid bankruptcies now running at the rate of 200 a day. But somehow monetary policy is not questioned. Instead farm lobbyists plead for credit subsidies. "I'm amazed at how many people there are around here [at the Fed] who insist we have nothing to do with the farm problem," says Fed Governor Martha Seger, who has been studying the parallels with earlier monetary deflations. "Nobody here but us chickens!"
Farm state House and Senate Republicans are worried about being ousted in the 1986 elections. They were recently comforted by Secretary of Agriculture John Block. He propounded the notion that when Congress cuts the budget by the Stockman/Volcker magic $50 billion, interest rates will fall and the dollar will weaken. This will lift farm prices relative to foreign competition. Volcker has encouraged this line of thinking with his observations that we should be thankful for the strong dollar because it sucks capital from Europe to finance our budget and trade deficits.
But when asked about this by Illinois Senator Alan Dixon at the Banking Committee hearings, Volcker said he "wouldn't be surprised" if a $50 billion budget cut instead strengthened the dollar! This news astonished the farm bloc, now hopelessly confused, having seen prices falling in recent years as the deficits mushroomed. The Fed chairman has also become enmeshed in contradictory logic.
So is the press. In his March 3 account in the Times, Peter Kilborn at one point says "the new Reagan approach officially acknowledges, for the first time, a link between Federal budget deficits and the might of the dollar. To get one down, the other must come down', James A. Baker III, the new Treasury Secretary, said a few days ago." Yet Kilborn concludes his article with a quote from a Heritage Foundation economist, Edward Hudgins, that "If the deficit went down, all other things being equal, the exchange rate of the dollar would go up." Which is it, Peter?
In line with Secretary Block's hypothesis, a group of farm-state congressmen recently asked Volcker to ease money growth and lower interest rates, to reduce demand for the dollar. In this case Volcker said a weaker dollar might help farmers but would hurt other segments that depend on foreign capital for financing. That is, farmers benefit from lower interest rates while others do not. To be fair, Volcker usually squares such arguments with time lags: Easing will lower interest rates but more growth will push up wages and prices and reignite inflationary expectations which will force interest rates up again.
It's also fair to suggest, though, that Volcker isn't terribly concerned about maintaining intellectual consistency. With the almost absolute power that goes along with his job, he has given himself over to daily hunches and ad hoc rationalizations. Where he at one time seemed aware of his limitations, he appears to have persuaded himself — with the help of his fans — that there's no need for any limits on his freedom to maneuver.
Again and again in the past year we've been seduced into believing he had at last decided to bring his deflationary policies to an end. The most recent cause for optimism came with the Fed's cut in the discount rate on December 21, not so much because of the cut as the reason given: "declines in sensitive commodity prices, and the strength of the dollar." This could only be seen as an end to the deflation.
At the time, gold was at $307.90, silver at $6.30, the pound worth $1.16. The franc was at 9.54 to the dollar, the mark at 3.12, the yen at 247. Three weeks later, with the dollar stronger against all these measures, Volcker was quoted again as saying "the strength of the dollar against foreign currencies and falling commodity prices in the last six months had...contributed to giving us more flexibility...."
It was a shock, then, to hear Volcker announce at his Senate Banking testimony that the Fed's policy of monetary ease had ended, although he said a tightening had not yet begun. As he spoke, gold was at $303, silver at $6.19, the pound at $1.09. The French franc had fallen to 10.13 to the dollar, the mark to 3.31, the yen to 260. By these measures, Volcker should have instead announced a cut in the discount rate. Not one member of the Senate or House banking committees demanded an explanation of why these price signals should now be ignored.
All we can surmise is that falling prices are still of less importance than renewed signs of economic growth; the Commerce Department's report of 4.9 percent growth in the fourth quarter of 1984 obviously restored Volcker's appetite for deflation. In his testimony, he noted that "inflation" is still running at about 4 percent and service prices are climbing at a faster pace. He of course knows that in order to level the Consumer Price Index, the Fed would have to plunge the Producer Price Index to perhaps -10.
We saw in the 1970s how easy it was to rationalize inflation as it crept along gradually. Now a commodity deflation that slowly strangles farmers, lumber and oilmen is winked at by the Eastern Establishment. A "we-have-too-many-farmers-anyway" idea has swept through policymaking circles in Washington and New York. A nasty liquidation of commodity producers may be the price we have to pay to enter into the high-tech, post-industrial world of the future!
It's a seductive notion. For more than a century the United States has been shifting farm population into the industrial sector. But as the Fed's Martha Seger observes, it was accomplished by having family farms sold to bigger farms, with a resultant increase in farm productivity. The transition was usually a smooth, free-market adjustment. Now, the process we observe flows from a government decision to deflate the currency, an action that falls most heavily on the farmers. Then comes David Stockman, insisting the government has no responsibility, picturing farmers as a privileged class feeding off government tax subsidies, land speculators gone bust. President Reagan has a bit more sympathy for the farmer, but he still hasn't quite grasped the unnecessary destructiveness of current monetary policy:
I think the farm problem is the result of things that have been done in the past. It's the result of the inflationary economy that we had for some time. There are a number of farmers now who their main problem is they borrowed on the basis of inflated land values and then we brought inflation down, that left them with loans and the collateral did not have the same value.
So far so good, but in response to a later question about the strength of the dollar, the President says: "I think if you start toying around with trying to reduce the value of the dollar...we put ourselves back into the inflation spiral, and that we don't want."
Volcker's remarks of February 20 had been discouraging enough, the dollar "talked up" and the bond market down. But President Reagan's words triggered an orgy of dollar buying and gold selling, the markets seeing less need to worry about being caught long in dollars in a surprise U.S. intervention. In addition, we were all reminded that the strict monetarist line against currency intervention has moved closer to the Oval Office.
The new chairman of the Council of Economic Advisers, Beryl Sprinkel, may be operating underground, but he will still be a serious problem through his influence on Chief-of-Staff Don Regan. And the new Treasury Secretary, expected to take a firm line with the Fed, has come out sounding weak and uncertain notes, as in his support of the daffy idea that a balanced budget would weaken the currency.
Unless the White House is willing to "toy around" with shaving the dollar's value — against sensitive commodities and foreign exchange — there is nothing the foreign central banks can do by themselves. The February 27 "massive intervention" by five major European central banks showed how futile it is to weaken the dollar without the Fed's participation. Only the Fed has the power to print or unprint dollars — to monetize or demonetize interest-bearing notes or bonds of the U.S. government. (In fiscal 1984, the Fed actually "unprinted" $405 million.)
The financial press routinely reports that intervention by foreign central banks involves the "dumping" or "selling" of dollars. But such banks have very little "cash dollars." What they "dump" are interest-bearing T-bills and bonds out of their monetary reserves. They use the dollars obtained to buy their own currencies. For example, Deutschemarks. There is a temporary surplus of dollars and scarcity of D-marks, and the dollar weakens against the German currency. But the Bundesbank uses the currency it acquires to either retire debt or buy other non-dollar reserves. The surplus dollars in the system are almost exactly matched to the surplus dollar bonds sold by the Bundesbank, and these are swapped.
When the smoke clears, we observe that nothing much has happened. There's been a shifting around of bills and bonds, but not a single dollar of new liquidity has been added to the pool. If the Bundesbank uses the D-marks it has mopped up to simply add to its cash position, this is the same as an open-market sale of bonds. The D-mark will strengthen against the dollar just as if it has sold bonds out of its portfolio or raised the discount rate. In any case, they have simply followed Volcker's deflationary lead. But mostly what happened February 27 was a lot of people making commissions pushing paper around.
Something else happens, though, when the Fed intervenes. The Fed writes a check of, say, $250 million to the Bundesbank in exchange for a bank interest-bearing asset. The bank uses the dollars to buy D-marks and the D-marks are used to buy interest-bearing assets. It has essentially bought and sold bonds in an equal amount. But there is now $250 million circulating that had not been around before. Via arbitrage, this new cash bids up gold, silver, oil and other sensitive commodity prices as well as foreign currencies and also traces its way back to the U.S., where it adds to bank reserves and lowers interest rates.
The Fed has simply added a bond (German) to its portfolio with $250 million in printing press money — just as if it had done so through an open-market purchase of bonds from New York banks. The only difference is that a German bond has been monetized. And within weeks, usually, arbitrage has replaced the German bond in the Fed's portfolio with a U.S. bond. The situation is exactly as it would have been had the Fed simply injected reserves in New York.
It would be fine if the Fed did just that. But there's no pressure on Volcker to ease, except from the farmers, and the word is around that there are too many farmers anyway. But it is important to understand that the monetary chaos of recent weeks is so much hokus-pokus, generating fees and commissions, but not much else. The bond market debacle of February 27, for example, was widely attributed to the successful intervention by the foreign banks in sinking the dollar — because this removed some of the Fed's "flexibility" and suggested a tightening on the way. But if so, a tighter Fed policy will boost the dollar, suggesting a Fed easing will follow. And so forth ad nauseam.
"What we may be seeing," says Columbia University's Robert Mundell, "is the break up of the floating exchange-rate system." It's odd to think of a non-system as breaking up. But Mundell seems to suggest that the "system" exists in the minds of the people who conceived it as being superior to the fixed system of Bretton Woods. And it's not working at all as advertised. The promise was of exchange rates and trade flows adjusting slowly, almost imperceptibly. Incipient trade deficits were assumed to translate into weaker currencies that automatically adjusted toward trade balance.
The last stages of Bretton Woods in 1971 were similarly accompanied by a "monetary chaos" that involved a circular capital flow over the Atlantic, a lot of huffing and puffing, but nothing real happening. Then, as now, the financial press reported the crisis in the foreign-exchange markets with never a mention of domestic monetary policy. The inflationary implications of the closing of the gold window and devaluation of the dollar were not addressed by The Wall Street Journal, the Times, the magazines and networks.
Why? Because then as now there is a jurisdictional agreement between the academic economists and their followers in the financial press. Monetarists cover the Fed. Keynesians cover the overseas dollar. And separate policies for separate dollars, when in fact there's only one. But Mundell remains as cheerful and as optimistic as the stock market. The economic, political and even intellectual forces that led to the breakdown of Bretton Woods are reforming to rebuild a new system. There's opportunity in crisis.