Friday, May 20, 2011

Strong Dollars and Bad ("Supply-Side") Economics

Conservative (academic) economist David Beckworth wrote a brief post in response to GOP leaders like Rep. Paul Ryan who are calling for "strong dollar" policies and a revival of talk of gold standard. "Hard Money Advocates are Their Own Worst Enemy." His basic point:

If you want our government to move from fiscal irresponsibility to responsibility, the only way to offset the huge decrease in output and surge in unemployment is through looser monetary policy. You can't have both "hard money" and "hard fiscal policy" at the same time without a massive recession.

A blogger at the Cato Institute recently wrote that the U.S. should do as Estonia did and massively cut government spending in response to its recession where the drop in tax revenues was creating deficits. Estonia is a "hard money" country with a currency board that operates almost identically to a gold standard. It eliminated its deficits via spending cuts to the tune of 14% unemployment(interestingly not mentioned by the Cato blogger).

Tightening the money supply, particularly now, would be akin to the mistake of 1937.

The "strong dollar = economic growth" argument has been around since the dawn of "supply-side" Republican thinking in 1973. This is perhaps why Paul Ryan and others have commented on the exchange rate. In 1973, Art Laffer argued that de-linking the dollar's exchange rate value from gold was the cause of double-digit inflation. (They then ignored all the other causes of the inflation.) We've since cured inflation without reinstating the Bretton Woods gold system, but the unsubstantiated claims have arisen again.

For example, the Republican Joint Economic Committee recently issued a report allegedly showing the relationship between the exchange rate value of the dollar and oil prices. The logic is basically "Since oil is priced in dollars and the Fed is printing more dollars, oil and gasoline cost more." This report was then relayed through the media as truth. However, well-known international macroeconomist Menzie Chinn took the JEC study apart on his blog. Chinn demonstrates how the authors would receive an "F" from any competent professor. Decades of econometric research has failed to make the link that the JEC study purportedly shows so simply. The JEC study is akin to me saying "as ice cream sales in the U.S. rise, so do car thefts. Hence, ice cream sales must cause car thefts." A multivariate model would quickly expose that the relationship is rather spurious-- there is something else (higher temperatures) driving both ice cream sales and car thefts (people leave their windows down when they park their cars). The JEC authors ignore the other causes of increases in oil prices-- namely good old supply and demand.

So, it appears to me the JEC authors are motivated by the same spurious argument about "strong dollar" policy.

Here's a graph of the (trade-weighted) exchange value of the dollar, measured against major foreign currencies:
We can see the dollar depreciated most rapidly after reaching its peak during the glory years of the Reagan administration. Reagan's Treasury Secretary, James Baker, roundly ignored the supply-siders pleas during the 1980s. In fact, the Plaza Accord under Reagan was all about intentionally devaluing the U.S. dollar. It depreciated even more during the Bush administration, but I don't remember Paul Ryan and others having qualms about it at that time. We've only now just reached the low we had reached before the Great Recession.

But it's not clear from the graph above why a "strong dollar" matters to the U.S. and to "supply-siders" so much. Perhaps it matters to foreign savers who buy U.S. bonds, as those dollar interest payments have become worth less in their own currencies. It matters to those in the U.S. importing foreign goods which are now more expensive. But it is also boosting U.S. manufacturing as the goods we produce cost less for foreigners to buy.

In fact, if the U.S. boosted its savings rate relative to other countries'-- which supply-siders are keen on-- standard economic theory says that the real exchange rate value of the dollar would have to depreciate. (You can't have lower real interest rates and a stronger dollar.) This is a contradiction of strong-dollar ideology that I don't think "supply-siders" reconcile at all.

It's not clear to me what logic, scientific evidence, or economic model Paul Ryan and company are basing their attacks on. The Federal Reserve is responsible for regulating the money supply, and when demand for money is high, as it is currently, it's the job of the Fed to increase supply in order to avoid recession. It's incorrect to claim that the exchange rate depreciation of the dollar is the sole cause of higher oil prices.

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