The fantasy of the free-floating dollar
Question: Should the U.S. maintain a strong dollar? Answer from U.S. Treasury Secretary Steven Mnuchin: Meh.
"Obviously, a weaker dollar is good for us as it relates to trade and opportunities," he told reporters Wednesday in Davos, adding that the recent fall of the dollar is "not a concern of ours at all."
The reaction was swift. The dollar fell on Mnuchin's heresy, and he was chided for his loose tongue by poobahs around the world, from International Monetary Fund (IMF) Director Christine Lagarde to former Clinton Treasury Secretaries Larry Summers and Robert Rubin. "The dollar is of all currencies a floating currency and one where value is determined by markets and geared by the fundamentals of U.S. policy," Lagarde said. A treasury chief interfering in a currency? The horror!
But everyone needs to calm down. A weak dollar has its virtues. More than that, the idea that we have a free global market in currency values is only a myth.
Let's begin with the U.S. dollar's role as the world's reserve currency. In plain English, other countries tend to carry out international transactions in dollars, and stockpile the currency to cushion against shocks. Right now, roughly two-thirds of all foreign exchange reserves are held in dollars. That leads to a lot of "extra" demand for the dollar — and thus a higher-priced dollar — over and above what you'd get if America was just another country.
Why is the dollar the world's reserve currency? First off, World War II decimated Europe, leaving America as the only unscathed major Western economy. Then an international gathering of economic officials from around the world created the Bretton Woods system to preserve some semblance of the gold standard: Everyone pegged their currencies to the dollar, while the U.S. stockpiled the world's gold, making it the center of the global economy.
World War II, the gold standard, and Bretton Woods are all long gone. But their legacy left the dollar as the world's reserve currency. It was a world war and a massive act of deliberate policymaking by governments that led to this state of affairs, not some "objective" judgment by the market.
Matters have been all over the place since.
The U.S. was still intervening in currency markets even in the 1980s: In particular, Reagan administration officials coordinated a sell-off of U.S. dollars to lower the currency's value and close the trade deficit. Similar efforts were made in the first years of the Clinton administration. Rubin's own "strong dollar" policy in the late 1990s was largely a repudiation of his predecessors, and a commitment to just leave the currency markets alone. After that, devotion to a strong dollar was a fixture of administrations from both parties.
Since then, America has enjoyed skyrocketing inequality, a booming trade deficit, financial instability, and social and political upheaval.
Then there's the rest of the world.
From World War II to the end of Bretton Woods, it was common for countries to have capital controls: rules that strictly limit the movement of money across national borders. Starting in the 1970s, international bodies like the IMF — with the backing of American policy — pushed for capital controls to come down around the world.
That was great for major international companies seeking natural resources and cheap labor to exploit. Less so for developing countries, who often saw the wealth produced by this new freedom flow back to Western owners of capital.
Many countries still maintain their peg to the dollar. This creates a straightjacket that prevents countries from managing their own business cycles and aggregate demand. Forced to run balanced fiscal budgets, they're reliant on private and foreign investment to fund growth and drive job creation. When those investments go bad, international pressure often forces countries to gut their public investments and bleed their citizenry to pay off foreign creditors. (Yet another reason they like to keep rainy day stockpiles of dollars on hand.)
Only in the last decade did it dawn on the IMF and other experts that capital controls might have played a useful role after all.
A world of free floating currency values and unhindered markets has always been an ideal more than a reality. There may be a case for it. But it would have to go along with ending dollar pegs, and embracing countries' freedom to run budget deficits and to use their fiat currencies to invest in the public good.
Instead, we've only pursued that ideal haphazardly for the last four decades or so. And for the most part, we created a godawful mess that didn't benefit anyone other than big business and big finance.
None of this means the Trump administration makes any sense on these matters — only that the conventional wisdom on global trade and exchange rates and money flows is wrong.
Yet in their undisciplined hip-shooting, the Trump administration occasionally hits a bullseye.