In the last section of my September 13 posting — Some Thoughts on the Credit Crunch — I made the case for front-loading monetary policy when it's changing direction, which would be the case at the September 18^th meeting of the FOMC.  That argument is especially strong when an element of financial crisis is present, as was the case.  In effect, I called for a 50 basis point cut in the fed funds rate (and discount rate), and concluded that posting as follows: "Under present circumstances, shock and awe is warranted."

The FOMC's bold move accomplished its purpose:  it calmed markets and bought some insurance against a severe recession.  While some additional insurance may be warranted tomorrow, it need not — and should not — be bold.  Healing has begun and a quarter-point follow-up should be sufficient to indicate the Fed is still awake and on the case.  In fact, the more we know about the nature of the credit crunch, the less the Fed's tools seem relevant.  If lenders are afraid to lend because they are afraid they won't be repaid or because they can't trust the collateral, a small difference in short-term market interest rates hardly matters.  This is going to take time.

Another consideration likely to loom larger tomorrow by many commentators will be the decline in the dollar and possible Fed reluctance to contribute further to it.  My educated guess is that that won't be a major consideration in the FOMC's deliberations. They are happy to have flexible exchange rates reconcile what they regard as proper policies for the internal economy to the external world.  Sure, they would prefer a stronger dollar, as would I, but when it comes down to trade-offs, the dollar will not be the highest priority.  To them, protecting the value or purchasing power of the dollar means keeping its domestic purchasing power — not purchasing power of foreign currencies.

Guests on financial talk shows frequently say they prefer a strong dollar as if they can order one off the menu as an appetizer along with an entrée of rapid growth and a dessert of price stability.  That restaurant is not in my neighborhood.  If the markets have finally decided that the unsustainable current account deficit really is not sustainable, and that the alligator finally has to be paid, then the realistic choices are:  hold up the dollar and let the economy sink far enough to curb import demand (in other words a sharp recession) or try to keep both the economy and the dollar strong by backsliding on free trade and investment.  Over time, maintaining a strong, and perhaps more importantly, an economy with excellent prospects going forward, is the best that policymakers can do for the dollar.

Most people miss an important distinction between the role of the dollar in trade and the role of the dollar in foreign investment.  For trade purposes — a one-shot transaction — the level of the dollar matters.  The lower dollar makes imports more expensive to us and our exports less expensive to our trading partners.  But for foreign investors contemplating investing in the U.S. — a two-shot transaction — the important thing is what happens to the dollar during the investment period.  Once the dollar becomes cheap enough for investors to conclude that appreciation is more likely than further depreciation, then they have an incentive to invest here, even if the dollar is still "low."  That point may be near (or here already) for all I know.  If so, the capital inflow that offsets a large current account deficit could return and keep the alligator at bay a while longer.

Let me close with a quote from the Flatlanders:

It might be sooner
And it might be later
But one thing's for sure
You gotta pay the alligator.

Who is harmed by the decline in the dollar?

As consumers, we are all harmed by the decline in our purchasing power.  Import prices go up directly, as everybody knows, but there is also an indirect increase in the prices of domestic goods and services that are also exported or potentially exported.  In addition, some of us are hurt as producers or workers:  people in the import business (foreign car dealerships for example).

Who is helped by the decline in the dollar?

Producers who are exporters or potential exporters at the more favorable exchange rate will experience an increased demand for their products.  Also helped are domestic producers who compete with imports, which will become more expensive.

Why is the dollar declining?  What is the problem?

The dollar is declining because of pressures on our balance of payments.  Some combination of our current account deficit being too big and creating an excess supply of dollars on the world market and our capital inflow (and demand for dollars) becoming inadequate to offset the deficit.

So, what is the relationship between our balance of payments and the market for dollars?

I'm glad you asked that since the connection between the two is key to understanding either one of them.  When we import goods and services or purchase foreign stocks or bonds, or real estate, those transactions are debits in our balance of payments.  When foreigners do those things, they are credits in our balance of payments.  Debits give rise to a supply of dollars and demand for foreign currencies.  Credits give rise to a supply of foreign currencies and a demand for dollars.  To a great extent these debits and credits balance out and so does the demand and supply of dollars and foreign exchange.  So, essentially we pay for our imports with our exports as do our trading partners.  However, it is unlikely that the balance will be perfect; so, there will likely be a small imbalance in trade that will be "financed" or offset by an equal imbalance in capital flows.  I just lost you with that last sentence; so, let me elaborate.

How is it that net trade balances and capital flows are exact mirror images of each other?

When I buy a BMW, I give the company a check on my bank.  If they deposit my check in their U.S. bank and leave the proceeds there, they have "loaned" money to a U.S. bank, which will be recorded as a capital inflow. Their increased bank balance is a capital inflow (credit in our B/P) that just matched my import purchase (debit in our B/P).  They may sell their U.S. dollar balances in the foreign exchange market for a Euro balance in a German bank in which case our dollar obligation is to a foreign bank instead of a foreign company, but the capital inflow remains the same and equal to the BMW import. You don't have to follow all that; just remember this basic point:  Every increase in our debits (from imports) is matched either by an increase in credits elsewhere in the B/P or by an offsetting reduction in debits elsewhere.  Double-entry bookkeeping keeps total debits and credits in balance as well as the dollars bought and dollars sold in the foreign exchange markets.  The balance of payments always balances.  Thus any net deficit or surplus in the trade portion of the B/P is always precisely matched by the opposite in the capital portion of the B/P.

So, what was the background to the recent decline in the dollar?

For several years we have had a large and growing deficit in our trade (goods) balance and our current account (goods, services, unilateral transfers) balance. It grew to more than 6 percent of our GDP, a very large imbalance in trade.  By itself this was supplying excess dollars in the foreign exchange markets.  By "excess" I mean more dollars that were being used to buy U.S. goods and services.  The current account deficit and the associated excess dollars were offset by an equally large capital inflow (surplus) which "mopped up" the excess dollars.

For years a huge trade deficit seemed unsustainable to most U.S. economists and for years they forecasted a decline in the dollar to correct the trade imbalance.  Another way of saying that is to say they didn't think the outside world (especially Europe) would continue lending us large amounts of money to finance our huge trade imbalance.  But year after year those forecasts never came true.  Finally, economists threw in the towel and stopped talking much about it.  (A watched pot never boils.)

Over the past year the U.S. growth has slowed largely in response to the housing situation while the world economy, even including Europe, became more robust.  As we ceased, at least temporarily, being the engine of world growth and as prospects here dimmed relative to prospects abroad, the capital inflow in combination with what was going on in trade became inadequate to sustain the dollar at past high levels.  Theoretically, the dollar will continue adjusting to bring our balance of payments into an internal balance consistent with world economic realities.  That doesn't necessarily mean until our trade becomes balanced, but it probably does mean that the deficit will be reduced.  That process has already begun modestly as our monthly trade statistics have improved of late.

What is the big picture of what's going on with our B/P and the dollar?

Like a family during the process of running up their credit card balances, our large current account deficit means we have been living beyond our means as a country.  We have been absorbing (consuming, investing, etc.) more goods and services than we have been producing. This isn't necessarily bad — you can use a credit card for worthy purposes — but it probably was unsustainable and it is the opposite of what one would expect of the world's richest large economy.  The "normal" pattern is for capital to flow from rich countries to poor countries, where presumably its return is greater.  The reverse has been happening.  Capital has moved to the richest country from poorer countries, presumably because our institutions and policies compared to our trading partners more than offset other factors.

What has to happen for "equilibrium" to be reached?

Our exports need to rise relative to our imports.  Resources will need to move from other industries into export industries.  The declining dollar will provide the needed price incentives by making our imports more expensive at home and our exports less expensive in foreign currencies.  Another way of saying that is that the exchange rate will raise the price of traded goods relative to the price of non-traded goods.

Is there an alternative to a declining dollar?

Yes, but they probably would involve more friction and more pain.  If the dollar is somehow prevented from falling, the needed adjustments would be the same in terms of exports needing to grow relative to imports, or imports needing to shrink relative to exports.  But with no change in the exchange rate, downward pressure on domestic income would push down domestic goods prices relative to international traded goods.  Our imports would have to shrink not because of higher import prices, but because of lower domestic incomes. If internal prices and wages were as flexible as the exchange rate, it would make little difference which is used.  But internal prices, and especially wages, tend to be sticky in a downward direction, so unemployment would be the likely result.  In effect a recession would be needed.

With inflexible exchange rates the temptation would be very strong to avoid the internal adjustments by restricting trade.  Our free trade policy would be in jeopardy.

So, McTeer, are you "dissing the dollar?"

I'm saying that, if adjustment is necessary, a decline in the dollar is probably the least-worst way of achieving it — less worse than domestic recession and less worse than trade restrictions.

Of course, an alternative might be to prolong the status quo ante by reinforcing the factors that made us a strong magnet for foreign capital despite being the most developed of the developed countries.  We could become more business friendly and attract capital keeping the tax cuts we already have and cutting capital gains and dividends taxes to zero, drastically reducing business taxes, etc.  This would postpone painful adjustments, but probably not forever.  However, those policies are needed on purely domestic grounds as well.

Aren't policymakers, especially the Federal Reserve, charged with protecting the value of the dollar?

Yes, but that commitment has always been understood to mean protecting its purchasing power over goods and services not over foreign currencies.  Even with the higher import prices coming from dollar depreciation, overall price indexes can be held down.  Of course, to the extent that a stronger dollar could limit the pressure on import prices, the rest of the job would be easier.

What do you expect our policymakers to do about the dollar?

They will continue to pay lip service to a strong-dollar policy, but deep down they will be grateful that the market is taking care of a potentially more difficult problem for them.  They know they will be criticized later for presiding over a shameful dollar decline, but they are less likely to be criticized for a prolonged recession or a reversal of our free trade policy.  And they will console themselves with the fact that if Congress would just listen to them we could have greater prosperity today and for years to come and leave correction of the trade deficit for a future generation of policymakers.

Naturally I bought the Maestro's book, Alan Greenspan, The Age of Turbulence, early on September 17, the day it came out.  I wanted to see if he said anything about me.  There was just one sentence on page 212.  Whew!  What a relief!

The price on its dust jacket was $35 in the U.S. and $43.50 in Canada, the 24 percent difference presumably reflecting the exchange rate between the U.S. and Canadian dollars.  The Prince of Darkness by Robert Novak had come out a little earlier with a 27 percent difference.  My other September book purchases had similar differentials, the lowest being 21 percent near the end of the month.  I buy a lot of books. I don't necessarily read them.  But I buy them.

Since book purchases are the main way I keep track of the U.S./Canadian dollar exchange rate, you can imagine my surprise to learn that before September ended, the Canadian dollar had climbed to parity with the U.S. dollar.  Or, perhaps I should say the U.S. dollar had declined to parity with the Canadian dollar.

Isn't it interesting that when the two dollars trade one-to-one, the U.S. dollar is called weak and the Canadian dollar is called strong. I guess what have you done for me lately is a question for currencies as well as for people.

If you don't hear from me for a while, don't worry. I'll be somewhere up north buying books with U.S. dollars and selling them across the border for Canadian dollars, which I will use to buy back U.S. dollars. Or, is it the other way around?  I hope I don't get confused.