Credits in the U.S. balance of payments give rise to a demand for dollars. Debits reflect the supply of dollars. Together, they determined the exchange rate for the dollar. So far, so good. Everybody knows that.

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

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I’ve been reading Amity Shlaes’ wonderful book, The Forgotten Man, A New History of the Great Depression, with an eye out for parallels and lessons for our current crisis. You will find some of those and much, much more.

Amity showed great restraint in writing her book. A scholar with her expertise could have driven the ideological lessons home and saved those of us on a practical mission some time. Instead, she patiently let the characters and the circumstances speak for themselves letting the nuance show through for us to savor.

While I wasn’t totally clueless about the depression, not having lived through it, you see, I must admit that my knowledge of many of the details was limited.

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Much hand-wringing is taking place over the reduction or possible loss of the dollar’s reserve currency status. That’s a bit ironic since the whole concept of a reserve currency is no longer valid in a system of floating exchange rates.

Under the dollar-exchange system established at Bretton Woods, New Hampshire after World War II, countries committed to keep their own currencies in a narrow band around a par value expressed in U.S. dollars. No reserves were needed to offset upward pressure on the domestic currency since the monetary authority could sell their own currencies for dollars in theoretically unlimited amounts. But to offset downward pressure on the domestic currency, a reserve currency was needed to purchase and support the domestic currency. A country’s ability to defend its currency from downward pressure was thus limited by the amount of the currency held in reserve. Since the parity was expressed in dollars, it was convenient to use dollars as the reserve currency.

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Financial TV is full of talk about Governor Warsh’s opinion piece in Friday’s Wall Street Journal. One theory is that it was a shot across Chairman Bernanke’s bow. I doubt it, but even if it was in some limited sense, my experience on the FOMC for almost 14 years suggests to me that the following probably happened. Governor Warsh wrote the piece, then showed it to Chairman Bernanke and asked if he was okay with submitting it to the WSJ. Whatever the Chairman really thought down deep, he probably said “That’s okay with me. Go ahead.” This, of course, is only a guess, but an educated guess.

The timing was odd, however, and awkward, for the Governor since it was so soon after an FOMC meeting in which he didn’t dissent. It looks like he’s trying to have it both ways. Of course, it’s always possible that he and the Chairman together are trying to have it both ways.

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(A More Realistic Look)

This is the year that the whole world apparently discovered the importance of the Fed's Balance Sheet. Unfortunately, their discovery was made when it suddenly doubled in the context of a severe financial panic. This is awful! Right? We've got to get it back down to size! Right?

The suddenness of these revelations prevented useful perspective on why the balance sheet is important and why the composition of the balance sheet is just as important as the size. Money and banking text books for decades have discussed the Fed's balance sheet in the context of bank reserves and the Fed has for decades provided a statistical release on "Factors Affecting Reserves."

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When I was in graduate school in the olden days (1960s), Professor Waller hired me as his grader in his money and banking and monetary policy classes. At first, he limited my chores to multiple-choice and true-false questions, but he gradually trusted me with essay questions-following his strict guidelines of course.

"Are budget deficits inflationary?" was one of his favorite questions on final exams, and he had a precise idea of the components of an "A" answer. Using T-Accounts (Remember the Chicago Fed's Modern Money Mechanics booklet?), the students were supposed to show the alternate ways of financing government spending, including deficits. The answer to the question, you see, depended almost entirely on the method of financing. Another way of saying that is that the impact of fiscal policy depended almost entirely on the accompanying monetary policy.

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Last year I said that I felt about a strong dollar like St. Augustine felt about chastity. "Lord, make me chaste, but not just yet." My version was, "Lord, give us a strong dollar, but not just yet."

My point was that while a strong dollar had benefits in normal times it would make a recession worse and more difficult to recover from. If someone from on high decrees a stronger dollar in a recession, our exports would be more expensive to potential foreign importers and imports would be more affordable to us at home. The decline implied for net exports pulls down GDP.

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A: No, Not directly, but Yes Indirectly.

Channeling the FOMC

I remember once when the head of the trading desk at the New York Fed was giving his report on international operations, the FOMC broke into applause when he announced that there had been no dollar intervention during the past year. While fixed exchange rates was once the orthodoxy, central bankers came to appreciate their ability to concentrate on domestic economic needs under flexible exchange rates. Do what's right for the domestic economy and let the exchange rate adjust to that. The alternative is to target the exchange rate and let the domestic economy do the adjusting. Fortunately, sound domestic policy promoting low inflation is more likely than not to produce a strong dollar.

So, when talking heads say the Fed's job is to support the dollar, Fed policy-makers agree, but they view supporting the dollar as protecting its domestic purchasing power. That's not usually what the critic had in mind; but they rarely acknowledge the downside of targeting the dollar.

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This morning on financial TV before the Federal Open Market Committee's (FOMC's) scheduled announcement today at 2:15 eastern, someone (Larry Kudlow) asked "Should the Fed begin its exit strategy?"

Let me offer the view that it already has. The Fed's balance sheet ballooned last fall and peaked in December. Since then there has been no net new growth in total assets, but the composition of those assets have changed with circumstances. First, borrowing through special loan facilities grew rapidly, but the FOMC pretty much offset that by reduction in Treasury bills. The liquidity went where it was needed most without bloating liquidity throughout the system.

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(The FOMC Should Start Making that Distinction)

Monetary policy is not interest-rate policy. Neither is it Fed balance-sheet policy. Monetary policy is money-supply policy.

Sometimes these distinctions aren't important, but they are important now, and the Federal Open Market Committee (FOMC) should begin educating the public on them because soon it may need to allow interest rates to rise a bit to reduce market distortions without easing money (the money supply) in an inflationary way.

Similar distinctions between monetary policy and the Fed's balance sheet, the monetary base, and excess reserves should be understood. A large balance sheet, monetary base, and excess reserves are not inflationary unless they lead to too rapid an expansion of the money supply given the state of money velocity.

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If I hadn't worked at the Fed for 36 years, I wouldn't know its history either. Several misconceptions muddy the current debate about the future role of the Fed as systemic risk regulator. The following statements, frequently heard in some forms, are very misleading.

1. The Fed was created to conduct monetary policy; so let it stick to it's knitting.

2. The Fed doesn't need to take on a new role on top of those it already has.

3. The Fed had a large role in creating the current mess, so it shouldn't be rewarded with new assignments.

The Fed was not created to conduct monetary policy. Monetary policy as we know it today hadn't been invented yet. The Fed was created to stabilize the financial system and prevent or ameliorate financial panics.

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I sat in on a presentation this week where a picture of the Fed's balance sheet growth was shown as prima facie evidence that inflation looms down the road. The presenter wasn't sure when inflation would arrive, but it would arrive and be caused by the balance sheet expansion. No chain of causality was laid out. Just balance sheet expansion then, later, inflation.

He may be right, but I don't think so. It may happen, but it isn't an inevitable result of the balance sheet growth. Here is my reasoning:

1. The first point I would make is that all the balance sheet expansion took place last fall. There has been no further expansion since December-7 months ago.

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If the money supply increases 10 percent in 3 months, we call it a 40 percent annualized increase. If it flattens at three months and is at the same level 3 months after that, it becomes a 20 percent annual rate for the 6 months. Six months later, if money growth remains flat, it becomes a 10 percent annual rate.

This is an oversimplification, but something like that has been happening. The money supply spiked, and then flattened out. Pre-spike until now still gives us pretty big numbers, but they are getting smaller every day. Yet, commentators treat the money growth statistics as if the rapid rise is ongoing.

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The FOMC met Tuesday and Wednesday.  I enjoyed two-day meetings when I was there, but we normally had only two two-day meetings per year, in February and July. The problems have grown lately and so have the number of two-day meetings.

The July meeting was usually close to July 4^th-closer than this one-and the British ambassador invited us to his residence for dinner on the evening between meetings. In my first few years, Alan Greenspan sat across from the ambassador of the time, and they discussed big-picture issues very eloquently. It was educational for me as well as entertaining.

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Once upon a time, people took rising interest rates as evidence of tighter money. Then, circumstances and growing sophistication led to recognition that rising inflation and/or rising inflationary expectations would show up in higher interest rates, especially longer-term rates. Then, apparently, everyone decided that rising long rates could ONLY be explained by easy money and inflationary expectations. They forgot about the tight money possibility. Sophistication crowded out the obvious.

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Today's (06-23-09) Wall Street Journal editorial page, of which I'm a fan, contains a fascinating look back at the monetary policy debate in December 2003. During the FOMC meeting on December 9, 2003, then Governor Bernanke referred to a WSJ editorial of that same day (Speed Demons at the Fed) that wondered if the FOMC was paying adequate attention to "yellow-flashing" price signals such as the $406 price of gold, higher commodity prices, and a weak dollar.

In referring to the WSJ editorial and similar arguments, Mr. Bernanke said he believed such critics are "not particularly well informed" and that "as a Committee, we should continue to remain patient and not choke off growth unnecessarily."

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In my guest appearance on CNBC's "The Call" program Tuesday morning, the topics were "Should the Fed Stick to Monetary Policy?" and "Is the Economy Back on Track?" On the economy, I made the same point about excess reserves and the Fed's mistake regarding excess reserves in the 1930s that I made in my June 10 posting.

We get evidence frequently these days of the relative youth of those on financial television, both interviewers and interviewees. Their historical frame of reference doesn't go back very far; so they miss obvious historical precedent for contemporary issues. In my June 10 post, I discussed the Fed's ill-fated attempt to remove excess reserves from the banking system in the 1930s. In this one I feature the Fed's announcement, and the reaction to it, that the Fed would purchase longer term treasuries in an effort to depress longer-term interest rates, including mortgage rates.

Since short-term rates under the Fed's influence are near zero, a policy of targeting longer-term interest rates represents an effort to change the term structure of interest rates or the slope of the yield curve as it is usually put today. This policy is usually treated as unprecedented. Not so. A similar policy, but for different reasons, was undertaken in the 1960s and was called "Operation Twist."

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People keep talking and writing about the explosion of the money supply and the coming inflationary tsunami. Let me point out once again that the M1 and M2 measures of the money supply spiked but have since come back down. There is no explosion of the money supply.

I

The monetary base (currency outstanding plus bank reserves) has exploded, and it's graph is indeed startling-startling that is until you realize that excess bank reserves on deposit at the Fed is the reason. We learned to pay attention to the monetary base because it provided the raw material (reserves) from which the banking system can create new money by lending and investing. Because of the money expansion multiplier, the monetary base has been referred to historically as "high powered money."

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I've tried to straighten this out before, but it obviously didn't take; so I'll try again.

Over and over on financial TV, I hear commentators and guests alike talk about how the Fed is printing money when it buys Treasuries (meaning long-term) and how runaway inflation is the inevitable result.

*The Fed doesn't literally print money. Most people who use that expression probably know that, but some obviously don't.

*The Fed does "create" money when it purchases an asset, but that is just as true whether the asset purchased is a 10-year treasury bond, a 3-month treasury bill, or a sack of potatoes for the cafeteria.

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