I know from personal experience as president of the Dallas Fed that GAO auditors are only too eager to support the political agendas of their Congressional sponsors. Past efforts to have ongoing GAO audits have excluded monetary policy and promised financial audits only. The current bill specifically targets monetary policy.

I’ve enjoyed my brief encounters with Mr. Paul. I like him personally, but I can’t get around the fact that his agenda is nothing less than abolishing the Federal Reserve.  Abolishing the Fed is not a hidden agenda on his part. In fact, End the Fed is the title of his latest book.

His book shows that he has given a lot of serious thought to his positions, including his lifelong study and admiration for Austrian economics, which longs for a gold standard. Unfortunately, in my opinion, he also praises the burning of dollar bills by young people at his campaign rallies. In fact, the title of his book, he says, came from the chants of students at a rally while holding up burning dollar bills. (Page 4 of End the Fed.) Burning dollar bills, to me, is almost as repugnant as burning the American flag–certainly not a source of pride.

Frankly, I’m flabbergasted at the attacks on the Fed in Congress. I think the Fed performed well in the financial crisis, pulling us back from the brink. The country and Congress owe it gratitude, not derision. I guess it’s true that no good deed goes unpunished.

The second paragraph acknowledges this implicitly when it says “Thailand, South Korea, Russia, and the Philippines have been snapping up dollars this week in order to hold down the value of their currencies.” It goes on to say that Brazil’s finance minister said the country’s currency remained too strong even after Brazil adopted some capital controls to weaken it.

While a majority of pundits on financial TV argue for a strong dollar to boost—or should I say “buck up” the U.S. economy, the rest of the world seems to understand that a weaker domestic currency would help them get out of recession, unless, of course, all or most countries do it and cancel each other out. Such confusion is an important reason countries should adapt domestic policies to domestic needs and let their exchange rate adjust to reconcile those with the outside world. 

Yesterday, rumors were going around that China might soon restore the gradual appreciation of its yuan, which implies a weaker dollar relative to the yuan. That would be helpful both to China and the U.S. since the U.S. trade deficit is largely China’s trade surplus. But wasn’t it just the day before yesterday that China was urging the United States to strengthen the dollar, which would imply a weaker yuan. Consistency is difficult to maintain as blog writers will tell you.

I visited China in 2003 and 2006 and made several speeches and gave several TV interviews. I kept making the point that China’s exchange rate was China’s business, but then I pointed out that holding the yuan down was subsidizing U.S. consumers at the expense of their own. The first part of my message was not really correct since every exchange rate has two sides and affects both parties, but I thought it best to be diplomatic about it. During both periods the U.S. was trying to pressure China to appreciate the yuan, and I was convinced that China would do so only if we quit urging them to publicly.

One of the huge mistakes made early in the Great Depression was the severe Smoot-Hawley trade law, which led to competitive devaluations all over the world and triggered a sharp shrinkage in world trade. We haven’t gone that far yet in our Great Recession, but we are on a slippery slope. Exchange rate manipulation can do harm similar to tariffs and non-tariff barriers to trade. Once we start the game of competitive exchange rate changes it can easily get out of control. Instead, let’s follow Milton Friedman’s advice and keep the float clean.

I attended a conference in Beijing in 2003 sponsored by the Chinese government. While in China, I also met with several Chinese officials, including the new Premier, Wen Jiabao, officials of the central bank, and the agency in charge of maintaining the exchange rate of the Yuan, or Renminbi.

In several television interviews I was asked about the dollar/yuan peg and whether it was appropriate. I tiptoed through the tulips on the delicate aspects of that question, focusing instead on the basic dilemma.

The dilemma was that China was pegging its currency to the dollar, which was sinking. While a depreciating dollar might help offset economic weakness in the United States, the sinking yuan tied to it certainly seemed inappropriate for the booming Chinese economy.

Diplomacy became trickier when I was leaving the exchange pegging agency and was asked to sign their guest book. The book was huge and they opened up an entire blank page for me. About all I was sure of was that a large handwriting font was called for. I have (or had) a photograph of that scene that I’ve looked for unsuccessfully for months. It shows exactly what I wrote. The best I can remember, it was something like this:

Now that I’ve guessed at it, I’ll probably find the picture tomorrow.

A highlight of that visit was the audience some of us had with the Premier in the Great Hall of the People. He went around the circle and asked some of us for any advice we had to give him. A distinguished scholar sitting next to me, a Harvard professor I believe, shared his concern about so many single male Chinese coming off the farm into the cities to work without the stability offered by family. He urged the Premier to allow wives to come too lest the husbands succumb to the temptations of the city.

I was called on next. My contribution was that I thought the professor had been watching too many episodes of “Sex in the City.”

On that visit, I reached the conclusion all over again that we don’t want a land war with China. While I was walking up a long stretch of the Great Wall, what seemed like millions of Chinese soldiers in ill-fitting green uniforms were walking down. I felt like a salmon swimming upstream. The soldiers were apparently on holiday. While they did not look menacing, they did look infinite in their numbers. They just kept coming and coming. I thought of what it must have been like during the Korean War when the Chinese poured across the 38^th parallel.

On a lighter note, there were two mysteries I never was able to solve during that trip. One was, when do you use Yuan and when do you use Renminbi for the Chinese currency. I had it explained to me several times, but the explanations were all different. I never got it.

The other, greater, mystery was this: Why did they change the name of the city from Peking to Beijing but didn’t change the Peking duck to Beijing duck?

Either way, they are highly overrated.

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.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

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.

Here’s what I thought I knew going in:

* There was still debate over whether the October 1929 stock market crash caused it, just preceded it, or how big a role it played.

There was general agreement that:

* The Smoot-Hawley tariff was a terrible mistake that made it much worse, and may have made the difference between recession and depression.

* The Fed made it worse by allowing the money supply to shrink.

* Things got better in the mid-thirties, but then worsened again, probably because of policy mistakes.

* Hoover was totally ineffective and did next to nothing to help, while

* Roosevelt was an activist who experimented with cures and generated public hope and was generally successful.

* The depression really didn’t end until WWII.

* The most important change made to prevent future depressions was the FDIC’s deposit insurance.

* The semi-socialist measures of the Roosevelt administration saved capitalism from something far worse.

Here’s what I thought of a couple of things mentioned above:

* I couldn’t really deny the Friedman and Swartz charge that the Fed erred by allowing the money supply to shrink.

* However, I thought insufficient attention had been paid by the economics community to the following factors:

- The shrinkage of the money supply was primarily a by-product of bank failures.

- The world was still on a gold-standard and policymakers were presumably supposed to follow the “rules” of the gold standard game.

- There was no consensus within the economics community on what to do to get out of a depression.

- This consensus would await the publication of Keynes’ General Theory in 1936 and its subsequent popularization and incorporation into economics textbooks.

Here are some of the things I learned by reading the book:

Much of what Roosevelt did on a large scale was begun or done first on a smaller scale by Hoover. Hoover was not sitting on his hands waiting for better times.

Hoover came off better in the book than I expected. Roosevelt came off badly, as expected, based on his economic policies and actions. What I didn’t expect to learn was that Roosevelt was rather petty and vindictive.

The Smoot-Hawley tariff, arguably Hoover’s biggest mistake (expected), came very early (1930) in the first year of his administration without a lot of thought given to it. Protectionism was apparently accepted Republican dogma at the time; so Hoover accepted it almost routinely. (He would try to improve it; not oppose it.)

Hoover’s “economic philosophy” was really an engineer’s view of the world where planning was useful and where problems can be fixed. He was willing to tamper with the machinery up to a point, but he respected the constitution, including the constitution of the gold standard, as limitations on government action.

Roosevelt, on the other hand, had no philosophy to speak of, he cared little about the constitution, and he broke the gold standard with his prolonged devaluation of the dollar. (I had known about the devaluation of the dollar, of course, but I had missed that it wasn’t an immediate thing. Instead, Roosevelt enjoyed setting the price of golf every morning from his bedroom. Different strokes for different folks.)

Roosevelt’s lack of a “North Star” to guide his way made him particularly vulnerable to being pulled in different directions by his staff and “brain trust.” During his administration, policy shifted back and forth between stimulus measures (job creating) and a desire to get back to fiscal rectitude by balancing the budget with large tax increases.

Large and untimely tax increases in the middle of the depression—probably not considered that way then—killed off an incipient recovery.

This should be a huge lesson for us today. Among other potential tax increases implied by various programs under consideration today, we have the pending reversal of the Bush tax-rate cuts looming next year. Could we possibly repeat that mistake?

As for other lessons, for now, I think Chairman Bernanke was very much influenced by this last factor and has resolved to avoid premature “fiscal rectitude.” He considers declaring victory prematurely a bigger danger than waiting too long.

He has already avoided the mistake of allowing the money supply to shrink and have deflation psychology take hold. His critics on that, however, are getting louder and louder, calling for an “end game” sooner rather than later.

One issue involving monetary policy is very much relevant for today: the excess reserves on banks’ (and the Fed’s) balance sheets. As in the 1930s, the banks have more reserves than the law or regulations require them to have—hence the term “excess” reserves. However, also as in the 1930s, banks have good reason to be cautious and remain even more liquid than the law requires. Attempts to “mop up” those excess reserves before they are used in ways that might contribute to inflation could have disastrous results. The fact that banks are holding them voluntarily is proof enough for me that they are “required” reserves in the minds of the bankers and that banks would try to restore them if they were removed by the Fed prematurely.

One final note:  I didn’t realize that our current mob-rule attitude toward successful people that has us cutting executive pay and hauling executives before congressional committees to be humiliated had a counterpart in the 1930s, but, apparently there is nothing new under the sun. Amity has an entire chapter on “Prosecutions” that amounted to political payback. It’s like our leaders are bent on taking the worst lessons from the past.

I had wondered whether Keynes had had much influence on administration policies during the depression since The General Theory came too late. Even though he had earlier influential books, I gather not. My favorite part of Amity’s book was when she describes a meeting that Keynes had with President Roosevelt on May 28, 1934, lasting fifty-eight minutes, about the time of a class-room lecture. Both Keynes and Roosevelt indicated that the meeting did not go well.

The President indicated that “Keynes had left him, disappointingly, with a ‘rigmarole of figures.’ He must be a mathematician rather than a political economist.”

Don’t you just love “rigmarole of figures?”

P.S. I worry that I have done Amity Shlaes, The Forgotten Man, a disservice by my inadequacy in describing it. Even if I haven’t conveyed its merits sufficiently, trust me, it’s great, and well worth your time.

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.

The U.S. commitment was to peg the dollar to gold at a rate of $35 per troy ounce by standing ready to buy or sell gold at that rate with foreign central banks or Treasuries. (That official rate was later changed to $42.22 when we devalued the dollar.) Other currencies were pegged to the dollar by exchange-market intervention while the dollar was pegged to gold the same way. Therefore, all currencies were indirectly tied to gold.

Under the “rules of the game,” a country’s policymakers were supposed to follow policies similar to what would happen automatically under a pure gold standard. If their currencies came under upward pressure, they should permit domestic economic expansion and/or inflation to correct the imbalance. Downward pressure on the domestic currency should prompt a policy tightening to correct the underlying imbalance while dollar reserves were used in the meantime to defend the peg.

Theoretically, the Bretton Woods arrangement was supposed to simulate a real gold standard where inflows or outflows of gold were allowed to raise or contract the domestic money supply. That was easier to do when domestic expansion was called for. Expansion is fun. It was less easy when contraction was called for. It was common for countries to “sterilize” the gold outflows and counteract their impact on the domestic economy.

In the early postwar period, and the early years of the Bretton Woods system, the world was starved for dollars and most countries gladly accumulated dollars in their reserves. This was a sweet deal for the United States because it meant we could buy real goods and services on world markets and pay with money unlikely to be redeemed in gold.

Over the years, however, the world accumulated as many dollar reserves as it needed and increasingly wanted to exchange some of them for gold, which they had the right to do. The United States, however, was not eager to lose gold; so it pressured its trading partners to continue holding dollars without demanding gold. “You don’t really want gold, do you?”

The dollars had been supplied to the world through deficits in the U.S. balance of payments and comparable surpluses by our trading partners. From our viewpoint, having the dollar used as the reserve currency was like playing poker with IOUs that the other players were willing to accept during the game and did not present for “redemption” after the game was over. (“There’s time enough for counting with the dealing’s done.” Kenny Rogers)

Eventually, the accumulated U.S. deficits had supplied more dollars than our trading partners wanted to hold. At the same time, U.S. policymakers did not want to follow the rules of the gold standard game and tighten policy to improve the balance of payments. So, President Nixon broke the last link between the dollar and gold in 1971 and we went on a system of floating exchange rates.

Under floating exchange rates, the exchange rate itself is supposed to trigger the internal economic adjustments necessary to restore and maintain equilibrium rather than changes in domestic policy. The rule of floating exchange rates is to let the market determine the exchange rate without policy interference. Let the float be clean. Policies to influence the exchange rate would dirty the float and would be considered inappropriate.

With no pegged exchange rate to defend, and with sporadic intervention considered inappropriate, there is no need for a reserve currency. Reserve currencies are a feature of fixed exchange rates, not floating rates.

Part of the angst over the potential loss of the reserve currency status of the dollar is really over the use of the dollar as a transactions currency in much of the world and in certain markets, particularly the oil market. There is now a long-standing tradition of pricing oil in dollars even if the United States is not a party to the trade. That means that a decline in the exchange value of the dollar makes oil effectively cheaper—good for buyers, bad for sellers. Of course, what has been happening is that oil sellers raise the nominal price of oil to offset the decline in the value cause by dollar depreciation. This peculiar relationship does not apply to most other commodities.

Pricing goods in dollars is a separate issue from the use of the dollar as a reserve currency.

Our reserve-currency equivalent is gold, which to my knowledge is setting in Ft Knox, on the books at $42.22 per ounce, the last official pegged price before the link was cut. And you thought all the gold was in a bank in the middle of Beverly Hills in somebody else’s name!

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.

One phrase in the piece scares me. He said

“. . . policy makers should continue to communicate as clearly as possible the guideposts, conditions and means by which extraordinary monetary accommodation will be unwound, including the removal of excess bank reserves.” [Emphasis added.]

As I’ve written here before, the treatment of “excess” bank reserves is fraught with danger, as the Fed’s experience in the Great Depression demonstrates. The reserves may be excess in the sense that they exceed the amount required by the Fed. However, they may not be excess in the minds of the bankers. Under the recent unusual circumstances, as with the Great Depression, bankers may think extra reserves are needed. If so, premature attempts to drain those reserves may lead to an unanticipated bank contraction. That happened during the Depression when the Fed raised reserve requirements to “mop up” excess reserves.

The Fed has a new tool—the payment of interest on reserves—that may help them navigate around the rocks, but it had better be sure that its view of those reserves is shared by their owners.

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."

The two main ways the Fed conducts monetary policy are to purchase and sell Treasury securities in the open market and to encourage or discourage discount lending to eligible institutions. Both these things add to or subtract from the Fed's total assets. But other purchases may also add to the Fed's total assets, such as building a new building or buying new computers. All expansion of assets may have monetary implications on the liabilities side of the Fed's balance sheet. The net effect of the other asset purchases on monetary liabilities are taken into account when the Fed conducts open market operations to deliberately affect bank reserves. For example, if it is buying lots of new main frame computers for the wire transfer or ACH systems, it would presumably buy fewer Treasury bills to achieve a given target expansion of bank reserves.

There is some justification, therefore, for looking at the sum of the assets on the Fed's balance sheet (which will equal the sum of its liabilities). The recent focus on the Fed's balance sheet, however, has been on total assets as if all the asset growth results in growth in bank reserves or the monetary base (reserves plus currency outstanding). There are nonmonetary liabilities on the Fed's balance sheet, however, that may rise or fall with the expansion or contraction of total assets without affecting monetary liabilities. To the extent that is the case, all the talk about the "doubling" of the Fed's balance sheet and how it has to be "unwound" exaggerates the problem and the difficulty of correcting the problem.

To put this in roughly textbook form, on the Fed's balance sheet, you have:

Total Assets = Monetary Liabilities + Other Liabilities,

Therefore:

Monetary Liabilities = Total Assets – Other Liabilities

Therefore in the Fed's H.4 release, assets are the factors supplying reserves and other liabilities are factors absorbing reserves. The difference represents the change in reserves. In other words, asset expansion may expand Fed liabilities other than bank reserves.

One easy example to illustrate the point that not all asset expansions are equally insidious, are central bank swaps, where we borrow foreign currencies and lend an equivalent amount of dollars to foreign central banks and agree to exchange back at the same rate some time in the future. Those transactions expand both the assets and the liabilities on The Fed's balance sheet without affecting monetary liabilities, and they can be reversed without affecting monetary liabilities.

In the future, when you hear extreme statements about the likely impact of the expansion of the Fed's balance sheet, check into its composition as well.

"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.

I'll spare you the T-Accounts and just summarize the conclusions: Government spending financed by taxes was not inflationary (or even expansionary) because the government's new spending was offset by a reduction in private spending. There would be little or no net change in total spending. That did not mean the alternatives of government versus private spending had no other consequences. Professor Waller greatly preferred people spending their own money rather than having the government doing it for them.

Government spending financed by bond sales to private individuals and companies had expansionary/inflationary consequences very similar to a balanced budget. The money the government got to spend was money the bond purchasers no longer had to spend. There was no net change in bank deposits, bank reserves, or the money supply.

Government spending financed by bond sales to commercial banks did increase bank deposits and the money supply and was presumably more expansionary. Commercial banks, however, used up excess reserves in buying the bonds that might have been used making other investments or loans. With the extreme assumption of no excess reserves prior to the deficit financing, the expansion of bank deposits and the money supply would likely be no greater than what would have happened anyway. The expansion in bank deposits that took place was a one-shot deal rather than the beginning of a multiple expansion process since bank reserves were not increased. So, financing government spending with bond sales to the banking system (under normal times with little or no excess reserves) may have been a little expansionary, but no more than would have likely happened anyway.

Government spending financed by bond sales (indirectly) to the Federal Reserve by having the Fed buying bonds in the open market at about the same time as the Treasury was issuing new debt was the most expansionary/inflationary financing method of all. That's because bank deposits initially increase by the amount of the Fed's purchases, but so do bank reserves. The reserve expansion creates sufficient excess reserves to permit the banking system to continue making loans and investments and creating deposit money in the process until the total money created reached a multiple of the purchases-that multiple being the inverse of the required reserve ratio.

In other words, if the Fed buys $10 million (in those days) of Treasury bills and the average marginal reserve requirement of banks was 10 percent, the total deposit expansion of the banking system could be $100 billion.

The previous example amounts, figuratively, to printing money. The Treasury has new money to spend that was not given up by the private sector. Everybody else still has the money they had and the Treasury has more. This is the most expansionary/inflationary method of finance of all. Note that I had the Fed buying the Treasury debt "indirectly" in the open market rather than directly from the Treasury because it is a process easy to abuse. The law restricts such direct purchases. Think "monetary incest."

Professor Waller insisted that an "A" answer to the question had to contain the essence of the above, but it must also contain the following point. Whether the method of financing government spending was expansionary or inflationary depends largely on the state of the economy. The closer the economy is to full employment of labor and other resources, the more likely the new spending with newly created money would cause inflation. An economy in a deep recession with high unemployment of labor and low capacity utilization might be able to produce more goods and services as a result of the new spending. To that extent it would be expansionary, not inflationary, or not as inflationary as it otherwise would be.

It seems to me that contemporary talking heads would do well to review some of these fundamental principles and include some of the important qualifications and caveats into their thinking. We rarely hear of the important role of the financing when we hear of the inflationary consequences of budget deficits. Professor Waller, we need you.

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.

On the other hand, if aggregate demand is sufficient for a reasonably full-employment economy, then a weak dollar is not needed for recovery and a strong dollar will raise our standard of living. It makes it cheaper to import goods and services from abroad and it keeps domestic producers' and potential exporters' feet to the fire to maintain competitiveness. I haven't heard the term in a long time, but it improves our terms of trade. That means we don't have to pay as much in exports for a given amount of imports.

The dollar is but one example of the confusion that arises if you aren't clear about whether you are in a "normal" classical world where efficiency and rising living standards are the issue or whether you have to adopt Keynesian thinking to get out of recession.  I never quite understood why, but Keynes was almost a dirty word among most of my professors. It just seemed to me that his General Theory  was special-case economics and it wasn't worth getting all worked up about. (Of course I kept that sentiment to myself on exams.)

It seems too simplistic, but I think the main problem was that Keynes's emphasis on making up shortfalls in private spending with government spending was interpreted as his being a "big government" man. So much emphasis on government spending seemed inconsistent with their belief in a free enterprise system. So, you were either for the government or for the market. They didn't buy the "special case" argument or the idea that you might have to deviate from the ideal a little to save it. That reluctance lives on today.