|The Economic Times
Friday, June 14, 2002
Leave the dollar alone
IT is always risky to write about exchange rates. If a currency's exchange
rate is falling, it may well be rising by the time one's article appears.
But the issue of how we should think about exchange rates and their
appropriate management is a perennial one. So what is at issue now is not
just the falling dollar, but rather what US officials intend to do about it.
Paul O'Neill, the outspoken US treasury secretary, suggests that there is
little the US could or would do to sustain the dollar.
His remarks were criticised by some as abandoning the strong dollar policy
that was the Clinton Administration's hallmark. One responsibility of
economic leadership is to dispel economic myths - certainly not to create
The "strong dollar" policy represents an especially egregious example of an
economic myth; it seems to suggest that the US treasury could, and would,
maintain the strong dollar, and that a strong dollar is good for the US.
When I was chairman of the President's council of economic advisers, I was
often asked if I supported the strong dollar policy. I replied that I
believed in an "equilibrium dollar." In other words, exchange rates are no
different from other prices.
Like the price of apples and oranges, market forces should determine them.
Anyone who says he believes in a "strong orange policy" would be ridiculed.
Yet some of those who seem to have the greatest faith in market forces treat
exchange rates as if they were governed by laws other than those of standard
economics, so that a word or even a look from a finance minister could lead
currencies to soar or plummet. Of course, there is considerable
irrationality in currency markets.
Keynes once described asset markets as beauty contests, in which the
objective is not to ascertain who is the most beautiful person, but whom
others will think is the most beautiful.
The objective in currency markets is, indeed, often to guess what others
will be thinking. But even if government intervention can affect exchange
rates in the short run, in the longer run, it is market fundamentals that
There may be a legitimate role for government in limiting excessive
volatility, but if underlying economic fundamentals do not drive the
exchange rate, what is the basis of our confidence in the market system?
Belief in misguided notions inevitably leads to further nonsense. On one
occasion, a reporter queried the US treasury on the adverse effects of the
strong dollar on exports (at the time, car sales and other exports were
The response was that the strong dollar meant a strong economy, and a strong
economy strengthens the ability to export. But of course, even the US
treasury, as powerful as it may be, cannot repeal the laws of economics.
Demand curves are downward sloping: typically, at higher prices, others will
demand less of Americana goods, and a strong dollar means that American
goods are more expensive.
Perhaps the most important objection to the strong dollar policy is that it
encourages precisely this confusion between a strong dollar and a strong
We should no more be emotionally attached to the exchange rate than to any
other price. A stronger exchange rate discourages exports, and when an
economy is facing rising unemployment, it can make a bad situation worse.
On the other hand, a higher exchange rate may also lead to lower inflation,
as import prices fall. When inflation is the primary concern, a strong
exchange rate may be good for the economy.
The strong dollar policy reeks of an economic nationalism that is out of
step with the era of globalisation. If the dollar is strong, then the euro
or the yen is weak. But how are political and economic leaders in other
countries to respond?
Should they simply agree to the strong dollar policy, even though it implies
a weak yen or euro policy?
What is required is a debate with the US, for the strong dollar has led to
an anomalous situation: the world's richest country seems unable to live
within its means and must continually borrow hundreds of billions of dollars
from abroad to finance its huge trade deficits.
The strong dollar - far more than Japanese protectionism - fuelled the
bilateral deficit with Japan. It also contributed to protectionism at home,
reflected in the new US steel tariffs.
It is high time that the nonsense of the strong dollar policy be laid to
rest. Paul O'Neill should be commended for helping in this effort.
Perhaps we can now begin to think more seriously about creating an
international economic system that acknowledges the devastating effects that
market volatility among major currencies has on less developed countries,
and that ensures greater stability.
For too long, we have blamed the victims. That has merely permitted us to
avoid taking a hard look at the system itself.
(The author is professor of economics and finance at Columbia University,
the winner of the 2001 Nobel Prize in Economics. Copyright: Project
Syndicate, June 2002)
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