To borrow a phrase from Larry Kudlow, “King Dollar” must be a cornerstone of U.S. economic policy. That said, let’s keep in mind what the government should or should not be doing when it comes to the economy. Its first duty is to do no harm, which means staying out of our business even when it is folly. Failure is an option, as far as the government should be concerned, when it comes to our private dealings. But that does not mean it has no role to play in the economy. That role is fundamental albeit limited.
The government must establish the rule of law that makes the free market possible. That means enforcing contracts and prosecuting fraud. This can also include basic regulations that facilitate market efficiency like standard measures and transparency in financial transactions. There is also a place for public works such as highways and ports, but only if their private construction is impractical and their benefits significantly outweigh their costs. Finally, the government must ensure the integrity of the free market’s primary medium of exchange – i.e., our currency.
A “King Dollar” policy concerns this last role of the government.
To best understand what the government should or should not do when comes to the measure of the dollar, we first need to define inflation (and by extension its counterpart, deflation). Inflation is frequently, and not very usefully, defined as a general increase in prices. However, there is an important difference between prices increasing because demand is greater than supply and because a dollar measures a smaller amount of wealth and so more dollars are now needed to buy the same goods. Think of it this way. One day you are six-foot tall. A little while later you are six-foot-six tall. If the government changed the measure of a foot from twelve inches to eleven inches, you are in fact no taller even though more feet are needed to measure your height. In other words the government inflated the foot. Your change in height is not real; it is an artifact of manipulating the measure of height. The same with prices that are higher because the government inflated the dollar. The change in prices is not real, but so what?
Two serious problems arise out of the dollar’s dual functions as a medium of exchange and a store of wealth. Regarding the dollar as a medium of exchange, the market will initially respond as though the change is real and react as though demand is outstripping supply. This causes people to make bad decisions about what to buy and sell, how to adjust costs, and where to invest. These decisions further distort the market and waste capital in fruitless endeavors. For example, if the price of corn rises because of inflation and a farmer takes this to be a consequence of increased demand, he diverts his capital to growing corn. But then he discovers that there is no new demand. Instead he has only added to the supply, driving the price of corn down while his costs have been driven up by inflation. He suffers a loss.
Regarding the dollar as a store of wealth, inflation is a thief. A hundred dollars saved is withdrawn as a hundred inflated dollars and cheats the saver. A thousand dollars lent is paid back with a thousand inflated dollars and cheats the lender. A million dollars invested is returned as a million inflated dollars and cheats the investor. While it is true that if the saver, lender, and investor are aware of inflation, they can demand interest that compensates them for their losses to inflation. But this is much easier said than done, because inflation is insidious, and it is matter of guesswork, even for the most sophisticated, what the effects inflation on the measure of the dollar will be. Plus we need to keep in mind that it is also unjust to those who must repay the saver, lender, and investor if the rate of interest is excessive because inflation isn’t as severe as anticipated (or even worse, turns into deflation). Neither the borrower nor the lender is entitled to a windfall from the government’s manipulation of the measure of the dollar.
This is why a “King Dollar” policy must be a cornerstone of our economic policy. The dollar’s integrity as a constant measure of wealth is matter of justice in the marketplace, which in turn allows us to put more confidence in our transaction, especially long-term ones. Furthermore, King Dollar does not pervert the market into pouring money into ratholes. A current example of this has been the loose money policy of the Federal Reserve during the first part of the Bush Administration which, combined with the Clinton Administration’s pressure on banks to make home loans to marginal borrowers, led us to this month’s financial panic. With the Bush Administration’s blessing, the Fed fixed interest rates at an artificially low rate to goose the economy. The taxpayer-backed home loan giants Fannie Mae and Freddie Mac exploited their access to this cheap money to make a market for subprime home loans. The banks, under pressure from the Clinton-era Community Reinvestment Act, to make more and more of these loans went through the door Fannie and Freddie opened for them (and kept open as congressional Democrats squelched any attempts to end this dangerous practice).
But at the end of the day, the piper must be paid. The dollar inflated by the Fed’s loose money policy weakened around the world. Commodity prices climbed, the economy stumbled, and the Fed went rapidly into reverse to jack up interest rates. At the same time the government-fueled boom in home-buying stalled, and the economy stumbled again. Foreclosures rose, the value of mortgage-backed securities fell, reducing the capital reserves of lenders, and so restricting the credit they could extend to businesses and consumers. The economy stumbled even further. The financial markets panicked, drove down the value of mortgage-backed securities to fire sale levels, and wrecked the weakest of the country’s large financial institutions. Now the taxpayers are called upon to cough up one trillion dollars (don’t forget the Fannie and Freddie bail-out on top of the $700 billion that Bush and congressional Democrats are demanding for the private sector) to bring sanity back to the markets. And where do you think that money will come from? Out of nowhere from the government’s power to print as much fiat currency as it wants. In other words, more inflation.
A “King Dollar” policy will not prevent our follies as private buyers and sellers in the free market. Because of our human – and so fallen – nature, greed, fear, and ignorance will from time to time puff up markets with euphoria and bring them crashing down with panic until the end of times. But those who lose from such folly will mostly be limited to those who made bad decisions about what to buy and sell. The harm will be contained, and the steady, the prudent, and the wise will carry on with little disruption. However, a “King Dollar” policy would have prevented today’s crisis in the financial markets. The Fed would have focused on keeping the dollar, as a measure of wealth, constant instead of manipulating that measure to fix interest rates. It would have also stymied the artificial demand for new homes resulting from the forced creation of new dollars for home loans by the Community Reinvestment Act (magnified by the recklessness of Fannie and Freddie unconstrained by the discipline of market because they were backed by the taxpayers – implicitly perhaps, but everyone correctly assumed it).
There remains the important question of how the government maintains King Dollar. Gold bugs will say we need to fix the dollar to gold. Others say to a basket of commodities. The problem with these proposals is that they amount to price-fixing, which puts the measure of the dollar at the mercy of changes in supply and demand. The gold bugs usually overlook the severe inflation and deflation that the U.S. economy suffered while on the gold standard as the supply and demand for the yellow metal fluctuated. The national banking system that preceded the creation of the Federal Reserve in 1913 did a lot to ameliorate the problem with the gold standard by allowing the market’s demand for credit guide the creation of new dollars. The Fed was a nationalization of this system, which has caused us nothing but woes in the 1920-1921 depression, the Great Depression, the Great Inflation of the 1970’s, and now the current financial panic. Nevertheless, a president does have the clout to keep the Fed from engaging in policies that working against King Dollar. Even if we don’t have the best way to maintain King Dollar right now, we can get pretty close with the existing machinery of government.