The Strong-Dollar Policy: Barking At the Moon

The Bush administration's "strong-dollar policy"—supposedly now abandoned, with alarming results—is one of the great recurring myths of modern economic punditry. There never was a "strong-dollar policy," whatever financial analysts may say, regardless of what Larry Summers or Robert Rubin or any of John Snow's other predecessors at the Treasury Department might have said. This is for the simple reason that, for most of the past 30 years, there has been no dollar policy of any kind. Financial markets certainly understand this, yet they go along with the pretense. In fact, they downright insist on it. However bogus the idea may be, the "strong-dollar policy" seems to meet a need.

To see why the administration cannot have a dollar policy, strong or otherwise, one must understand just one obvious point. To have a policy on the dollar, as opposed to an idle preference about what the dollar's value ought to be, you need an instrument—a lever of some kind that you can use to change that value. No doubt the Pentagon would like to be able to control the phases of the moon, but given present technology, nobody spends much time worrying about Donald Rumsfeld's policy on the duration of the lunar month.

True, there is a lever that governments can push to influence the value of the dollar—interest rates. In America, however, that lever belongs not to Treasury or to any other part of the administration but exclusively to the Federal Reserve.

Perhaps the administration can exercise influence over the Fed's interest-rate policy, and implement its dollar policy that way? No chance. The Fed's overriding responsibility is to steer demand so that output grows steadily, unemployment stays low, and prices stay broadly stable. The Fed's chairman, Alan Greenspan, takes that responsibility very seriously, as would anybody else in that job. That is how he will be judged, and he alone is accountable. If the Fed had more than one policy lever to push, it could aim to regulate demand and do other things as well. In fact, it has just one instrument—interest rates. Therefore, it can aim at only one target—demand. If Greenspan uses interest rates to guide demand, he cannot use them to guide the dollar.

The need to think straight about targets and instruments could hardly be clearer than it is right now. If the Fed wanted to drive up the dollar's value on foreign exchanges, its only way to do this would be to raise interest rates. But higher interest rates would make domestic demand even weaker than it is already, adding to the risk of mounting unemployment and outright deflation. Out of the question. So the Fed, which could in fact have a dollar policy if it wanted to, prefers to leave well enough alone. In contrast, it makes no difference what Treasury would like: The administration cannot have a dollar policy, whether it wants one or not.

Confusion arises partly because the formal position is different. When Greenspan or his officials are asked about the dollar, they usually decline to answer, saying that this is the Treasury Department's responsibility. That is easier and safer than trying to answer the question properly—and in one sense, it is also true. The overall currency regime is Treasury's business. International negotiations on currencies fall to Treasury, not to the Fed. Greenspan could not go out and agree with the European Union to fix the dollar's value against the euro, for instance. Any such pact would be for the administration to conclude (even though its result would be to cripple the Fed, which would no longer be able to use interest rates to stabilize the domestic economy). In this quasi-constitutional sense, Treasury is the senior partner on the dollar. Short of regime change of that kind, however, its supervision of the dollar is largely theoretical.

Strictly speaking, there is a further exception, though, again, it amounts to little in practice. Treasury can instruct the Fed to buy and sell currencies on the foreign exchanges in an effort to either push the dollar up (by selling euro or yen) or drive it down (by buying them). The Fed cannot act in this way on its own initiative. These intervention operations, as they are called, are sometimes done in concert with other finance ministries and central banks, once governments have agreed that currencies have moved far out of line, or if instability in the currency markets has become a big worry.

Currency intervention, you might think, provides the missing instrument of policy—a lever to control currencies without detaching interest rates from their main job of stabilizing the domestic economy. Moreover, intervention is a lever that Treasury controls. So perhaps the administration's strong-dollar policy meant something after all—a willingness to use intervention to keep the dollar's value up. When John Snow said last week that he was unconcerned about the dollar's decline over recent months, perhaps the currency markets took this as a sign that intervention to defend the dollar—which, let's suppose, they had begun to anticipate—was not about to happen. That would amount to a change in policy, would it not? And it would explain why the dollar fell further after the Treasury secretary's comments.

The logic may hold, but as a practical matter this reasoning is a heck of a stretch. To begin with, this was not the first time Snow has been invited to say he was worried by the dollar's fall, and refused. The same thing happened in March. Whether Treasury has a policy or nonpolicy on the dollar, its thinking has not suddenly changed. More important, the markets were not in fact expecting intervention to defend the dollar, for the good reason that the recent depreciation is fortuitously helping to buoy demand in the economy at a time when the scope for further cuts in interest rates is running out. On balance, and as long as it does not get out of hand, the dollar's fall is a good thing for the United States.

Anyway, the record of intervention in the currency markets is mixed, at best. The resources available to central banks for such operations are puny compared with typical flows of capital across today's financial markets. Many economists would argue that currency intervention has never worked, unless it was undertaken as part of a more comprehensive shift in monetary policy. Until economic activity picks up, no such shift is in the cards.

Given all this, the financial analysts who were so dismayed and censorious about Snow's lack of concern over the dollar would have been far more upset if the Treasury secretary had said the opposite. Suppose Snow had said he was shocked and alarmed by the dollar's slide and was urgently investigating ways to reverse it. Analysts would have been quick to accuse the administration of panic; of scaring the markets needlessly; of preparing to resort to measures which usually fail, and which were especially likely to fail in present circumstances. They would have deemed those measures unnecessary or undesirable in the first place, pointing out that if intervention had by some slim chance succeeded in shoring up the dollar, the Fed would soon have had to put things back as they were before, by reducing interest rates. And all of this would have been true.

What then is a poor, helpless Treasury secretary to say in these circumstances? The plain truth—which is that this administration, like the Clinton administration, has no policy on the dollar, and is right to have no policy on the dollar—appears to be unsayable. Paul O'Neill came as close as anybody to saying it, and see what happened to him. Politics requires the Treasury secretary to pretend to have a dollar policy. Not having one is just too undignified. And the markets require it as well. Foreign-exchange analysts are paid to read between the lines of the administration's statements, work out what the dollar policy is, and opine on whether it is good or bad. If they were ever to acknowledge that there was no policy, nor could there be, they would have no material.

Treasury's nonpolicy on the dollar is fine. Its nonpolicy on the long-term budget deficit is not. If you want to criticize a nonpolicy, let that be the one.

The tax cuts that the White House regards this week as a political success are bad economics. Not because it is wrong to cut taxes: Taxes, including taxes on dividends, should certainly be cut when spending plans and the long-term fiscal balance allow. Unfortunately, they do not allow, because this is a spendthrift administration. Just as stable prices are the Fed's chief responsibility, balancing the budget over the long term is Treasury's. On this core responsibility, Snow seems ready, if not proud, to fail.