The Bear’s Lair: Tumbril time for King Dollar

Larry Kudlow, the President’s new chairman of the National Economic Council, is a well known proponent of the idea of “King Dollar.” That concept states, basically, that the U.S. should aim for a strong dollar, even though it produces large trade deficits, because it allows the country to buy more foreign goods and services and increases its importance in the world economy. This is precisely the reverse of the optimal policy, given the world we live in.

In a properly run Gold Standard economy, a country can indicate its economic strength and willingness to act as a global leader by joining the Gold Standard. That’s what Britain did from 1819 to 1914, benefiting greatly from the move, at least until the last few decades of that period, when its manufacturing economy was hollowed out by its policy of unilateral free trade.

The United States, however did not initially join the Gold Standard. Before the discovery of gold in California in 1849, the country had an acute shortage of hard currency, so ran its economy on the basis of innumerable issues of dodgy bank notes, causing a huge national depression when President Jackson de-chartered the Second Bank of the United Sates, leaving nothing but mostly worthless local bank paper as currency. Then the 1850s supplied the United States with adequate gold, but the Civil War caused an immense surge in government spending, that led to yet further issues of paper, this time by the Federal government (the “greenbacks”). Only in 1879 did the United States join the Gold Standard, on which, unlike Britain, it remained through World War I, until 1933.

Under a Gold Standard, trade and investment flows are to a large extent self-correcting. If a country runs a trade deficit, gold flows out of the country, and can only be brought back by a period of higher interest rates, which causes foreign gold holdings to flow back into the system. These higher rates also cause a reduction in domestic consumption, reducing the level of imports and closing the trade deficit. In the very long term, a country on the Gold Standard can find itself becoming uncompetitive, as Britain did in the decades before 1914, but even in this case, Britain’s huge base of foreign investments meant that it was decades away from having to abandon the Gold Standard, had World War I not intervened.

Alas, we are no longer on the Gold Standard, we live in a fiat-money world. In such a world, there is no automatic mechanism like a gold outflow to correct trade imbalances. When trade is imbalanced, paper, whether in the form of government bonds or simply banknotes, or IOUs from the banking system, simply flows out to cover the shortfall. Since more paper can always be printed, there is no correcting mechanism, and the deficit can carry on ad infinitum until foreigners will no longer take the country’s paper. That becomes the correcting mechanism, but it is a very slow one, and very cruel when it kicks in, producing a situation like Argentina in 2001-02.

That’s what is wrong with a King Dollar policy. With a strong dollar, the deficit is maximized, so foreigners have to take ever more astronomical quantities of worthless U.S. paper. If the government then runs gigantic deficits, foreigners buy Treasuries. But with a strong dollar, they have to buy more Treasuries to balance the payments. This accelerates the moment at which they will no longer do so, at which point the whole house comes crashing down.

King Dollar has other disadvantages. It makes U.S. exports internationally un-competitive, so factories close down all across the country, as production is outsourced to cheaper-labor countries in the Third World. This in turn deprives the working classes of decent factory jobs, artificially lowering their living standards and sending more of them spiraling into depression, addiction and crime. The social costs of King Dollar are gigantic, even in the short term; they are far greater than any benefit to the middle classes from cheap imports, or to the plutocracy from importing millions of undocumented immigrants (who are attracted by wage rates that are astronomical in peso, rupee or yuan terms) to drive down the cost of their domestic services.

The long-term future of a King Dollar policy is inevitable disaster. The country’s exporting industries atrophy, while its overseas liabilities pile to ever more astronomical levels. At some point, international investors refuse to take any more dollar assets, and a gigantic crash occurs. This will generally happen suddenly, without any warning, as the housing crash did in 2006-08 or the Argentine collapse of 2001. It will also cause huge extra liabilities to be imposed on taxpayers, as the financial system collapses yet again. Without a Gold Standard, a King Dollar policy runs the economic engine of the country without a safety valve; the inevitable end result is a gigantic explosion.

There is an alternative – to allow the dollar to sink, indeed encouraging it to do so, while raising short-term interest rates to counter the inflation that a sinking dollar will bring. If the dollar is allowed to sink far enough, exports will increase, illegal immigration will decline (because subsistence-level dollar wages no longer look so generous in pesos or kwacha) and genuine manufacturing jobs will be re-created in America’s heartland. The United States, a country with a relatively flexible and competitive economic system (except for all the lawyers) will find its natural level as a high-wage economy without excessive costs.

Since a declining dollar will, possibly after a modest lag, also produce a declining balance of payments deficit, the need for massive inflows from foreign investors will decline. What’s more, the inflows themselves will decline, because the foreign investors will no longer want to hold a declining dollar asset. This will push interest rates up further, closer to a market determined level, which will reduce the amount of misguided investment in the U.S. corporate, tech and real estate sectors. The huge long-term actuarial liabilities in social security and Medicare will also decline, because higher rates will make pension schemes better funded and a lower dollar will reduce the real value of these astronomical burdens on our future. With no hordes of foreigners clamoring to take its paper, government will have to straighten up and fly right.

A weak dollar produces higher employment, a declining payments imbalance, a decline in the need for foreign funding and increased competitiveness for U.S. exports. What on earth is there not to like? Admittedly foreign competitors growl at you about “competitive devaluation” but since there are no sanctions available to them, it is surely better in that competition to be the growled-at rather than the growler.

In the case of the United States, those growling about “competitive devaluation” would not have an intellectual leg to stand on. Germany, for example, runs a perpetual balance of payments surplus while trapping its economy in the euro, which given the uselessness of most euro members’ economies means Germany has a perpetually undervalued currency. However, the U.S. runs a perpetual balance of payments deficit, and would still do so under a weaker dollar, unless the devaluation was 30% or so. That means those complaining about competitive devaluation would still have the difficulty of explaining away that deficit. There is no “competitive devaluation” in a country seeking to return its payments to balance and reduce the endless build-up of foreign liabilities.

Presidents and National Economic Council chairmen who want to brag about the strength of their currencies should put their countries back on the Gold Standard. That way, their currencies will be “good as gold” and they will also have a self-correcting mechanism for ensuring that their fiscal and other economic policies are sound enough to keep them there. Merely engaging in macho posturing about their strength brings no self-correcting mechanism. Only if they are incredibly disciplined will they run a budget surplus and a sound monetary policy, with high real interest rates, that will play the role of the Gold Standard’s self-correcting mechanism.

I am a fan of the current administration, I really am. But “incredibly disciplined” is not how I would describe it.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)