Policymakers would do well to keep in mind a couple of universal truths when preparing to embark upon fundamental changes to long-standing programs and entrenched policies, such as creating personal retirement accounts and simplifying the federal tax code. One such truth is: What we don't know usually doesn't harm us nearly as much as what we think we know that isn't true.
Nowhere is this more evident than where debt, deficits and the dollar are concerned.
An entire belief structure, completely at odds with empirical evidence, has arisen about how debt, deficits and the value of the dollar affect the economy. The belief structure, which prescribes high taxes and floating currencies, was concocted by neo-Keynesian economists and popularized by pundits, politicians and Wall Street participants who scavenge academic scribbling in search of theological support for their own financial interests or political ideologies.
This economic belief structure about debt, deficits and the dollar - call it "3-D economics" - is grounded in two illusions: First, it believes a currency is just another commodity, and its value is set by foreign exchange markets according to the forces of supply and demand. As a Wall Street Journal editorial recently pointed out, however, "A currency isn't just another commodity, like wheat or copper." The dollar is a measure of value not intrinsically valuable itself.
The dollar is a unit of measure - a numeraire - and the currency, when calibrated against this unit of measure, provides a store of value. Foreign exchange markets merely reflect the changes in demand for a currency, the supply of which is established by central banks, in our case the Fed, which has monopoly power over the issuance of fiat U.S. dollars.
Shrinking demand for the dollar manifested in a falling foreign-exchange rate can be one indirect signal that the central bank is running too loose a monetary policy, generating inflation and depreciating the dollar's value. However, since the Fed has this monopoly power over the issuance of our fiat currency, only the Fed can alter the supply of dollars and ultimately the dollar's value. It is impossible for government to correct the monetary error or rectify the declining economic competitiveness emanating from the error by manipulating foreign exchange markets (whether by word or deed), by raising taxes or by any other fiscal policy.