The dollar

Posted: Dec 06, 2003 12:00 AM

One of the reasons why administrations fail is that they often fall victim to the law of unintended consequences. The Bush administration discovered this when it imposed tariffs on imported steel last year in order to help steel producers. What it forgot is that there are far more people working in steel-using industries than for producers. Steel users were harmed by the tariffs because their costs increased, leading to reduced sales and employment. After 18 months, the administration finally figured this out and eliminated the tariffs it should never have imposed in the first place.

Unfortunately, the Bush administration is in danger of making the same mistake with respect to the dollar. Having become obsessed with the trade deficit, it is looking for other ways to reduce imports and raise exports. One way of doing this is to reduce the value of the dollar on foreign exchange markets. A lower dollar makes imports more expensive and exports cheaper in terms of foreign currencies. When this happens naturally, economists view it as part of the free market's automatic adjustment mechanism for trade imbalances.

The problem is that this process is not taking place on its own, nor is it costless. The Treasury Department has been signaling for some time that it would not be displeased if the dollar fell. This sort of "benign neglect" can be as effective as direct action in foreign currency markets, such as having the Treasury sell dollars. When currency traders know that we won't defend our currency, they take advantage of it by selling dollars against other currencies. That is a key reason why the dollar has fallen sharply against the euro and is now at a record low.

Another effect of this weak dollar policy became evident in recent days when the OPEC oil cartel indicated that it might raise prices to compensate for the falling dollar. It has always priced oil in dollars, so a fall in the dollar means that its members have to pay more for goods and services purchased in Europe, Japan and elsewhere. Ali Naimi, the oil minister of Saudi Arabia, complained on Thursday that the dollar had fallen 35 percent in the last three years. He said OPEC would price oil to maintain "the purchasing power of the old, good dollar."

This is all very reminiscent of the early 1970s, when OPEC first raised the price of oil in response to a falling dollar. As early as 1970, it passed a resolution at its annual conference saying that it would adjust the price of oil to reflect changes in real purchasing power. The following year, it passed a resolution complaining about "worldwide inflation and the ever widening gap existing between the prices of capital and manufactured goods ... and those of petroleum." In other words, the prices of things that OPEC countries imported were rising faster than the oil that they exported.

By 1973, OPEC had had enough with U.S. inflation, and it moved to sharply raise the price of oil. Although the war between Israel and Egypt precipitated the price rise, it couldn't have been sustained unless supported by fundamental economic forces. These same forces also pushed up prices for gold and other commodities. Basically, the 1973 OPEC oil price increase just kept the price of oil in line with other commodities. It was more jarring only because of the circumstances in which it occurred and because it happened all at once.

Nevertheless, there are those who still believe that OPEC caused the inflation of the 1970s, through some sort of "cost-push" mechanism. In truth, OPEC was responding to inflation, rather than causing it. The root cause was the creation of too many dollars by the Federal Reserve. This came about because Presidents Lyndon Johnson and Richard Nixon cajoled the Fed into running an inflationary monetary policy in order to keep interest rates artificially low. They also removed many of the institutional constraints that prevented previous presidents from doing the same thing.

In short, the Fed, not OPEC, caused the stagflation of the 1970s. A recent paper by University of Michigan economists Robert Barsky and Lutz Kilian confirms this analysis. Writing in the prestigious NBER Macroeconomics Annual (2001), they conclude, "The Great Stagflation of the 1970s could have been avoided had the Fed not permitted major monetary expansions in the early 1970s. ... The stagflation observed in the 1970s is unlikely to have been caused by supply disturbances such as oil shocks."

Although the signs are nascent, indications are that inflation is starting to show its ugly head again, the result of an extremely easy Fed policy over the last three years. Sensitive commodity prices like gold are up, the dollar is down, and OPEC is again complaining about lost purchasing power. It's like deja vu all over again.