- The Washington Times - Monday, December 6, 2004

The dollar has fallen about 35 percent against the euro over the last three years. What in practical terms does the fall mean, how important is it, and what should be done?

Three years ago, the typical American worker had to work about 15 minutes to earn enough after taxes to buy a “Big Mac Meal” in either the U.S. or Italy, while the typical Italian worker had to work approximately 25 minutes to buy the identical “Big Mac Meal” in either country. Today, the American worker still has to work about 15 minutes to buy that same “Big Mac Meal” in the U.S., but if he travels to Italy, it will cost him about 25 minutes of U.S. work time to buy the same meal. Likewise, an Italian worker will still have to work 25 minutes to buy the “Big Mac Meal” in Italy, but if he travels to the U.S., it may only cost him 15 Italian work minutes. (Note, Italy uses the euro as its currency.)

If you say the above makes no sense, you are correct. Nothing has happened in the relative economic performance of the Italian and American economies in the last three years to justify such a swing in purchasing power. Relative productivity and domestic prices are still roughly the same in the two countries, so why the big change in exchange rates? Before answering, I shall first explain what has not caused the rate change.

You may have read the U.S. budget deficit has caused the big shift in exchange rates. However, the U.S. budget deficit is rapidly falling and is likely to be lower (as a percent of GDP) than that of Italy, France or Germany in the next year or so. The U.S. economy is growing more rapidly than the major European economies, and the fiscal outlook for the costly European welfare states with their stagnant or declining populations is far bleaker than that for the U.S. Over the long run, the dollar seems a much safer bet than the euro.

Others argue the U.S. trade deficit is causing the dollar’s fall. Actually, that argument is backward. It is the foreign demand for U.S. dollars that largely causes the trade deficit. Foreign governments want dollars to back their own currencies. At the same time, foreign companies and individuals want dollars to invest in the United States because U.S. rates of return have generally been higher than many other places in the world, such as Japan and Europe, over the last couple of decades, and the United States is viewed as a “safe haven.”

Foreigners obtain dollars by selling goods and services in the U.S., which requires them to offer a better price and quality combination than U.S. suppliers. This causes our trade deficit.

The central banks of many countries, most notably Japan and China, hold huge quantities (approximately $1 trillion) of U.S. government securities as their own reserves. In recent months, many governments have slowed their purchases of U.S. government securities and bought more euros as a way of building a more balanced portfolio. However, Japan, China and the others are in a trap because, if they slow too much or even become net sellers of U.S. dollars (in the form of U.S. government securities), this will decrease the value of their enormous portfolio of U.S. securities.

The huge swings in currency values increase risk and hence reduce investment and, in turn, hurt global economic growth. Firms active in more than one country can see sharp changes both in costs and profits, much of it beyond their control.

The problem is that central banks, like the U.S. Fed, are charged with maintaining price stability (in their own countries). But without a common point of reference, which the gold standard once provided, it is hard to determine “price stability.” Computers and high-tech equipment tend to fall in (relative) price because of technological and productivity gains. Oil prices can fluctuate rapidly because of unexpected supply-and-demand changes. The price of a house is less relevant to buyers than the mortgage cost, a function of interest rates.

A currency is supposed to provide a benchmark to determine the relative value of goods and services. So long as the major central banks use different and elastic benchmarks, the world will suffer from exchange rate instability. Neither Alan Greenspan, nor the leaders of the European Central Bank or the Bank of Japan (and even yours truly) know how to properly define money or determine how much should be supplied.

What is to be done? The great and Nobel Prize-winning economist F.A. Hayek provided the answer for us more than 30 years ago: Governments should give up their monopoly over money. If the market could operate freely, private parties would compete to provide the “best” money. Ultimately, we might end up with a global commodity basket standard, a gold standard or some other measure that best provides the functions of money.

Governments would still need to define the appropriate measure for tax and government payments, but private parties could contract in whatever “money” they wished to for all goods and services, including labor. For private monies to compete effectively, all capital gains’ taxes would need be eliminated from currency transactions. Short of this reform, destructive exchange rate swings probably will continue to plague the world.

Richard W. Rahn is a senior fellow of the Discovery Institute and an adjunct scholar of the Cato Institute.

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