The Strong Dollar Bench Presses the Party Line

By Justin Fox

On those awkward occasions when he is asked about his nation's currency, President George W. Bush has a simple response. "We believe in a strong-dollar policy," he'll say--or words to that effect. For his Treasury Secretary, Hank Paulson, the mantra is, "A strong dollar is in our nation's interest."

The dollar hasn't been paying much attention, apparently. It has lost 41% of its value against the euro, its main global competitor, since Bush took office in 2001. And Paulson, when he's not busy battling financial crises here, can usually be found in China beseeching the authorities there to let their currency rise against the dollar.

It should be pretty obvious, then, that the U.S. doesn't have a strong-dollar policy. What's more, it almost certainly shouldn't have one. The huge trade deficits that the country has been running for the past decade seem like a pretty good indication that the dollar was overvalued in global currency markets and needed to come down.

So why do Bush and Paulson keep saying they're in favor of a strong dollar? Well, the last time a top U.S. official tried to talk halfway honestly about what kind of currency we wanted--then Treasury Secretary Paul O'Neill in 2001--he spooked markets and was criticized mercilessly for it.

The strong-dollar mantra was originated by O'Neill predecessor Robert Rubin in the mid-1990s precisely to avoid such confusion. "It was boring, it was dull, it was repetitive, it was nonintellectual, and it worked like a charm," is how Alan Greenspan once described it when he was Fed chairman. "By not varying the statement, an issue never arose about whether a comment involved a subtle change or not in the policy toward the dollar."

And there hasn't really been a significant change in dollar policy post-Rubin. In the 1970s and '80s, the Treasury Department was constantly buying or selling foreign currencies to push the dollar this way or that. Since 1995, when Rubin took office, Treasury has made only a couple of token moves and since 2000 hasn't intervened at all. World currency markets are so huge and active, the thinking goes, that trying to manipulate the dollar is largely futile.

Which brings us back to a basic question: How strong a dollar do we actually want? Over time, a currency's value reflects an economy's fundamentals--how well a country allocates resources, how productive its workers are, how it contains inflation, etc. So in that sense, a strong currency is reflective of a strong economy. It's something any country would want.

But for years on end, currencies can move in directions that seem to have little to do with fundamentals. They overshoot their correct values, in part because nobody is ever sure exactly what those correct values are. In this medium-term cycle, it's just as bad to have an overvalued currency as an undervalued one. Worse, actually, because it means a fall is inevitable.

When your currency is in the declining part of the cycle, as the dollar has been since 2002, that puts upward pressure on inflation, spooks investors and generally leaves people feeling cranky. It eventually gives an important boost to the economy by stimulating exports, but that takes years. During an upswing, by contrast, everything feels good. But it's the downswing that makes the upswing possible.

The difficulty is that it's hard to distinguish a cyclical downswing that's clearing the way for good times ahead from the wheezing of a currency and a nation in decline. Pessimists look at the budget deficits being run by the Bush Administration and the easy-money policies of the Federal Reserve and see a dollar that will never recover, leaving Americans permanently poorer.

Economists who study currency movements aren't so sure. They figure the usual cyclical ups and downs are a big factor in the dollar's fall. How much of a factor? Who knows? "I try not to talk to reporters too much these days," says Menzie Chinn, a University of Wisconsin economist who is one of the nation's leading academic currency watchers. "Because, frankly, I'm confused."

So what should U.S. dollar policy be? Probably something along the lines of "We'd like it if the dollar got a bit cheaper, especially against the Chinese yuan and a few other Asian currencies, but then stopped falling." Can you blame the President for not wanting to say that at his next press conference?

Dollar Wise To read Justin Fox's daily take on business and the economy, go to time.com/curiouscapitalist