classical economics
for analysis,  forecasting
and policy design

Downside of Mercantilism

By Wayne Jett
© December 10, 2007

    We who relate to the economic world through the classical model of theory sometimes fail to realize just how badly irrational Keynesian theoreticians have become. True, Keynesians dominate academia and the media, so how can we be unaware of their views? Classical economic theory is so self-contained and reliable for analytical and forecasting purposes that Keynesian views are not beneficial, so they can be ignored.
    Nevertheless, when Cambridge economist John Maynard Keynes in 1936 created a theoretical model to advance mercantilism, big government and its mercantilist allies in the financial world and academia grabbed the ball and ran with it. Keynesian analysis and rhetoric are now so dominant they require examination for grounding in where public policy is heading. The dollar’s value has fallen steeply since mid-2005 despite repeated assurances from the Fed and Treasury that U. S. policy favors a “strong dollar.” Thus, the question arises: are the Fed and Treasury prevaricating or failing?
    For a clue to the answer, consider Keynesian commentary published in Taipei Times authored by respected professor of economics at the University of California (Berkeley), J. Bradford DeLong. His commentary begins with this title and sub-title: “IS THE DOLLAR LEADING US INTO A DEPRESSION? A fallen greenback could mean economic turmoil, or … economic crisis. Economists are having trouble predicting the outcome because investors are not behaving rationally.” Psst, professor, your slip in respect for free markets is showing.
Those Pesky, Irrational Investors
    At the outset, professor DeLong would benefit by honoring, as all economists should, the first rule of poker players: when all others at the table are acting irrationally, re-check your hole card. The fault may lie not in our investors, but in our economists.    
    DeLong observes that the falling dollar is causing “profound global macro-economic distress,” putting the world economy at risk. He posits that, if investors expect the dollar’s fall to continue, they will flee the currency, causing interest rates to soar and recession to follow. On the other hand, he reasons, if investors think the dollar will fall no more or even rise, interest rates can remain low and economic growth relatively robust. DeLong says so far there are “no signs” other than market volatility that investors think the dollar will continue to fall, and opines that this may be “wishful thinking” because the “… still-large current account deficit guarantees that the dollar will continue to fall.” (Emphasis added.) He shakes his head that he and fellow economists cannot understand why “typical investor[s] … have not taken steps to protect themselves … against the very likely US dollar decline in our future.”
    Funny thing, though. On May 1, 2007, Fed chairman Ben S. Bernanke, in a speech enunciating the close relationship between open international trade and prosperity, said “the existence of a trade deficit or surplus, by itself, does not have any evident effect on the level of employment.” Bernanke emphasized that “… willingness to trade freely with the world is indeed an essential source of our prosperity.” These observations are at odds with DeLong’s view that the U. S. current account deficit guarantees the dollar’s continued fall and economic crisis. Current account deficits coexist with prosperity for long periods, portending calamity only in Keynesian theory.
The Problem Is Bad Policy
    DeLong’s comments illustrate Keynesians’ approach to economic crises produced by their own policy. He observes the crisis and ponders why private parties fail to protect themselves from inevitable collapse.
    Why not step back and examine the doctrine that produces dollar devaluation and a potentially cataclysmic outcome, rather than summarily dooming the public to live (or die) with that outcome? A continuously deteriorating dollar is not an inevitable result of the U. S. current account deficit, any more than was the overly strong dollar produced by the Federal Reserve during 1997-2002.
    Relative to gold, the dollar is presently worth less than one-third of its 1999 value. The dollar’s extreme swings in value are caused by Fed operations. The FOMC manipulates domestic interest rates to assist price-fixing of bank credit costs. Simultaneously, the Fed issues instructions to the New York Fed’s open market desk to inject or drain liquidity without a guideline for the dollar’s value except foreign exchange rates. In 1997-2002, the Fed was far too stingy with liquidity, and in 2005-2007, too generous. In both periods, the Fed set credit costs too high, favoring banks.
    Forex rates are dependent both on the dollar’s value and on the results of foreign central bank practices with their own currencies. Each foreign bank attempts to maintain parity with the dollar so as to remain competitive in the U. S. market, following a falling dollar downhill and a rising dollar uphill. Thus, forex rates are chaotic, unhelpful measures of the dollar’s health.
The Dollar’s Fall Was (And Is) Planned
    The concern for a sharp fall in the dollar is real, considering current Fed practices that continue to weaken the currency. However, foreign capital continues to flow into the U. S. for an entirely rational reason, even considering existing Fed policy. No other currency presently enjoys national security capable of defending it from foreign aggressors. In that circumstance, any alternative currency can be attractive relative to the dollar only until the U. S. is no longer able or willing to defend it. This does not excuse bad U. S. monetary policy. Under present circumstances, which may be fleeting, national security pre-eminence overcomes flawed economic policy.
    Reasoning that the current account deficit makes a weak dollar inevitable suggests that the weak dollar is intended – not accidental. Why? Because devalued currency is prescribed by DeLong and other Keynesians as the cure for current account deficits. Thus, a continuation of the dollar’s fall is “inevitable” only in the sense of inevitability the Fed will follow Keynesian advice. Economic calamity can result from debasement of the currency, but would be the fault of Keynesians at the helm rather than deficit in the current account.
The Solution is Monetary Policy Reform
    Having already diagnosed the ailments of DeLong’s analysis, we have at hand the best remedy for the weak dollar. The twin scourges of severe credit strains and weak dollar can be relieved by dual responses. Credit strains are curable by floating the overnight funds rate to allow a normal yield curve, thereby enabling credit to flow to economic growth as determined by the market. Robust health can be restored to the dollar, eliminating inflation, if the Fed manages liquidity towards a stated gold price value for the dollar. This reformed U. S. monetary policy would delight every foreign user of dollars, including producers of all goods and commodities, as well as every investor in U. S. equities and bonds.
    With such a positive outcome, we could stop worrying about the rationality of investors and economists, not to mention the looming economic turmoil and crisis Keynesians now foresee. ~