The causes and consequences of a falling dollar

Ben Bernanke has been repeating the very actions of his predecessor Alan Greenspan that fuelled the last catastrophic bubble.

The instability of the dollar is due to inflationary policy
John Phelan
On 4 May 2011 16:43

QE3 remains in dry dock for now but the dollar is still shipping water. Last week the dollar tumbled to its lowest level since July 2008 against a basket of five major currencies on speculation that Ben Bernanke, Chairman of the Federal Reserve, plans to hold interest rates to the historic lows of 0-0.25%, where they have been since 2008.

Bernanke’s dollar printing is based on the thinking that “price stability should be a key objective of monetary policy”. If the price level falls, deflation, debtors see the real value of their debts increase and have to devote a greater portion of their wealth to paying them off. Likewise, it is believed, consumers seeing falling prices may hold off on purchases in expectation of even lower prices in the future. Both forces will act to decrease spending and kick the economy into a downward spiral. Following Milton Friedman and Anna Schwartz’ prescription for the Depression, Bernanke sees the Fed as having to pump as much money as it takes into a failing economy to keep prices stable.

An obvious result of this has been an explosion of dollars. In the last two years the Federal Reserve has more than doubled the base money supply. Yet core inflation, the Fed’s favoured measure, crept up by just 0.1% in the last month. Economist Paul Krugman uses his New York Post column to smugly deride anyone who raises concerns about inflation.  

The truth is that core inflation is a swindle. It strips food and energy prices out of the Consumer Price Index to give a figure which is artificially low. These are the prices which have been rising fastest and make up 17.2% of the spending of the average American consumer. On a columnists salary Krugman may well not notice meat prices rising at 7% in the last year, milk prices rising by 8.7% in four months or petrol prices rising at 8.4% in two weeks. As the chart below shows, however, the poorer an American is the more they will get mangled in the gears of Ben Bernanke’s printing press.


There is a striking degree of consensus among economists that just such an extended period of low interest rates played a key role in stoking the property bubble that burst so disastrously in 2007. New Keynesian Nobel laureate Joseph Stiglitz has written that following the burst of the dot com boom in 2000:

“…Greenspan lowered interest rates, flooding the market with liquidity…[the lower interest rates] worked - but only by replacing the tech bubble with a housing bubble, which supported a consumption and real estate boom”

Newly prominent mainstream economist Nouriel Roubini wrote:

“The bubble eventually burst in 2000, and Greenspan’s Fed responded by slashing interest rates by 5.5 percentage points – from 6.5 percent to 1 percent – between 2001 and 2004. The rising tide of easy money helped cushion the bursting of the tech bubble, but it fed another bigger bubble in housing”

From the perspective of the newly resurgent Austrian School Thomas E Woods writes:

“That year [June 2003 to June 2004] saw eleven rate cuts. The unsustainable dot-com boom could not, in the end, be reignited…But the Fed’s easy money and refusal to allow the recession of 2000 to take its course led to an even more perilous bubble elsewhere”

From the profession which gave the world the joke about laying all its practitioners end to end and never reaching a conclusion this is remarkable. Yet Bernanke has been repeating the very actions of his predecessor Alan Greenspan that fuelled the last catastrophic bubble.

But now we are in a crisis, Bernanke and inflationists like Krugman would retort, and normal rules no longer apply. Except we always appear to be in the midst of a crisis. In his 2004 H Parker Willis Lecture Bernanke, who made his name elaborating on Freidman and Schwartz’ work on the monetary origins of the Depression, said that the stock market crash of 1929 was “largely the result of an economic slowdown and the inappropriate monetary policies that preceded it”. The ‘inappropriate’ policy Bernanke referred to was a tightening of monetary policy in 1928 – 1929 to head off budding inflation and a roaring stock market.

But if monetary tightening isn’t appropriate when inflation is rising and there is a speculative bubble, as there was in stocks in 1929, when is it appropriate? Krugman seems to think that we should be repeating the monetary ease which followed the 2000 recession, the ease Stiglitz, Roubini and Woods hold at least partly responsible for the housing boom, for another two years. In fairness to Krugman he has been consistent with this.     

Bernanke says little about what circumstances would cause the Fed to tighten. The trouble is that he may get locked into the same inflationary ratchet Greenspan did. Greenspan responded to every slump by flooding the market with liquidity via low interest rates. But when inflation began to tick up as a result he would tighten causing a downturn which would necessitate a new period of low interest rates. A graph of the Federal Funds rate shows ever lower lows and smaller peaks.     

The trashing of the dollar’s value at home and abroad is a long term trend caused by this policy. Successive interest rate cuts 1989 – 1992, 1997 and 2000 flooded the world with dollars. On one estimate the number of dollars in circulation increased from about $3.5 trillion to over $10 trillion on the M3 measure between 1987 and 2006. One analyst, Adrian Van Eck, estimated that $3 trillion dollars were created between 2003 and 2006 alone. In early 2006 the Fed stopped counting M3.

Given its status as the world’s reserve currency a collapse in the dollar would be a disaster. To avoid it the Federal Reserve needs to break the reliance of the American economy on ever lower interest rates. With Ben Bernanke in the chair and the likes of Paul Krugman cheering him on from the bleachers, this looks unlikely anytime soon.


John Phelan blogs at The Boy Phelan and has written for Conservative Home and The Cobden Centre

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