Comments on R. McKinnon’s “The Worth of the Dollar”.

Dr. Ronald McKinnon, a well-known international economist, wrote an article in today’s Wall Street Journal called “The Worth of the Dollar.”

Oddly enough, the article never addresses the title of the article; Dr. McKinnon never explains what determines the value of the USD. While there is some discussion of how changes in monetary policy affect exchange rates, this does not speak to the essential ‘worth’ of the dollar, only changes in it. Offering a theory of how something changes over time is not the same as explaining how it came to be. Of course, the USD has no intrinsic value; this is why its purchasing power erodes over time. The dollar is worth about 5% of what it was worth at the inception of the Federal Reserve system in 1913.

Dr. McKinnon begins with a provocative question: “Shouldn’t the market now discipline the world’s biggest debtor and bid the dollar down to reduce the trade deficit? Essentially, the answer is no.”

I confess, it’s a bit hard for me to know how to interpret a statement like this. At first, I thought it means the argument that follows will show why a rapid depreciation of the USD is unlikely. But this is not what the author shows. My next thought was that perhaps Dr. McKinnon is arguing that the market should not be allowed to depreciate the USD. Upon reflection, it’s an odd way to begin an argument about the worth of the dollar, because since the worth of the dollar is determined by the global currency market; we can say all we want about the value of the dollar -- it should be higher, it should be lower -- but the reality is that markets don’t run on ‘shoulds’. Why is it, then, that statements by important figures in the US can effect the value of the dollar on the international market? Obviously, currency speculators scrutinize statements made by Federal Reserve officials, the Treasury secretary, and others positioned to affect US policies.

Another odd statement is made in the second part of the piece, where Dr. McKinnon writes, of the US current account deficit: “The “problem” is not new and there need be no crisis unless the never-ending Greek chorus of editorial writers in the Financial Times, The Economist, the New York Times, and so on, praising every (random) decline in the dollar as a welcome step in helping correct global imbalances, somehow foment a run on the dollar.”

Dr. McKinnon makes this sound like a truly bizarre scenario. If the worth of the dollar is secure, then how could the writings of financial journalists destroy the dollar? Are international and domestic holders of dollar-denominated assets so swayed by the opinions of these writers that they’d abandon a sound asset to their own ruin? Then again, if the value of the dollar is perhaps not as secure as one might think, aren’t these sorts of warnings due?

Finally, near the end of the piece, we get to some policy: “The US current account deficit simply reflects the excess of expenditures in the US relative to income, or, equivalently, the amount by which America’s moderate level of investment exceeds its very low saving rate -- both by households and the federal government. So the first order of business in correcting the trade deficit is to reduce the structural fiscal deficit of the US and possibly run with surpluses. The second order of business is to provide incentives -- possibly tax incentives -- for American households to increase their saving. Both require major changes in US public finances and should be phased in gradually but very deliberately.”

It’s hard to argue with this prescription. Although it’s equally hard to actually see it happening. Does either party seem inclined to do what is needed to balance the budget? That is, either large spending cuts, large tax increases, or some combination. As we teeter on the edge of a recession, can you see Democrats voting for a tax increase? Can you see them cutting spending? If the budget was balanced, it would clearly cause a major decrease in aggregate demand, driving the country deeper into recession. How might that affect the value of the dollar? Would the Fed respond by raising interest rates, to keep the dollar attractive to foreign investors, deepening the recession? Or would the Fed yield to political pressure, easing rates and thereby weakening the dollar, raising the prices of most imported consumer goods, which would probably also deepen the recession? It’s hard for me to see a way out of this one.

Dr. McKinnon is willing to provide us not only with policy ideas that will not be implemented in the US, he has policy ideas for the rest of the world as well. Since we have less control over the rest of the world than we do over our own economic policy, it’s hard to see these policies being pushed forward by anyone. These ideas involve the rest of the world (particularly Asia and the oil producers, which Dr. McKinnon incorrectly labels ‘oil emirates’ -- is Venezuela an 'emirate'?) increasing consumption at exactly the same time and rate as the US decreases consumption. This is truly a Panglossian vision. While Dr. McKinnon is probably right that such a thing could theoretically work, he seems to think that there is some country to be found in the world which has as its first order of business ‘stabilizing the world economy overall.’

No country cares about the world economy. Each country only cares about its relative position within the world economy.