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Dollar Bears



How can $20 billion in Bear Stearns market value evaporate overnight? Though many are asking this question today, few are noticing the fact that, since 2002, trillions of dollars worth of business and U.S.-government debt value has evaporated. This happened because the Federal Reserve has neglected the dollar.

There is much talk now about restoring 'trust' in U.S. financial markets. You cannot restore trust while signaling that no steps will be taken to prevent the further fall of the greenback. Capital, be it to shore up financial institutions, or buy up much-devalued U.S. assets -- in terms of some currencies, U.S. real estate has plunged by more than 40% -- will stay on the sidelines as long as the Federal Reserve and the government do not take action to fix monetary policy.

In a Financial Times op-ed the other day, Alan Greenspan says that a measure of stability will be restored when house prices stabilize, which may be accurate. But why would capital flow into real estate denominated in dollars that are still expected to plunge?

The view expressed on this page by former Federal Reserve Board member Robert McTeer -- that the Fed now must give priority to the liquidity crisis and neglect the dollar -- is inaccurate, too. The liquidity crisis and the stable dollar are related. The vast extension of credit since 2002 could have never happened if the Fed had sustained a stable value for the dollar. And by stable, I do not refer to focusing on short-term 'core inflation,' which has been leaving out food and energy prices and mismeasuring much else.

There were many signals suggesting that the Fed has been mismanaging the dollar, which, with the mismanagement of the yen and the uncertainty of the unique euro (the first paper currency not anchored in either gold or backed by a government), became the sole reserve currency in the late 1990s. When one manages a reserve currency, it needs an 'outside' anchor to keep global credit expansion under control. The Fed has not provided one, which it could have done by keeping the dollar stable compared to gold and other commodities.


There are many 'moneys' in circulation -- a few of them domestic and others foreign. We have $100, $10 and $5 bills. We also have quarters, dimes and pennies, and an array of foreign currencies circulating. They all function as a medium of exchange here and around the world. The U.S. denominations stay in fixed relation one to the other, whereas the others have been fluctuating by 50% or more relative to one another.

Ask then: Why can the $10 bill always be exchanged for 40 quarters, whereas it varies daily in terms of how many foreign units it can be exchanged for? After all, the demand for the $10 bills and quarters fluctuates. With fewer parking meters, more automatic machines accepting credit cards and more cell phones, the demand for quarters has been dropping, and the demand for paper bills rising. Why doesn't the value of the quarters drop relative to the $10 bill? The answer is that as fewer coins are being used, they get returned to the central bank, which perhaps sells them as scrap metal, issuing $10 dollar bills instead.

This same process can work for any two currencies of two different countries. If people decide that they intend to spend less in the U.S., they show up at a bank or brokerage house and ask to exchange their unwanted U.S. dollars for, say, Canadian ones. The Fed notices that the demand for the U.S. dollar decreased, so it absorbs the unwanted U.S. dollars by selling U.S. denominated bonds on the open market (or selling Canadian dollars or Canadian dollar-denominated bonds).

The exchange rate between the two countries stays stable -- pretty much as the 'exchange rate' between the two U.S. denominations stays stable. Technically, the value of the Canadian dollar to the U.S. dollar can be as easily fixed as the value of the one U.S. denomination relative to another.

But why is it important to keep exchange rates between two countries stable to start with?

Whereas we can have as many mediums of exchange as we want, we must price goods and services, and get into longer term contractual agreements, to ensure stable capital flows. But should we price in euros or in U.S. dollars? Or, as has been done for centuries, in terms of gold?

What matters is to have an agreed-upon unit of account in terms of which trading partners could price every contractual agreement, preferably having the medium of exchange serve as the unit of


account, too. This anchor is missing in the international monetary system today, and is one reason for the financial havoc surrounding us. The volatility around a downward trend of the U.S. dollar -- which was closest to playing the unit of account/exchange double role for half a century -- has diminished its efficiency for these uses. As a result, contracts are shorter. Companies pay substantial insurance fees (and derivative contracts are in the trillions) to stay in their line of business and not get into exchange-rate trouble. Resource-rich countries keep their resources in the ground longer, rather than selling them for papers with uncertain values. And some investors have been loosing substantial amounts by holding bonds of devaluing currencies. Now people are deciding not to invest in U.S. dollar-denominated assets.

The issue isn't that 'we will never have a perfect model of risk,' as Mr. Greenspan appears to think. What we need is accountability, not perfection. With the proper anchor, central banks can sustain a stable value for their currency, and that is what they must be held accountable for. If they do that, even if financial institutions experiment with a wide range of innovations they cannot expand credit too much.

Crises bring us back to the basics. There is prosperity when talent is matched with capital and everyone can measure in a predictable unit of account. Stable currencies bring about long-lasting, wealth-creating employment. The destruction of wealth by debasing currencies occasionally 'creates' employment (with people being forced to accept lower-paying second and third jobs) but it signals poverty, not prosperity.

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