THE FUTURE OF THE DOLLAR ECONOMIC EDUCATION BULLETIN Published by AMERICAN INSTITUTE for ECONOMIC RESEARCH Great Barrington, Massachusetts About A.I.E.R. MERICAN Institute for Economic Research, founded in 1933, is an independent scientific and educational organization. The A Institute’s research is planned to help individuals protect their per- sonal interests and those of the Nation. The industrious and thrifty, those who pay most of the Nation’s taxes, must be the principal guardians of American civilization. By publishing the results of scientific inquiry, car- ried on with diligence, independence, and integrity, American Institute for Economic Research hopes to help those citizens preserve the best of the Nation’s heritage and choose wisely the policies that will determine the Nation’s future. The Institute represents no fund, concentration of wealth, or other spe- cial interests. Advertising is not accepted in its publications. 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ECONOMIC EDUCATION BULLETIN Vol. XLVI No. 1 January 2006 Copyright © 2006 American Institute for Economic Research ISBN 0-913610-42-9 Economic Education Bulletin (ISSN 0424–2769) (USPS 167–360) is published once a month at Great Barrington, Massachusetts, by American Institute for Economic Research, a scientific and educational organization with no stockholders, chartered under Chapter 180 of the General Laws of Massachusetts. Periodical postage paid at Great Barrington, Massachusetts. Printed in the United States of America. Subscription: $25 per year. POSTMASTER: Send address changes to Economic Education Bulletin, American Insti- tute for Economic Research, Great Barrington, Massachusetts 01230. Contents Foreword .................................................................................................. 1 About the Contributors ............................................................................ 3 WHAT TO DO ABOUT THE DOLLAR Anna J. Schwartz ............................................................................... 7 LET MARKETS DETERMINE THE VALUE OF THE DOLLAR Lee Hoskins ..................................................................................... 13 HISTORICAL PERSPECTIVES ON GLOBAL IMBALANCES Michael Bordo ................................................................................. 17 EXCHANGE RATE REGIMES: CHOICES AND TRADEOFFS Kenneth Rogoff ................................................................................ 33 DID POLICYMAKERS LEARN ANYTHING FROM THE 1970s? Margaret Greene Yeo ....................................................................... 39 STRONG DOLLAR: THE TREASURY’S POLICY IN THE 1990s Karin Lissakers ................................................................................ 45 WHAT THE CLASSICAL ECONOMISTS TAUGHT US ABOUT FOREIGN EXCHANGE John H. Wood .................................................................................. 53 FOREWORD N May 2005, the American Institute for Economic Research (AIER) sponsored a conference at its campus in Great Barrington to discuss a Imatter that has profound effects on the American economy—namely, the future of the dollar. Much of the conference was devoted to discussion of two particular issues that have attracted growing attention in recent years: the foreign exchange value of the dollar and the ballooning U.S. current account deficit. This book is a collection of selected papers and presentations that focused on these issues. From 2002 to 2004, the exchange value of the dollar decreased sharply against most other major currencies, including the euro, the yen, and the pound. When the conference was held in the spring of 2005, the question of where the dollar was headed loomed over discussions of the world economy. Some analysts, including some conference participants, thought at the time that a serious adjustment was underway and that the dollar faced a growing challenge to its role at the world’s major reserve currency. As events turned, the exchange value of the dollar subsequently re- bounded over the remainder of 2005, demonstrating once again that it is hazardous to try to predict or explain exchange rate movements. Still, the underlying questions remain: What determines the exchange value of a currency? What role do governments and their policies play, and what role do markets play? What lessons have we learned from the past 30 years— an era of “managed floating rates,” exchange rate volatility, and periodic efforts by government officials and policymakers to prop up, drive down, or stabilize the exchange rate? As for the U.S. current account deficit—the gap between the value of what America imports and what it exports—it has increased from two per- cent of Gross Domestic Product in the late 1990s to more than six percent in 2005. This is unusually—and, many economists say, unsustainably—high. There is no consensus, however, on when or how this “unsustainable” trend will end. Will the adjustment be gradual, with the exchange value of the dollar edging downward and thereby fueling export growth and restraining imports? Or might international concern over the U.S. trade deficit (or some other development) prompt foreigner investors (including foreign central banks) to suddenly decide to “dump” their holdings of U.S. dollars, trigger- ing a precipitous and disruptive drop in the dollar? These issues are not new. In the essays that follow, Professors Michael Bordo and John Wood offer historical perspectives on the dollar and the trade deficit, looking particularly to the experiences of the 19th century. 1 Bordo describes the “benign” view and the “gloomy view” of the current situation, and notes encouragingly that a previous period of global imbal- ances, prior to World War I, had a “benign” outcome. Wood observes that the current problems of the dollar are fundamentally related to our reliance on politicians and central bankers, rather than a mechanism such as the gold standard, to preserve the purchasing power of the dollar. “With nei- ther rudder nor anchor,” he says, “we cannot guess the Fed’s behavior or therefore the future of the dollar. Professors Kenneth Rogoff and Anna Schwartz, and Lee Hoskins, a former president of the Federal Reserve Bank of Cleveland, offer global perspectives. The dollar and the deficit, notes Schwartz, are influenced by factors outside of the United States, such as the amount of saving and lending in the rest of the world. If the market has created imbalances, she and Hoskins argue, the market will correct them, and official intervention is unlikely to be effective or beneficial. Rogoff notes that the U.S. economy is “marvelously flexible” and can “handle shocks better than any other large country in the world.” The eventual correction of current exchange rate imbalances may be harder for other countries, he says, especially Europe. Finally, two contributors offer insights based on their professional ex- periences in the world of foreign exchange and foreign policy. Margaret Greene Yeo was in charge of foreign exchange operations at the Federal Reserve Bank of New York during the 1970s and 1980s, when the postwar system of fixed exchange rates collapsed and was replaced by a new ar- rangement of floating rates. Although there are important differences be- tween then and now, she says, the experience of that time offers some lessons for today. Karin Lissakers was the U.S. Executive Director for the International Monetary Fund (IMF) in the 1990s. She describes at length the “strong dollar policy” of the Clinton Administration. As with all AIER conferences, the views expressed by the participants are their own and do not necessarily represent the views of AIER. As with previous such events, however, we believe that the discussions in the pages that follow are both timely and pertinent. 2 ABOUT THE CONTRIBUTORS Michael Bordo is professor of economics and director of the Center for Monetary and Financial History at Rutgers University. He is a research associate at the National Bureau of Economic Research (NBER). He has been a visiting professor at various leading universities and a visiting scholar at the International Monetary Fund (IMF), the Federal Reserve Banks of St. Louis and Richmond, and the Board of Governors. He is the author of many articles and books on monetary economics and monetary history, including A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform, co-edited with Barry Eichengreen (1993). Lee Hoskins is a senior fellow at the Pacific Research Institute in San Francisco. He served as chairman and CEO of the Huntington Bank of Ohio, Columbus, and previously was president and CEO of the Federal Reserve Bank of Cleveland. He is a member of the Shadow Open Market Committee,