It is a matter of gospel among neo-Keynesian economists, especially on the sliver of the center-left that is left, that devaluing the currency will be a step to solving our unemployment problems. I know the arguments, because 25 odd years ago, I believed all of them. Reality, however, has intervened. Keynes quipped that when the facts changed, he changed his mind. Since devaluation orthodoxy was set, the facts have changed. Dr. Krugman tossed off a particularly dishonest – and that is the correct word - blog post today. In it he used that old trick of rhetoric – enumerating all of the arguments against him except the important one – that devaluation of the US Dollar has been tried, and did not work, namely by George W. Bush, Alan Greenspan, and Ben Bernanke. Recent experience shows that devaluation doesn't work for the US. The facts have changed, and it is time to outline them to Captain Carnage's favorite professor.
Let's look at the dollar under Bush. First, it happened. Second, economic growth was terrible, despite a great deal of orthodox macro-economic stimulus. Third it didn't work: we got the most explosive economic meltdown since the Great Depression.
This is a graph of the trade weighted dollar index from the Federal Reserve:
As even an economist should be able to observe, the dollar has peaked twice: once in the early 1980's when high real returns on bonds made the dollar attractive, and the second when a combination of high dollar returns on bonds, and an internet bubble which created an urgency to invest in the "New Economy" created demand for dollars, as well as the build up of reserves by economies trying to avoid contagion. In both cases, the end was not particularly pretty: the Crash of 1987, which led to a bright depression that is still the reality in Japan, and our own late depression.
This can be backed up by many more arcane numbers, and is even stronger in some of them than others. But the fact is fairly clear: the Bush-Greenspan policy was to pay for much of their war and spending binge by devaluing the dollar. This amounted to a tax on developing economies, that had to sell their own currencies to buy bonds. They did this in pursuit of the trade advantage that Krugman, and the Peterson Institute people, and many others, think will come from waving the dubious magic of currency devaluation.
So what really happened? Did we get a strong jobs economy under Bush?
As even an economist should be able to observe, the answer is no. There was the longest recovery to the previous number of jobs since the Great Depression, and wages, minus increases in health care costs, for most workers were flat. So there were neither good jobs, nor were there many of them. This coincides with the period of devaluing the dollar. Clearly devaluation did not work its magic just recently, and no item in Krugman's laundry list tells us any reason why things should be different now. Nor in anyone else's.
Was it a lack of government macro-economic stimulus? Did the government fall down? We know better.
Some wikipedian was nice enough to take the CBO data and give us this graph:
Again, as even an economist should be able to observe, the Federal government ran a significant real budget deficit during this period. So accusing it of not engaging in macro-stimulus is incorrect. One can go through more complex gyrations, but the answer is the same: the government held interest rates low, and spent. And yet, there were no jobs, even with the devaluation.
So what did happen?
The price of oil and other commodities went up.
Again, as even an economist can observe, the real price of oil rose substantially in the last decade.
Now here is where a degree in economics can actually help. If you need to explain away inconvenient correlations, the best thing to do is pick numbers that don't matter. First, one pushes the survey time back far enough for underlying realities to be different, that is compare apples to oranges, and then pick a number which hides those realities, that is balance this by comparing oranges to apples. The way to do that here is by throwing the data back to the 1970's, and then using the broad dollar index, which has been abandoned, rather than trade weighted. Then wave your hands in the air and mumble "supply and demand" and citing a benchmark price for crude, Brent Heavy, which was known to be off. Then argue since oil went up so much more than the dollar went down, that it can't be a correlation. Good job in passing lying with statistics 201.
Instead let's look at why the correlation worked in the last decade as it did, namely those countries who exported oil had a lower demand for dollars than the countries that imported oil had a demand for oil. As with many supply and demand curves, it isn't a nice even line, but instead curves upwards sharply at the end, in no small part because the next marginal barrel of oil is much more expensive than the last one – from Saudi $8/barrel up to tar sands that are close to $30. And each step up the chain yields fewer barrels, and because it is marginal production with heavy capital outlays, the people who sell it need to take into account that they could be out of business at any time. They need to make hay now.
So that means that increase in demand for oil means a much larger step up in the price.
The other hole in the "devaluation isn't driving oil prices" argument is that it lies about the purpose of devaluation: to create jobs, which is to say demand. Devaluation works in creating demand – the supply of dollars does not just mean that oil producers need to charge more, but also that they can charge more. They have pricing power.
So the result of devaluation, is to send money to resource producers, at the cost of labor and capital. In China, this is leading to good old fashioned macro-inflation. In the US and the developed world, it leads to the red queen's race: our rich fall behind their rich, so our rich demand lower taxes and corporate welfare, in the form of bank bail outs and so on, to keep up with their rich. Devaluation creates demand, and that gets sucked right up to the top of society. No point in devaluing just to make the rich richer.
To say it simply: saying that oil went up because demand went up, is the same thing as saying that oil went up because the supply of dollars went up, which is the same thing as saying that oil went up, because the dollar went down. The two parts: pricing power of resource elites, and the flooding of dollars producing demand, reinforced each other. There was more demand, because more people had dollars to buy the oil, and because currencies such as the Yuan, which were previously play money, became strong enough to buy oil. But they became strong enough, because of the flood of dollars.
The problem with the devaluation tactic is that resource producers can unilaterally raise prices, and no one can stop them. The failure of the Iraq invasion to free up the flow of oil from their fields is a demonstration world wide that the US cannot exercise fiat over oil producing areas. The whole Bush gamble was to devalue, invade, occupy, and pump. The neo-conservative idea, was that if Iraq became a consumer society, it would have to pump oil as fast as possible, driving the global price down.
What happened then, and here Dr. Krugman should read Dr. Krugman, is New Economic Geography in action. Under NEG, loosely speaking, consumer preference, economies of scale, and transportation costs form a triangle. Consumers want cheap goods, and some choice. Capital does better when it is centralized, but transportation costs give local producers an advantage. Therefore, according to NEG, as transport costs fall, industries centralize, until they reach the minimum number of choices that consumers will pay for. What is important about NEG, is that the change between transportation costs ruling over economies of scale changes very fast. On one side of the line, there are lots of local producers of a good or service, on the other side, a few big producers. This will vary by the good or service. Few producers of jumbo jets, many producers of tomatoes.
When the price of oil spiked, the global economy was faced with a series of problems. Not only did demand dry up, but the price of transportation went up very fast. Too fast for industries to adjust by moving production. Trade dropped through the floor, and there was a massive bleeding of jobs.
The root problem then, with the weak dollar play, which we are in, is that oil producers can raise prices, and in a highly liquid world, with lots of dollars, those who have dollars can drive up the price of commodities in the expectation of demand. This has been one of the factors killing the economy: as soon as it looks like there might be a recovery the price of "stuff" goes up, because the loose dollars flood into oil, gold, copper, silver, platinum, steel. The nascent recovery is choked off.
So does this mean I am a strong dollar acolyte?
No, because let's look at the few strong dollar plays: recently, when there were even attempts to strengthen the dollar, say early in 2008 when oil inflation was choking the economy, demand dropped very quickly. Holders of dollars could just sit. This has made it so that much of the trading has been to park in bonds, rush to stuff, and then back to bonds. The "landing" we are in, with virtually no job growth, has cut the price of oil substantially, at the cost of economic stagnation.
That is a policy bind: damned if you do the weaker dollar, damned equally so if you do the stronger dollar.
The root cause of the problem is something that Krugman touches on: the inability to tax. Under normal circumstances, by which I mean the now over post-World War II period, the game was to do macro-economic policy, fiscal policy, and then tax those that did too well. The assumption was that if someone was making a killing, he or she was killing the economy. This is how to smooth over, for example, inflation: stimulate, and then tax those parts of the economy doing really well, and give it to the others.
The weak dollar policy self-admittedly suffers from the obvious problem that it is hard to tax Saudi Arabia, or China. Yes, it forces them to hold dollars, but they can then, in turn, tax their own populations. They have tax fiat. The US cannot easily tax Chinese consumers, or force Saudi Arabia to open its economy and its society.
The strong dollar policy has a similar, though not as theoretically strong, problem. That is, let us imagine that the US were to strengthen the dollar, and accept the stagnation, but tax gasoline to pay for infrastructure heavily. It could blunt the effects of cheap "stuff" by finding ways of taxing it. Don't think I am saying anything that isn't known, a "carbon tax" is exactly a means to do this: taxing imported oil. It's been floating around for ages. However, the reality is that no government in the US could do this: strengthen the dollar and raise gasoline prices to $4.00 a gallon with taxes and spend the money. The US has lost tax fiat over itself, it can't raise taxes even on its own people, even if it is the right thing to do.
Getting back to China. The US, not China, wrote the rules of world trade. If we don't like the result, it is not because China is cheating, but because we wrote the rules so that we could cheat, by running deficits that would be intolerable for any other nation, and we don't like that China is exploiting our need to keep inflation very very low. This too is a weakness in the strong dollar policy: to run a true strong dollar, interest rates must be higher, and inflation lower. We can't do that either.
So what is the solution? First, there is no magic wand solution of unilateral action. The US has many unilateral powers. We can unilaterally assassinate people around the world. We can unilaterally invade countries. We can unilaterally restrict IP.
We can't unilaterally weaken the dollar, because weakening in response is easy. Any idiot can weaken their own currency. We should know, Ben Bernanke is such an idiot. For a weak dollar to work, we need to be able to stop oil producers from being able to raise prices. They don't want another global meltdown any more than we do, but they are harmed far less by a global meltdown than we are. Putin? Doing just fine thank you.
We could weaken and play the game of chicken that energy inflation becomes food inflation, and food inflation leads to rebellions: Egypt, Tunisia, Libya, Syria, Yemen. But notice the list. Not Saudi Arabia, Bahrain, Iran, Russia. As long as the revolutions substitute one regime for another that is no different, and that has been largely the case, it isn't a threat, until it is felt as a threat in Tehran, Moskva, Riyadh.
Could we go back to a fixed exchange rate system? No, because there is no consensus for it. The Euro, which is such a system, is having problems surviving even now. It isn't that it cannot be done, it is that the global elites, and electorates, are not willing to pay the cost.
So no, Dr. Krugman, you can't wave a magic wand and devalue, because all you do is hand more money to the oil producers, and, in turn, more firepower for anti-tax sentiment here, that is the American Thermidor thesis, now proving durable in its second decade. And no, you can't wish away that the policy that you are proposing was tried, by some of the same people who will have to do it again, and it did not produce the jobs here in the US that you want. It produced jobs, but in China and India, and Russia.
Is there a solution? Yes. But we are not going to do it. Either, for a fixed rate, it requires either international coöperation, and the only kinds possible are for austerity for the developed world's working class and middle class one one hand, and bank bailouts on the other. And that second is getting thin. Or for a weaker dollar, the ability to tax the oil producers. And they aren't listening to our threats to invade.
This is why the evidence indicates that there needs to be a generation of global conflict, including some outright wars, but not driven by them, which leads to a complete catastrophe. If there is one lesson of 2008-2010, it is that mere economic disaster is not enough to pry the developed world of its course, or the developing world off of its course. Only at a peace conference with a devastated world will there be the kind of far reaching and international consensus required to put a system in place, and the people to run it, that have a mandate for "never again." That is what the post-war era was: the results of a peace in a shattered world.
Since disaster after disaster has not been enough, only catastrophe will be enough.