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The falling dollar is on most everybody's mind, especially in financial markets here at home and globally. A currency war? World protectionism? Race to the bottom?
The dollar is the lynchpin of the world's financial system, and it's still the world's reserve currency. But as the Federal Reserve gets ready for its so-called QE2 pump-priming expedition to re-inflate the U.S. economy, the greenback has fallen about 10 percent, while gold and broader commodity indexes have soared. Despite a weak-kneed jobless recovery, inflation is in the air.
Apparently, the weak dollar doesn't concern Fed-head Ben Bernanke all that much. But in a new wrinkle to this story, one wonders if Treasury Secretary Tim Geithner is suddenly paying attention to the greenback.
Most Treasury men chant a mantra that a strong dollar is in the nation's interest. And until this week, Geithner had not even done that. In fact, he has said little to nothing about the dollar during his tenure.
But then on Monday, in a Silicon Valley speech to businessmen, he said the following: "It is very important for people to understand that the United States of America and no country around the world can devalue its way to prosperity, to be competitive. . . . It is not a viable, feasible strategy, and we will not engage in it."
Answering a question at this meeting, Geithner said the U.S. needed to "work hard to preserve confidence in the strong dollar." And when asked if the dollar would lose its status as the world's reserve currency, he said, "Not in our lifetime."
So, is Tim Geithner out of the closet as a hard-money dollar protector? Or is he engaging in some sort of cognitive dissonance, blowing smoke at us? Is he speaking with forked tongue, or is he going to mean business about protecting the dollar?
I don't know the answers here. But I do know that if the Fed sets sail with its pump-priming campaign to put one trillion new dollars in circulation, the greenback is going to fall mightily more.
Last year, during QE1, the trade-weighted dollar fell 17 percent from peak to trough. Guess what? Coming out of the worst recession in at least 30 years (if not longer), the consumer price index jumped higher -- regardless of the high 10 percent unemployment rate. On a quarterly basis, the CPI fell 9.2 percent in the fourth quarter of 2008, and dropped another 2.2 percent in the first quarter of 2009. Then, as the dollar fell, the CPI increased 1.9 percent in last year's second quarter, 3.7 percent in the third quarter, and 2.6 percent in the fourth quarter, all at annual rates.
And all this despite a moribund economy.
So the falling dollar is, in fact, a very strong transmission mechanism for higher inflation. And inflation is the cruelest tax of all on the economy. With the dollar rising earlier this year, inflation has cooled in the last six months. But many now fear the falling dollar will reignite the price indexes.
Nobelist Robert Mundell recently said there's about one-year lag between a sinking dollar and a higher inflation rate. But that lag may be even shorter.
Now, Mr. Bernanke has never really understood the inflationary power of the falling dollar. Witness the oil shock of 2007-08, which decimated the economy. But the question is whether Mr. Geithner suddenly does grasp this relationship.
What exactly is Tim Geithner telling us? If he opposes devaluing our way to prosperity -- a sensible position -- does that mean he disagrees with Bernanke's QE2 campaign. Is there a Fed/Treasury split in the works? (The White House has never publically opined on QE2.)
Is Tim Geithner actually preparing to intervene to defend the dollar in foreign-exchange markets, even while the Fed pumps another $1 trillion into the system? Or is Geithner just jawboning the exchange markets in a futile attempt to slow the dollar's plunge amidst QE2?
This weekend the G-20 convenes to discuss currencies. In my view, they should develop a policy of worldwide currency stability. And I would prefer a golden anchor for that stability. To paraphrase Mundell, low tax rates and currency stability is the key to prosperity.
But more immediately, what will Geithner do? The greenback already has fallen about 10 percent, and it will surely drop at least another 10 percent if the Fed follows through and radically increases the quantity of money. Another dollar plunge will do great harm to the economy. Foreign investment in the U.S. will dry up. Domestic investment will flow out of the country. Liquidity will be drained. The inflation tax will kick in.
So will Tim Geithner resurrect King Dollar? That's a very big question.
This article first appeared on Kudlow's Money Politic$ Blog.