No Option to Strong Dollar Policy By Jim Griffin Special to TheStreet.com 7/29/01 10:00 AM ET

I referred last week to the Weber-Fechner Effect, a biological version of what economists refer to as diminishing returns. Apply electric shock to a frog's leg muscle and that muscle will contract. Do it again, and it will respond again, but less vigorously. Repeated applications of stimulus eventually will be unable to provoke a measurable response.

Kind of makes you wonder whether stimulating the U.S. consumption and residential investment sectors is necessarily the best way to speed up the global economy. Lower interest rates in this country haven't yet helped the sectors where the problem is -- technology, farming, manufacturing -- but they have helped the sector where the problem isn't -- housing. It is working, so far, to keep the U.S. economy skating along the edge of recession without falling in. And through the means of the cash-out refinance phenomenon, whereby homeowners liquidate and spend a portion of the equity in their homes, it has supported consumption in this country and -- through imports -- production and employment in other countries.

The persistent sturdiness of housing investment, in graphic contrast to the collapse in business investment, stirs memories of the 1980s period of excessive valuation of the dollar vs. the yen and deutsche mark. Dollar strength then, you may recall, effectively partitioned the U.S. economy into "tradable" vs. "nontradable" sectors, i.e., those facing foreign competition and those immune to it. Those businesses in the tradable goods sectors, such as agriculture, mining, energy and manufacturing, were undercut by competitors who had the advantage of cheaper currencies.

Real estate, in contrast, had no such competition and disproportionately benefited from the stimulative policies of the Reagan era. Real estate boomed while the farm patch and the Rust Belt suffered. No doubt you remember how that story turned out. Bust followed boom, banks failed, recession ensued, "50 mph headwinds," etc.

There is a point of view currently, put forward with passion by those who represent farming and manufacturing, that the dollar is too high vs. other currencies, and that it ought to be brought down. I agree with the front end of that perspective, but not with the policy prescription. Don't bring the dollar down, bring other currencies up.

Let me frame this as a "what" vs. "how" question. The what of adjusting the dollar's value down may make sense, but the various how options do not.

How might it be done? Because the Treasury Department is the agency responsible for dollar policy, Secretary O'Neill could start talking it down. But the chief financial officer of this nation bad-mouthing its liabilities would amount to malpractice. Any Treasury secretary who can't in good conscience recommend and defend the dollar ought to resign. Further, Treasury would have to fight the Fed because, although the Fed is not the official arbiter of dollar policy, it is the agency ultimately able to defend it, or trash it. A Fed that dedicates itself to a goal of price stability cannot be complicit in a dollar-weakening scheme.

On PBS's "News Hour with Jim Lehrer" last week, Robert Rubin -- former head of Goldman Sachs, former Treasury secretary, and current Citigroup vice chairman -- offered a defense of the strong dollar policy after viewing a bit of videotape in which a Goldman Sachs economist, in testimony to a congressional hearing, argued that dollar strength needs to be curtailed.

Their difference in perspective is a fine example of what vs. how. Currencies may be in need of realignment, for the global good, but abandoning the strong dollar policy is not how it should or can be done. Policies that would cheapen the dollar are the wrong way to bring about a realignment of currency valuations. But policies that would strengthen the euro and yen would be a boon to all concerned.

Strangely, the Clinton/Greenspan years replicated the dollar strength that occurred in the Reagan/Volcker era. Both fiscal/monetary regimes resulted in a dollar valuation that was then, and appears to be now, too strong. But these were very different fiscal policies, with Reagan pumping up the national debt and Clinton paying it down. Reagan fiscal thrust and Clinton fiscal drag both pushed the dollar higher.

How can this be? Perhaps the answer lies in the behavior of our trading partners. It's fair to say that in the Reagan years, the U.S. speeded up its economy and left its partners behind. In the 1990s, in contrast, it might be closer to the truth to say that our trading partners slowed, by means of their own devising, and allowed, indeed forced, us to take the point.

In the first case, the necessary adjustments -- tax increases and spending restraints -- fell to the U.S., as our good friends took every opportunity to point out. In the current case, the necessary adjustments are matters for their attention. If you don't believe me, ask Robert Rubin. There really is no alternative to a strong dollar policy, even if it hurts.

Despite any clear evidence of a change in policies in Europe or Japan, the dollar has softened a bit in July. Perhaps this is due to hopes of more stimulative policies from the European Central Bank, or prayers that Japan's elections will strengthen the hand of Prime Minister Koizumi. Whatever the reason, it bears watching; recall the investment disasters that followed the downward adjustment of the Reagan-era strong dollar -- Americans lost billions in U.S. real estate, and the Japanese lost trillions of yen in U.S. government bonds.

I don't know what the right value for the dollar ought to be. But by the effects of its current value -- seen in the economic pain visited on U.S. farms and factories, and their workers, and seen in the fervent political action taken on Capitol Hill by lobbyists on their behalf -- I can see, obliquely, that the dollar is too strong, and is therefore more likely to move lower than still higher. Currencies have adjusted before and will do so again. When it happens, it is likely to have an adverse effect on the "nontradable" sectors in the U.S., such as residential real estate and its financiers.

It's a bad idea, for all concerned, to let key currencies get so far out of alignment, but Americans can run only American economic policies. On this side of the water, there is no alternative to a strong dollar policy. If the rest of the world will not take effective action to bring their own economies up to speed, there may be no way, finally, to avoid an unnecessary global recession. If you keep stimulating the same muscle, over and over again, say Messrs. Weber and Fechner, eventually it will give out. The U.S.' interest-sensitive, nontradable housing sector can't indefinitely propel the global economy.

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