The Dilemma for Europe

One of the most important conclusions reached in modern open-economy macroeconomics is captured in what is called “The Trilemma.” The principle presented in this analysis is that governments cannot achieve all possible policy goals simultaneously.

More specifically, a government cannot, simultaneously achieve a fixed exchange rate, international capital mobility and economic policy autonomy. Only two can realistically be achieved at any one time.

Governments within the euro-zone have been attempting to achieve all of these goals at the same time. And, that is why they are experiencing the current difficulties. The euro represents the fixed exchange rate between euro-zone countries. Although an attempt has been made to bring economic policies within certain boundaries either through stated requirements to join the community or ongoing standards of behavior once a country joins the euro-zone, strict adherence to these rules have not really been observed. Consequently, nations within the community have been able to act with relative autonomy in regards to the economic policy they have followed.

Finally, membership in the euro-zone has provided all nations with greater access to international capital and this, as much as anything seems to have been one of the major attractions to countries on the periphery of Europe to join the body. Becoming a member of the euro-zone has allowed less credit-worthy countries to gain access to capital and at lower interest rates than would have been possible had they remained independent. In this, the creation of the euro has been a great success.

However, that very success is undermining the community. Ken Rogoff, the co-author of “This Time Is Different,” agues in the May 6 edition of the Financial Times, that “Europe Finds that the Old Rules Still Apply,” (See http://www.ft.com/cms/s/0/be41b758-58a7-11df-a0c9-00144feab49a.html.) It seems as if people, and governments, living well beyond their means ultimately have to “pay the piper.”

Martin Wolf in his ft.com/wolfexchange of May 4 raises the question, “Must All Capital Inflows Always End In Crisis?” (http://blogs.ft.com/martin-wolf-exchange/). One conclusion is that if a country has a large capital inflow and it cannot allow for a change in the value of its currency in the foreign exchange market then it must adjust its internal economic policy. If it is not willing or cannot do so in a sufficient magnitude then a financial crisis must take place.

And, this brings us right back to the Trilemma dilemma. A country cannot have a fixed exchange rate, run an autonomous economic policy, and enjoy the fruits of international capital flows. So, the question boils down to the problem of how is this going to be resolved?

The International Monetary Fund has now moved to approve a three-year, €30 loan to help the Greek government. Also, French President Nicolas Sarkozy and German Chancellor Angela Merkel Sunday said they are in complete agreement with measures to be unveiled later on Sunday by the Ecofin, the group of the European Union's 27 finance ministers.

NOTE: Exit polls predict Merkel defeat in federal state election (see http://www.ft.com/cms/s/0/7a717746-5b60-11df-85a3-00144feab49a.html) making it more difficult for Ms. Merkel to effectively govern in Germany.

So, the euro-zone seems to be moving toward some combined help for Greece and possibly others within the European community. But, there seems to be an absence of real leadership. And, that is a problem, for people really don’t like a leadership void. How this void is going to work itself out is anyone’s guess right now.
The problem is, as I see it, that in situations like this one the drift goes one of two ways. Either the community moves toward the country that is most fiscally sound, in this case Germany, or the community moves toward those that are the weaker links: Greece, Portugal, Italy, and Spain.

If left alone, I would bet that the countries that are more in control of their finances would come out on top! Why? Well, because the less disciplined ultimately have to get their act together in order in order to be able to compete with those countries that are in better shape than they are.

One can easily use a sports analogy in this case and that is why sports can be so popular because it can be used to explain life. Usually, the most talented and most disciplined player or teams come out as the winner or champion. Other individuals and teams know that they must practice and train and discipline themselves if they are going to have a chance to compete. Those that don’t have the attitude to commit themselves to this regimen are not kept around.

But, we have another model to work with. In this model, those that are weakest and least disciplined draw on others so that they can keep playing the game. Here, the weakest links become a drag on the performance of others and define the nature of the relationship.

Why are Greece…and Portugal…and Spain…and Italy…having such a difficult time? Their economies are as undisciplined as are their finances. They still, according to Rogoff in the article mentioned above, are emerging nations, if not worse. Their entry into the European Union provided them with an opportunity to move beyond the “emerging” classification more rapidly than the amount of time usually needed to achieve this maturity. The problem is that these countries have “wasted” the opportunity. They have used their access to capital to “buy off” voters with social programs and benefits and have devoted very little attention toward developing a more competitive economy.

Bailing these countries out only exacerbates the situation. Can these countries really deliver the fiscal discipline needed to move into the modern world? The rioting in Greece does not give us much hope for such an outcome.

One further problem seems to be that European banks have purchased too much of the debt of these countries. And, in this respect, the difficulty is not just the Greek debt, but the debt of these other countries that people are now raising questions about. Of course, this is the problem when something turns out worse than thought. Thus, questions arise about others with similar difficulties.

Coming to the support of the Greek government may be a signal of the extreme concern that exists over the safety of the European banks.

Few officials want to talk about a debt restructuring. The problem again seems to be the feeling that if the Greek debt is restructured then this will have to be followed by a restructuring of the debt of other European nations. Then the problem just becomes that much more severe.

Yet, the economics of the situation give little hope that the Greek government, and possibly other governments, will be able to resolve their situations through massive changes in their governmental budgets. That is why many analysts are betting that, sooner or later, a write down of the debt will have to occur. The picture is something like that enacted by Argentina who wrote down their debt by 50%.

I would argue that this is the only real way to begin the move beyond the solvency crisis.

As far as the fate of the euro and the euro-zone? According to the “Trilemma” analysis, the only way the euro and the euro-zone can survive without recurring “political” difficulties is to coordinate the economic policies of the member nations. That is a lot to hope for at the present time…or, maybe at any time.

The Euro and the European Union

When have you last heard that the dollar might drop into the $1.05 to $1.15 range? This morning we are trading at about $1.34.

The lower number is projected if some country leaves the European Union or if there is a national default in the euro area.

The cost of protecting debt from default over the past six-months has risen dramatically in several of the major European countries: Greece leads the world in this category. But, Portugal is right behind as credit-default swap data, compiled by Bloomberg, indicate an increase of about 150% in the last six months. (Remember the debt rating of Portugal was just reduced by Fitch last week.)

Major increases in the cost of protecting debt from default have also been registered against the debt of Spain, Italy, Belgium, England, and France.

The bottom line: governments cannot just spend and spend and spend expecting either the bond markets or the central bank to bail them out. Social programs or not, a democracy has to balance the competing ends within a country and if the social programs cannot be financed through sound finance then they will just have to wait. The lesson is very clear.

Historically, it is government spending that drives the finances of a country and not the central bank. Remember the European Central Bank and the Bank of England have been much more conscious “inflation targeters” than was the United States. Also, governments, historically, were always the leaders in financial innovation and not the private sector. The late 20th century is no exception to this rule. (See Niall Ferguson’s “The Ascent of Money” and also http://seekingalpha.com/article/120595-a-financial-history-of-the-world.)

In the past, if a country over-extended its finances then they would generally have to devalue their currency and then proceed into the future. With a common currency, the euro, a country loses the choice about devaluation because that country is now one among many and so must accept its position in the community. The poor country that has over-extended itself must bring its budget back into line, a very painful process as Greece is now experiencing. This is tough medicine to take.

What about the countries that were prudent and disciplined? Their emphasis on sound finance is now being called a vice by some because they do not want to be overly generous to those countries that were not prudent and disciplined. (One prominent critic has been Martin Wolf of the Financial Times: http://www.ft.com/cms/s/0/924b4cc0-36b7-11df-b810-00144feabdc0.html.)

And, the current crisis is bringing out those that are or have been opposed to the European Union as it is now constructed. For example, an op-ed piece in the New York Times “Euro Trashed” by a German professor, captures some of the tone of this side of the argument: http://www.nytimes.com/2010/03/29/opinion/29Starbatty.html?ref=opinion. A suggestion is made that the “strong” governments could pull out of the current arrangement and form a bloc that would “fulfill the euro’s original purpose” and would not have to worry about “laggard” high-debt states.

The betting is against the euro right now. John Taylor, the chairman of the currency hedge fund, FX Concepts Inc., argues that “Those people who are calling for the euro to go up are thinking the stock market is going to continue higher and that the euro zone problem is not going to spin out of control. I disagree with both of these things.” So, of the three areas that have experienced, in the recent past, the most negative vibes concerning the value of their currencies, the United States, Japan, and the euro zone, the pointer has rotated to the euro zone, taking the pressure off the other currencies, at least for the short run.

This could change. The reason for the current focus is that the euro zone faces the most current difficulties that have to be dealt with. But, this focus could be altered overnight because of the things happening in United States financial markets. The first has to do with the Federal Reserve signaling that it will honor its statement that its purchases of mortgage backed securities will end as March 2010 ends. The 10-year U. S. Treasury issue has bounded up to a 3.85% yield again, a level it was at in June 2009, August 2009, and January 2010. The concern by some is that yield could accelerate through 4.00% in the near term.

Why is this of concern? Well for one reason, upon the reaction in the bond markets, mortgage rates have moved above 5.00% with the expectation that they could go higher as the liquidity in the mortgage area of the capital markets declines. Banks and mortgage banks have already put a hold on committing to mortgage rates in the near term because of the uncertainty connected with the future level of mortgage interest rates. This, of course, is problematic because of all the variable rate mortgages or teaser mortgages that must re-price over the next 12 months.

There is also the concern about how easy it will be to place the upcoming quantity of the federal debt coming to the market over the next six to nine months. How much added pressure these new amounts of debt will have on interest rates is highly uncertain at the present time.

And, then what about the Fed’s exit strategy, the Great Undoing? How is the Fed going to act or react to all these market pressures? The exit strategy is planned to take place in an orderly financial market. What if the financial markets don’t cooperate and become dis-orderly over the next year due to everything else going on in the world? Just how is the Fed going to accomplish its Great Undoing in such an environment?

So, the emphasis is all on the euro right now and the political problems being dealt with by the nations of the European Union. Except for Germany’s Chancellor Merkel, the current batch of European leaders seem extremely weak at the present time. The weakness claim extends to the Prime Minister of England as well. What comes out of this mess is anybody’s guess right now, but it would seem that a country, like Germany, who is in relatively good fiscal shape and with a leader that can command some significant backing from her people, can be pretty adamant about what they want. The other countries in the EU may not like what Merkel is advocating, but they are not in the strongest position to suggest alternatives.

If this is the case, then it would seem as if the European Union will continue to battle on, but the debt-heavy countries that are now experiencing significant difficulties obtaining funding will have to get their houses in order for the Union to continue to function. Otherwise, as suggested in the New York Times this morning, we might see a move to one bloc of countries with a single currency who are relatively sound, financially, and all of the others who will re-establish their own currencies once again.

Politicians in the United States should pay attention to what is going on in Europe and take some lessons about their own fiscal responsibilities.

Why Should China Change?

Paul Krugman takes on China in his column this morning: “Taking on China”: http://www.nytimes.com/2010/03/15/opinion/15krugman.html?hp=&adxnnl=1&adxnnlx=1268654957-6LHafkNf0eW6a/enaOOFeQ. He begins, “Tensions are rising over Chinese economic policy, and rightly so” because it “has become a significant drag on global economic recovery.”

Why should China change direction at this time?

There was a time when the United States could do just about anything it wanted to. It was, by far, the strongest economy in the world. It had, by far, the most powerful army on the planet. It provided, by far, the best education anywhere. In essence, it could get away with about anything.

In fact, there are quite a few nations now in addition to China, such as Brazil, India, Russia, Canada to name a few, that can ask the same question, “Why should we change direction at this time?”

The gap has closed. There has been more and more talk about this diminishing gap. One of the more prominent books on the subject is by Fareed Zakaria titled “The Post-American World and another is by PIMCO’s Mohamed El-Erian’s “When Markets Collide.” The problem arises, not because the United States has been replaced at the top. No, the United States will remain the world’s number one power, economically and militarily, for many more years.

The problem is that the relative gap has changed putting the nations mentioned above relatively closer to the United States and this, consequently, gives them a stronger position is how things are played out. We see this in the shift to the G-20 rather than some other G-something. We see this in discussions around the World Bank and the International Monetary Fund. We see this in the growing influence of these other countries around the world.

The world has changed and we in the United States have not accepted the fact.

Why should China change direction at this time?

China is growing stronger and stronger. The United States, and most of the rest of the west, is in a weakened state. The United States, and most of the rest of the west, has gone through a very severe financial crisis and the worst recession since the 1930s. The United States, and most of the rest of the west, is beginning to recover, although the pickup has been very weak up to the present point.

Krugman is arguing that those big bad Chinese are hurting us when we are weak, when we are least able to defend ourselves.

Well, we got ourselves into this situation. We, the United States, created an inflationary environment which resulted in the purchasing power of the dollar declining by about 85% over the past fifty years or so. We, the United States, produced an environment that fostered, even celebrated, the creation of debt. We, the United States saw the value of our currency in international markets decline steadily, with a few exceptions, over the past fifty years. The only respite experienced recently has been that the dollar and U. S. Treasury securities have become a haven for risk-averse investors throughout the world.

Now, the United States is suffering through the consequences of this lack of discipline and is pointing its finger at the big bully that is taking advantage of the situation.

But, the big bully is pointing his finger back at the United States and even accusing the United States of not playing fair itself. (See “Chinese Leader Defends Currency and Policies”, http://www.nytimes.com/2010/03/15/world/asia/15china.html?ref=world.) China is even playing international economics against the United States (see China Uses Rules on Global Trades to its Advantage”, http://www.nytimes.com/2010/03/15/business/global/15yuan.html?hp.) and continues to acquire natural resources, companies, and trade ties throughout the world (see “CNOOC in $3bn Bridas deal”, http://www.ft.com/cms/s/0/c9636dba-2f63-11df-9153-00144feabdc0.html.)

Imagine the nerve of these people!

In the end, the lack of fiscal discipline comes back to haunt one, whether it be a person, a family, a business, or a nation. On the upside, the ride can be great. However, once the bubble bursts, there are no good choices available to one. There is pain regardless of what one does.

Now, however, there are other players in the game and this lack of fiscal discipline can really hurt. The economy of the United States, and the rest of the west, is weak, budget deficits are projected to go on forever, and the dollar is expected to weaken again as international investors become less risk-averse. We need everyone to cooperate with us so that we can bail ourselves out of our past behavior.

Unfortunately, that is not how the world works. And, it is human nature to sense weakness in others. The United States, and the rest of the west, is in a weakened state right now. It will not always be so, but it is for the time being. Thus, others have an opportunity to increase their relative position within the world.

My guess is that China does not plan to overdo it for they have more to gain in the future if trade is more open than not. One piece of advice someone gave me several years ago about the Chinese has proven to be very perceptive. They said that whereas people in the West have very short time horizons, generally in the three to five year range or less, the Chinese have a much long perspective of history. They think in decades rather than years.

I believe that the Chinese know that they will be better off over the longer run if world trade is more open rather than more restricted. Hence, they will not go far so as to create a trade war that will be detrimental to achieving a more open world trade. China’s investments in natural resources and companies throughout the world underscore this bet.

However, the United States is in a weakened position. Thus, the Chinese can achieve more now by taking advantage of this weak position and still achieve the longer-term goal of more open trade. The United States is in no position to resist this and will not be in a position to resist this for some time. And, it would hurt us more to act aggressively at this time to introduce more trade protection than it would China. Hence, advantage China.

Quite a few other countries are also in a position of strength relative to the United States at this time. Brazil seems to be following a more and more independent line. India is acting more in tune with its own interests. Russia, except for its athletics, is also stepping out here and there. And, so on and so on.

It is interesting to see people from the school of economics that led the United States into the position it is in, like Krugman and Joe Stiglitz, begging for help from others in the world that are taking advantage of the weaknesses created by the application of the policies forthcoming from that school. The lack of discipline has consequences. Why should we expect or depend upon others to bail us out of the conditions that we ourselves have created? Why should China change

The Chinese Dilemma

China seems to be determined to continue to peg the value of its currency against the dollar. Then it points its finger at the United States anytime someone representing the United States raises a question about its practice.

As long as China continues to follow this policy, the United States is locked into a corner with no really good options.

The problem of the United States is the problem of a country that has lost its discipline: a person, an organization, a nation, that loses its discipline is only left with painful decisions. And, given an adversary like China that knows when it has a favorable advantage over another, the bad situation only becomes worse.

The assumption of United States supremacy which most presidential administrations worked with since the 1960s created an aura of invincibility, a feeling that the government could conduct its monetary and fiscal policies without regard for the rest of the world. The Bush administration “strutted” into power in its cowboy boots and its Colt 45s ready to enforce this attitude on other nations.

Unfortunately, for the United States this assumption no longer holds. Although the United States is still the most powerful nation on this planet, both in terms of its economic machine and its military presence, it is not in the same place it once was relative to other nations. As a consequence, the country pays a price if it tries to disregard the rest of the world in the conduct of its monetary and fiscal policies.

The prodigal nature of Bush 43 resulted in the value of the dollar, using almost any measure, declining by about 40% between early 2002 and the summer of 2008. Obviously, the monetary and fiscal policies of Bush 43 were not well received by the international financial community.

After the flight to quality into the dollar during the financial crisis of 2008, the value of the dollar has dropped about 14% from its near-term peak in March 2009 to the present time. World financial markets are not approving the economic policies of the United States government!

Meanwhile the Chinese sell goods to the rest of the world and live off of an export driven economy.

And, what happens if the United States does nothing about this?

The value of the dollar will continue to decline and the prestige of the United States in the world will continue to fall. And, the carry trade will continue to prosper and big financial institutions and financial players will continue to rake in billions of dollars in profits by borrowing dollars at ridiculously low United States interest rates, selling the dollar, and investing in higher interest rates throughout the world.

The big banks will continue to get stronger…and bigger. The rest: well that is their problem!

The two major alternatives being suggested are either to raise interest rates and try to moderate the rise in government debt or to raise protective barriers against international trade.

The first of these alternatives does not seem realistic to expect at this time. With unemployment at current levels and with foreclosures and bankruptcies remaining high, the political interests in the United States are not going to condone higher interest rates and a less expansionary fiscal policy. Using monetary and fiscal policy to stem the decline in the dollar is, it seems to me, just not going to happen.

The other major alternative now being floated: greater protection for United States manufacturing and industry. Paul Krugman, the Nobel prize-winning economist, writes about “Chinese New Year” in last Thursday’s New York Times (see http://www.nytimes.com/2010/01/01/opinion/01krugman.html). He concludes as follows:

“there’s the claim that protectionism is always a bad thing, in any circumstances. If that’s what you believe, however, you learned Econ 101 from the wrong people — because when unemployment is high and the government can’t restore full employment, the usual rules don’t apply.

Let me quote from a classic paper by the late Paul Samuelson, who more or less created modern economics: “With employment less than full ... all the debunked mercantilistic arguments” — that is, claims that nations who subsidize their exports effectively steal jobs from other countries — “turn out to be valid.” He then went on to argue that persistently misaligned exchange rates create “genuine problems for free-trade apologetics.” The best answer to these problems is getting exchange rates back to where they ought to be. But that’s exactly what China is refusing to let happen.

The bottom line is that Chinese mercantilism is a growing problem, and the victims of that mercantilism have little to lose from a trade confrontation. So I’d urge China’s government to reconsider its stubbornness. Otherwise, the very mild protectionism it’s currently complaining about will be the start of something much bigger.”

If unemployment remains high and economic growth continues to stagnate, and the value of the United States dollar continues to decline, the argument that Krugman presents will become more and more convincing, especially as we move to an election. Krugman is now saying that a double-dip economy is more probable than it was a month or two ago and the current stimulus will disappear after the middle of the year. Thus, tighter monetary and fiscal policies, toeing this line, are not appropriate.

This alternative can, therefore, become a real threat and we could experience a rising tide of interest in greater amounts of protectionism as 2010 proceeds. Once the ball gets rolling in this direction it becomes hard to stop and other nations must respond in kind to protect themselves. This would just be a replay of the 1930s, when an earlier death spiral of globalization took place. Even a person who was generally in favor of free trade like John Maynard Keynes became, for a while, a supporter of protectionism because the British government was doing nothing else.

The United States is in a corner and there are no real good choices available to it. As said earlier, when one loses their discipline nothing becomes easier. Bush 43 was totally undisciplined and we are currently paying the price for it. No one seems to have a good idea how to get out of the current malaise and so alternatives like protectionism are bound to gain ascendency.

A Word on the Dollar from Mr. Wolf

Another commentary on the state of the dollar, well worth reading, is that written by Martin Wolf and presented by the Financial Times this morning (see “The Rumours of the Dollar’s Death are Much Exaggerated”: http://www.ft.com/cms/s/0/9165b8b0-b82a-11de-8ca9-00144feab49a.html.)

Wolf begins by stating that “It is the season of dollar panic.” He then specifically lists two, gold bugs and fiscal hawks that believe that the dollar “is on its death bed. Hyperinflationary collapse is in store.”

I presume that Mr. Wolf would classify me as a “fiscal hawk”, but I do not believe that “Hyperinflationary collapse is in store.”

I do believe that the dollar will remain weak as long as the fiscal stance of the United States government remains as it is, so that the trend in the value of the dollar will continue to be downward. I do not believe that a “hyperinflationary collapse” is imminent.

The reason I believe that this will be the case is that the international investment community will continue to be on the sell side of the dollar as long as the United States government continues to run the size of deficits that it is now running and has no credible plan to bring future deficits under control.

I believe this for the same reason that was stated by Robert Altman, former deputy US Treasury secretary, in his commentary in the Financial Times yesterday (see “How to Avoid Greenback Grief”: http://www.ft.com/cms/s/0/8bdc802e-b675-11de-8a28-00144feab49a.html.) Altman was present when the international investment community moved against the dollar in the latter half of the 1970s. He was also present in the 1990s when the Clinton administration had to calm international markets that had battered the dollar from 1985 until attention was given to its falling value. He has seen, at first hand, how international sentiment can respond to fiscal irresponsibility and monetary ease to force a country to adjust its economic policies.

And, this response on the part of international investors was a common thread in the latter part of the 20th century. France, as well as a dozen or more other countries can provide similar stories.

And Altman argues that “the dismal (US) deficit outlook poses a huge longer-term threat. Indeed, it is just a matter of time before global financial markets reject this fiscal trajectory.”

I support Wolf’s reading of the recent decline in the value of the dollar. He states: “In the recent panic, the children ran to their mother even though her mistakes did so much to cause the crisis. The dollar’s value rose. As confidence has returned, this has reversed. The dollar jumped 20 per cent between July 2008 and March of this year. Since then it has lost much of its gains. Thus, the dollar's fall is a symptom of success, not of failure.”

Note, however, Wolf’s statement, I believe, that the mother, the United States, “did so much to cause the crisis” through “her mistakes” needs to be clarified. What he doesn’t say is that United States monetary and fiscal policy contributed a decline in the value of the United States dollar of about 40 per cent ending in July 2008! I agree with Wolf that the jump of 20 percent came about due to the fact that “In the recent panic the children ran to their mother.”

The subsequent decline in the value of the dollar, in a perverse way, is therefore “a symptom of success” because through the actions of the United States government (as well as many other governments throughout the world) the financial panic ended and so “failure” was avoided.

To me, the return to a declining value for the dollar is nothing more than a return to the pre-crisis situation in which the world investment community is concerned with the huge deficits being produced by the United States government and the fact that there is really no credible scenario being presented by the leaders of the government that these will be in any way reduced in the future. The connected concern with this fact is that, historically, governments cannot contain the underwriting of these deficits by the nation’s central bank over the longer haul. It’s not the fact that the international investment community sees hyperinflation coming down the path, just that historically the evidence is not in place to have a strong belief that an independent monetary authority will be able to offset the substantial increases in debt that are forecast.

I also agree with Mr. Wolf’s assessment that nothing, at the present, can replace the dollar. Whereas I don’t have the space in this post to go into the very cogent discussions that are presented by Mr. Wolf on this issue, I can come out where he does, without having travelled exactly the same road that he has followed.

I believe that over time the global role of the dollar will lessen. I believe with Mr. Wolf that “the global role of the dollar is not in the interests of the US. The case for moving to a different system is very strong.” I agree that the reason that a different role for the dollar is needed is because the current role “impairs domestic and global stability.”

I would just like us to get to this new system by a different path than that proposed by Mr. Wolf or by his colleague at the Financial Times, Gideon Rachman (see my post of October 6, 2009: “The G20: Time for a US Attitude Adjustment”: http://seekingalpha.com/article/165088-the-g20-time-for-a-u-s-attitude-adjustment.)

The world has changed and will continue to change. The United States and the United States dollar will continue to be powerful; they just will not be as relatively powerful in the future as they have been in the past. This has to be taken into consideration by the United States government as it goes forward, but the new system must not be negotiated with the United States government reeling and in a defensive position from continued pressure on the value of its currency.

The Beat Goes On Concerning the Dollar

More headlines this morning on the dollar strategy of the Obama administration. First, the main headline in the Wall Street Journal contains the blast: “U. S. Stands By as Dollar Falls.” (See http://online.wsj.com/article/SB125498941145272887.html#mod=todays_us_page_one.) Then the lead editorial follows up with “The Dollar Adrift.” (See http://online.wsj.com/article/SB10001424052748703746604574461473511618150.html.)

We also learn that the administration was worried enough about this type of thinking to send out Chairman Bernanke and presidential advisor Larry Summers to indicate how serious the Obama Administration is in maintaining a strong dollar.

Again the phrase “Watch the hips and not the lips” comes to mind. There is very little the administration can do right now to introduce fiscal responsibility into what they are proposing. The die has already been cast and no one sees a quick reversal of the administration’s mindset.

And, this is the problem. Time-after-time in the last half of the 20th century countries got themselves into predicaments like the one being faced by the United States. Uncontrolled government budgets with the promise of growing amounts of debt outstanding. Connected with this fiscal irresponsibility was the concern that central banks were really not independent of the national government. This is a situation not unlike that currently in place in the United States.

There were a number of books that came out in the late 1980s and early 1990s that basically asked the question: “Is national economic policy in the hands of unknown bankers and financial interests around the world?” The general scenario depicted was that of a national government that proposed large and growing budget deficits that seemed unsustainable without the support of a captive central bank that would monetize the debt as pressure on local interest rates grew. The reaction of these “unknown bankers and financial interests” was to sell the currency of that nation and force the national government to reverse direction and introduce fiscally responsible budgets.

The primary example of such a historical event was that which occurred during the presidency of François Mitterrand in France. The French Franc came under such pressure that Mitterrand backed off his budget proposals and became fiscally quite conservative and supported the independence of the French central bank.

The issue here is not so much the size of the deficits, although that can be important, or the ratio of the deficits to GDP, or the ratio of government debt to GDP. The question relates to whether or not the government is acting in a fiscally responsible way and will it continue to do so in the future. The side question to this is the independence of the central bank.

Absolute numbers are fine, but it is the direction those numbers are going that are the crucial concern.

The facts to me are as follows: since the 1960s, the United States government has erred on the side of fiscal ease in terms of the budgeting process. This has not been a Republican or a Democratic fault. The leadership in both parties has contributed to the stance of fiscal leniency that has existed within the federal government over this time period.

During this time the value of the dollar has trended downward, with one or two side-trips.

During the Bush (43) administration fiscal irresponsibility got way out-of-hand. The fiscal irresponsibility was supported by monetary irresponsibility. Thus, we get to the current situation.

Nothing has changed!

Financial markets are seeing the same behavior in the current administration that they observed in the previous administration. O’Neill, Snow, Paulson, and Geithner are all of one package. Greenspan and Bernanke are linked at the hip. And, the words coming out of the mouths of our leaders seem to be “pre-recorded.”

I have been trying to call attention to this issue for four or five years now. Very little attention has been paid to the issue even though at one time in the Bush (43) administration the value of the dollar had declined by about 40%.

The problem is that there are no good solutions to the situation when you let it go for that long. The obvious picture is that of a binge drinker that has been an alcoholic for a lengthy period of time. More and more people are going to get hurt and this will just add to the many that are feeling pain at the present time. But, that is what happens when people lose their discipline and become addicted.

The event we see over and over again in economics is that ultimately the system has to correct, either on its own or with the help of those that are a part of the system. And, the correction takes place sooner, or, later, but it eventually takes place. Unfortunately along the way, as with alcoholics, some of the best attempts of “friends” to cure the patient only end up exacerbating the situation.