I have always kept track of the U.S./Canadian dollars by comparing the two prices inside new book dust covers. I wrote about this here on October 4, 2007 in a post titled McTeer on Dollars and Books.

Chairman Greenspan’s book, The Age of Turbulence, was released on September 17, 2007, priced at U.S. $35.00 and Canada $43.50. That was a 24 percent difference despite the parity in the exchange markets that month. His publisher obviously didn’t think the parity would hold.

The Prince of Darkness by Robert Novak had come in with a little earlier with a 27 percent difference. Other books I bought around that time had a similar premium on the dollar, the lowest being 21 percent.

With dollar weakness again in the news, I’ve done a bit of empirical research on my recent purchases. A Colossal Failure of Common Sense, The Inside Story of the Collapse of Lehman Brothers by Lawrence G. McDonald and Patrick Robinson is priced at $27.00 U.S. and $33.00 Canadian. That’s a 22 percent premium for the U.S. dollar, in line with two years ago.

In Fed we Trust by David Wessel is priced at $26.99 U.S. and $33.99 Canadian. That’s a 26 percent premium, still in the middle of the range of two years ago. So was Glenn Beck’s, Arguing With Idiots, (a gift) at 23 percent–$29.99 U.S. and $36.99 Canadian.

This Time is Different, Eight Centuries of Financial Folly, by Carmen M. Reinhart & Kenneth S. Rogoff was a gift from my son who was vastly overestimating my scholarship and patience. Speaking of patience, Ken Rogoff and I once spent a week in London one afternoon visiting financial firms there. He was a delightful guy and great company for a professor at a school that doesn’t have a good football team. Anyway the publisher of Ken’s book apparently punted on the exchange rate question. The price was $35.00 U.S. with no Canadian price listed. I’d better not speculate, so that’s all I have to say about that.

Hold on. Stop the presses. I just bought Charles Gasparino’s The Sellout. Same thing: A USA price of $27.99 with no Canadian price.

Do I have to have a conclusion?  What about “The dollar hasn’t really lost any value in the last two years in terms of books, but some publishers are backing away.”

I attended a conference in Beijing in 2003 sponsored by the Chinese government. While in China, I also met with several Chinese officials, including the new Premier, Wen Jiabao, officials of the central bank, and the agency in charge of maintaining the exchange rate of the Yuan, or Renminbi.

In several television interviews I was asked about the dollar/yuan peg and whether it was appropriate. I tiptoed through the tulips on the delicate aspects of that question, focusing instead on the basic dilemma.

The dilemma was that China was pegging its currency to the dollar, which was sinking. While a depreciating dollar might help offset economic weakness in the United States, the sinking yuan tied to it certainly seemed inappropriate for the booming Chinese economy.

Diplomacy became trickier when I was leaving the exchange pegging agency and was asked to sign their guest book. The book was huge and they opened up an entire blank page for me. About all I was sure of was that a large handwriting font was called for. I have (or had) a photograph of that scene that I’ve looked for unsuccessfully for months. It shows exactly what I wrote. The best I can remember, it was something like this:

Now that I’ve guessed at it, I’ll probably find the picture tomorrow.

A highlight of that visit was the audience some of us had with the Premier in the Great Hall of the People. He went around the circle and asked some of us for any advice we had to give him. A distinguished scholar sitting next to me, a Harvard professor I believe, shared his concern about so many single male Chinese coming off the farm into the cities to work without the stability offered by family. He urged the Premier to allow wives to come too lest the husbands succumb to the temptations of the city.

I was called on next. My contribution was that I thought the professor had been watching too many episodes of “Sex in the City.”

On that visit, I reached the conclusion all over again that we don’t want a land war with China. While I was walking up a long stretch of the Great Wall, what seemed like millions of Chinese soldiers in ill-fitting green uniforms were walking down. I felt like a salmon swimming upstream. The soldiers were apparently on holiday. While they did not look menacing, they did look infinite in their numbers. They just kept coming and coming. I thought of what it must have been like during the Korean War when the Chinese poured across the 38^th parallel.

On a lighter note, there were two mysteries I never was able to solve during that trip. One was, when do you use Yuan and when do you use Renminbi for the Chinese currency. I had it explained to me several times, but the explanations were all different. I never got it.

The other, greater, mystery was this: Why did they change the name of the city from Peking to Beijing but didn’t change the Peking duck to Beijing duck?

Either way, they are highly overrated.

Then why is it that virtually all the commentary on the dollar on financial TV and in blogs fails to mention the balance of payments when discussing the dollar? The dollar is considered super-important these days while the balance of payments isn’t considered important enough to mention. That’s like saying the price is important, but supply and demand don’t matter.

Instead, a strong dollar is treated as both the evidence of U.S. economic strength and a major cause of it. A weak dollar reflects and causes economic weakness. This relationship is either taken as self evident or is based on historical periods when the economy and the dollar were strong together or weak together. Unfortunately, these conclusions are the opposite of what economy theory teaches.

Other things equal, a primary result of an exogenous weakening of the dollar is an increase in foreign demand for U.S. exports, since they are now cheaper in terms of foreign currencies. A weaker dollar also makes foreign exports (U.S. imports) more expensive in dollar terms. Therefore, the weaker dollar will stimulate U.S. exports and depress U.S. imports. This increase in net exports (U.S. exports minus imports) adds to total spending as measured by GDP. If GDP is at recession levels, a weaker dollar helps pull us out of recession.

I don’t deny that many other economic variables have an influence on these relationships. However, the relative price change brought about by changes in the exchange rate are considered dominant among economists who study the matter.

The positive jolt to domestic GDP caused by a depreciating home currency is well known all over the world. That is why during a global slump such as we are in today we have to guard against competitive devaluations where each country tries to boost its economy through depreciation or devaluation which has the opposite effect on its trading partners. The term of art is “beggar thy neighbor” policies, sometimes called “beggar my neighbor” policies.

While the competitive advantages of currency depreciation are widely understood around the world, most of the talking heads on financial TV seem to believe that the opposite is true for the United States. They imply that a stronger dollar will lead to a stronger economy and a stronger economy will lead to a stronger dollar.

Apparently forgotten is the pressure U.S. officials put on China in the not-too-distant past to let the yuan appreciate, which would effectively depreciate the dollar against the yuan. I wasn’t in favor of pressuring China on that point, but at least those who did understood that a more expensive yuan and less expensive dollar would help restore more balance to trade between those countries. Today’s proponents of dollar appreciation are pulling in the opposite direction. It is amazing to me that China has completely turned the tables on us by arguing that it is us with the weak currency while touting their own artificially weak currency (roughly pegged to the dollar and protected also by exchange controls) as a potential reserve currency.

I’m changing focus now. Pay attention.

While a weaker currency helps a country pull out of a recession, a strong currency is beneficial if there is no recession, or shortage of aggregate demand. A strong currency relative to those of your trading partners helps consumers by making imported goods and services cheaper in the domestic currency. The added competition from imports also lowers the price of many domestically produced goods and services. A strong currency puts pressure on producers, exporters, and potential exporters to remain competitive, which isn’t always possible. Businesses may fail and jobs may be lost.

A strong currency generally harms producers and exporters. To repeat: a strong currency generally helps consumers and harms producers.

So, how do you choose which group to help?

The answer is you don’t. Under our system of market-determined exchange rates, the rules-of- the-game call for hands off. Keep the float clean, not dirty. Government tinkering with a floating currency opens it up to intense lobbying by pressure groups that is best avoided.

In the quandary of whether to favor consumers or producers, importers or exporters, a couple of points should help. One is no matter what we do for a living, we are all consumers. Even those harmed as producers will be helped as consumers. Another question to ponder is this: Who is an economy for, consumers or producers? I think the answer is consumers. This is similar to the question, do we work to eat or eat to work? Or, do we import to export or do we export to import. I think the unstated consensus in a democracy is we work to eat and we export to import. Consumption is the end; production is the means. A more totalitarian government, like China, is usually tempted toward mercantilism, which includes a higher priority on exports than imports.

So, my conclusion is there is a strong argument to be made for a strong currency. It just doesn’t apply in the midst of a deep recession when the main problem is inadequate aggregate demand. Many people who don’t acknowledge that are, in my opinion, trying to avoid sounding “Keynesian.”

I’ve said this many times before. My position on a strong dollar is similar to St.Augustine’s position on chastity in his famous prayer: “Lord, make me chaste, but not just yet.” My prayer is, “Lord give us a strong dollar, but not just yet.”

The front page of today’s Wall Street Journal features a useful breakdown of the third quarter real GDP statistics. On the negative side, it shows that the strength in consumption spending benefited from various temporary government programs: primarily cash for clunkers and the first time home buyers’ credit. Those will eventually go away.

Showing imports as well as exports is almost a breakthrough since commentators typically focus only on exports as a positive to GDP growth. The chart showed exports as contributing 1.5 percentage points of the total increase of 3.5 percentage points. Fair enough. But it also showed imports subtracting 2.0 percentage points, making net exports (exports minus imports) a net drag of 0.5 percentage points.

It’s important to remember that imports are a subtraction from U.S. GDP numbers because the various categories of spending listed have import components that generate income abroad rather than at home. Imports are subtracted to prevent over counting in those other categories.

A very positive detail is the contribution of inventory investments. Inventories have been drawn down in recent quarters, and I was expecting a boost from some rebuilding of inventories in the third quarter. Instead, the boost came from a slower liquidation of inventories than in the previous quarter rather than a rebuilding. (A smaller minus has the effect of a plus.) The reason this is so positive, in my opinion, is that the rebuilding of inventories and its boost to GDP is still in our future. It will likely boost the fourth quarter GDP number; if not, the first quarter. It’s an ace in the hole.

I find it disconcerting that everyone seems to equate an increase in the GDP number as an end to the recession even though everyone expects employment to continue falling for some time. Falling employment is hardly consistent with a recovery in my book.

One might think me a killjoy for raining on the recovery parade, but I do believe too much positive spin on current numbers sets us up for disappointment in the near future. The stock market, in particular, swings up and down on exaggerated news spin. More realistic interpretation of incoming economic data might help the stock market have a slower, but more sustainable, increase.

But just to be clear: a 3.5 percent increase in the third quarter is a good thing.

Amity showed great restraint in writing her book. A scholar with her expertise could have driven the ideological lessons home and saved those of us on a practical mission some time. Instead, she patiently let the characters and the circumstances speak for themselves letting the nuance show through for us to savor.

While I wasn’t totally clueless about the depression, not having lived through it, you see, I must admit that my knowledge of many of the details was limited.

Here’s what I thought I knew going in:

* There was still debate over whether the October 1929 stock market crash caused it, just preceded it, or how big a role it played.

There was general agreement that:

* The Smoot-Hawley tariff was a terrible mistake that made it much worse, and may have made the difference between recession and depression.

* The Fed made it worse by allowing the money supply to shrink.

* Things got better in the mid-thirties, but then worsened again, probably because of policy mistakes.

* Hoover was totally ineffective and did next to nothing to help, while

* Roosevelt was an activist who experimented with cures and generated public hope and was generally successful.

* The depression really didn’t end until WWII.

* The most important change made to prevent future depressions was the FDIC’s deposit insurance.

* The semi-socialist measures of the Roosevelt administration saved capitalism from something far worse.

Here’s what I thought of a couple of things mentioned above:

* I couldn’t really deny the Friedman and Swartz charge that the Fed erred by allowing the money supply to shrink.

* However, I thought insufficient attention had been paid by the economics community to the following factors:

- The shrinkage of the money supply was primarily a by-product of bank failures.

- The world was still on a gold-standard and policymakers were presumably supposed to follow the “rules” of the gold standard game.

- There was no consensus within the economics community on what to do to get out of a depression.

- This consensus would await the publication of Keynes’ General Theory in 1936 and its subsequent popularization and incorporation into economics textbooks.

Here are some of the things I learned by reading the book:

Much of what Roosevelt did on a large scale was begun or done first on a smaller scale by Hoover. Hoover was not sitting on his hands waiting for better times.

Hoover came off better in the book than I expected. Roosevelt came off badly, as expected, based on his economic policies and actions. What I didn’t expect to learn was that Roosevelt was rather petty and vindictive.

The Smoot-Hawley tariff, arguably Hoover’s biggest mistake (expected), came very early (1930) in the first year of his administration without a lot of thought given to it. Protectionism was apparently accepted Republican dogma at the time; so Hoover accepted it almost routinely. (He would try to improve it; not oppose it.)

Hoover’s “economic philosophy” was really an engineer’s view of the world where planning was useful and where problems can be fixed. He was willing to tamper with the machinery up to a point, but he respected the constitution, including the constitution of the gold standard, as limitations on government action.

Roosevelt, on the other hand, had no philosophy to speak of, he cared little about the constitution, and he broke the gold standard with his prolonged devaluation of the dollar. (I had known about the devaluation of the dollar, of course, but I had missed that it wasn’t an immediate thing. Instead, Roosevelt enjoyed setting the price of golf every morning from his bedroom. Different strokes for different folks.)

Roosevelt’s lack of a “North Star” to guide his way made him particularly vulnerable to being pulled in different directions by his staff and “brain trust.” During his administration, policy shifted back and forth between stimulus measures (job creating) and a desire to get back to fiscal rectitude by balancing the budget with large tax increases.

Large and untimely tax increases in the middle of the depression—probably not considered that way then—killed off an incipient recovery.

This should be a huge lesson for us today. Among other potential tax increases implied by various programs under consideration today, we have the pending reversal of the Bush tax-rate cuts looming next year. Could we possibly repeat that mistake?

As for other lessons, for now, I think Chairman Bernanke was very much influenced by this last factor and has resolved to avoid premature “fiscal rectitude.” He considers declaring victory prematurely a bigger danger than waiting too long.

He has already avoided the mistake of allowing the money supply to shrink and have deflation psychology take hold. His critics on that, however, are getting louder and louder, calling for an “end game” sooner rather than later.

One issue involving monetary policy is very much relevant for today: the excess reserves on banks’ (and the Fed’s) balance sheets. As in the 1930s, the banks have more reserves than the law or regulations require them to have—hence the term “excess” reserves. However, also as in the 1930s, banks have good reason to be cautious and remain even more liquid than the law requires. Attempts to “mop up” those excess reserves before they are used in ways that might contribute to inflation could have disastrous results. The fact that banks are holding them voluntarily is proof enough for me that they are “required” reserves in the minds of the bankers and that banks would try to restore them if they were removed by the Fed prematurely.

One final note:  I didn’t realize that our current mob-rule attitude toward successful people that has us cutting executive pay and hauling executives before congressional committees to be humiliated had a counterpart in the 1930s, but, apparently there is nothing new under the sun. Amity has an entire chapter on “Prosecutions” that amounted to political payback. It’s like our leaders are bent on taking the worst lessons from the past.

I had wondered whether Keynes had had much influence on administration policies during the depression since The General Theory came too late. Even though he had earlier influential books, I gather not. My favorite part of Amity’s book was when she describes a meeting that Keynes had with President Roosevelt on May 28, 1934, lasting fifty-eight minutes, about the time of a class-room lecture. Both Keynes and Roosevelt indicated that the meeting did not go well.

The President indicated that “Keynes had left him, disappointingly, with a ‘rigmarole of figures.’ He must be a mathematician rather than a political economist.”

Don’t you just love “rigmarole of figures?”

P.S. I worry that I have done Amity Shlaes, The Forgotten Man, a disservice by my inadequacy in describing it. Even if I haven’t conveyed its merits sufficiently, trust me, it’s great, and well worth your time.

Under the dollar-exchange system established at Bretton Woods, New Hampshire after World War II, countries committed to keep their own currencies in a narrow band around a par value expressed in U.S. dollars. No reserves were needed to offset upward pressure on the domestic currency since the monetary authority could sell their own currencies for dollars in theoretically unlimited amounts. But to offset downward pressure on the domestic currency, a reserve currency was needed to purchase and support the domestic currency. A country’s ability to defend its currency from downward pressure was thus limited by the amount of the currency held in reserve. Since the parity was expressed in dollars, it was convenient to use dollars as the reserve currency.

The U.S. commitment was to peg the dollar to gold at a rate of $35 per troy ounce by standing ready to buy or sell gold at that rate with foreign central banks or Treasuries. (That official rate was later changed to $42.22 when we devalued the dollar.) Other currencies were pegged to the dollar by exchange-market intervention while the dollar was pegged to gold the same way. Therefore, all currencies were indirectly tied to gold.

Under the “rules of the game,” a country’s policymakers were supposed to follow policies similar to what would happen automatically under a pure gold standard. If their currencies came under upward pressure, they should permit domestic economic expansion and/or inflation to correct the imbalance. Downward pressure on the domestic currency should prompt a policy tightening to correct the underlying imbalance while dollar reserves were used in the meantime to defend the peg.

Theoretically, the Bretton Woods arrangement was supposed to simulate a real gold standard where inflows or outflows of gold were allowed to raise or contract the domestic money supply. That was easier to do when domestic expansion was called for. Expansion is fun. It was less easy when contraction was called for. It was common for countries to “sterilize” the gold outflows and counteract their impact on the domestic economy.

In the early postwar period, and the early years of the Bretton Woods system, the world was starved for dollars and most countries gladly accumulated dollars in their reserves. This was a sweet deal for the United States because it meant we could buy real goods and services on world markets and pay with money unlikely to be redeemed in gold.

Over the years, however, the world accumulated as many dollar reserves as it needed and increasingly wanted to exchange some of them for gold, which they had the right to do. The United States, however, was not eager to lose gold; so it pressured its trading partners to continue holding dollars without demanding gold. “You don’t really want gold, do you?”

The dollars had been supplied to the world through deficits in the U.S. balance of payments and comparable surpluses by our trading partners. From our viewpoint, having the dollar used as the reserve currency was like playing poker with IOUs that the other players were willing to accept during the game and did not present for “redemption” after the game was over. (“There’s time enough for counting with the dealing’s done.” Kenny Rogers)

Eventually, the accumulated U.S. deficits had supplied more dollars than our trading partners wanted to hold. At the same time, U.S. policymakers did not want to follow the rules of the gold standard game and tighten policy to improve the balance of payments. So, President Nixon broke the last link between the dollar and gold in 1971 and we went on a system of floating exchange rates.

Under floating exchange rates, the exchange rate itself is supposed to trigger the internal economic adjustments necessary to restore and maintain equilibrium rather than changes in domestic policy. The rule of floating exchange rates is to let the market determine the exchange rate without policy interference. Let the float be clean. Policies to influence the exchange rate would dirty the float and would be considered inappropriate.

With no pegged exchange rate to defend, and with sporadic intervention considered inappropriate, there is no need for a reserve currency. Reserve currencies are a feature of fixed exchange rates, not floating rates.

Part of the angst over the potential loss of the reserve currency status of the dollar is really over the use of the dollar as a transactions currency in much of the world and in certain markets, particularly the oil market. There is now a long-standing tradition of pricing oil in dollars even if the United States is not a party to the trade. That means that a decline in the exchange value of the dollar makes oil effectively cheaper—good for buyers, bad for sellers. Of course, what has been happening is that oil sellers raise the nominal price of oil to offset the decline in the value cause by dollar depreciation. This peculiar relationship does not apply to most other commodities.

Pricing goods in dollars is a separate issue from the use of the dollar as a reserve currency.

Our reserve-currency equivalent is gold, which to my knowledge is setting in Ft Knox, on the books at $42.22 per ounce, the last official pegged price before the link was cut. And you thought all the gold was in a bank in the middle of Beverly Hills in somebody else’s name!

Given the explosive growth in the budget deficit recently and prospectively, positive growth in domestic investment relative to domestic saving will require a larger current account deficit to attract a larger capital inflow. It seems counterintuitive, but this need for foreign saving to supplement domestic saving in financing domestic investment will put upward—yes upward—pressure on the dollar.

That probably wouldn’t be a good economic outcome since it perpetuates global imbalances, but it may satisfy those who want a stronger dollar above all else. And, it may be a better outcome than having investment fall to match a diminished flow of saving.

Our national saving—made up of personal, business and government saving—is being supplemented by the foreign capital inflow that finances our current account deficit and helps support domestic investment. The floating dollar adjusts to help maintain the necessary relationships.

China has absorbed fewer dollars lately because our trade deficit has shrunk as reduced domestic demand has reduced our demand for imports more than reduced foreign demand has reduced the demand for our exports. China’s dollar holdings are influenced by everything that affects our trade deficit and capital inflow, including our budget deficit, along with personal and business saving.  Those holdings aren’t independent of these complex relationships.

If any category of our national saving increased, other things equal, our current account deficit would tend to shrink. An appreciating dollar would likely be part of that adjustment process. So, more personal saving, more business saving, or more government saving (a smaller deficit) would all tend to strengthen the dollar. Conversely, a reduction in those categories by our trading partners would have a similar effect.

One caution: if the government increases its deficit to increase transfer payments, which get saved by the recipients, there is no increase in national saving. The greater government dissaving offsets the greater personal saving.

Everyone would be happier campers if we saved more domestically and China and other trading partners would consume more and save less domestically. This would indirectly reduce the trade imbalances and the comparable capital flows and ease the downward pressure on the dollar.

Of course, government saving is tax revenue minus government expenditure; so more government saving could occur either through less spending or more tax revenue. Note that I said tax revenue, not tax rates.

Under those circumstances the dollar would be strengthened by the fundamentals. Attempts to support the dollar without the underlying support of the fundamentals would be like moving the dial on a thermometer without changing the temperature.

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