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November 6, 2007
Happy Times?

Obsessed with the trade deficit and oblivious to real economic fundamentals, George Shultz and John Taylor are happy about the falling dollar, the subprime mess, Wall Street volatility, $100-oil, and $820-gold:

Turmoil in the US's financial markets got the top billing in news reports about the recent meetings of the world's leading international policymakers in Washington. Virtually everyone expressed concern that the housing slump and the financial crisis triggered by the subprime mortgage market would significantly slow down the US economy, and perhaps the world economy. But there is a surprising silver lining. Signs of it were revealed by the absence of reporting on the big bugaboo of the past few years: the US current account deficit.

The good news is the recent reversal of the steady upward climb in the current account deficit. During the past three quarters for which we have data the deficit has been cut by $119bn, falling from about 6 per cent of gross domestic product to 5 per cent, and the adjustment appears to be continuing.

Why the reversal? One explanation is the implementation of policies that these same international policymakers agreed to at recent past meetings. The basic economic principle that led to these policies is that the US current account deficit is caused by the gap between saving and investment. Accordingly, a three-pronged strategy was called for -- reducing the US budget deficit to decrease government dissaving, raising economic growth abroad relative to the US in order to stimulate US exports and increasing the flexibility of exchange rates, especially in China, to facilitate the adjustment.

David Malpass of Bear Stearns has a much better take:

Rather than "reflecting" fundamentals, the exchange rate is itself a key fundamental. It affects capital flows, jobs, inflation, and interest rates. Currency changes harm the relationship between debtors and creditors and dominate the profitability of many companies.

John Taylor is an influential economist -- his "Taylor Rule" is often thought to be the model the Fed uses to set interest rates. He was also Treasury undersecretary in the current administration and is partly responsible for America's current weak dollar policy. It appears Taylor is now rationalizing his easy money, weak dollar policies in the face of overwhelming historical evidence that such inflationary manipulation of any currency -- let alone the world's key reserve currency and unit of account -- is very dangerous.

Bret Swanson

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