Kudlow on Reagan’s Strong Dollar Policy

Cactus brought to our attention the latest insanity from Lawrence Kudlow but I don’t think this is the main criticism:

The Federal Reserve’s Major Currency Index for January 1981 was: 96.023. In January of 1989, it was 90.5499.

As our first graph shows, the dollar did appreciate significantly from early 1981 through mid 1985. What I find amazing is that Kudlow thinks this was a good idea then and it’s a good idea now:

If Sen. John McCain wants to run as a candidate of change, and if he’s truly interested in distancing himself from President Bush, he should reverse the declining fortunes of the Bush wartime dollar. America’s prestige is on the line. Right now the greenback is in virtual freefall. It’s a disorderly drop. As a result, U.S. inflation rates are rising across the board as the global commodity boom leaks into higher domestic inflation. Inflation is the cruelest tax of all. It robs consumer and wage-earner purchasing power. It erodes business profits. It reduces the real worth of investor portfolios. It’s also the single biggest cause of recession, and it may well be tipping the economy into negative territory. For the first time in a decade I’ve become genuinely worried about inflation. Over the last year and a half, inflation has climbed from 1.5 percent to nearly 4.5 percent, and in the past three to four months it has trended sharply higher. But there’s another side of the dollar story that’s equally important. The falling U.S. greenback has become a symbol of American decline. Folks are making fun of the dollar. Our enemies around the world are pointing to the unreliable dollar as evidence of American weakness. It’s as though the administration’s neglect of the dollar is “peso-izing” or “Latin-Americanizing” the greenback … For patriotic reasons alone it is time to reverse the decline of the dollar. A strong dollar should be emblematic of a strong America and a strong defense.

Prestige? Patriotism? I guess if one is as clueless about economics as Lawrence Kudlow appears to be, then maybe all one has is prestige and patriotism as excuses for a really bad policy prescription. Kudlow’s line about inflation being the cause of recessions is idiotic. Now it is a lack of aggregate demand.

Kudlow is advocating contractionary monetary policy, which will have two adverse effects on aggregate demand. One is to drive up real interest rates which will discourage both business and residential investment demand. But the main on point transmission channel is the appreciation of the dollar that Kudlow wants, which would lower net export demand. Let me address this by doing two things. First – I ask you to listen to Dean Baker:

USA Today ran a piece today discussing trade policy in the context of lost manufacturing jobs in Ohio. It treats the loss of these jobs as a mystery, with some experts saying that trade played a role and others denying it. More importantly, the piece never discusses the high dollar, which is the most important reason that the United States has lost jobs through trade … The other huge flaw in this article is the failure to mention the value of the dollar. The dollar rose by close to 30 percent against the currencies of our trading partners in the late nineties. This was the main cause of the explosion in our trade deficit. If the dollar rises by 30 percent it has approximately the same impact on trade as imposing a 30 percent tariff on all goods exported from the United States and providing a 30 percent subsidy for all goods imported from the country. It is virtually inconceivable that the United States will be able to reduce its trade deficit to a sustainable level unless the dollar falls considerably further against the currencies of our trading partners.

Dean is very critical of the strong dollar policies from the 1990’s onwards as he realizes that a strong dollar lowers net exports, which is one component of aggregate demand. But Kudlow was praising the strong dollar policies of the early 1980’s. So our second graph shows real exports (blue line) and real imports (real line – all figures in 2000$) from 1981 to 1985. Notice that real exports failed to grow during this period while real imports grew after we recovered from the 1982 recession. The dollar appreciation and its negative impact on net export demand in fact was one of the reasons why the 1982 recession was so deep.

Now Cactus is right – the dollar did devalue during Reagan’s second term. Some of us believe that was a good thing as it temporarily reversed the deterioration of the current account deficit. I would hope policy makers realize that what Kudlow is advocating would not only reduce aggregate demand making the recession worse but would also have negative consequences for the current account. But maybe John McCain will be stupid enough to think this idiocy from Kudlow makes sense.

Let me close by saying we may indeed be facing some Latin-Americanizing of the dollar but here the problem is not with the proper use of monetary policy to moderate business cycles. The problem lies in the fiscal fiasco created by Bush’s tax cuts – both of which Kudlow supports. If the next President is smart, he or she will abandon the policies recommended by the likes of Kudlow. But then John McCain doesn’t seem to get fiscal policy either.