In the Dollar We Trust.

Lindsey, Lawrence B.

The Bush administration's strong defense of a strong dollar.

Editor's Note: With the start of a new U.S. administration, financial markets around the globe have been wondering whether the Bush team will follow the strong dollar policies of Robert Rubin and Larry Summers. The early speculation has been that President Bush's selection of former Alcoa CEO Paul O'Neill as Treasury Secretary was a signal that the Bush administration might favor a weak dollar that would help old-line U.S. industries, like Alcoa, compete against foreign rivals.

Not so, counters the administration. That is why TIE asked President Bush's chief economics adviser, Lawrence Lindsey, to write the following article on the administration's dollar policy.

Since the end of the Second World War, the dollar has been the world's pre-eminent currency. Fifty years ago that position was held by default. The rest of the industrial world was suffering from the devastation of war. The United Kingdom, issuer of the dominant currency before the war, was wracked by huge war-related debts and focused on the challenge of adjusting to a diminished role in the world. Accounting for nearly half of the world GNP, the dollar was chosen by common agreement as the benchmark currency. The Bretton Woods system came into being.

By 1970, the arrangements of the post-war years were no longer ideal. Global growth had removed the dollar's monopoly role. More importantly, fixed exchange rates were creating too rigid a box for growing global trade and capital markets. The attraction of flexible exchange rates grew, because macroeconomic divergences at the nation-state level were worked out by the currency markets without creating periodic balance of payments crises.

Indeed the notion of a "balance of payments crisis" became nearly obsolete among developed countries. Instead of asking whether a nation could service its international obligations, the question became: at what price? Flexible exchange rates both allowed and necessitated the development of thick, liquid, currency markets. This permitted global trade to continue to expand at a rapid pace in spite of the currency risks involved for buyers and sellers of traded goods and services. These more liquid markets also allowed vastly increased movements of capital as the risks involved in transnational lending could also be hedged.

The role of the dollar has been tested in each of these regimes. Today the dollar's pre-eminence can no longer be taken for granted, but must be earned. It continues to be the case that the great majority of all foreign trade conducted on the planet is invoiced in dollars. But this is a matter of consent between the contracting parties, a choice, which could be altered if confidence in the dollar as a stable medium of exchange were lost.

Of even more importance, people all over the world look to the dollar as a reliable store of wealth. They are convinced that it provides a secure and portable asset that will hold its value over time. As a consequence, more than 70 percent of the value of all U.S. currency circulates outside the United States. Equally important, the U.S. capital markets offer global investors the opportunity to invest their funds in dollar denominated assets valued in the trillions.

Again, this has become a matter of choice, reflecting the confidence of millions of individual investors and portfolio managers. It is not something that we should take for granted.

During the 1970's, the world's confidence in the dollar declined as faith in our currency's purchasing power slipped. The decision in the early 1980's to opt for a "hard," non-inflationary currency led to a twenty-year expansion of confidence in the dollar and in foreign willingness to hold dollar assets. This includes the currency itself, as the number of dollars in circulation has risen 25 percent more quickly than American GDP in spite of a proliferation of alternative, non-cash methods of making payments. Obviously the willingness of Americans and others to hold dollars, and dollar denominated financial assets, has increased.

This global willingness to hold dollars and dollar denominated assets is fundamentally what is meant by a "strong dollar" policy. The Bush administration is committed to maintaining global confidence in our currency. The reason for such a commitment is straightforward. America benefits from the willingness of foreign investors to hold both our currency and assets denominated in it. Foreign investors thicken our capital markets making them more liquid and, by increasing the total supply of funds available to dollar-denominated borrowers, lower the net cost of borrowing.

The administration's commitment to a strong dollar policy is linked to our belief that the best way to underpin a strong currency is to follow policies that make investments in America and in dollar denominated assets attractive. There are three fundamental policy pillars behind such a policy.

First, the Bush administration is committed to continuing support for a non-inflationary monetary policy. A fundamental prerequisite for maintaining the confidence of foreign investors in any currency is a faith that it will hold its purchasing power over time. The Federal Reserve has done an outstanding job in carrying out a non-inflationary monetary policy during the past two decades. In this regard, not only does the administration recognize the Fed's independence, it also shares and supports the Fed's objective of maximum sustainable growth with low inflation.

The second policy pillar behind a strong dollar is making sure that the United States is an attractive place in which to invest capital. We are fortunate to be endowed with secure political, legal, and constitutional foundations. It is incumbent on the government to maintain a regime of sensible regulation and moderate taxation in order to maintain the attractiveness of America as a place to invest. We must also work to make sure our legal system protects property, assigns liability only to those who have committed a wrong, and assesses damages that are commensurate with the harm done. Again, the Bush administration is committed to maintaining a healthy business climate that attracts capital from around the world to our shores.

The President's first months in office are proof of this commitment to a sound business climate. Each of the administration's first three major economic initiatives was designed to enhance our competitive position. The President's first priority is to our nation's schools. He is determined to make sure that all children in America are prepared to participate in the rewarding high-technology economy of the Twenty-first Century. An educated workforce will attract investment. The President also has made clear his commitment to enhancing the energy available to run that economy. We have learned in the past five years that the high-tech economy is one that will use more, not less, electricity, and the President has committed his administration to finding ways to generate and transmit that power to where it is needed. Finally, the President has laid out a tax reform and relief plan that will return about a quarter of the projected federal budget surplus to the taxpayer. Equally important, the tax reductions will reduce the most burdensome parts of our tax system and thereby encourage labor supply, capital formation, and innovation. Prudent management of fiscal policy will also contribute to a strong economy and a strong dollar.

Aside from maintaining a sound business environment and promoting an anti-inflationary monetary policy, the third key to maintaining global confidence in the dollar is establishing an open and robust trading environment. Goods, services, and capital must flow freely between trading partners with minimum encumbrance. Confidence in a currency that is the world's choice for trade invoicing matters little if no trade takes place. Again, the Bush administration is committed to maintaining the principle of free trade and to opening markets around the world.

America's interest in a strong dollar is not academic. We obtain some very practical benefits from our currency's position in the world. First, as the world's leading trading nation, we benefit enormously from our ability to use our own currency in our international transactions. Even though foreign currency markets have developed sufficiently to allow buyers and sellers of goods to hedge their currency risks, such hedging is not without cost. The advantages to a firm in having its costs and revenue denominated at no added cost in the same currency provides a clear competitive advantage.

Second, the government of the United States benefits from the seignorage, which we obtain from having more than $400 billion of Federal Reserve notes held by non-citizens. At the current average cost of borrowing, the interest saved on this foreign holding of currency amounts to roughly $20 billion annually.

Third, our capital market benefits from its unparalleled ability to attract capital from around the world. The depth of our capital market and the enormous liquidity it provides allows U.S. firms unrivaled access to capital. This provides both a direct cost advantage to domestically domiciled firms and a large indirect benefit to the economy in the form of high quality, high paying jobs.

The advantages of a deep and highly liquid capital market have also benefited our country in pursuit of its international objectives. During the 1980's, for example, confidence in the dollar allowed the government to borrow the large sums necessary to rebuild our country's defenses. That investment was undoubtedly crucial to our ultimate success in the Cold War and in ending the specter of Soviet imperialism.

The same capital market advantage has been deployed to peaceful economic development. During the 1990's, the willingness of investors around the world to participate in our capital markets led to the greatest capital-spending boom in history. That boom allowed America to make enormous technological advances in telecommunications infrastructure and computer technology. The surge in U.S. productivity during the late 1990's was no doubt attributable to that investment.

Of course, these benefits also carry with them some responsibilities. Unilateral efforts to manipulate exchange rates have, in the past, contributed to misalignments in the dollar relative to other currencies, particularly the yen. For example, this mispricing of exchange rates played a role in skewing investment to third countries that were linked to the dollar, but which traded actively with Japan. When these currencies became more appropriately valued, these investments proved unprofitable. This played a part in the ensuing Asian financial crisis.

The costs of this crisis are still being borne by the people of East Asia and the taxpayers of the developed world. Borrower nations that act upon the main lessons of that experience will reform and strengthen the regulation and transparency of domestic financial markets. This will enable economic growth to put the costs of the crisis quickly behind. As for creditor nations and institutions, a policy of bailouts by international institutions cannot be a substitute for basic responsibilities in maintaining respect for and the value of the currency to which other nations look as a numeraire for their own currencies.

The Bush administration recognizes that the benefits of having a strong currency are not free, and they require careful and responsible attention to the formation and articulation of national economic policy. However, the benefits of a strong currency for our country far outweigh the costs. Thus, a commitment to a stable, non-inflationary currency, a good business environment, and open trade will remain the cornerstones of American economic policy.

The Lindsey File

Lawrence B. Lindsey, 46, is President George W. Bush's chief economic adviser, a position he also held during the 2000 presidential campaign. In the latter role, Lindsey took the lead in shaping Bush's $1.6 trillion tax-cut plan and his proposal for reforming Social Security.

Before joining the White House staff as director of the National Economic Council, Lindsey held the Arthur F. Bums Chair in Economics at the American Enterprise Institute in Washington for four years. He also was managing director of the New York consulting firm Economic Strategies.

Lindsey was a member of the Federal Reserve's Board of Governors from 1991 to 1997. He was appointed to that post by President George H.W. Bush, for whom Lindsey served in the White House as a domestic policy adviser. A former economics professor at Harvard University, Lindsey served on the staff of President Ronald Reagan's Council of Economic Advisers for three years as a tax policy specialist.

A native of Peekskill, N.Y., Lindsey received his Bachelor of Art's degree from Bowdoin College and his Master's and Ph.D. in economics from Harvard. He is the author of two books: an analysis of the impact of Reagan's "supply-side" tax cut, The Growth Experiment: How the New Tax Policy is Transforming the U.S. Economy (Basic Books, 1990), and an assessment of the Fed's influence on the economy, Economic Puppetmasters: Lessons from the Halls of Power (American Enterprise Institute for Public Policy Research, 1999).

Lawrence B. Lindsey is Assistant to the President for economic policy and Director of the White House National Economic Council. He was a Governor of the Federal Reserve Board from 1991 to 1997.