Whither the Strong Dollar?

CAMBRIDGE: In his first international outing America’s new Treasury Secretary Paul O’Neill got tripped up – by telling the truth. During the Clinton Administration, Treasury Secretary Robert Rubin and then Lawrence Summers stated that America had a “strong dollar policy.” O’Neill reportedly said that “We are not pursuing... a policy of a strong dollar.” Immediately attacked for reversing a long-held policy, he quickly retreated. Too bad, because his comment made a lot more sense than his predecessors’ statements.

The truth is, America really doesn’t have an exchange rate policy. When Alan Greenspan ponders the next move in US interest rates, little attention is paid to the dollar’s exchange rate vis-à-vis the Euro, Yen, or other currencies. American monetary policy decisions depend on the strength or weakness of the domestic economy and on US inflation. If the economy is slowing, if there is excess capacity, and if inflation is low, interest rates are reduced; if the economy is strong, if excess capacity is limited, and if inflationary pressures are growing, interest rates are raised. Nor does the Fed intervene directly in foreign exchange markets except in extraordinary circumstances.

In only one sense does the US actually pursue a “strong dollar” policy: the Federal Reserve’s monetary policy is designed to keep inflation low. The dollar is kept “strong” in terms of its purchasing power over US goods and services. But this is not what markets believed the “strong dollar”policy meant. They believed that the strong dollar policy referred to exchange rates. In this sense, the “strong dollar” policy would mean that America has a “weak Euro” policy or a “weak Yen” policy. It has no such thing.

So why did successive Treasury Secretaries say that the US has a strong dollar policy? Part of the answer is that support for a strong dollar is an easy slogan; it sounds patriotic. Moreover, it would have been viewed as hostile if Secretaries Rubin and Summers insisted that they believed in a “weak Euro”, even if they were implicitly saying that. A truer statement for Rubin and Summers would have been to say that America actually has no exchange rate policy, the answer that O’Neill tried to give.