Dollar's weakness in perspective

                                                                By Eileen Debold

                                                        Published: January 24 2004

      Sir, Financial markets should not be concerned about the dollar's weakness "stifling the eurozone's recovery" but rather the fact that policymakers show a troubling ignorance of the mechanics of "fiat money" [money printed by a government as legal tender that is not redeemable] ("Bank chiefs drive euro down from record high against dollar," January 17-18). Sadakazu Tanigaki, Japanese finance minister, urged the US to take action, arguing that US deficits "need fixing" so that currencies will reflect "economic fundamentals".

       The idea that debt and deficits are "bad" and a surplus "good" is  a throwback to a fixed exchange rate framework.
       Taxes in the fixed rate model serve to remove convertible currency  that could drain reserves of gold. Government spending leads to a  reduction  in gold, while a government surplus with a fixed exchange rate requires  the  non-government sector to "sell" gold to the central bank in exchange for  local currency to discharge tax liabilities, building gold at the  central  bank.
       Mr Tanigaki also notes that "the US economic recovery is firm but  the  dollar is weakening for other reasons". This makes perfect sense to  those  who understand fiat money. Today the government creates money when it  spends, via a credit to a bank reserve account. Money is extinguished  when  taxes are paid by the private sector via a debit to a reserve account.  In  the case of the recent US fiscal surplus, more dollars were extinguished  from the banking system via tax payments than were being created via  fiscal  spending.
       But the US has now turned a $281bn fiscal surplus into an expected  $500bn deficit, creating new dollars in the process. The US economic  recovery is now reaping the benefits of government purchases of goods  and  services from the private sector. The dollar's weakness has also been  caused  by the sheer amount of new fiat money created by US fiscal spending.
       The Fed's role in all of this is limited. It manages an overnight  rate  of interest via open market operations, substituting one form of money  (government debt) for another (bank reserves). The currency damage  occurs  when central banks attempt to use monetary policy to create or  extinguish money, which is a fiscal function, with fiat currencies. In this case  the  central banks can only add to volatility, creating financial market  bubbles.  The winners are hedge funds and bank proprietary traders.
       Eileen M. Debold, Piscataway, NJ 08854, US

posted January 25, 2004