The Guest Blog

Tony Fratto: The Tell-Tale Dollar

Halloween is fast approaching, so no one should be surprised to hear spine-tingling tales of myths and legends intended to give you the willies.

So let's gather around the campfire, and listen through crossed fingers at nightmarish horror stories of...the pending collapse of the dollar. 

S'mores anyone?

Although it inexplicably strengthened a bit this week — putting fright in the minds of equity traders — the U.S. dollar has certainly been under pressure this year, helping to inflate prices for some dollar-denominated assets and commodities — like oil and gold.

One blood-curdling myth of the season is that the U.S. has had a policy of seeking a "weak dollar" -- the Poltergeist equivalent of going into the light. The story goes that despite repeated assertions that a "strong dollar is in the nation's interest", U.S. officials wink and nod, secretly seeking a weaker currency to promote exports, inflate away debt, whatever.

In the Bush Administration, I worked with three Treasury secretaries, four directors of the National Economic Council, four chairmen of the Council of Economic Advisers, two Federal Reserve chairmen, other senior economic officials, and the President himself. None believed a weak dollar was good for the country. None believed the U.S. should take actions to weaken the dollar. None believed it possible to devalue our way to prosperity. No winks. No nods. No Jekyll-and-Hyde transformations. (Note to David Malpass.)

In fact, when a U.S. official so much as whispered some benefit to the U.S. economy of a weaker currency, he was quickly hushed and scolded, and someone (frequently me) would go out and reiterate that U.S. dollar policy hasn't changed, a strong dollar is in the nation's interest.

While I haven't worked directly with current Treasury Secretary Geithner nor NEC Director Summers, my discussions with Administration officials confirm for me that they do not seek a weaker dollar, either, and I've seen no evidence to contradict that view.

The Obama Administration has policies that would result in a weaker dollar, and some may even recognize a short-term benefit, but not policies actually aimed at seeking a lower valued currency.

The dollar both strengthened and weakened in dramatic fashion during the Bush Administration, but the relative value of the dollar in currency markets was seen as a residual effect of complex and dynamic financial and macro-economic events, including, but not limited to: U.S. and global inflation expectations; central bank policy rates; dramatic increases in cross-border capital flows; portfolio choices by investors; the build up of savings and central bank reserves in emerging market economies and "global imbalances"; relative rates of economic and productivity growth; currency management activities by certain trading partners; and occasional flights to safety in times of economic distress.

Considering all those factors, reality can be more frightening than myth: even if U.S. officials wanted to manage the value of the dollar, many factors determining its value in global markets are largely beyond their reach. Even the Exchange Stabilization Fund, the pool of funds intended for market interventions, is puny given the size of today's currency markets. (The best suspense films feature a lack of control of one's environment — that's truly scary!)

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Why do I say "even if" the U.S. wanted to manage the currency, after just asserting that U.S. officials of both parties desire a relatively "strong dollar"?

Because a key pillar of U.S. international economic policy — along with the free flow of goods, services, and capital — is a belief in the necessary complement of flexible currencies, where values are determined in open, competitive markets. While the U.S. may desire a relatively strong currency, it is necessary and more desirable to have flexible currency exchange regimes that reflect changes in all the factors cited above, in addition to short-term national economic conditions and goals.

As Milton Friedman argued, economic forces in different countries are not always the same, and "the right exchange rate for a country in general may be one thing one time and another thing another time."

Trying to maintain a specific level for the dollar at a certain point in time may only be fleetingly possible (if at all), but dangerous and counterproductive over time.

Managing the level of the dollar isn't easy. Clinton Treasury Secretary Robert Rubin famously espoused a stronger dollar and benefited from a variety of economic conditions that resulted in a stronger dollar — some for which he could even take credit. Some would like to pull out the Ouija board and bring the voice of Rubin, if not the Citibank-tainted incarnation, back to Washington. But Rubin, it's now forgotten, eventually tried weaken the dollar both through subtle jawboning and actual market interventions.

Finally, the U.S. has led, and the Geithner Treasury continues, a campaign to encourage currency flexibility among our trading partners. It would be hypocritical for the U.S. to upbraid China for managing its currency, the renmimbi, while actively trying to manage the value of our currency.

So then, what is that thumping under the floorboards telling us? Should we be frightened by the dollar's slide this year? What can or should we do about it?

There are legitimate long-term reasons to be concerned about the durability of the greenback as the pre-eminent global reserve currency — and all the benefits such status accrues to the U.S.

These concerns give the market goosebumps when we hear rumors that oil nations are in secret discussions to exit the dollar as the unit of account, or speculation that nations holding massive dollar reserves, like China, are seeking an “alternative” reserve currency. But those changes would only take place over time, would be expensive to implement, and at least in the near-term, are not a threat. Changing the pricing of commodities would be costly, and no one has intelligently answered the question "Change to what?"

As for China, lurking like Jason in a hockey mask, that country still needs to figure out what it would do with all the dollars it accumulates through trade with the U.S., and as long as it continues to largely peg to the dollar, China has to buy dollar-denominated assets -- like U.S. Treasury securities.

But the dollar's fall this year hasn't been precipitous, and I believe the greenback's place as a reserve currency remains safe for the time being.

For now, U.S. economic policy — both fiscal and monetary — effectively or not, is focused on spurring growth. The fiscal measures mean we're going to be running huge deficits and monetary policy will be loose for some time. The double, double toil and trouble bubbling from the cauldron of those policies conjures the ghost of potential inflation in the future -- and that's probably the most significant factor in sending the dollar lower this year.

No magic "strong dollar" words from Treasury can change that. The only way to excise the inflation phantom is for the Federal Reserve to signal its intent to withdraw accomodative monetary policy, and the Obama Administration to present a credible path to reduce fiscal deficits.

Until then, we'll be peeking under the bed and checking the closets before sleeping.

Tony Fratto is a CNBC on-air contributor and most recently served as Deputy Assistant to the President and Deputy Press Secretary for the Bush Administration.