An Engineer Measures the Falling Dollar

The magnitude of our fundamental unit of market value is not defined -- and that's the problem.

The U.S. dollar is in a scary slide. Gold and oil are hitting record highs, while the dollar is hitting record lows. To get how strange this all seems to an engineer like me, imagine the following headline: “Foot Falls against Meter for Fifth Straight Day.”

The accompanying article would breathlessly report that after the U.S. abandoned its “antiquated” fixed-exchange-rate system (one foot equals 0.3048 meters), our beloved foot began plunging in length. A “length trader” would predict that if the foot fell below the “psychologically important 0.2800 meter support level,” it could fall as low as 0.2500 meters. But an economist would say that as long as the foot didn’t fall more than 10 percent, everything would be okay.

The story would then describe the plight of a homeowner whose garage was no longer within his lot lines. Then another economist would argue that the falling length of the foot was actually a good thing, because it caused people to be taller, which reduced their “body mass indexes,” thus fighting obesity. The head of the U.S. Bureau of Standards would be quoted as saying the bureau is committed to “a strong foot,” although, “given that imports are longer than exports, there is only so much we can do.” The story would conclude with Paul Krugman blaming the falling foot on “Bush’s tax cuts for the rich.”

What is going on with the dollar right now is every bit as ridiculous as the fictional story above. Here’s how an engineer would explain the problem.

Economic transactions involve the exchange of “something” for “money.” The “something” is specified in terms of number (1, 2, 3, etc.); length/area/volume (“the foot”); weight (“the pound”); and/or time (“the second”). “Money” is specified in terms of “the dollar.”

The problem with this scheme is that the magnitude of our fundamental unit of market value, “the dollar,” is not defined. Being undefined, the value of the dollar can change. This fact gives rise to huge economic costs and risks for which there are no offsetting benefits.

Rather than being rigorously defined like all other units of measurement, the value of the dollar is left to the market. This is an extraordinarily strange way to determine the magnitude of a basic unit. For one thing, the absolute magnitude of a fundamental unit doesn’t matter – what matters is that it be precisely defined and unchanging. The market also has absolutely no way of determining what the value of a unit “should” be, whether that unit is the foot or the dollar.

Having had the job of determining the value of the dollar thrust upon it, the market does the best it can. Moment by moment it equilibrates the supply of dollars and the demand for dollars at some market value. This market value is reflected in the price of gold.

And what about the mighty Federal Reserve? Well, the Fed could exercise absolute control over the value of the dollar since it controls the supply of dollars. The Fed has the power to vary the size of the monetary base from zero to infinity. Given this, the Fed has the power to fix the dollar’s value (in terms of gold or anything else) at any level it chooses.

However, the Fed doesn’t do this. Instead, it exerts a vague influence over the size of the monetary base by targeting the federal funds rate. That is, the Fed creates money in response to demand for short-term capital. Given that one use for short-term capital is commodity speculation, and given that commodity speculation is one way to profit from inflation, the Fed is operating a system that is designed to respond to inflation by creating more money.

Such a system exhibits “positive feedback” (like a nuclear reactor) and is dangerous.

Why would the Fed employ a monetary-control approach that is both indeterminate and dangerous? I believe the underlying problem is an intellectual confusion between “money” and “capital.”

“Capital” is measured in terms of money (dollars), is mobilized by money, but is not money. Capital represents real economic resources. The Fed cannot create capital. All it can do is create money and use that money to commandeer capital. Unfortunately, this can cause inflation.

Once inflation gets going it tends to run away, with rapidly rising prices and escalating inflationary expectations. Ultimately this must be stopped. Unfortunately, raising the fed funds rate in order to halt inflation can cause an economy to “overshoot” into recession. Then, to fight the recession, the Fed will cut its fed funds target, thus starting the next oscillation of the business cycle.

Is there a way out of this trap? Yes, but the solution has to be based on engineering.

We need to approach the dollar just as we approach our other units of measure. We must first define a fundamental abstract unit of market value (“the dollar”). We must then devise a system for producing official instantiations of that unit (“dollars”) that are faithful to that definition. The dollar thus would be analogous to the foot, and dollars (the green things in your wallet) would be analogous to foot rulers produced by the U.S. Bureau of Standards.

Private entities, such as banks, would be allowed to create dollars as long as they were faithful to the dollar. Checking accounts would be like tape measures; money market accounts would be like laser range finders. They would simply reflect the dollar.

The money supply in this formulation would be as irrelevant as the number of foot rulers on the planet. It doesn’t matter how many instantiations of a fundamental unit there are. What matters is that each instantiation is faithful to its unit.

A logical definition of the dollar might be “equal in market value to one five-hundredths of an ounce of gold.” The value of all the dollars in the U.S. monetary base would then be maintained by having the Fed’s open-market operations target the price of gold to keep it near \$500 per ounce. Because the real market value of gold cannot run away to zero or infinity, the new monetary control system would be determinate and stable.

What I am describing is not a classic “gold standard.” Back then, gold was the monetary base. Instead, the monetary base would be the same “fiat” currency that we have now. Banks would maintain the value of their dollars the way they do now — by redeeming them with the dollars of the monetary base upon demand.

This new system would not be concerned with the federal deficit or the U.S. trade deficit. These relate to capital, and capital is not money. Similarly, the system would not be concerned with interest rates, which represent the cost of capital, not money. (As an aside, if the dollar were as stable as the foot, interest rates would be very low.) There would still be a role for the Fed as “lender of last resort,” but this would be a “banking” function separate from monetary control.

Fixed exchange rates between the dollar and (say) the euro are just as desirable as between the foot and the meter. The belief that “floating” exchange rates are needed to deal with trade imbalances between nations represents more intellectual confusion between money and capital.

If you want real prosperity, give monetary control to the engineers.

Louis R. Woodhill, an engineer, is a member of the leadership council of The Club for Growth.

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