The Rising Dollar and the Market's Decline.

Last May in The WSJ, I noted that despite commodity inflation, supply-side guru Robert Mundell predicted “a return to recession later this year when QE2 ends and the dollar begins its inevitable rise. Deflation, not inflation, should be the greater concern.”

Mundell has since noted he sees little threat of substantial US inflation because M1 money velocity has collapsed by half and is likely to stay down.



In the Journal article, I wondered how Mundell could be concerned with deflation when commodities including gold and oil were rising sharply, and explained his answer came from the exchange rate between the dollar and the euro, which Mundell calls “the most important price in the world.”

According to Mundell, the financial crisis of 2008 was set off by the dollar's rapid fall versus the euro from summer 2007 to spring 2008, followed that summer by an historic 30% dollar rise within three months, the largest major currency appreciation in peacetime history. (The dollar's rise is represented by the steep decline in the euro:)





The rising dollar caused gold to drop sharply:



Oil plummeted from $140 to below $40:

And the consumer price index plummeted from 5.5% to 0% that December, then to -2% in early 2009:



This rapid dollar appreciation caused liquidity to become tight in the midst of the subprime mortgage solvency crisis, freezing the financial system and causing the near-systemic failure.

Despite radical actions by US monetary authorities in the years since, in Mundell’s view, the gravitational pull on the dollar has been back to its strong position versus the euro.

In winter 2009, the Fed initiated its first quantitative easing program (QE1), which pushed the euro/dollar rate down, easing the liquidity crisis. When it ended in late 2009, the dollar rose sharply again, weakening the recovery. QE2 was initiated in summer 2010 and the dollar declined again, improving prospects for recovery.



Now, QE2 has ended, and there is talk of monetary easing from the ECB. These factors, perhaps combined with Europe’s mounting debt crisis, have pushed the dollar up versus the euro, with the euro falling from $1.45 in late August to $1.31 yesterday, a decline of about 10% in one month:
 


Confirming the stronger dollar, commodities have sold off impressively in recent weeks. Gold is down about $250 since its September high above $1,900:



While a rising dollar is usually a bullish signal, it may be that the Dow’s recent decline is due to investor memories of the last two dollar surges which coincided with tighter money, debt crisis, and contractionary pressures. Today’s market weakness may be due as much to worry about a soaring dollar as to other factors.

Time will tell, but so far Mundell’s unconventional analysis is holding up. Exchange rates -- the relative value between major currencies -- are as important as the absolute value signaled by gold in any discussion of stable money.

Weekend items.

On DNA India, Robert Mundell offers a must-read overview on the dollar, euro, yuan and gold.

Another must-read comes from Asia Times, where Hossein Askari and Noureddine Krichene provide a fascinating explanation of the global currency situation. (Hat tip: Ralph Benko.)

At RCM, Larry Kudlow wonders whether the administration’s new jobs czar, GE CEO Jeffrey Immelt, can convince the president to cut corporate taxes.

On The Kudlow Report, Don Luskin discusses roadblocks facing the economy:



Echoing Mundell, at Forbes Reuven Brenner argues for reform of corporate taxes.

Business Week reports conservative Keynesian John Taylor is the House GOP’s leading advisor on Federal Reserve policy.

Mediaite posts video of this weekend’s Real Time with Bill Maher where Stephen Moore, Rachel Maddow and David Stockman debate Reaganomics:



On Bloomberg, Caroline Baum notes the U.S. is exporting inflation to China.

At The WSJ, Stephen Green analyzes the numerous challenges facing China’s economy.

In The NY Sun, Seth Lipsky calls Sen. Joe Lieberman (CT) a Kennedy liberal, though he notes Lieberman’s lack of focus on sound money.

AEI reports on historical budget consolidations that the U.S. can emulate.

Dshort breaks down the consumer price index.

Friday items.

At Forbes, historian and Econoclasts author Brian Domitrovic suggests higher economic growth, even at lower tax rates, would reduce the deficit.

On Asia Times, David Goldman agrees with Goldman Sachs’s estimate of $1650 gold.

At The Kudlow Report, Don Luskin abandons classical sound money and endorses monetary stimulus:




In The WSJ, monetarist Allan Meltzer argues Milton Friedman would opposed quantitative easing.

On The NYT, Paul Krugman points out that austerity has not been positive for Germany’s economy:



In The Financial Times, Brazil complains about U.S. monetary policy.

On CNBC, David Malpass analyzes the economy:



On Forbes, Reuven Brenner proposes a novel way to resolve the housing crisis.

The Shadow Stats site explains that inflation is significantly higher than CPI indicates:



In an op-ed, David Stockman strikes a hopeless note about the budget deficit.

Monday update.

In the Cato Journal, Jude Shelton calls for a new global institution to promote currency stability.

On RCM, Louis Woodhill critiques CBO's Keynesian economic model.

At Commentary, Jennifer Rubin advocates revival of the GOP’s pro-growth wing.

But modern conservatism’s success, both in policy and electorally, did not come from being the green-eye-shade party. It stemmed from an enthusiasm and celebration of free markets and from policies that sought to unleash the potential of individuals, investors, and employers. And it was Reagan whose embrace of supply-side economics, free trade, and modest regulation unleashed an economic boom — and launched a conservative political vision that was inclusive and successful.

At Asia Times, David Goldman supports an export-led recovery.

In Forbes, John Tamny sees high government pay weakening the private sector.

At Business Insider, Gregory White explains that debt-to-revenue is more important than debt-to-GDP.

In The WSJ, Harvard's Robert Barro argues unemployment benefits contribute to high unemployment.

U.S. Rep. Paul Ryan (WI) focuses on fiscal deficits in assessing the weak economy.

Keynesian Robert Samuelson diagnoses the demand-side of the economic malaise.

Bloomberg’s Caroline Baum defends Milton Friedman's monetarism.

The WSJ reports on Japan's effort to weaken its currency:

AEI’s Kevin Hassett says Gov. Chris Christie (NJ) is popular because he has cut spending and refused to raise taxes.

Regarding the

10-Year Treasury rate

chart from yesterday's NYT, a longer-term chart makes clear today's rates are close to their pre-Great Inflation level. Also note the lag: rates stayed high well into the 1980s even though gold and CPI had fallen to low-inflation levels.

Monday update.

Alan Reynolds responds to Paul Krugman's claim that revenue to government was low under Reagan.

John Tamny doesn’t see the U.S. succumbing to a Japanese style deflation.

From winter 2009, here’s a similar item.

In 2001, Jude Wanniski distinguished between falling prices due to contraction versus monetary deflation in which the dollar’s value is rising.

At New World Economics, Nathan Lewis discusses This Time is Different by Reinhart & Rogoff.

Joe Weisenthal at www.businessinsider.com charts CPI's progress since the dissolution of the gold standard:

In The WSJ, Cato's Gerald P. O'Driscoll explains why loose money from the Fed won't help.

While O'Driscoll's piece is good, he falls into the trap of blaming low short term interest rates, rather than the dollar's lower quality as measured against gold, for the recent asset boom.