The Buck Stops Where?

In the credit market panic that began in August, we have now reached the point of maximum danger: A global run on the dollar that could become a rout. As the Federal Reserve's Open Market Committee prepares to meet tomorrow, this should be its major concern.

Yet the conventional wisdom -- on Wall Street and in Washington -- continues to be precisely the opposite. In this view, the Fed is "behind the curve" and needs to cut interest rates even faster and further than it has. Never mind that this is precisely the path the Fed has followed since August, yet the crisis has grown worse and now bids to tank the larger economy. Does it make sense to do more of what isn't working?

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The Fed's main achievement so far has been to stir a global lack of confidence in the greenback. By every available indicator, investors are fleeing the dollar for other currencies and such traditional safe havens as gold and commodities. Oil has surged to $110 a barrel, up from under $70 as recently as September. Gold is above $1,000 an ounce, up from $700 in September, and food prices are soaring across the board. The euro has hit record heights against the buck, and for the first time the dollar has fallen below the level of the Swiss franc.

Speculators are adding to this commodity boom, betting that the Fed has thrown price stability to the wind in order to ease U.S. housing and credit woes. The problem is that dollar weakness is making both of these problems worse. The flight from the dollar has made U.S.-based investments less attractive, at a time when the U.S. financial system urgently needs to raise capital. And the commodity boom is translating into higher food and energy prices that are robbing American consumers of discretionary income. In the name of avoiding a recession, reckless monetary policy has made one more likely.

Meanwhile, and disconcertingly, we keep hearing new explanations for the virtues of dollar weakness. One of the most popular is that the increase in commodity prices has nothing to do with the dollar but is merely a change in "relative prices" -- commodities compared to other goods -- caused by surging global demand.

No doubt strong world growth explains part of the commodity price rise this decade. But the dollar price of oil has surged by some 60% since September, even as U.S. growth has slowed sharply. If the dollar had merely retained its value against the euro, oil would be in the neighborhood of $70 a barrel. Dollar weakness explains a large part of the oil price surge.

We are also told that the U.S. is merely importing inflation from the rest of the world, such as China. Import prices have surged nearly 14% in the last year, but that is mainly recycling the inflation that the Federal Reserve has inspired. Like other countries that have linked their monetary policies to the U.S., China has been importing inflation due to dollar weakness. Its official price level has tripled in a year, and it is now letting the yuan rise more rapidly against the dollar to slow that domestic inflation.

Kuwait has already dropped its dollar peg to stem its inflation, and other Persian Gulf countries may follow suit. These are all signs that the world is losing confidence in the Fed's commitment to price stability.

Another excuse is that a weak dollar is useful because it helps to boost exports, and thus reduces the U.S. trade deficit. Exports have certainly been strong, but exports in goods are being more than offset by the rising cost of oil imports. In January, the U.S. trade gap actually widened thanks to oil imports. In any case, rising exports won't comfort Americans whose standard of living falls due to rising import prices.

Then there is the "just deserts" school, which claims that dollar weakness is the inevitable result of America living beyond its means for so long. This road-to-perdition view is especially popular in Europe and the U.S. media. To believe it, however, you have to conclude that the world was willing to ignore the U.S. trade deficit for decades only to awaken in horror now.

The truth is that, as ever, the fate of the dollar is in our own hands. Inflation is always a monetary phenomenon, determined by the supply and demand for a currency. The supply of dollars is controlled by a monopoly known as the Federal Reserve, and at any moment the Fed can produce more or fewer dollars. The Fed can also influence the demand for dollars by maintaining a commitment to price stability, or it can reduce that global demand by squandering its anti-inflation credibility the way it is now. Once squandered, it is difficult to regain -- as we learned the hard way in the 1970s and 1980s.

The Bush Administration is also not helping confidence in the dollar. While President Bush is doing well to fight protectionism and higher taxes, his Administration continues to give the impression that it quietly favors a weak dollar. Yes, the official Treasury mantra is that it prefers a "strong dollar." But that mantra was the same when the dollar was strong and oil was $20 a barrel in the 1990s as it is now when oil is $110 and the dollar is weaker than at any time since the 1970s.

Last week Mr. Bush dared to wander from this script and told the Nightly Business Report that a strong dollar "helps deal with inflation" and rued its weakness against the euro. He was quickly reeled in by his advisers, and in his Friday speech at the New York Economic Club Mr. Bush reverted to the boilerplate language that investors now interpret as favoring a weak currency.

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Which brings us to tomorrow's Fed meeting. The markets are expecting another cut of 50-75 points in the benchmark fed funds rate, and if recent history is a guide will immediately price into futures another 50-point cut down the road. The stock market may rally, until it once again decides that easier money can't remedy what is fundamentally a problem of bank solvency. That problem can only be resolved by financial institutions and regulators coming to grips with the losses, raising more capital to cushion the blow, and closing or selling those banks that can never recover. That will require a more aggressive, and pre-emptive, regulatory role for the Fed -- and that we would applaud.

What the U.S. and world economy don't need is a Fed that continues to insist that inflation expectations are "well-anchored" when everyone else knows they aren't. The Fed needs to restore its monetary credibility, or today's panic could become tomorrow's crash.