Policymakers shouldn't waste time worrying about a falling dollar. As Milton Friedman wisely advised, the exchange rate of our currency should be set by markets, not by fallible and fidgety politicians.
President Bush sounded the right note in his interview on the Fox Business Channel on Tuesday when he said, "We have a strong dollar policy, and it's important for the world to know that. We also believe it's important for the market to set the value of the dollar, relative to other currencies."
A weaker U.S. dollar is a two-edged sword for Americans. The declining dollar has boosted U.S. exports to record levels, partially offsetting the downward tug on the economy from turbulence in the housing and mortgage markets. It's also moderating the U.S. trade deficit in goods and services, which is on track to end 2007 almost 10% smaller than the 2006 deficit.
On the downside, the slide in the dollar has fueled higher import prices, most spectacularly for oil, imposing costs on U.S. consumers and producers alike. It's no coincidence that a sharply depreciating dollar has preceded every major spike in oil prices since the early 1970s.
The right response from Washington should be to let the dollar find its own value in global markets while avoiding policy mistakes that undermine its worth. Spiraling inflation, runaway government spending, hostility to foreign investment and the specter of protectionism would scare away foreign investors, causing the dollar to falter further and maybe even crash.
A freely floating currency allows our economy to adjust to shifting fundamentals. Any attempt to intervene would soon be overwhelmed by the $2 trillion exchanged daily on global currency markets. Efforts to artificially boost or depreciate a currency only postpone needed adjustments, as South Korea, Thailand, Brazil and other countries painfully discovered in the late 1990s.
Instead of manipulating the currency, policymakers should keep their eyes on the sound fundamentals that ultimately determine its value. The most important are low inflation, an open and flexible economy, fiscal restraint, and an attractive investment climate, including reasonable regulations and low tax rates. As long as the U.S. government pursues such policies, the world will want our dollars.