Mundell: Deflation Risk for the Dollar; The Nobel winner says a stable dollar-euro rate is the best economic medicine.
Conservative economists have been raising alarms for months about the Federal Reserve's second quantitative-easing program, QE2. They argue it has lowered the dollar's value, leading to higher oil and commodity prices--a precursor to broader, more damaging inflation.</br></br>Yet the man many of them regard as their monetary guru--supply-side economics pioneer and Nobel Laureate Robert Mundell--says dollar weakness is not his main concern. Instead, he fears 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. Avoiding the recession is simplicity itself: Just have the U.S. Treasury fix the exchange rate between the dollar and the euro.</br></br>Mr. Mundell's surprising statement came at a March 22 conference in New York sponsored by the Manhattan Institute, The Wall Street Journal and the Ronald Reagan Presidential Foundation. His economic predictions carry great weight because, unlike most economists of his generation, he is often right. His analysis of international economics has revolutionized the field, making him the euro's intellectual father and a primary adviser to China's economic policy makers.</br></br>Nevertheless, with gold around $1,500 and oil above $100 a barrel, supply-siders are scratching their heads: How can he possibly see deflation ahead? How can dollar weakness not be the problem?</br></br>The key to Mr. Mundell's view is that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. For example, when the dollar declines significantly against the world's second-leading currency, the euro, commodity prices rise. This creates U.S. inflationary pressure. Conversely, when the dollar appreciates significantly against the euro, commodity prices fall, which leads to deflationary pressure.