Cheap Dollar Means Expensive Oil

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Back in December 2002, one dollar equaled one euro. But that exchange rate didn't last. The dollar was on its way down, a trend that had started more than a year earlier, and has lasted, with occasional oscillations, to this day.

On the day in 2002 that the value of a dollar was exactly the same as the value of a euro, the price of a barrel of oil was, therefore, the same in dollars and euros -- about 25. Since that day, it's like the two currencies have traded on two different planets.

Certainly energy prices have risen, regardless of what currency you use. In Europe, the price of oil has risen by 50 euros in the past 5 1/2 years. It now stands at about 75 euros per barrel, which is three times what it was then. But in the United States, the price of oil has risen to more than $120 per barrel and is now almost five times what it was then.

The sole reason for this enormous difference is the incredible depreciation of the dollar against the euro. From one for one at the end of 2002, it now costs nearly $1.60 to buy a euro.

The chorus of complaints about the price of gasoline gets louder every day and is even becoming a campaign controversy both across and within parties. The same old solutions we have heard for years are being proposed -- conservation, increased domestic exploration and manipulations of the tax on gasoline. But no one is pointing to what is by far the biggest reason for the exorbitant cost to fill up a tank of gasoline these days. The collapse of the dollar exchange rate, alone, explains at least half of the increase in the pump price of gas over the past five years. If it were not for the falling value of the dollar, the price of gasoline wouldn't be an issue.

Maybe the reason nobody talks about it is because they don't think you can do anything about it, or that it's somehow too esoteric to talk about exchange rates. But, economically speaking, what is more fundamental to the United States than the value of its currency? Why has the United States allowed the value of a dollar to fall so much?

The conventional wisdom, followed by U.S. administrations for the past 30 years, is that "the market" knows what it's doing in setting these rates, based on "the fundamentals" of the economy. This is, by the way, more or less the same market -- the same band of traders, both on and off Wall Street -- that, based on some view of the fundamentals, valued Bear Stearns at $100 a share one year ago. As the prevailing view of its fundamentals rapidly shifted, Bear's stock value collapsed, but it hurt only Bear's stockholders. The collapse of the dollar hurts everyone -- a lot.

The fact is that the dollar exchange rate is way out of line with the fundamental strength of the U.S. economy, and even with such well-known fundamentals as relative inflation rates.

But when it stays out of line for too long, it starts to feed back on the fundamentals themselves. The dollar has been so weak for so long that it's now causing inflation even at a time of recession. It is to blame for the excessive price of gasoline and now is pushing dangerously into wholesale price inflation, based on the most recent data published by the U.S. Labor Department.

Will the market, accommodated by hands-off policymakers, now dictate that the United States needs more depreciation to offset the inflation that depreciation itself has created?

Exchange rates can be managed, and the United States needs to implement and effective exchange-rate policy.

David King, a former chief of the New York Federal Reserve's Industrial Economies Division, is a managing consultant for Emerging Markets Group, in Arlington, Virginia. This comment appeared in The Wall Street Journal.