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Something rather momentous happened over the weekend -- not quite as momentous as the invasion of Iraq or the upcoming final episode of Friends, but still, pretty important. The United States dropped its eight-year-old policy of supporting a "strong" dollar.

By "strong," I mean having a relatively high value in the foreign exchange markets, the traditional definition of the word. However, as usual, the Bush Administration believes a word should mean precisely what it wants it to mean -- nothing more and nothing less.

And so, Red Queen-like, Treasury Secretary John Snow announced on Saturday that from now on, "strong" actually means "hard to counterfeit" in the administration's dictionary:

You want to see a currency that is a good medium of exchange; you want the currency to be a good store of value, something people are willing to hold, and difficult to counterfeit," Mr. Snow said.

Hookay, have it your way John, the currency markets replied. The dollar plummeted as soon as markets opened Japan last night, and continued to tumble as Monday arrived first in Europe and then the United States. The euro -- the butt of every Wall Streeter's jokes when it was launched (or rather, dropped) into the global currency arena in 1999, came within spitting distance of its dollar birth value this morning, and is expected to jump even higher in days to come.

So who cares about the falling dollar? Well, Wall Street cares -- rather more than Mr. Snow may have expected. The Dow Jones Industrial Average fell more than 2% today. Stock market losses overseas were, not surprisingly, even heavier, at least in local currency terms.

Pill Pusher

Driving down the U.S. stock market is probably not the treatment most doctors would prescribe for our fragile, deflation-prone economy. In fact, the surgeon general says it definitely could be hazardous to your employment prospects. This post and more particularly this post explain why.

But of course, we're not dealing with the surgeon general. We're not even dealing with doctors - unless you include Jack Kevorkian. Which wouldn't be very fair, since Dr. Death helps terminal patients end their suffering, while these guys take normal, healthy economies and turn them into Dr. Death's patients.

Why did the stock market take the news so hard? Because to Wall Street, Secretary Snow's comments sounded suspiciously like a prescription for financial chemotherapy.

Now by chemotherapy, I don't mean letting Halle Berry give you a nice relaxing full-body massage -- which would probably be the Bush administration's definition of the word. I'm talking about a painful, dangerous course of treatment designed to cure an even more painful and dangerous disease. In this case, the chemical of choice is what economists call a "competitive devaluation."

Wall Street doesn't want to be a cancer patient. It knows what the side effects are like. Snow may not have much hair left, but professional investors would rather hold on to theirs. They also want their dollars kept strong - in the traditional, not the Snowian, sense.

Deflationitis

But the disease (deflation) is real enough, even if the consulting physicians are currently mumuring "there, there" and telling the patient he'll be up and running around in "no time". This is also the tone taken in a new report from the International Monetary Fund, which rates the odds of a serious deflationary crisis in the United States as "low."

Given Dr. IMF's track record, we may want to order the wheelchair now -- just in case. Dr. IMF is big on amputations, as many of his patients learned during the great 1997-98 Asian Economic Crisis:

Thailand: Doc, I think I've caught the Financial Flu.
IMF: Saw both your legs off and call me in the morning.

Behind the scenes, however, America's doctors are clearly getting a little worried. The Consumer Price Index fell 0.3% in April, bringing the year-over-year increase down to 2.2%. The so-called "core" CPI -- which exludes highly erratic food and energy prices -- was flat, for a 1.5% annual gain.

The CPI suffers from some fairly well-known distortions that lead it to overstate the "real" rate of inflation. By how much is less well-known, but the studies I've seen put it in the 1-2% range. So the U.S. economy already may be teetering on the brink of generalized price deflation.

The real problem, though, is that Dr. Greenspan and Associates don't have too many pills left in their little black bag. With short-term interest rates now hovering just about 1%, the Fed has one, maybe two decent-sized interest rate cuts left before it gets caught in the dreaded liquidity trap.

It looks like Dr. Snow and Dr. Bush have decided on a more drastic course of treatment. They may not particularly care about finding a long-term cure, but they do want the patient resting comfortably by November 2004. So they're going for the chemo now.

Begger's Bowl

Competitive devaluation is one of those bland economic euphemisms that is actually way uglier than it sounds -- like "supply-side tax cut," or "structural adjustment program" (the technical term for Dr. IMF's advice to Thailand a few paragraphs back).

Back in the '30s, when economics was all about ugly, people used a different term. Competitive devaluation was one of a number of economic measures that came to be known collectively as the "begger thy neighbor" policy.

You'll notice I used a different vowel in the title of this post. In the end, though, it can amount to the same thing. To switch metaphors for a moment, picture a drowning man trying to climb on top of another drowning man's head. Then imagine lots of drowing men all trying to climb on top of each other's heads. No you have an idea of what "begger thy neighbor" really means.

In a deflationary environment, the key to survival is stealing market share -- by whatever means necessary. Why? Because the only way to protect revenues when prices are falling is to keep sales from falling, too. When domestic demand is slack, the easiest, and maybe the only way to do that is to take orders away from foreigners. Collectively, a country can accomplish this either by boosting exports or reducing imports.

Devaluing your currency is a tool to that end -- a thumb to stick in your drowning neighbor's eye while you try to climb on top of his head. Other "begger thy neighbor" policies include slapping high tariffs on imported goods and providing equally high subsidies to makers of exported goods, so they can cut prices on their foreign rivals.

Sales Competition

Human nature being what it is, it's no surprise that "begger thy neighbor" policies often evolve into "shoot thy neighbor" policies in fairly short order. During the '30s, cutthroat economic tactics were widely credited with destroying global trade, prolonging the Great Depression, and promoting the political fortunes of some rather eccentric fringe groups, one of them being the German National Socialist Workers Party.

Which is why, after World War II, the allies tried to create a New Economic Order based on free trade, free investment and fixed exchange rates. This was the so-called "Bretton Woods" system, in which all major currencies were pegged to the dollar. It was hoped that this would give the world the best of both worlds -- currency stability (a kind of economic arms control treaty) and some degree of monetary flexibility.

As custodian of the almighty dollar, the United States would provide liquidity to the system. And if countries ran into temporary cash flow problems, the IMF would loan them a few bucks -- "until pay day" -- so they could keep their currencies pegged to the dollar.

The system wasn't meant to be fixed in stone. Countries that needed to devalue were supposed to be able to do so. But the process was expected to be collaborative, with devaluations decided through negotiation.

Human nature being what it is, however, that was probably not the most realistic expectation. As the system aged, exchange rates grew progressively out of whack. The German mark and Japanese yen became more and more undervalued; the British pound became more and more overvalued. So did the dollar.

The problem (then as now) is that currencies aren't just used to pay for goods and services. They can also be used to buy assets - factories, land, stocks, bonds. And in the 1950s and '60s, U.S. corporations wanted to buy lots of foreign assets. So dollars poured out of America to pay for those assets. But as Europe and Japan recovered from the war, they began to export more goods to the United States. More dollars flowed out to pay for those goods. Pretty soon the outflow of dollars became a river, then a flood. But nobody wanted to adjust the value of their currencies to correct the problem because . . . well, who wants to mess with a good thing?

Until, not surprisingly, the good thing ended. Under Bretton Woods, the USA was obliged to swap dollars for gold on demand. But by the late '60s, foreigners realized the U.S. didn't have enough gold to go around. Gold, not dollars, started to pour out of the country. Finally, in 1971, President Nixon suspended gold payments. Bretton Woods was dead.

Follow the Bouncing Dollar

From the early '70s until now, with a few exceptions, the major and minor currencies have floated uneasily and sometimes violently in a sea of global FX traders, who at times seem to combine the mental stability of Michael Jackson with the analytical skills of a headless chicken. As a result, currency volatility -- and lots of it -- has become the norm, not the exception.

Loose currencies also can be toyed with by loose politicians. And since the end of Bretton Woods, competitive devaluation -- safe, legal and rare for the 25 years following World War II -- has degenerated into the economic equivalent of an abortion mill.

Countries also have been known to push their currencies higher, thus making imported goods cheaper. This can seem like a relatively painless way of dealing with a homegrown inflation problem. And it usually is -- until suddenly it isn't, at which point the pain of a massive currency devaluation can make passing a kidney stone seem downright enjoyable by comparison. Russia, Mexico and Argentina all discovered (or rediscovered) this the hard way during the 1990s.

The dollar itself has seen plenty of action -- both devaluation and upward revaluation. Massive dollar depreciation helped fuel the inflation surge of the '70s. The Reagan Administration took the opposite tack during the '80s, promoting a strong dollar as a way of fighting the inflation problem that '70s dollar depreciation had helped create.

By 1986, however, the dollar's rise was beginning to deflate the Reagan economic recovery. So administration tried to talk it down again. And like Secretary Snow, the Reaganites got a little more than they'd bargained for. Then, as now, investors suspected they were the white blood cells the Reagan team was willing to sacrifice to kill the deflation tumor. And so they cleared out. The dollar plunged, bond yields soared and in the fall of 1987 the Dow collapsed in the worst stock market crash since 1929.

Clearly, Secretary Snow recognizes a bright idea when he sees one.

Robert Rubin, on the other hand, believed it probably wasn't such a great idea for the world's largest debtor to threaten to repay its creditors with funny money. So he began to talk up the dollar as soon as he became Treasury Secretary. This -- like the Clinton deficit cuts -- helped keep bond yields low even as the economy boomed and the U.S. trade deficit soared.

Which may explain why Robert Rubin successfully ran one of the biggest and most profitable investment banks on Wall Street, while John Snow ran a railroad -- into the ground.

Healthy Debate

But, as I said earlier, the deflation threat is real, and growing. Times change. The right policy for the '90s isn't necessarily the best policy for the Age of Terror. So let's try to keep an open mind. Is competitive devaluation a smart strategy? Does America need a weaker dollar? Or is the Bush economic team simply flailing around with its usual incompetence, looking for any old pill it can shove down the patient's throat?

Given the administration's track record (and the stock market's reaction to Snow's comments) the answer may seem obvious. But the case isn't quite open and shut.

Some economists believe debasing a currency can stimulate growth and ward off deflation -- not just in the country doing the debasing, but other countries as well. The argument runs something like this:

• If country A devalues its currency, then country B (as well as countries C through Z) will see their currencies gain value.

• A stronger currency will make Country B's imports cheaper and its exports more expensive. This will reduce inflation.

• Seeing that inflation is lower, Country B's version of the Fed will be able to cut interest rates. This will stimulate economic growth.

Result: Country A will sell more exports and Country B will grow faster. The classic win-win scenario.

There's only one problem: The win-win scenario assumes that Country B doesn't have a deflation problem. It assumes that Country B is still worried about inflation, which is why a stronger currency might be needed to prod its version of the Fed into cutting interest rates.

But right now, the rest of the world is also threatened by the dreaded deflation virus. Indeed, Dr. IMF rates the danger of a deflationary spiral as "high" in Japan, Germany, Hong Kong and Taiwan, and "moderate" in Singapore, Sweden and Switzerland.

If other countries are also in or near the liquidity trap, then they may not be able to cut interest rates -- or cutting rates may not do much good. So even if the Team Bush produces a weaker dollar, the result may not be faster growth abroad.

Result: the drowning man climbs on top of the other drowning man's head, and then they both sink to the bottom of the river.

The world isn't in quite such desperate shape yet. Europe's central bank, the ECB, still has some room to cut interest rates. A plunging dollar might scare the eurocrats into doing it -- in which case some good might come of this.

The Good, the Bad and the Incompetent

But the potential benefit must be balanced against the damage this particular form of chemotherapy could do -- the financial vomiting and weight loss, the falling white blood cell count.

A plunging dollar could destroy billions, if not trillions, in international asset values. A plunging U.S. stock market could eradicate billions more. This kind of balance sheet damage is the last thing the global economy needs right now. The deflationary impact could completely overwhelm whatever boost the weaker dollar might give to U.S. exports.

I guess it comes down to this: Given the Bush team's questionable medical credentials, do we really want them administering radical chemotherapy -- not just to the United States, but to the entire global economy?

If your answer is yes, just don't be surprised if you hear someone yelling "Code Blue" over the hospital intercom sometime in the very near future.