The Fed is foolishly weakening the dollar

Devaluing the dollar is spoiling global economic recovery. The Fed and President Obama must reject easy money and ever-larger deficits.

Has America's Federal Reserve become the single greatest obstacle to global economic recovery? Central bankers around the world are increasingly asking this question as the American greenback continues its Fed-inspired decline and damages the export-driven growth of countries from Latin America and Asia to Europe.

Historically, the Fed has responded to economic downturns by cutting interest rates to stimulate domestic business investment and consumer purchases of "big-ticket" items, like automobiles and housing, that are sensitive to the cost of loans. However, in the current crisis, this traditional formula is simply not working.

It's not working in part because the Fed's "solution" has been a concentrated dose of the problem. After years of promoting the easy money and loose credit that fueled asset bubbles, it has responded with even easier money and even looser credit. It's like fighting fire with gasoline.

American consumers are not responding to the Fed's liquidity surge because high employment, high oil prices, bottoming home prices, and stagnant wage growth have squeezed their purchasing power. Business investment has likewise failed to fill the recessionary gap because much of the investment US corporations used to make on American soil is increasingly being sent off shore.

Despite this lack of responsiveness, Fed Chairman Ben Bernanke continues to throw monetary stimulus at the problem – and thereby has created an international dollar crisis now threatening the global recovery.

The declining dollar story is one of weakening demand for, and a massive oversupply of, the greenback. It is a sad and sordid tale scripted almost entirely by the Fed.

During the worst months of the global financial crisis, investors flocked to the dollar as a haven amid the storm. But since March 2009, when economic policy under the Bernanke Fed and the Obama administration became clearer, they have fled the greenback. In that time, the dollar index has fallen 16 percent.

You can't blame investors for selling. By first driving, and then maintaining, short-term interest rates near zero, the Bernanke Fed has made it far less attractive for them to hold dollars.

In a desperate effort to break the back of the credit crisis, the Fed has also engineered the most massive increase in the money supply in US history. Since 2007, the Fed has roughly doubled the monetary base. This, however, is only half of the oversupply story.

The other half of the tale involves the willingness of the Bernanke Fed to help accommodate the rapidly rising, and historically unprecedented, US budget deficits. Such accommodation involves the Fed's willingness to print new money to purchase many of the government bonds being issued by the Treasury Department to finance the budget deficit.

The practical effect of the Fed's easy money policies has not been to stimulate the US economy through traditional channels of domestic consumption and business investment. Rather, it has debased the dollar and thereby, in true beggar-thy-neighbor fashion, helped to stimulate demand for US exports while discouraging imports from the rest of the world. To the rest of the world, this policy seems cynically aimed at bootstrapping the American economy through exports at the expense of its trading partners.

This beggar-thy-neighbor effect is further complicated by the Chinese government's pegging of its currency to the falling greenback. Because of this peg, every time the dollar falls, the Chinese yuan falls with it. The steadily weakening yuan has further boosted the already formidable competitive advantage of Chinese manufacturers in markets across the globe.

In response to sluggish export demand in their home countries and the loss of market share to China, central bankers around the world are beginning to retaliate with large-scale interventions in the currency markets designed to brake the dollar's decline relative to their own currencies. The clear danger is that this tactical retaliation will devolve into a longer term strategy of competitive devaluations that will ultimately pit nation against nation and destabilize the already fragile international monetary system.

Washington officially supports a strong dollar. But its policies suggest otherwise. To avoid this destructive cycle, it is critical that the Fed and the Obama administration find the courage to end easy money and the accommodation of ever-larger budget deficits. This certainly won't be easy, but the road to global economic recovery must ultimately be paved with both fiscal and monetary discipline in the US – not with Great Depression-style competitive devaluations.

Peter Navarro is a business professor at the University of California-Irvine, a CNBC contributor, and the author of "Always a Winner: Finding a Competitive Advantage in an Up and Down Economy."

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