President Reagan once quipped that an economist is someone who asks, “It works in practice, but will it work in theory?” The gibe came to mind as we’ve read in recent days of the debate over whether the plunge in the value of the dollar against gold can be blamed on President Bush’s tax cuts. This certainly seems to be the theory of some in the liberal camp. They blame the federal budget deficits for the recent declines in the value of the dollar and, since they blame the tax cuts for the deficits, the logic would follow that tax cuts are bad for the dollar. Feature, however, the accompanying chart, which casts doubt on the idea that federal deficits must weaken the dollar.

In classical economic thinking, taxes and regulation set the pace of growth. The supply of money is involved here too. When ancient Roman emperors called in their currency and clipped or shaved some of the gold and silver from it and then injected new currency into the market, prices rose. The currency was worth less because there was more of it, and it bought less in goods, in services, and in other currencies. This principle has never changed. If the supply of money grows more quickly than the supply of goods and services, then each unit of currency is worth less. This is called inflation.

It turns out that this doesn’t just apply to the purchase of traditional goods and services. The debauching of currency shows up most quickly in the purchase of highly liquid assets such as gold and other currencies. If it takes more dollars to buy an ounce of gold than it did before, it’s because the dollars aren’t worth as much as they were before. Ditto for foreign currencies. The reason the dollar has fallen in value is because the Federal Re serve System has been creating too many of them. The Federal Reserve has been creating too many of them because the Bush tax cuts did not get fully implemented until last May, and so until that time, the economic recovery was rather languid.

Because the Fed chairman is not sure from week to week whether he is a supply-sider or a Keynesian, he didn’t mind throwing a lot of money at a slow recovery. Last week’s high gold prices and low dollar are the market’s way of telling him that he’s done damage. Meantime, tax cuts, if they have any impact on the value of the dollar at all, enhance the value of the currency. Not only do tax cuts stimulate the production of goods and services – the same number of dollars chasing more goods and services is deflationary – but they create a more hospitable environment for international investors. Asian and European investors like to put their capital to work in countries that are growing; that’s why they like America.

That’s why the chart appearing here is instructive. The late 1970s were a time of modest deficits and a rapidly depreciating dollar. The 1980s were a time of tax cuts, deficits, and a strong dollar. The 1990s were another strong dollar decade, but the lowest gold prices and highest dollar valuations occurred after President Clinton’s capital gains tax cut in 1997. The Democrats and their friends may be right in that the plunge of the dollar against gold is something to watch. Nice to see them watching the gold price. But the decline of the dollar isn’t because the president cut taxes. Sound money and lower taxes are the solution to the dollar’s current decline.