Executive Summary: The unwitting inflationary policies of the Federal Reserve, which have continued throughout 1978, have invited both recession and serious inflation for 1979. Although President Carter will blame OPEC for the recessionary effects of its price boost, the world dollar price of oil is inextricably tied to U.S. monetary policy and, once again, has been forced up by the Fed.
The European Monetary System that formally begins January 1, yet another global reaction to consistent error by the Fed, will intensify downward pressure on the dollar and upward pressure on the dollar price of gold. Such events translate into even higher interest rates, greater inflation, and deeper recession. Most of this pain still could be obviated, though, by a sharp reversal of the Fed's high-interest rate policy — a reversal more likely to take place after the damage of current error has already been done.
Inflation and Recession, 1979
In the summer of 1977, Vice President Lane Kirkland of the AFL-CIO was asked at a Washington conference what he thought should be done about the U.S. economy. "Bring down interest rates," Kirkland said without hesitation. A question came back: How would he bring down interest rates, by raising the money supply or by lowering it? Kirkland, showing the savvy of the likeliest successor to George Meany, neatly sidestepped the invitation to debate monetary theology. "Arthur Burns knows what he's done to get interest rates up as high as he has them," said Kirkland. "I'd tell him to do the exact opposite and bring them down."
This was the wisest possible advice Kirkland could have given at the time, and it is just as pertinent at the moment, with the Federal Reserve now under the stewardship of G. William Miller. Since March, when Miller succeeded Burns as the Fed's helmsman, he also exceeded Burns as a booster of interest rates. The prime went to 11.5 percent early in December from 8 percent in March. This escalation of interest rates reflects the theory that has dominated the Fed under both Burns and Miller. The theory, basically Keynesian, posits that inflation is caused by business and labor, which, being overutilized in an overheated economy, are able to bid up the general price level. Putting up interest rates, therefore, discourages excessive commerce. With the resulting slack in the economy, business and labor are unable to bid up prices. This is the essence of the so-called Phillips Curve, the tradeoff between unemployment and inflation.
Operating under this economic framework, fighting inflation becomes a matter of "courage," as the people are asked to bear the austerity implied by high interest rates. Aside from the fact that the theory has never worked in practice, this view of the economy fails to recognize that interest rates are forecasters of future inflation.1 Interest rates on dollar loans are low when the market believes the dollar will maintain its purchasing power during the period of the loan. Interest rates on dollar loans are high when the market believes the dollar will lose purchasing power (inflation) during the period of the loan. If the Federal Reserve has as its objective a reduction in the rate of inflation — the dollar holding its purchasing power — it must have as its central aim the lowering of interest rates.
Which brings us back to the question sidestepped by the AFL-CIO's Kirkland: How does the Fed go about lowering interest rates, by increasing the money supply or by decreasing it? The Fed, after all, can do only one or the other, creating money by buying Treasury securities from the banks, or extinguishing money by selling Treasury securities to the banks. Put another way, how do you persuade the market that the dollar will maintain purchasing power, by increasing the dollar supply or by making dollars scarcer? The answer, obviously, is that the value of a thing, a piece of paper, is enhanced by its relative scarcity and reduced by its abundance. Insofar as the market believes that scarcer dollars will hold their value, in terms of purchasing power, interest rates would be lower than they otherwise would be.
While this chain of argument seems logical, an opposite case is being made: that as more money is created its price, subject to the law of supply and demand, must fall, interest rates being the "price." This widely prevailing view, held by most advisers to the Fed, requires that we assume the demand for money remains constant when its supply is increased. We know, however, that when money is expected to lose purchasing power in the future it is advisable to borrow more of it now and pay it back in the future when it is easier to earn. Supply rises, but demand rises faster, and interest rates climb until demand and supply reequilibrate.
All this is theoretical. What of experience? How has G. William Miller in fact been so successful in raising interest rates since March, by creating money or extinguishing it? The answer is put cogently in the Dec. 31 issue of Fortune in an article by A.F. Ehrbar: "The monetary base has been growing at a breakneck pace under Chairman Miller." Indeed, throughout the period, the monetary base has been growing at between 9 percent and 10 percent of its previous year level.
An indication of the confusion in the debate surrounding Fed policy is provided by Fortune's analysis, however: "If the Fed had not increased the money supply so rapidly, there would have been much less credit available and interest rates would have risen much higher than they did." The confusion is over "money" and "credit." Credit involves the willingness of an individual to give up part of his production to another individual in exchange for a future claim on resources. Money is a medium of exchange, a medium which, if it promises to lose future purchasing power, discourages the willingness of individuals to extend credit. Interest rates are the price of credit, whereas the price of money is its purchasing power.
This confusion, which grips Fortune's analyst, also has the Fed stymied. Chairman Miller wants interest rates to go up to fight inflation, but he doesn't want interest rates to go up because that will bring on a deeper recession. And even "conservatives" who plead for restraint in the growth of the monetary base believe such restraint will put interest rates higher.
There is nothing in our analysis that suggests the Fed has been acting irresponsibly. A better word is unwittingly. The results, though, have been horrendous for the U.S. economy and for financial markets. The private exchange economy that does business in dollars — business and labor around the world — is powerless to adjust to a depreciating dollar in any other way but to put up nominal prices of wages and goods in order to maintain the terms of trade. President Carter, a victim of this unwitting confusion of theory, is led to believe that inflation is being caused not by the Fed's depreciation of the dollar, but by the exchange economy's attempt to maintain terms of trade. Thus, his program of "voluntary" wage and price controls, an attempt to have American business and labor refrain from adjusting their terms of trade to a depreciating dollar.
There is absolutely zero chance such an effort can succeed, it being mathematically impossible to avoid a worldwide adjustment of the terms of trade in all transactions using dollars as the medium of exchange. The most visible signs of adjustment are in the dollar prices of internationally traded commodities, including gold and foreign currencies, and of course oil. The decision by the Organization of Petroleum Exporting Countries (OPEC) to raise the nominal price of its benchmark crude by 14.5 percent in 1979, in stages, is simply a delayed adjustment to this mathematical imperative forced by Federal Reserve policy. OPEC does not sell oil for dollars. It trades oil for world goods and services, using dollars as the medium of exchange. The President can no more jawbone OPEC into refraining from making adjustments than he can jawbone down the price of gold or the dollar price of foreign currencies in the exchange markets.
In this context, it is useful to look back on a forecast by Canadian economist Robert Mundell, who with Arthur Laffer elaborated the model of "global monetarism" used for analytical purposes in this paper. On June 3, 1969, Mundell predicted that the 1970s would bring worldwide experimentation with flexible exchange rates, as policymakers hoped to fool transactors into trading with cheaper currency without adjusting prices — a process called "money illusion." Mundell forecast that the experiment would be a "dead letter" by 1980, but that "American economists will be slower at seeing the implications of the decline in money illusion than their foreign counterparts." He said, a decade ago:
Economists will increasingly adopt the view that the advantages of a world-wide regime of flexible exchange rates have greatly diminished. There are intellectual and practical reasons for this. The case for flexible exchange rates has never been a very sound one. It is based on the Keynesian assumption of money illusion and fixed money wage contracts. But money illusion is rapidly disappearing because of the acceleration of the rate of diffusion of information, the increased sophistication of the public on monetary subjects, and the increasing awareness on the part of workers that an increased price level lowers real wages and that devaluation raises prices.2
In 1971, as the United States moved in earnest toward experimentation with flexible exchange rates — President Nixon cutting the last nominal tie between the dollar and gold — Mundell warned that "retention of monetary leadership in the U.S. will depend on the quality of U.S. performance, with erratic or antisocial behavior ultimately forcing Europe into a currency coalition. The greater the departure from acceptable norms the more likely is the emergence of monetary leadership in Europe."3
By viewing economic events through this framework of global monetarism (as opposed to theory that attempts to treat the U.S. economy in isolation) we see how Mundell could be so uncannily prescient. Since 1971, first under Burns, then Miller, the quality of U.S. performance on monetary leadership has been dismal. The Federal Reserve, in attempting to influence the exchange economy by manipulation of interest rates, has been both erratic and "antisocial," antisocial in the sense that at times it has explicitly disregarded the effects of its policies on those parts of the world outside the United States that have, over time, come to transact in dollars and to rely on its purchasing power as an invoice currency. "Malign neglect," is how Fritz Leutwiler, president of the Swiss central bank, put this attitude on the part of the Fed last year. And as Mundell had foreseen in 1971, this behavior would only be tolerated so long before monetary leadership would emerge in Europe. Germany's Helmut Schmidt and France's Valery Giscard d'Estaing finally gave up on U.S. monetary leadership in 1978 and drew up plans for a European Monetary System, which formally begins operations on January 1, 1979. The explicit purpose of this currency coalition is to try to insulate Europe, and any other countries that wish to join the coalition, from the erratic and antisocial behavior of the U.S. monetary authorities. Of the Common Market countries, only Britain refuses to join in this coalition, the British Keynesians being the source of theoretical confusion at the U.S. Federal Reserve. To help understand what is afoot, here again are Mundellian observations, of November 1976:
There is still a vast dollar area that commands the central tendency of the world economy and the rates of inflation in that area call the tune of world prices after allowance for exchange rate changes.
It is for this reason that U.S. monetary policy is so influential in the world economy, and its regulation, no longer checked by the gold convertibility discipline, is still the most important policy variable in the arsenal of global stabilization weapons. The monetary policies of other countries, of course, affect their respective national price levels, and differential rates of change in inflation rates imply exchange-rate depreciation rates. Under the old system, the fixed-rate objectives gave the world a monetary unity, in effect the framework of a single international money based on a gold-convertible dollar, tying the monetary world together into a single global unit. In that system, world liquidity was ultimately controlled by the gold base supplemented by the use of the reserve currencies, which were, at least in principle, convertible into gold. Gold convertibility represented the theoretical means by which the control of the reserve currency center was shared by other countries. With the 1971 collapse that lever was given up and multilateralism broke down into balkanization in Europe and major bilateralism around the dollar, with an outside center about the mark.4
This "outside center about the mark" is the pivot of the incipient European Monetary System. While Germany and France are advertised partners, sharing responsibility in running the EMS, Germany will provide the reserve currency center with the D-mark. It will be some time before the mechanisms to make the EMS work will evolve, but it is clear from the outset that the system will make use of gold at least as an error signal in determining whether joint monetary policy is optimum or not. Each member will be required to establish a monetary price for their monetary gold, and if the price rises in terms of all currencies linked together, the signal will be to make currencies scarcer. If the price falls, the signal will be to expand money creation. No central bank, though, will buy or sell gold at an established price in order to maintain that price, there being an international agreement with the United States not to do so. Stabilizing the price of gold by coordination of monetary policies would theoretically work just as well, however.
The implications for the U.S. economy are enormous, although this fact seems not to have penetrated into the heart of the Carter Cabinet. Treasury Secretary Blumenthal sees it as a good thing, if it increases stability in Europe, and that is correct. But he also says the administration favors "orderly evolution" toward a lesser world role for the dollar as a reserve currency. No matter how hard he tries, Secretary Blumenthal can not stop "talking down the dollar." To the degree the Europeans can evolve a monetary unit of account that retains its purchasing power, the dollar will continue to suffer, the "vast dollar area" cited by Mundell shrinking during this "orderly evolution," with a consequent decline of the United States as a banking center. Of course, this evolution would be accompanied by continued inflation in the United States and price stability in the economies successfully tied into the EMS currency grid. Every day that the EMS can demonstrate movement toward its goal will mean increased downward pressure on the dollar in the foreign-exchange markets along with upward pressure on the dollar price of gold. Eventually, one would expect, the U.S. government — in particular the Federal Reserve — will come to understand the profound error of current policy and reassert monetary leadership.
On the eve of the new year, financial markets see little grounds for such optimism. With the price of gold pushed well above $200 per ounce again and the dollar resuming its decline against European currencies, upward pressure on interest rates continues, forecasting a double-digit rise in the price indices in 1979. The shock to the economy anticipated by the stock market reflects the impact the continued increase in the general price level has on real rates of taxation, via the progressive nature of the tax system. Given current tax structures, higher rates of inflation would not only be reflected in higher interest rates but would also lower real after-tax, economic corporate profits — an important determinant of equity prices. That is, inflation forces corporations to pay higher effective tax rates by creating statutory tax liabilities on illusory profits generated by the undercosting of goods sold and depreciation, a phenomenon likely to be recognized by financial markets.
It is important to keep the real sector, the exchange economy, separate from the monetary dimension. The real sector will respond positively to lower tax progressions, but we will have to await the 96th Congress to see if that has potential in 1979. Meanwhile, we can all watch the Federal Reserve and hope it stumbles upon Lane Kirkland's advice, doing exactly the opposite of what it has been doing and fighting inflation with low interest rates.
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1 For a more detailed discussion of this topic see: Arthur B. Laffer and R. David Ranson, "Some Practical Implications of the Efficient Market Concept, H.C. Wainwright & Co., July 6, 1977
2 Source: Remarks of Robert A. Mundell presented at Queens University, Kingston Canada, 1969. Reprinted by the University of Toronto Press in Bretton Woods Revisited, 1972, pg. 101
3 Source: Monetary Theory, Santa Colomba Press, Siena, Italy, 1971
4 Source: The New International Monetary System, Columbia University Press, New York, 1977, Editors Robert A. Mundell and Jacques J. Pollak, pg. 239