Memo To: SSU Students
From: Jude Wanniski
Re: Guest Lecture
We're fortunate today to have as guest lecture in our fall semester monetary series the text of a speech delivered just yesterday at the Los Angeles Economic Round Table by Polyconomics' West Coast representative, Wayne Jett. Our lessons are almost "evergreen," covering general topics, but Jett addressed the most timely of topics, the fall in the international value of the dollar.
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NO RETURN TO A STABLE DOLLAR?
By Wayne Jett © December 9, 2004
Since April, 2001, the dollar has lost 44% of its value, and has dropped 16.5% since April, 2004. The Federal Reserve Board chairman has alerted foreign owners and buyers of U.S. Treasury bonds that they should be concerned about the wisdom of those investments unless the U.S. current account deficit and the federal budget deficit are reduced. The Economist magazine is asking editorially how much longer the dollar can remain the world’s most important reserve currency. Concerns are expressed in the Wall Street Journal that the U.S. government may soon face a cut in credit rating of its debt instruments. What is going on?
Understanding the current dollar dilemma requires examination of U.S. monetary policy and the Federal Reserve Board. On January 3, 2004, the Fed chairman since 1987, Alan Greenspan, came to San Diego to address the American Economics Association convention. At the time, Mr. Greenspan was a candidate for re-appointment as Fed chairman. As a candidate, he was exposed to at least a slight chance that he would not be re-appointed. What better reason than this to reprise his successes during 16 years as Fed chairman?
However, Mr. Greenspan did, indeed, have a more important reason to extoll the successes of the Fed as “extraordinary crisis fighter without portfolio.” He did so to make the case that the Fed should continue to engage in “risk management” of the economy, and should not be required to follow any “simple rule” of monetary policy.
In favoring risk management and opposing any “simple rule” of monetary policy, Chairman Greenspan summarized his views of difficulties faced under his leadership of the Federal Reserve Board. He set out to prove the advisability of “ad hoc problem-solving… with special care for downside risk.” But, in my opinion, the Fed chairman provided conflicting reports of historical facts and was unpersuasive in his statements of perceived wisdom.
The Chairman’s Account
In his San Diego remarks, Chairman Greenspan described “… a two-decade long decline in inflation that eventually brought us to the current state of price stability….” He said the decline in inflation since 1982 had occurred within the context of an environment for monetary policy “… particularly conducive to the pursuit of price stability.” The primary factor cited by the Chairman as producing this favorable environment was political support, a curious contradiction of the FRB’s fabled independence from political influence.
Greenspan credited Milton Friedman for inspiring universal recognition that inflation is “always and everywhere” a monetary phenomenon. But, as you may recall from my previous remarks to ERT, it was Professor Friedman who led President Nixon to float the dollar’s value in 1971. That historic error was made as Robert Mundell, the 1999 Nobel laureate, correctly predicted the monetary chaos to flow from unleashing market forces on the dollar’s value.
When Greenspan’s accounting reached the late 1990’s, he said earlier notions that even high single-digit inflation did not impede economic growth had been abandoned, and GDP growth was relatively steady as inflation rates dropped. “To preserve these benefits, we engaged in our most recent preemptive tightening in early 1999 that brought the funds rate to 6-1/2 percent by May 2000,” he recalled. “Our goal of price stability was achieved by most analysts' definition by mid-2003. Unstinting and largely preemptive efforts over two decades had finally paid off.” In those words, the Fed Chairman applauded as a triumph a moment of perceived price stability, without mentioning the cataclysmic $13 trillion reduction in private U.S. equity capital during 2000-2002.
But there was more to the Fed chairman’s speech, and it got worse. Chairman Greenspan reflected upon the “greatest irony of the past decade” as being this: The Fed’s victory over inflation may have contributed, not to the stock market crash lasting three years, but to the “stock price bubble” that preceded it! Here is his rationale explaining the preposterous premise that tight monetary policy contributed to unwarranted, extended advances in stock prices: Irrational investor expectations of (1) earnings growth (caused by technology-driven productivity increases) and (2) risk (resulting from Fed-induced “macro-economic stability”) did it. Confronting such flawed analysis, objective commentary must place the irrationality within the Fed itself.
This bubble, Greenspan stated, was “an especial challenge” for the Fed. Any hope the Fed could correct the problem through a “calibrated tightening,” he said, was “almost surely an illusion.” Instead of calibrated tightening, he reported, the Fed decided in mid-1999 to refrain from pricking the bubble, and to be ready to clean up the debris after the burst. In summary, Chairman Greenspan described the Fed’s sole transgression during the past decade as creating such “macro-economic stability” that investors reacted irrationally, creating a financial bubble-burst that required Fed assistance in the aftermath!
In light of this stellar record, the Chairman argued, the Fed should retain its portfolio of discretionary authority to engage in “risk management” of the economy. The world economy is so complex and evolutionary no single economic model is trustworthy in forecasting and interpreting events. For that reason, he said, “both econometric and qualitative models need to be continually tested.”
Unwinding the Fed-Spin
Classical (supply-side) economic theory has earned the opportunity for influence at the Fed. This is so partly because classical theory has made important contributions to economic growth through fiscal policy (cuts in marginal tax rates on income and capital in 1964, 1981, 1986, 1997 and 2003). But, since the Fed has been dominated by demand-side economists since 1971, classical monetary theory has had to prove its worth as, on repeated occasions, the Fed has elected to follow the advice of other economic models, often with highly adverse consequences.
The Fed chairman’s reluctance to adopt any single economic model is understandable in the context of his views presented January 3. Classical economic theory would shine light on the inconsistencies of reasoning and policy mistakes that glare from the record of actions taken at the Fed. Other economic models afford more complimentary explanations of Fed practices and actions than does the classical model, especially when the chairman can move among the various models in mid-sentence.
Since inflation, as Chairman Greenspan conceded, in all cases and everywhere is a monetary phenomenon, so is deflation. Inflation and deflation alike result from the Fed’s own monetary policy and practices as they interface with the markets. The straight-forward means of viewing both inflation and deflation is by a chart of the dollar price of gold. Gold is the most monetary of commodities, with the largest existing inventory and a non-wasting quality. The price of gold reflects a mirror image of the dollar’s changing value daily. The dollar’s value fluctuates wildly, while gold’s value remains steady.
The dollar/gold price chart shows unmistakably that a significant deflation flowed from the Fed’s practices from 1996 to 2001. The dollar/gold price fell from almost $420 per ounce in early 1996 to about $255 in mid-1999, repeating that $255 low in early 2001. This reflects an increase of 64.7% in the value of each dollar within five years. In no sense may this monetary environment be accurately described as “macro-economic stability.”
In this light, it is no surprise that those who borrowed dollars in 1996, such as the growing economies of southeast Asia and expanding U.S. telecommunications companies like MCI, were crushed by those debts. Their obligations, whether denominated in dollars or other dollar-pegged currencies, had been surreptitiously increased 65% by the Fed’s undisclosed practices. Concurrently, the pricing power and profitability of all businesses were reduced and then destroyed by the dollar’s downward pressure on prices as operating expenses remained relatively static.
In this manner, the Fed-produced deflation of 1996-2002 certainly contributed to the sharply rising stock prices that crested in March, 2000. But the mechanism by which the contribution operated is much different from that described by Chairman Greenspan. Commodity prices, as usual, were early signals of the dollar’s increasing value in 1996 and years following. Commodity prices collapsed. Capital that would have been invested in commodity-based industries went elsewhere. Those industries, including oil exploration and production, reduced capacity.
As deflationary effects spread, other basic industries lost pricing power and profitability. Capital continued its search for acceptable return, abandoning each falling industry sector in turn, and finally concentrating in intellectual properties. Technology offered improved productivity growth, seeming to retain the pricing power other industries were losing. Capital concentrated in the still-rising technology stocks, and they soared even higher. Then the purchasing power of technology’s customers broke, and the last of the business sectors fell hardest of all.
Thus, the Fed’s contribution to both the rise and fall of stock prices was pervasive. As Chairman Greenspan said, the Fed’s practices reflected “… preemptive tightening in early 1999 that brought the funds rate to 6-1/2% by May 2000.” The Fed maintained this “preemptive tightening” strategy at its highest rate of 6.5% fully 10 months after the collapse of stock prices began in March, 2000.
Precisely what was the Fed preempting? The Chairman had already told us that the environment was one of “macro-economic stability” and that the defeat of inflation was approaching its culmination. Indeed, he expressly surmised that this stability had taken such hold that it inspired investor irrationality, causing a “bubble” in stock prices. The Chairman denied that the Fed acted to bring down stock prices. But what else was a worthy target for the preemptive tightening begun in early 1999 and continued relentlessly until gradual loosening began in early 2001?
The Chairman’s remarks are an unintended confession that, three years into a severe deflationary trend, the Fed began a regimen of rate hikes intended to tighten monetary policy even further. This was not a sound decision taken to promote macro-economic stability. Despite repeated advice from Jude Wanniski of Polyconomics that classical analysis showed the destructive effects of deflation, the Fed persisted with a tight-money, inflation-fighting stance that was a death-wish for the economy and the markets.
Chairman Greenspan said “price stability was achieved by most analysts' definition by mid-2003.” The Fed’s demand-side economic models use backward-looking indicators that measure experience in months long past. This provided a rationale for the Chairman’s report that mid-2003 was the turning point in the inflation battle.
But the Fed, as the Chairman well knows, had actually turned in earnest from deflation to reflation in October, 2002, as stock prices plunged yet again. With this long-delayed reversal of practices by the Fed, stock prices finally bottomed and began their recovery.
Indeed, the Fed had moved the dollar from its deflationary value peak value of about $255 gold in early 2001, reaching $280 gold by January, 2002, before finally surpassing the equilibrium dollar/gold price of $350 by year-end 2002. The dollar spent the first half of 2003 reasonably near that equilibrium value, but then the Fed dropped the dollar into inflationary territory.
After seven years of battling non-existent inflation unto near destruction of U.S. equity markets, the Fed within 18 months has inflated the dollar a full 30% below its proper value. This is “macro-economic stability?”
Dollar Stability Manages Risk Best
Clearly, allowing the Fed to operate as risk manager for the economy is not achieving price stability. That being the case, why not consider what Chairman Greenspan described as the alternative: a “simple rule” of monetary policy?
What does he mean by a “simple rule?” A simple rule would require the Fed to keep the value of the dollar stable. The rule should target a dollar price of an ounce of gold and require the Fed to manage its balance sheet (buying or selling Treasury bonds) to hit the target.
Shortly after Chairman Greenspan’s January 3 speech, Fed governor Ben Bernanke delivered remarks in February arguing there could be no return to the gold standard. To make his case, Bernanke resurrected every mythical bugaboo of the Crash and Depression. Then last Thursday, December 2, Governor Bernanke addressed the Economic Club of Washington, D.C., seeking to shore-up Chairman Greenspan’s plea for continuing “risk management” discretionary power.
This time, Governor Bernanke presented his case as a matter of “logic.” He said the choice of monetary policy is to be made by the Fed, and the choice is not between a “strict rule” versus a discretionary policy for “risk management,” but rather is between “feedback based policy” and “forecast based policy.” In Bernanke’s view, no reasonable person would deprive policy-makers of discretion in setting policy. So Bernanke simply discards a strict rule from the debate.
Moreover, Governor Bernanke takes the Fed’s role in “risk management” as beyond debate because Chairman Greenspan has said the Fed should do it. Then he says risk management requires forecasts of economic performance and approaching crises, and forecast based policy is best suited to the purpose. Thus, Bernanke puts his policy objective (risk management) beyond challenge and then uses it to tip the scale in the choice between feedback based policy and forecast based policy. This is called framing the debate to favor the desired outcome.
Specific financial crises of the type requiring “risk management” by the Fed were not mentioned either by Chairman Greenspan or by Governor Bernanke. The crises most likely on their minds include the near-default of the Mexican government on its U. S. bank debts in 1982, the Crash of 1987 in the U.S. equity markets, and the Long-Term Capital Management hedge fund crisis of 1998.
What shouts for acknowledgment as the common characteristic of these crises is that each crisis was precipitated by the absence of a so-called “simple rule” governing U.S. monetary policy. The severe deflation of the dollar in 1981-82 caused the near default by Mexico. The weakening dollar caused capital flight from the U.S. markets in October, 1987. And, the Long-Term Capital Management crisis was the outcome of leveraged speculation based on erroneous forecasts of monetary policy and currency exchange rates.
With a “simple rule” or “strict rule” of monetary policy requiring and providing a stable dollar value, any financial problem will have entirely private origins and will be resolvable accordingly. Without such a rule, crises resolvable only through extraordinary measures by the Fed will inevitably continue to arise, and with greater frequency.
This is so because a central bank must make stable currency value its overriding focus or it cannot succeed. A central bank that elects an interest rate target as its focus, as the Federal Reserve Board has done, will be unable to achieve sovereignty over either its targeted interest rate or its currency value.
The reason is simple. If we had a mathematical formula to calculate the value of a dollar (which we do not), the federal funds interest rate might be one of the variables. Changing the interest rate would not change the dollar’s value proportionally because other variables would adjust. The dollar’s value would change, if at all, in unpredictable ways. No directly proportional relationship exists between the federal funds interest rate and the dollar’s value. So the Fed has no chance of achieving dollar stability by adjusting the funds rate.
Yet, serious economists argue that the Fed can achieve price stability by using funds rate adjustments, even while conceding that the funds rate “tool” cannot stabilize the dollar’s value. I had a recent exchange with a well-regarded economist responsible for managing assets valued at hundreds of billions of dollars. He asserted to me that the Fed can achieve price stability (i.e., the Fed can control domestic core inflation) by “managing the output gap [by] managing aggregate demand [by using] an interest rate target….” He made this assertion even while conceding that the funds rate target cannot stabilize the dollar’s value.
I assure you, as I assured him: dollar prices cannot be stabilized without stabilizing the dollar’s value. When the currency unit of account changes, the price of goods and services will change as soon as practicable.
While few economists acknowledge that targeting interest rates cannot stabilize the dollar, almost all persist in thinking that the Fed can strengthen the dollar by raising the fed funds rate. In fact, most economists are in one of two camps: one camp that supports higher rates at a “measured pace” or the second camp that thinks rates should be jumped higher rapidly “to get ahead of the inflation curve.” These views are based in part on reasoning that higher interest rates will stimulate demand for dollar-denominated debt.
When the Fed embarks on a regimen of rate increases, as occurred in 2004, Polyconomics is presently alone in seeing inflationary effects. Prospects for higher financing costs and tighter lending standards reduce demand for dollars by discouraging business and investment. Reduced demand for dollars leaves more excess liquidity, meaning more inflation unless the Fed acts to remove the excess. We see this in the weakening dollar, as the gold price has moved from below $380 in April, 2004, to above $455/oz. In 1999, with oil at $10/bbl, the growing economy kept money tight. In 2004, even with oil above $40/bbl, economic growth was able to reduce the growing excess liquidity until the rate increases began.
No matter how much imagination and complexity the demand-side economists put into circular reasoning – funds rate target to aggregate demand to output gap – they cannot make water run uphill and they cannot stabilize the dollar by targeting the fed funds rate.
Nor can they solve monetary problems with fiscal solutions. An example of the propensity of demand-side economists to confuse monetary and fiscal issues is found in the December 4, 2004, New York Times front page, above-the-fold three-column headline story “Dollar’s Fall Tests Nerves of Asian Central Bankers.” The story details the worries caused among Japanese and Chinese central bankers by the dollar’s falling value. Yet, within the story, we find this quoted statement:
"What China and Japan are trying to do is say [to the U.S.], 'Please get back on track with fiscal reform,'" said Robert A. Feldman, chief economist for Morgan Stanley Japan.
Fiscal reform? Meaning balance the federal budget? This is economic nonsense!
Allow me to quote Chairman Greenspan again: “Inflation is always and everywhere a monetary phenomenon.” So we must have monetary reform, not fiscal reform, to resolve our inflation problem. Robert A. Feldman of Morgan Stanley Japan apparently has fallen for Chairman Greenspan’s recent public finger-pointing at trade imbalances and budget deficits as the culprits causing the dollar’s inflationary binge.
U.S. fiscal policy is presently more favorable to capital formation than at any time since 1966 and has prospects to get even better if President Bush’s agenda is adopted. But the economic boat needs two oars pulling together – both fiscal policy and monetary policy. U.S. monetary policy has been seriously deficient since President Nixon’s economic team floated the dollar’s value.
The Federal Reserve Board can mend this historic error by targeting a stable dollar value with a reference point to gold. This would keep the dollar’s value stable while allowing the markets to set interest rates. The stable dollar value target would be easier for the Fed to achieve than the existing overnight funds rate target, and would automatically furnish the correct level of dollar liquidity.
In June, 2003, Milton Friedman conceded his theory of targeting money quantities had failed as a mechanism for stabilizing the dollar’s value. In August, 2004, Martin Wolf, the leading Keynesian economist of Europe, wrote in the Financial Times that floating currency values and the resulting chaotic exchange rates are an unsatisfactory international monetary system. What remains is for U.S. monetary policy to be reformed accordingly.
The benefits of a dollar value target do not end, but only begin, with accurate liquidity flows. One of the most harmful effects of the floating dollar value continues to be the misallocation of investment capital. For example, consider the dot.com and technology stock prices prior to March, 2000, or the currently soaring prices in oil, other commodities and certain residential real estate markets. When the dollar’s value remains stable, market forces can resume their naturally efficient role in allocating capital to its best uses.
When the dollar’s value swings upward and downward within a broad range, as it has only since 1971, life becomes much more complex. People have the value of their accumulated capital destroyed, either through inflation or lost employment opportunities. Both parents are pressed into the work force to support the family. The standard of living lags far below where it would be if our economy and the world had the benefits of a stable dollar.
If the FRB remains unwilling to mend the critical monetary policy flaw created by the 1971 presidential executive order, President George W. Bush should act to correct the error. The President can put our nation’s monetary policy back on the right course with an executive order fixing the value of the dollar to a reference price of gold. The alternative is more monetary, economic and financial turmoil ahead.
Hopefully, the current exchange rate turmoil will not end in a dollar so weak as to cause another exodus of foreign investors reminiscent of the crash of 1987. That ’87 episode occurred shortly after Alan Greenspan began his tenure as chairman by announcing the acceptability of a weaker dollar. No one wishes to see two such events as book-ends for his long tenure as Fed chairman.