Inflation and the 'Arc of Crisis' Jude Wanniski February 29, 1980

Executive Summary: Signs of runaway inflation and its companion — political collapse — are evident on the edges of the Western alliance. Iran is the most visible symptom of the disintegration of world political order — its revolution being spawned in Nixon's 1971 closing of the gold window. Now Turkey nears economic collapse and anarchy on the destructive monetary and fiscal advice of the International Monetary Fund.

Against this background, evidence of commercial prosperity is an illusion, continued brisk trade reflecting the acceleration in the unloading of inconvertible dollars. There is an unsettling parallel to the assignat inflation of the 1790s. The decline of the dollar as a store of value reduces OPEC's appetite for dollar-denominated financial assets, suggesting a continued decline in Saudi Arabian production and/or increased political tension in the Middle East. Similarly, American labor and capital participate in the "unloading" of dollar assignats, given the global collapse of the dollar as a storehouse of value. Thus, the bond market collapses amidst historic declines in productivity and savings rates.

Inflation and the Arc of Crisis

In 1876, Andrew Dickson White, the founder of Cornell University, first published his classic essay on the paper-money inflation in France in the 1790s. The whole of the essay is chillingly apropos to the current inflationary milieu, but one passage especially illuminates early 1980.

The issues of paper money continued. Toward the end of 1794 seven thousand millions in assignats were in circulation. By the end of May 1795, the circulation was increased to ten thousand millions; at the end of July, to fourteen thousand millions; and the value of one hundred francs in paper fell steadily, first to four francs in gold, then to three, then to two and one-half. But, curiously enough, while this depreciation was rapidly going on, as at various other periods when depreciation was rapid, there came an apparent revival of business. The hopes of many were revived by the fact that in spite of the decline of paper there was an exceedingly brisk trade in all kinds of permanent property. Whatever articles of permanent value certain needy people were willing to sell, certain cunning people were willing to buy and to pay good prices for in assignats.

At this, hope revived for a time in certain quarters. But ere long it was discovered that this was one of the most distressing results of a natural law which is sure to come into play under such circumstances. It was simply a feverish activity caused by the intense desire of a large number of the shrewder class to convert their paper money into anything and everything which could hold and hoard until the collapse which they foresaw should take place. This very activity in business simply indicated the disease. It was simply legal robbery of the more enthusiastic and trusting by the more coldhearted and keen. It was the "unloading" of the assignats upon the mass of the people.1

The passage was cited to a New York businessman, in a conversation in early February, and he took up the parallel with 1980 without hesitation: "At least so far we have been able to unload on the Arabs."

Although the mass of the people have been stuck with plenty of assignats (U.S. dollars) as well, the picture of "enthusiastic and trusting" Arabs being swindled by the "coldhearted and keen" American inflationists is a useful one. Conventional wisdom, including President Carter, has it that the now runaway inflation is caused by OPEC, aided and abetted by masses of Americans who are bidding up all prices in an attempt to keep up with rising energy costs. This view denies the existence of the law of supply and demand, which the neo-Keynesian economists are quite prepared to do. The simple view of the President's economists is that OPEC controls the supply and that the U.S. more or less controls the demand, and because Americans are uncontrollably wasteful demanders of oil, OPEC can set the global price of oil, in dollars, almost anywhere it wants.

The economic advisers to Presidents Nixon and Ford made the same elementary errors in failing to observe that the Arabs are not only suppliers of oil but also demanders of goods, and that the U.S. is not only a demander of oil but also a supplier of goods. This is what trade, between individuals or nations, is all about. The terms of trade are set by incessant haggling in the marketplace — so many barrels of oil for so many bushels of wheat or boxes of widgets — and a contract is drawn in a unit of account that expresses the terms of the trade.

The unit of account in trades with OPEC is, and has been, the U.S. dollar, and the United States, not OPEC, controls this standard of measure. From the OPEC point of view, once the terms of trade are set, and expressed in dollars, the United States changes the value of the dollar in a way that alters the terms of trade in favor of oil consumers. We have unloaded U.S. assignats on them.

In its own way, though, the OPEC view is as incomplete as our conventional idea of what's going on. We can't forget that the United States also heavily influences, through its monetary and fiscal policies, the supply of goods that the U.S. offers in exchange for OPEC oil. What goods do we offer? Almost everything that isn't nailed down and almost everything that is nailed down, including real estate. Indeed, Arab purchases of U.S. real estate indicates they have had some success in unloading assignats back on Americans.

Broadly speaking, though, we offer present goods and future goods. Present goods include output that must be delivered now, either consumer goods or capital goods. Future goods are our promises to deliver consumer goods or capital goods in the future. These promises, or bonds, are dollar-denominated financial assets. Citizens of the OPEC nations and representatives of the nations rummage about in the U.S. marketplace, spending their petrodollars until they have satisfied their appetites for the present and future goods that we are offering. At such a point, they will withdraw the goods that they are offering in exchange, reducing (or not increasing) the supply of oil presented in the marketplace.

Since the 1973 oil embargo, advisers to Presidents Nixon, Ford and Carter have almost totally overlooked this aspect of trade. They failed to see that the surest way to get OPEC to increase the supply of oil offered in the market — which would lower the price—is to increase the quantity or quality of present and future goods offered in the U.S. marketplace. A better widget or a gilt edged bond, which would hold its purchasing power over the years instead of melting away like an assignat, would once again whet the appetite of the OPEC producer.

Failure to see this supply-side argument has resulted in a perpetual focus on policies designed to reduce the demand for OPEC oil. There is fascination with the idea of austerity, belt-tightening, sacrifice, conservation, hefty gasoline taxes, intense regulation of the auto industry, "windfall" taxing of domestic oil production to finance synthetic fuels and conservation subsidies. Gone, at least, is the idea popular in 1974 that we could "break OPEC" with a U.S. recession that would collapse the U.S. demand for imported oil. By now there are studies kicking around that suggest only one barrel of oil saved for each $250 decline in real gross national product in the United States.

The correct domestic policy that continues to elude U.S. policymakers is a real expansion of the U.S. economy, which of course would increase the demand for imported oil, but also increase OPEC's demand for U.S. goods and financial assets at a greater rate. If dollar-denominated financial assets were yielding higher rates of return than oil held in the ground, more oil would be produced to exchange for such assets.

There is really no problem with oil supply. In 1970, Saudi Arabia and Aramco jointly projected the feasibility of lifting 18 million barrels a day by 1980. That was at a time when foresight could not predict the great stagflation of the decade, in which the industrial/financial side of the marketplace caved under the unprecedented impact of inflation and progressive tax systems. The Saudi appetite for current goods and financial assets is now satisfied with only 9 1/2 million barrels a day of production. Even this level of production has probably been sustained only by corruption in the royal family.

There are persistent rumors of books being juggled by as much as $20 billion, with individuals piling up dollar assets abroad in the style of the Shah of Iran. The recent seizure of the Grand Mosque at Mecca by political revolutionaries, an unsuccessful attempt to overthrow the Saudi government, reflected the same national outrage that overthrew the Shah for his handling of Iran's petroleum patrimony. If talk of "reform" in the royal family is to be taken seriously, we might expect gradual reductions in the daily production. The Saudis are of course aware that they are having "dollar assignats" unloaded on them.

Who doesn't? On February 17, in a "Meet the Press" appearance, Walter J. Levy, an international oil expert, proposed that the United States issue bonds redeemable in a "basket of commodities." The idea, of course, is to offer a product that has disappeared from the marketplace: a dollar-denominated financial asset tied to the value of real assets. The OPEC nations would no doubt jump at this new product, and probably increase production in order to acquire such bonds. But inflation-proof bonds could not be reserved to oil-producing nations, as Mr. Levy seems to imply. The fact is that everyone in the United States who produces goods or services for sale in dollars is in the same fix as the OPEC nations. The Toledo carpenter is just as interested in acquiring future goods, i.e., "savings," as the Kuwaiti sheik. They are equally discouraged from producing when they see their dollar assets melt away like assignats. Thus, the savings rate in the United States is at a historic low, pushing zero. Productivity is registering negative numbers. The price of gold, which unerringly monitors the decline in the value of the dollar, is now nearly twenty times higher, in dollars, than its price of a decade ago. The price of oil, too, is approaching a factor of 20 times. The wholesale price index rose in January at a 20 percent annual rate, a process that continues as the dollar is "unloaded" from one commodity to another. Long-term government bonds yield the highest interest rates in U.S. history, forecasting double-digit inflation for the rest of the century. Meanwhile the "brisk trade in all kinds of permanent property" as the world unloads dollars provides an illusion of commercial prosperity and the economists haggle over whether or not there will be a recession.

The only way to reverse the process is a combination of fiscal and monetary policy that is not now in sight: A sharp reduction in the progressivity of the tax system, to re-ignite national productivity, and a return to a gold-exchange standard — a convertible dollar useful again as a store of value, for both the Kuwaiti sheik and the Toledo carpenter.

A convertible dollar is, after all, what Walter Levy is groping toward with his proposal of a commodity-basket bond. The historic difficulty with a "basket" lies in deciding what commodities go into it, all tastes being slightly different. If all individuals on earth went into the global supermarket with $100, the chances of two people emerging with an identical basket are no doubt close to zero. In other words, in fixing the Levy basket, its appeal as a bond is reduced slightly or a great deal to the rest of the marketplace. The other difficulty with a basket bond is its credibility as a store of value. In issuing, say, a 30-year bond, we are asking a sheik to believe that in 30 years we are going to tax the resources of the American economy sufficiently to redeem his bond in the specified commodities.

Gold, though, is a proxy for every commodity basket, acceptable everywhere in the world at all times as a store of value. Still, it will be difficult to restore faith in the government's pledge to redeem dollar assets in a fixed weight of gold. President Nixon broke such a pledge in August 1971, when he closed the gold window to the dollar assets of foreign central banks. But at least the opening of the window and the U.S. government's daily buying and selling at a precise rate of exchange between the dollar and gold would lend confidence to the holders of 30-year bonds. And, the U.S. Government does own some $200 billion in gold at a price of $700 an ounce.

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Through the 1970s, American foreign policy was conducted in a vacuum, insulated from international economic policy. Henry Kissinger knew little or nothing of international economics. The same can be said for Zbigniew Brezinski. Kissinger did not participate in the August 1971 decision to cut the dollar link with gold and Brezinski to this day does not see how it directly led to the "arc of crisis" that he now fumbles with, from the Middle East through Southwest Asia. In fact, the theory behind the closing of the gold window reflected the autarchic monetary arguments of Milton Friedman, who explicitly urged the floating of the dollar in order to insulate U.S. monetary policy from the rest of the world. The move freed the monetarists to experiment with dollar manipulation, just as the monetarists of the 1790s urged experiments with assignats.

The most celebrated casualty of this foreign-policy vacuum, so far, is the Shah of Iran, clearly a victim of the "dollar assignats." Had he not been hypnotized by the run-up in the nominal price of oil in 1973-74, which left Iran suddenly awash in dollars, he would not have been tempted to conceive of his master plan for Iran. He would not have spent his nation's patrimony and borrowed against it in order to build a gleaming, modern Iran, on bloated, cost-plus contracts with American industrialists and arms merchants. The ensuing boomtown atmosphere would not have been there to offend the religious sensibilities of the various ayatollahs, and the Shah would not have tried to halt the local boomlet inflations by price freezes, enforced by the police via jailings of shopkeepers. The commercial class would thus not have been invited to the ranks of the revolutionaries, and the secret police would not have had to resort to torture, etc., to attempt repression.

It's impossible to "prove" such a hypothetical scenario. But in a rough way this is what lurks behind the Iranian demands for a "trial," not of the American hostages, but of the Shah and his "crimes" in complicity with the United States. A political caricature would picture the Shah as a hick rube, coughing up a wad of petrodollars to Uncle Sam in exchange for the Brooklyn Bridge. Uncle Sam would bear a curious resemblance to David Rockefeller, the banker in many of these "dollar assignat" transactions, a friend of the Shah's and of Henry Kissinger's, and founder of The Trilateral Commission.
It is silly to think that the United States should have to apologize to Iran for having fleeced the Shah. Nations, like individuals, bear the responsibility for their own political leaders. But Iranian President Bani-Sadr will get satisfaction for Iran out of his international commission if he can make dear that it was the exploitation of Iran inherent in the debasement of the dollar that is at the bottom of things, the unloading of assignats. The U.S., hopefully, will benefit too if this is the picture that emerges. The greatest of nations should not be playing around with its currency or fleecing hick Shahs into buying the Brooklyn Bridge.

The lesson has to be learned because the United States still has the awesome power to destroy little, unsuspecting countries in the same blind way that led to the Iranian revolution. In that same "arc of crisis," for example, we are now engaged in destroying the economy of Turkey. Our NATO ally of 50 million people is now the basket case of Europe. For a decade, it has followed the economic advice of the International Monetary Fund, dominated by the United States and especially the austerity agenda of the Trilateral Commission. The IMF is not a "fund" but a bank, and like almost all banks it is wholly concerned with lending money and getting paid back. To whatever economically distressed nation it goes — Italy, Jamaica, Peru, Zaire — the deal is always the same: It will lend more money if the government imposes austerity policies, i.e., raising taxes and currency devaluations that allegedly improve competitiveness by making imports dear and exports cheap.

In 1970, Turkey had a thriving economy. It was jolted by the global recession of 1974-75, especially as Turkish "guest workers" in West Germany became unemployed and not only stopped sending cash home to Turkey but came home themselves, to join the unemployed lines. International borrowing began in earnest to finance the external deficits, and IMF policies of tax boosts and currency devaluations followed, further burdening the economy and forcing new loans, conditioned on new devaluations, etc.

In 1970, ten Turkish lire equalled one U.S. dollar. The series of IMF-induced devaluations during the decade has now put the lire at one-seventh of its 1970 value relative to the dollar, which itself lost nearly half its real value during the 1970s. The exchange rate is now 70 lire to the dollar. In 1979, consumer prices were up 800 percent over 1971 and are rising now at a 100 percent annual rate.

In the entire decade, there were no adjustments to the progressive personal income-tax rates to offset the effects of inflation. Where, in 1970, the top rate of 68 percent was encountered at the equivalent of $100,000, it is now encountered at $14,000. Where the 55 percent bracket had been encountered at $12,000 in 1970, it now met at a mere $1,600. The tax wedge now rivals that of Bangladesh and it is little wonder that Turkey's tax base is dwindling to the vanishing point. The income tax produces only a trickle of revenues as the economy has been overtaken by the subterranean black market.

The government only survives by foreign loans and its external debt now approaches $15 billion. In January, the government borrowed $600 million from the IMF, agreeing to yet another 48 percent devaluation. Debt service now takes $2 billion a year and will rise to $3.6 billion in 1983. In effect, the West is simply lending Turkey the funds to service the debt. The debt thus mushrooms without resources ever coming into the country. Suleyman Demirel, the prime minister, is now pleading with Western governments for another $1 billion to stave off financial crisis. He promises a "tax the rich" tax reform later in the year.

Meanwhile, the Soviets simply barter, trading oil credits to Turkey for future grain deliveries without any offsetting demands for austerity, tax boosts or devaluations. The Financial Times of London observed on January 21 that "at times Turkey seems to be receiving better aid from the Soviet Union than from its treaty allies." This is a vast understatement considering the destructiveness of IMF "aid" policy. Indeed, it is difficult to see how Turkey can remain a Western ally much longer on its current path. Should it move into the Soviet orbit, the Trilateral Commission will no doubt ascribe the loss to Soviet subversion and terrorism.

The subversion, though, is from the West through Western, not Marxist, ideas. There are no tax progressions in the Marxist model, and fiat money inflation is proscribed by Marxist-Leninist doctrine. The Soviets in many ways mismanage their economic system, but there are some things that Karl Marx, a classical economist, learned about inflation and debt that survives in the Kremlin's policies. The strategic shift in favor of the Soviet Union, the flaring along the "arc of crisis," has at its root the theories of Keynes and the monetarists, replicating the paper inflation of France in the 1790s.

1 Fiat Money Inflation in France, Foundation for Economic Education, Inc., Irvington-on-Hudson, N.Y., 1959. pp. 87-88.

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