Q&A on Lesson 10 Mundell & International Monetary Reform Jude Wanniski April 28, 2000

Q1: Marilyn Wood. Several times in Professor Mundell's article the term "sterilization" is used. I have run across this term in the past in financial articles and it is always assumed that the reader knows what it means. I have no financial training, so I have had to infer a meaning. My conclusion to date is that "sterilization" is a term used to denote the process and result of the process by which a central bank negates or cancels out the effect of one action on liquidity by a counterbalancing action in a different but related area. In other words, "sterilization" means that the net final result of liquidity change is zero. My questions are the following: 1. Is my notion of sterilization correct? 2. What is the thinking process that leads the central bank to do this?

A: You are correct in your understanding. If the Fed buys a foreign asset -- perhaps yen -- with $100 million dollars, there is now that much extra liquidity in the world. It would cause the dollar to devalue against the yen. But if the Fed is following a monetary policy rule that keeps the fed funds rate at 6%, and the extra liquidity is pushing that rate down, the Open Market desk in NY would have to drain $100 million from the system in order to hit that target. It does not seem very smart, does it? It was Mundell in other essays who pointed out that you cannot hit two targets with one instrument, one "arrow." He did so in arguing the "fiscal arrow" should be aimed at the growth target and the "monetary arrow" should be aimed at the inflation target.

The attempt is made anyway with economists offering the rationalization that it might discourage "speculators" by burning their fingers. If there is a temporary period of a day or so before liquidity created abroad washes up in NY and must be "sterilized," the hope is that behavior will change. Of course it never does. But the banks which conduct the transactions on the Fed's behalf make their fees anyway. Twenty years ago, when sterilization was first explained to me, I had the picture of a man in a rowboat with a hole in it, trying to bail out the water, but throwing it over his shoulder into the back of the boat. It is another problem of the zero-sum demand model. Economists want to subtract liquidity but are afraid of the consequences, so they add it back. If there are any economists reading this answer who have a better argument for intervention and sterilization, I would sincerely like to hear it.

Q2: Bill Mullen. I was discussing the Gold Standard with a friend of mine who has been into economics far longer than I, and he asserts that we've had inflation even through the years we had a gold standard. On these pages, I've heard over and over that there is no inflation under a gold standard. Is my friend correct? Did we have inflation while under the Gold Standard? If so, what causes the inflation?

A. By a gold standard, we mean a dollar that is defined as a specific weight of gold, "a dollar that is as good as gold." Prices of other goods and services can rise or fall even though gold remains constant in its dollar value, but there is nothing wrong with that. Prices of all other commodities change so that the market can judge where to send fresh capital and where there is no need for more. If the index of prices includes a cluster of commodities which happen to rise together, then that index may seem to show an "inflation," and when they fall together, may seem to show a "deflation." These wiggles always disappear over a long period of time and I never think of them as inflation or deflation, and the market does not act like it does either. If the market does smell a monetary inflation on the horizon, it pushes up bond yields. Yields of long-term bonds would not have remained low during all the periods of "inflation" cited by the academics. Alan Reynolds, the supply-side economist who until recently directed economic research at the Hudson Institute, made the point more than a decade ago: "All inflations, everywhere, are preceded by a rise in the price of gold in that country's currency."

England went on the gold standard in 1717 and went off during the Napoleonic wars and during World War I. Each time it returned to gold after those wars, it returned at the pre-war price (rate of exchange). On an index of prices constructed by the late Professor Roy Jastram of Berkeley in the early 1970s, producer prices that were 100 on the index in 1717 were also at 100 in the year 1930. The index rose and fell in the interim, as commodity prices rose and fell with harvests and business cycles, but the unit of account was constant and so there was no monetary risk to people engaged in commerce.

When Alexander Hamilton persuaded Congress to define the dollar in terms of gold in 1791 the Jastram index was at 100. With ups and downs that followed, it was also at 100 in 1930. Although the index shot up in the Civil War when the dollar/gold link was broken and the war financed with "greenbacks," it came back down when the dollar/gold link gradually was restored at the pre-war rate in 1879. The big burst of genuine inflation that occurred during the greenback period rarely is cited by those anti-gold economists who argue that inflation occurs under a Gold Standard. Milton Friedman, author of A Monetary History of the United States, has been a habitual offender in this regard. Prices rose sharply during WWI in the indices, when the government began buying commodities beyond the economy's ability to produce at short notice. When the war ended, prices declined and reestablished their equilibrium with gold.

Q3: (Mullen.) My friend also mentioned that under a Gold Standard, it is possible for one country to screw with another countries gold supply, causing economic upheaval. True or no?

A. Excellent question. This is another widespread fallacy, stated as fact by professional economists who have been taught it in school, but never checked it out for themselves. To begin with, they would never be able to find an example of a country that even attempted to manipulate another country's gold supply. That happens only in the movies, as in the James Bond "Goldfinger," where the villain would supposedly paralyze the international economy by making Fort Knox radioactive, the gold unusable. This is the reductio ad absurdum, yet even if Goldfinger were successful, he would only have physically immobilized the gold for the number of years it would take for the gold stock to be replenished. When the movie was made 40 years ago, the U.S. held about 8% of all the gold in the world. It now holds a bit less because it has not added to the stock while the total in the world has increased by perhaps 2% a year in private and public hands. Gold does not have to be mobile in order to serve as a monetary anchor to the dollar. The dollar is sufficiently mobile and can be transmitted electronically in a split second from New York to London or Beijing. As long as the central bank and U.S. Treasury keep the supply of dollar liquidity equal to the demand for it, at a precise exchange rate with gold, it scarcely matters where the gold physically resides. If the radioactive gold in Fort Knox were scattered in clouds around the world, even that event would not shake the gold standard as gold mines around the world would work double shifts to replenish the supply demanded by world markets.

The textbooks point out that there was an inflation after gold was discovered in California in 1849, which is of course the opposite of gold disappearing because of Goldfinger. There really was no significant change in the general price level recorded after 1849. Fresh supplies of gold came into the world market at the official prices guaranteed by England, the United States and almost all the rest of the world that linked their currencies to the major gold nations. This easily- mined gold simply caused gold mines elsewhere in the world to cut back on production until world demand caught up with the new supply. The use of gold as a unit of account did not in any way disturb global commerce.

Think of it in another way. Suppose the old Soviet Union decided to manipulate our gold standard in the 1960s by ordering its state mines to produce twice as much gold and dump it on the world markets. If it sold the gold for dollars at $35 an ounce, the official price back then, it would have twice as many dollars. But it would have had to divert capital and labor into the effort, pulling them away from coal mines, which would mean it would be short on coal. It would have to use its dollars to buy coal from the world market to fuel its other industries. The effort would have been far greater than any problem it would have caused the United States, which can add or subtract from global dollar liquidity by buying or selling bonds from the Fed's portfolio, which merely took a phone call in the 1960s.

Q4: Bill Kunberger. No wonder Robert Mundell won the Nobel Prize. He could have written this article for the Trilateral Commission. What's wrong with gold as a world currency? All other currencies freely convertible into gold would be readily interchangeable. No tinkering by global bureaucrats. No World Government. No?

A: What Mundell proposes is exactly what you recommend, except he does it in a roundabout way, so as not to frighten the establishment, which worries about arguments made by economists and Goldfingers. All change takes place at the margin, which means Mundell would like to get where you propose to get all at once, if you were king of the world. You are free to support radical all-at-once change, but, meaning no disrespect, it is not realistic to think you will ever get anywhere with that approach. Revolutions are extremely difficult to pull off. Most of the important ones took centuries. We're trying to pull one off in our lifetimes. Note that his solution, in the end, involves the linking of the dollar, euro and yen to gold. He gets to that point by eliminating all other possibilities, one at a time.

Q5: Douglas Fairbanks. Mundell writes in "Threat to Prosperity" in Lesson #10 that "The combination of pegged or pseudofixed exchange rates with an independent monetary policy is no doubt the worst of all exchange-rate systems." Why have central banks even tried to have incompatible policies in the first place, and how have they tried to justify this particular course of action?

A. In the years since Nixon broke the dollar/gold link in 1971, Europeans in particular have tried to avoid the turbulence that resulted from having a dozen different central banks conducting independent monetary policies. Before they finally arrived at the "euro" as a solution to this internal turbulence, the Europeans tried "snakes," a term used to describe the path the currencies would take in trying to stabilize all currencies against each other. Imagine a convoy of a dozen ships crossing the ocean in the fog, with no compass and no means of communication except megaphones to shout at each other. They would not go in a straight line and might actually go in a circle. The European experiment with a snake would work for a while as they would use the dollar as a reference point, but when the dollar wobbled in one direction or another, it would throw the snake on more circuitous paths.

Q6: (Fairbanks.) Why is the euro so unstable, falling against the dollar since it was unveiled at the beginning of 1999? When it made its debut, it was worth $1.16 and now it is only worth 91 cents and the financial press says openly that nobody knows why. What do you think?

A. In the original WSJournal op-ed series in 1998, Mundell noted that when eleven currencies were transformed into one, Europe would need much less liquidity. Individuals and enterprises that had to keep cash balances in several currencies, because they traveled or did business in several currencies, would be able to do so with only one -- the euro. Mundell should have directly warned Euroland that the European Central Bank would have to "mop up" the surplus liquidity as the continent gradually converted out of old local-currency contracts into euro contracts. He assumed they would understand that, but they have not. Even after winning the Nobel Prize in economics last year -- explicitly for his original work 40 years ago on optimum currency areas -- Mundell is now being ignored by the Eurocrats as he urges the ECB to sell assets in order to mop up the surplus liquidity. Instead, the chief economists, all trained in Keynesian or monetarist demand models, try to fiddle with the euro by raising interest rates and by targeting the "money supply." I normally do not run material from our client letters in SSU to close to publication, but here is what Polyconomics Thursday told its clients on this topic:

EURO: Our global clients have been reminded a number of times that the Euro’s continued weakness was foreseen by Robert Mundell in his Wall Street Journal series last year, prior to the announcement he had won the Nobel Prize for his work in this realm. When individuals and enterprises of eleven countries no longer need eleven currencies, there will be far less need for liquidity. Mundell said there would be a one-time adjustment, and that calibration process has been under way as Europe adjusts to the new efficiencies. Mundell erred, though, in thinking the ECB bureaucrats would have the smarts to realize they would have to mop up the surplus via the sale of Eurobond assets. Instead, the ECB is fiddling with interest rates and a monetarist M-3 target. As our Michael Darda reported Wednesday to our global clients, the currency will have to continue sinking, with the inflationary implications, until the tax cuts being discussed throughout Europe increase the demand for liquidity faster than the surplus is appearing. We urge those of you who have not seen our global product in some time to take another look. It has improved enormously under the new team leader, Mike Churchill.

J.W. We had many more questions on Mundell than we could cover in this lesson and will perhaps be able to return to them at a future date. As an exercise, I'd like all of you to think of a puzzle that Mundell presented me with 25 years ago, in 1975, when I was struggling to learn his analytical model. Jerry Ford was President as I recall Mundell posing the question: "Suppose President Ford came on television tonight and asked everyone viewing to take out all the cash in their wallets and purses and to cut the bills in half, and to assure them that each half would now be legally worth as much as the whole. What would happen to prices?" Please think this through as carefully as you can and submit your answers. The best will get a prize, of some sort, which I will think about carefully.