Money and Exchange Rates Jude Wanniski February 14, 1997

Supply-Side Economics Lesson No. 11

Memo To: Website students
From: Jude Wanniski
Re: Money and Exchange Rates

The recent strength of the dollar relative to the Japanese yen and German Deutschemark is inviting analysis of how the exchange rates will affect trade flows in various American businesses. In the NYTimes this past Wednesday, business reporter Keith Bradsher finds that the same American companies who were complaining about a loss of export competitiveness when the dollar was soaring in value in 1985 are shrugging it off this time around. Bradsher's account valiantly tries to explain why there is a difference between now and then, but in the end the article doesn't explain much at all and is not very satisfying. The best he can do is note that while the dollar has appreciated by 54% against the yen since April 1995, it has appreciated by only 17% on a "trade-weighted basis." That means it has risen by 17% against the currencies of the countries we do our trading with.

There are a great many variables that bear on the difference between 1985 and today, but easily the most important revolves around the price of gold. Neither the NYTimes nor the other financial media take this variable into account. In 1985, the dollar price of gold had fallen to almost $300 from an average closer to $400 in the previous five calendar years — 1980 through 1984. If the price of gold had only been at $400 for one year and then skidded to $300, the deflation would not have caused as much pain to the economic world. But a five-year stretch meant the dollar world had been making dollar contracts that much longer at a significantly higher price plateau. To knock 25% off the dollar gold price was causing excruciating pain to all dollar debtors, as the deficiency in dollar liquidity was making it exponentially harder for them to meet their dollar obligations. If the dollar fell only against gold, there would not be a problem, because the only debtors who would lose would be those who had borrowed with gold as collateral. They would have to sell more gold to pay their dollar debt.

Gold is only the first commodity that rises or falls in price when there is a monetary error by the central bank — which is responsible for creating money or extinguishing it when it is not needed. This is because it is the most monetary of all commodities, because of its six thousand years as the world's primary money. When the gold price falls, the price of oil is generally the first to follow in train. Because  there is a lot more oil produced and consumed than gold, it causes more of a problem to those who have borrowed against their oil    -inventories. As price declines extend from gold and oil to other commodities, those who produce them must lay off workers, and on the margin debtors who are at the limits of their financial reserves must declare bankruptcy. Even a tiny deflation causes suffering around the edges of an economy, but as it progresses it cuts wider swaths out of the commercial world, which is built on an intricate network of debits and credits. This is why 1985 was so painful, why there was so much screaming from business and industry. It led to a decision by the Reagan Treasury Department to end the period of "benign neglect" of the dollar, and a concerted effort with the Federal Reserve to add liquidity to the banking system to allow the dollar to inflate against gold.

In the current period, the dollar gold price had been hovering at the price of $383 for nearly three years. Prior to these three years, it had spent eight years hovering around $350. The decline in the gold price we have seen only began in late November, we think because of confidence that the President and the Republican Congress would take actions to reduce the risks attendant to capital formation. This would mean an increase in the demand for dollars at home and abroad, and if the Federal Reserve did not supply those dollars fast enough, the dollar price of gold would fall — dollars becoming scarce next to the most monetary of all commodities. In addition, the gold price decline is only 12% in this most recent period and has only been at this level for a short period of time. If it went below $340 gold for several months with gridlock in Washington — no relief on taxation — there would be problems in both the stock market and the economy.

If the dollar deflated to $330 gold, the only way we would see good things happening in the financial markets and the real economy would be if there were a formal announcement at that point of a permanent fixing of the dollar/gold rate. What's the difference? A $330 gold price would cause increased risks to dollar creditors, as debtors may not be able to pay. On the other hand, a fixed $330 price would remove the enormous risks surrounding future dollar contracts. These reduced risks would overwhelm the higher risks of the slight deflation. As you can see, there are several variables involved in the puzzle, having to do with time and space as well as price and volume, supply and demand. If there were not myriad variables, everyone would be able to figure out the financial markets and get rich quick.

In the NYTimes article cited above, Keith Bradsher makes one glaring error when he observes that the dollar would have to fall by 2 or 3 percent annually in order to keep dollar prices constant relative to the yen, because our inflation is that much higher. The error is an old one, which I recall first seeing 25 years ago in the London Economist, which argued that because the inflation rate in England was 10% in the  previous year, the money supply had to be increased by that amount to prevent recession. This was all backwards. The recorded inflation was already the result of the exchange rate between the pound sterling and gold having changed. In other words, when a currency devalues against gold by 10%, there will be a 10% inflation in the country of that currency in the years following — depending upon how long previously the currency had been stable. If you then devalue the currency by 10% to catch up with the inflation, you are simply inducing a new round of inflation.

If the United States were to now fix the dollar/gold price exactly where it is, by an executive order of the President, or an act of Congress signed by the President, there would instantly be a great boom in the bond market and with Wall Street stocks as well. Indeed, there would be a worldwide boom in financial markets everywhere, because the dollar would become the anchor that protects everyone from unanticipated inflations and deflations. In a Wall Street Journal op-ed piece last June 18, Jack Kemp made exactly this point. The idea was first floated in September 1981 by Canadian economist Robert Mundell, the modern father of supply-side-economics. It isn't done because too many people are making money playing the volatility of the commodity markets and the bond markets. But we will get there sooner or later, at least by the end of this millennium.