Pegging to the Dollar Jude Wanniski August 1, 1997

Supply-Side Summer School Economics Lesson #7

Memo To: Students of Supply-Side University
From: Jude Wanniski
Re: Pegging to the Dollar

Jeff Pippin, a Polyconomics client who manages the Pepperdine University pension account, asks today’s question: “With respect to the recent devaluations in Asia, I’m wondering how the situation in Thailand could have been managed differently. Is there something inherently wrong with a developing country pegging their currency to the dollar? What could they have done differently given the monetary regime that they had set up?”

In the absence of a gold dollar, every country is faced with the problem of how to manage its own money when the Fed is mismanaging ours. The Fed mismanages the dollar when it permits the dollar price of gold to move from its optimum point, which we reckon to be $350 these days. The Bank of Thailand has to consider several things that are going on at the time of the mismanagement, especially which direction the dollar/gold rate has swung. If the dollar is inflating and the dollar gold price rising, the baht will be dragged with it. If the dollar gold price is falling, deflating, the baht gold price will fall too. These inflationary/deflationary impulses will then ripple through the entire price structure of goods and services, but with different effects as they impact tax policies and at different rates of transmission in the two countries.

Here are four points to bear in mind:

1. Those countries that have maintained a rough dollar peg for a long period of time will have fewer problems when minor swings occur in the dollar/gold rate. If a country is able to sell government five-year debt instruments at fairly low rates, it is a sign that debt maturities are roughly in line with ours. Remember, the dollar/gold swing that just occurred took place over a seven-month period. Countries that have trouble selling one-year notes at single-digit rates are going to have more financial stress than those who do not.

2. Countries that have tax structures much different than the United States will also have varied experiences in the stress caused by monetary swings. When we err on the inflationary side, it causes more problems for those countries tied to the dollar which do not have indexation systems that respond rapidly to an inflation bias.

3. In a deflation, countries that are in an export phase of a trade cycle will be strained relative to countries exporting with a currency not fixed to the dollar. The prices of their goods will be higher in real terms than those of their competitors. Countries in an import phase of the trade cycle will benefit with a dollar/gold deflation because their costs will be lower. These "benefits" are only relative. This is because within the country, the exporters who are hurt on the margin can't meet their debt obligations; nor can they afford to buy the imports of those who benefit from the lower import prices. This only shows that there are no gains when the unit of account moves around.

4. Countries that import oil are hurt in an inflation and helped in a deflation. Gold's importance is as a monetary commodity. Oil is an industrial commodity, black gold, and its prices are usually the first important transmissions of dollar inflation or deflation around the world. Japan, for example, has some benefit in the dollar/gold deflation where the U.K. does not.

When there are strains in a small country like Thailand which tied its currency, the baht, to the dollar, the strains can be eased in several ways. Because prices are based on expectations, strains in the system can be eased by changing expectations. The easiest way is for the government to convey to the markets an understanding of why the strains have occurred. That is, the Bank of Thailand could have indicated to the people of Thailand that the dollar peg was causing problems -- because the Fed was allowing the dollar to deflate against commodities and that this would produce temporary pressures on baht debtors. The markets would give credit to the Bank for at least understanding the source of the stress, as part of the risk associated with both debt and equity is the risk that people in charge of the government have an incorrect diagnosis of the problem.

With that accomplished, a second thing that could be done would be to announce that the baht is being re-pegged at a dollar/gold rate closer to $350 instead of the $320 that was in place. The bank could accompany this with the promise that if the Fed got the price back to $350 in short order, the Bank of Thailand would reverse the process and restore the original exchange rate. It is hard for Thailand to simply peg the gold price, with the rest of SE Asia moving with the dollar or the yen, but it could make adjustments like the one described to balance the interests of its internal economy and international trade.

If the monetary strain is not too big, the government can still maintain the dollar peg but relieve it with fiscal policy, by lowering tax rates. This is clearly called for in an inflation, via an indexing scheme. In a deflation, lower tax rates on the inputs of exports -- lower income and excise taxes -- will offset the temporary negatives in the terms of trade. The worst thing to do is raise taxes to offset revenue declines associated with a deflation. The deflation itself has a small positive effect in countries with steep progressions in their tax systems. Instead of creeping up brackets during an inflation, you creep down in a deflation.

Countries whose currencies are pegged to the dollar do not always run into financial strains because the Fed mismanages the currency. Even if the Fed were pegged to gold and Thailand was pegged to the dollar, strains in the financial system will develop if the country mismanages its fiscal or regulatory policies. After World War II, the U.K. was part of the Bretton Woods system, around which currencies were linked to a $35/oz. gold. The U.K. made the mistake of leaving its WWII income-tax rate in place instead of scaling it back. Unfortunately, a dollar inflation occurred after price controls were lifted in the United States. This happened in permitting the general price level to adjust to the change of the dollar/gold rate in 1934, to $35 from $20.67, a 67% devaluation which had not fully rippled through the price structure during the Depression. This inflation caused a sharp rise in real tax rates in the U.K., where rates ranged as high as 95% at $30,000. In the U.S., rates ran to 90%, but at $100,000. The Republican Congress in 1947-48 three times sent tax cuts to Democratic President Truman and three times he vetoed them. On the third try they overrode the veto, which brought relief to the U.S. economy. In the 1948 presidential election, Truman came from behind to defeat the GOP nominee, Thomas E. Dewey, who had disavowed the 80th Congress and made no mention of taxes.

In the 1950s, President Eisenhower reneged on his campaign promise to cut tax rates, as we were at war in Korea and the budget was out of balance. He tried to keep the economy rolling by getting the Federal Reserve to push more money into the economy. This had the effect of draining gold reserves out of Fort Knox. It also caused Canada to break loose from the incipient inflation it was feeling by having its dollar attached to ours. In 1958 it "floated" its dollar, and it floated to a five-cent premium. In 1959, when I traveled through Canada by car on the way to Anchorage, Alaska, I had to pay $1.05 U.S. for a $1 Canadian lunch.

When Mexico devalued the peso at the end of December 1994, it was running into the first strains of the Clinton tax increase of that year. Instead of draining off the surplus dollar liquidity that accompanied the tax increase, Greenspan let gold ride up 10% instead, to $383 from $350. The peso, tied to the dollar on a glacial crawling peg, had been battered all year by political negatives, but stayed fixed to its peg by selling off its cache of dollar reserves. At year's end, when the government changed hands, its bias switched in favor of a currency devaluation instead of a monetary tightening. The Bank of Mexico could easily have maintained the peso rate, by selling peso assets out of its portfolio. After all, it was not, like Thailand, contending with a stronger dollar, but a weaker one. It not only got bad advice from the U.S. government, it got a push from Treasury and from the folks at the IMF, who thought Mexico's currency was overvalued -- because it was running such a big trade deficit. That deficit, though, was a healthy sign reflecting the capital inflows of the Salinas regime and its bias toward a strong peso.