Pegging an Exchange Rate Jude Wanniski November 21, 1997

Supply Side University Economics Lesson #11

Memo To: Website Students
From: Jude Wanniski
Re: Pegging an Exchange Rate

This may seem like a small topic for an entire lesson. Unless I am mistaken, you would never find a chapter in a modern economics textbook on the subject, at least not in the kind of detail you will find here. It is critically important in any discussion about monetary policy and is at the heart of many of the world's problems today. In Lesson #9, which I hope you have all read at least twice, Reuven Brenner makes the observation that we left the gold standard in 1967-71 because there was no understanding among the professional economists on how to maintain the dollar/gold peg. It was believed that it could only be done by raising interest rates sharply, which the political leaders believed would result in a recession and cost President Johnson (in 1968) his re-election and President Nixon (in 1972) his re-election. There are very few economists who understand the issue, because they have not thought about it. There is probably not one member of the 535 members of Congress who understand the issue — perhaps including the two with PhDs in economics — House Majority Leader Dick Armey and Sen. Phil Gramm, both of Texas, both trained in demand theory.

In a demand model, there is only one way to "tighten" or "ease" monetary policy — and that is to raise or lower the one interest rate more or less controlled by the Federal Reserve — the overnight "federal funds" rate. The mechanism of control is the result of the need each bank in the Federal Reserve system has for closing out its books at the end of each business day. The Fed requires every bank to hold a percentage of its deposits in reserve — the reserve requirement. At the end of each day, some banks have more in reserve than they need, others are in deficit. They borrow from each other to even things up. If the Fed sets the funds rate at 5l/2 %, which is where it is today, the "open-market desk" in New York City will add reserves if the rate pushes up from 5!/2% as the banks bid for reserves in order to close their books on target. They add liquid reserves by buying U.S. Treasury bonds, which the private banks hold as part of their reserves against deposits. This "creates money." The banks can actually take the liquid dollars on their books and buy actual cash from the U.S. Mint.

If the funds rate falls below 5l/2 %, the open-market desk (which buys or sells U.S. Treasury bonds in the open market for the Fed's account in the open market), of course sees this as a surplus of liquidity, over and above the needs of the banks. It sells bonds on the open market to the banks, taking in the reserves that pay no interest. This destroys money, in the sense that it simply disappears. There is no place for it on the Fed's balance sheet, as it was also created out of thin air when the Fed bought the bonds from the banks in the first place. Do you see the power of the Fed and Alan Greenspan in particular? As a result of the Federal Reserve Act of 1913 it has the power to buy assets from the banks with a check book that has nothing behind it but the authority of Congress — which has the Constitutional power to coin money. In 1913, Congress gave this power to the Fed, but of course could always withdraw it or set new conditions on the exercise of that power.

To repeat: The Fed tightens or eases by raising or lowering the fed funds rate in order to expand or contract reserves, which makes it harder or easier for the banks to lend money to borrowers for one sort of investment or another. Got it?

In a supply model, this operating mechanism is extremely inefficient. Years ago, when it was first explained to me by a banking editor at the WSJournal, I thought of an automobile which is driven from the back seat by a driver with a remote control instead of hands on wheel, foot on brake. Instead of having 12 men and women on the Federal Open Market Committee sit around a table every six weeks trying to decide what the fed funds rate should be for the next six weeks, how much simpler it is to instruct the open-market desk to buy bonds when the price of gold seems to be falling and sell bonds when the price of gold seems to be rising. All that need be done is decide on what the dollar/gold price should be, and the FOMC need never meet again. When I explained this methodology to Paul Volcker when he was Fed chairman, sometime in the 1982-85 period, he said: "You want to turn me into a robot," and I said that was exactly what I wanted to do. Why should the whole world rely on a few men and women to determine the value of money by pondering an interest rate target — when it could let the whole world market make that decision? Is it better for 12 people to decide the laws of government, which is how monarchy worked, or have the whole population in the broad marketplace make the decisions?

What am I talking about? In The Way the World Works, I quoted Alexander Hamilton, who explained to Congress how a gold standard works. He said if the bank issues more money than is demanded at the guaranteed gold price, the money will return upon the bank.

The stamping of paper money is an operation so much easier than the laying of taxes, that a government, in the practice of paper emissions, would rarely fail, in any such emergency, to indulge itself too far in the employment of that resource, to avoid, as much as possible, one less auspicious to present popularity. If it should not even be carried so far as to be rendered an absolute bubble, it would at least be likely to be extended to a degree which would occasion and inflated and artificial state of things, incompatible with the regular and prosperous course of the political economy.

Among other material differences between a paper currency, issued by the mere authority of Government, and one issued by a bank, payable in coin, is this: That, in the first case, there is no standard to which an appeal can be made, as to the quantity which will only satisfy, or which will surcharge the circulation; in the last, that standard results from the demand. If more should be issued than is necessary, it will return upon the bank.

In the United States today, if the gold price were pegged at $350, the Fed would pay no attention to the overnight fed funds rate. If it issued too much "money," i.e., bank reserves, the banks would never have to make what appear to be risky loans. The surplus money would in the first instance buy gold, putting the gold price nearer the ceiling of the acceptable gold band. If the band was five dollars on each side of $350, the open-market desk would have to immediately sell bonds as gold began to touch $355. This would make dollars scarce relative to gold and the gold price would retreat from its upper band. The market would determine the gold price between $345 and $355. If gold approached $345, the open-market desk would buy bonds, putting more dollars into the system and making gold scarce relative to dollars.

Remember we are talking about two methods of pegging an exchange rate: Raising or lowering interest rates, or expanding or contracting the central bank's balance sheet. The Fed's balance sheet expands when it buys bonds with its magic checkbook. It contracts when it sells bonds, the money it acquired disappears just as magically as it appeared. The Fed hates to contract its balance sheet. It hates to get smaller. And it always assumes that if it destroys "money," banks will become illiquid and fail. This is because a great many banks failed in the early 1930s when the Fed contracted its balance sheet in order to maintain the price of gold at $20.67 per ounce. Economists are horrified at repeating this "mistake," but in fact the banks failed because of the dramatic increase in tariffs and taxes in the Hoover administration. Milton Friedman to this day refuses to accept the tariff/tax argument I presented in The Way the World Works, preferring instead his argument that the Fed could have prevented the Depression if it had printed paper money when there was no demand for it relative to interest-bearing bonds. This is why PhD economists like Dick Armey and Phil Gramm have blind spots when it comes to monetary policy. They have always assumed Friedman was correct.

In pegging an exchange rate, normally you think of an exchange rate as one currency exchanging for another. We are not talking about these exchange rates, but the exchange rate between the paper dollar and gold specie. The price of gold in dollars is an exchange rate. Get it? Three hundred and fifty dollars exchanges for one ounce of gold. It is not in the interest of Americans to have the Fed peg the yen rate, although it could, just as Thailand had been pegging its currency, the baht, to the dollar. For us to peg the dollar to the yen means we will give the Bank of Japan control over our currency. If the BoJ fouls up by letting the yen price of gold fall, we will be forced to deflate with it, by raising interest rates or selling bonds. And vice versa.

Alan Greenspan also has the blind spot on how to peg a currency to gold. In 1993, after several years of keeping the gold price close to $350 by pegging interest rates, gold climbed to $385 beginning in September of that year. As we observed at the time, the demand for liquidity had fallen as a result of the Clinton tax increases of 1993. Greenspan had warned that the Fed would not "accommodate" the tax increases by lowering interest rates. Instead, he tried to drive down the gold price by raising overnight interest rates, which he did six times over a period of a year and a half. The gold price did not budge. Throughout the whole process, Polyconomics advised its clients that it was a hopeless endeavor to try to bring down the gold price and inflation expectations by raising interest rates. Only the selling of bonds to withdraw liquidity and make dollars scarce relative to gold would work. The Fed could not do this unless it changed its operating procedures.

Why wouldn't raising interest rates cause the gold price to fall? Expectations of still higher interest rates caused an increase in demand for reserves, which pushed the fed funds rate higher. The Fed then had to add liquidity to keep the funds rate on target. Interest rates climbed across the board, from the overnight rate to the 30-year bond. The very idea of raising rates to slow the economy is a perverse one, as it automatically changes the dynamic between the supply and demand for liquidity. When we were going through this experience in 1993-96, there was a conscious agreement among Fed and Treasury officials that it was necessary to slow the economy to prevent the return of inflation. Greenspan never considered the possibility that a draining of liquidity, a  shrinking of the balance sheet, was an option. If he had, he still did not have an operating mechanism. All he had was interest rates, and every hike caused declines in the financial markets, but gold would not budge. Only when the prospect of a cut in the capital gains tax began to show itself last November, after the elections, did it happen that there was an increase in the demand for liquidity. When the Fed did not supply that demand, the price of gold began to decline. I sincerely hope that all of you in this class understand what I am talking about and if you do not, please tell me so. Ask questions. This seemingly tiny issue is at the center of global monetary turbulence.

In Japan today, the economy is being driven into the worst recession since the late 1940s because the Bank of Japan is trying to revive the economy by lowering interest rates when it should be buying yen bonds from the Japanese banks, injecting huge amounts of liquidity in order to drive up the price of gold. In the last ten years, my colleague at Polyconomics, David Gitlitz, finds the average price of gold in yen has been ¥46,000 per ounce. It is now ¥38,000 per ounce. Can you imagine how low the overnight interest rate in Japan is today? It is less than 1/2%. The bureaucrats at the Bank of Japan, almost all trained at United States Ivy League schools or at Stanford, Berkeley and UCLA, are operating in the demand model. It seems not to dawn on them that interest rates are too low. If the market will not borrow at V2%, it must mean the market fears the yen rate will remain at this low level or fall further. Meanwhile, the value of all assets in Japan have been burdened with a broad deflation in the price of the collateral that underpins the banking system. If the banks were forced to mark to market the value of the assets they hold, they would all be bankrupt. That is, they hold enormous amounts of equity in their portfolios, the stocks of Japanese companies, at the price they were valued at when the loans against them were made. If they "marked them to market" at current prices, the balance sheets of the banks would reflect negative equity. The bank stocks are still selling at a positive equity price, but that is only because the market assumes the government will not do something stupid, like force the banks to mark to market.

What should Japan do to save itself from depression? From banking collapse? From an implosion throughout Asia? They need only have the central bank buy government bonds from the banks, which would signal the end of deflation and the beginning of inflation, at least until the gold price climbed back to its average of the last 10 years, ¥46,000 an ounce. At the current dollar/gold price, this would mean the yen/dollar rate would be 138 instead of 126. Jf Japan did this, the Tokyo stock market would go through the roof, from 15000+ to 22000+ in a short period of time. The Asian stock markets would all go berserk as well. Hallelujah! The Deflation is ended!

What would happen to interest rates in Japan if the Bank injected this massive liquidity? They would rise, reflecting the sudden demand of business to borrow with the expectation that prices would stop falling. Short-term rates should not be lower than 2%. Long-term rates, now less than 2%, should not be lower than 3%. The higher rates would reflect confidence in the future, not inflation. In five of the last six months, wholesale prices in Japan have fallen. How about that for deflation? In the United States, since last spring commodity prices minus energy prices have fallen by about 10%. Energy prices are propped up by the sanctions against Iraq, which are designed to keep energy prices high to benefit the other oil producing states of the Middle East. (Sorry, but I cannot help but inject a political note into this lesson.)

One point I make here parenthetically relates to Lesson #10, which describes "two kinds of deflation," one monetary in nature, one fiscal. It should go without saying, but monetary ease will have no positive effects on a fiscal deflation. The monetarists to this day insist the Great Depression was a monetary deflation and could have been corrected by massive injections of dollar liquidity. The Austrian economists correctly argued that this would be like "pushing on a string." Monetary ease only has positive effects when . the currency has appreciated against gold, i.e., when it is scarce relative to the equilibrium price of gold — where the interests of debtors and creditors are in balance.

In another clear example of pegging a currency, consider Mexico in 1993. The price of gold in pesos was rising and Mexicans and foreigners were scrambling to unload pesos in favor of dollars, which were rising, but at a lower rate. All the Bank of Mexico need have done was to sell peso bonds out of its portfolio, taking in and destroying pesos. Contracting the bank's balance sheet! Why wouldn't they do it? The government was afraid this would cause an increase in interest rates! Just before the devaluation, three-month peso notes were fetching 16% at an annual rate, nervously up from 12% a year earlier. Okay. They refused to contract the balance sheet, and where did interest rates go on 3-month paper? For starters, 65% at an annual rate. The "Asian flu," which is the term we coined at Polyconomics to describe the virus that spread in the currencies of Southeast Asia, beginning with Thailand, we covered in Supply-Side University's summer school Lesson #7, August 1. I encourage you to re-read that lesson now in light of what has happened since, to see that we were then alone in the world in understanding the deflation that was unfolding.

And those of you who really want to add to your understanding of this issue, please read the current issue of National Review, dated  November 27, in which Milton Friedman and his protege, Allan Meltzer, declaim against "fixed exchange rates." There is no hyperlink to it, so you will have to buy it on the newsstand. The editor of the magazine, a fine fellow named John O'Sullivan, is also a Friedman protege, which means he can be excused for following the monetarist line without question. In Lesson #9, we find Reuven Brenner, one of the best economists in the known world, finally pulling away from monetarism, expatiating on the need for a monetary anchor. I append below a letter I wrote to the National Review in response to the Friedman/Meltzer articles.

P.S. Those of you who are registered will receive by special e-mail, a client letter we sent October 14, an open letter to Malaysian Deputy Prime Minister Anwar Ibrahim, explaining the nature of the problem. At the time, remember, the Malaysians were blaming George Soros and "Jewish speculators" for infecting them with the devaluation virus. Also, there will be a Thanksgiving Break. No lesson next week. Mull over what you have learned in these first 11 lessons and pose questions of me, of David Gitlitz. or of Reuven Brenner. Happy Thanksgiving.

November 18, 1997

Letters Editor
National Review
215 Lexington Ave.
New York, N.Y. 10016

Dear Editor:

Milton Friedman is correct in criticizing The Wall Street Journal editorial page for asserting that currency devaluations are "invariably" bad. When a smaller country pegs to another's currency, it ties itself to that country's policy mistakes. If the mistake is monetary deflation, always accompanied by a falling price of gold, the smaller country has little choice but devaluation if it is to escape widespread bankruptcies and economic depression.

This is what happened in Asia this year, as the Bank of Thailand, which pegged the baht to the dollar, was forced to drain liquidity from its banking system as the dollar price of gold fell to $310 from $385 after earlier rising from a $350 plateau. In the first instance, the central bank of Thailand had to create more baht liquidity to maintain the peg. The banks loaned the reserves into the best available investments, real estate. When the gold price fell, the central bank had to destroy baht liquidity to maintain the peg, and this wiped out the real estate investors.

Friedman understands Thailand imported its inflation and deflation from the Fed. In his commentary in the same issue, "Asia Afloat," Allan Meltzer misplaces the source of Thailand's problem. Meltzer blames the bad investments instead of the Fed. He also errs in arguing the Crash of 1987 was caused by the fixed rates of the Louvre accord. The Louvre accord fixed the rates in early 1987, but there was no guide to the central banks on whose responsibility it was to ease or tighten. When the price of gold climbed in both Deutschemark and dollars, the Bundesbank decided to tighten to prevent inflation, and we refused, thus ending the experiment and sending the world again into a floating regime.

As usual, my disagreements with Prof Friedman over the past 25 years center on his belief that paper currencies can be strung together or floated separately, and somehow operate without the use of gold as a guide. He recognizes that the monetary world was more stable when gold served that function, but continues to insist that politicians will not live with its discipline. Politicians of course benefit most from the kind of chaos we have seen in the past 30 years, since we began breaking the gold link in 1967 and finally completed the job in 1971-73. It has been my belief that because ordinary people benefit the least from such chaos, they would happily return to the discipline of gold.

Sincerely,

Jude Wanniski