Reuven Brenner Q&A on Politics and the Market Jude Wanniski April 17, 1998

Supply-Side University Economics Lesson #13

Memo To: Supply Side Students
From: Jude Wanniski
Re: Reuven Brenner Q&A on Lesson #11

Following his guest lecture on March 27, Professor Brenner engaged in Q&A discussions with two SSU students. They were of sufficient interest and importance that I thought they should be shared with all of you. Because Dr. Brenner has a different perspective than I, he can often explain what it is we both see from different angles, in a different formulation that will help you triangulate in grasping the concepts. This is actually what happened to me. From summer 1971 to May 1974, all my exposure to these supply-side ideas came from Art Laffer. I thought I knew what he was trying to teach me, but when I met Robert Mundell for the first time, at a conference in Washington, D.C., the lightbulb really went on. In one three-hour discussion in his hotel room in Georgetown, I asked him dozens of things I'd learned from Laffer, and he rephrased the ideas. I was not only excited with finally seeing the world clearly, but also agitated because I realized the United States was headed toward a recession later in the year and in 1975 — when all other professional economists were forecasting growth. I realized how important it was that this triangulation took place. I'm hoping that the issues raised here will begin a similar process for those of you who are having difficulty with my lessons.

* * * * *

Q. [Russell Whiting] A friend, who has extensive experience in Thailand, asked me recently. "What does Jude Wanniski think about the baht now? It has appreciated dramatically in the last month. Why?" So, I thought about this question in the light of Jude's proviso. 'The market is efficient.' This would seem to mean that the Thais have implemented policies to restore faith in the baht, but what policies?

A. [Reuven Brenner] Now you have to understand what Jude means by "markets being efficient." That they use all the information. In the U.S. this would be all publicly available information. In Thailand, I doubt this is the case, and so I would be reluctant to use the word "efficient." I have read reports that ministers in Thailand have their own trading rooms, so they can certainly use information which has not been made public. Say, they decided no more devaluations. The baht would go up. But, since the change in policy was not made public, you would just not know. I would not use the word "efficient" for situations such as this, and I would guess that the Thai's stock, bond and currency markets would not have great depth (there would be few buyers, sellers). I do not know if such data are available for Thailand. (By the way, this is one of the points in Lesson #11).

Q. I should mention that the baht reached a low vis-a-vis the dollar of 57 about six weeks ago. Since that time, it has been steadily appreciating; at the present time the baht trades at 38 to the dollar. Enter Jude's second proviso. 'If the financial markets know that a government is serious about "fixing" a currency, those markets will help in fixing the problem.1 In the latter case, does this mean that a government or governments might purchase baht and hold them hoping to reap a "windfall" of sorts as the baht appreciates?

A. Yes.

Q. [This being] the case, is there a downside to the financial markets helping in the fix? That is, will the currency be "dumped" after an investor is satisfied that he has reaped the profits?

A. No, because if indeed the political decision is credible once it is made public, when the "insiders" resell, by this time others may buy the currency. But it is a fragile situation.

Q. Is Jude's reference to the financial markets a reference to capital inflows? In the latter case, I can understand that investors might see Thailand as a case where "things have gotten as bad as they're going to get and the Thais have the labor force, investment opportunities and work ethic to bounce back" but how would these investment inflows effect the value of the baht?

A. The answer to the last part of the question: no, not necessarily, as you can understand from the above. It depends on the credibility of the political commitment and whether there are other changes happening within Thailand to increase the demand for the baht.

Q. Finally, one other point Jude made in his analysis of currency devaluations has me thinking about Thailand's problems as well. Jude stated in a lesson that "until there is a dollar-gold unit of account, countries will always be able to find their currency weakness in mismanagement of tax, trade or regulatory policies."

A. Are you sure you quoted this sentence properly? I do not understand it.

Q. I am aware that Jude formulates a different hypothesis with regard to the problems of the Asian economies.

A. No, I do not think so. His point is that a country will be better if it has a non-political monetary standard (gold), the price of which can serve everyone to price contracts (also re-read my numeraire lecture: itfs on this point). Once this is done, the fiscal question is separate from the monetary one: Governments can no longer use monetary policy for fiscal purposes, creating credit for state-owned enterprises with impunity (since less credit will then be available for private enterprise and that will become instantly visible) etc. Once currency is separated from political-fiscal considerations, the effects of government policies come into much sharper focus, can't be confused with claims of "globalization," "speculators," etc. That's why governments do not want the separation to happen, and pay an army of economists to sustain macro-economic mythologies and their obscure, confusing jargon.

Q. Here is the quote in question: "The best defense of a currency will differ in every situation, at least until the United States takes on the global responsibility of first fixing the dollar to gold. Once all other countries can then fix to the dollar/gold unit of account, they will always be able to find their currency weakness in mismanaged tax, trade or regulatory policies." I believe I had mistakenly substituted 'upon' for 'once.' Does this clear things up?

A. Yes, you see this quote puts in different words and more clearly what that Schumpeter quote at the end of my Numeraire lecture said.

Q. In examining the problems of the Thai economy, Jude's hypothesis is different in the sense that he does not posit the blame for what has gone wrong in Thailand with the Thais. He was quite emphatic about this. I seem to recall him stating, "Don't blame the poor bastards in Thailand for what's happened. It's not their fault." Rather, Jude placed the responsibility for their economic woes squarely at the feet of our Federal Reserve System in the person of Chairman Greenspan. It is Jude's contention that the decline in the price of gold is an indication that there is a "liquidity crisis" and Greenspan's Fed has been too tight-fisted. Apparently, the Thais were the unfortunate victims in all of this, linking the baht to the dollar and being unable to hold on as the dollar appreciated vis-a-vis gold.

A. There is no contradiction: once the baht was linked and went up together with the dollar relative to gold, it meant that if contracts were signed between borrowers and lenders relative to $350 gold price (and the dollar liquidity this price assumed), if the dollar liquidity diminished, you start selling gold to return the dollar debt. Maybe Jude should have put together his attack on the Fed with the one on Japan's central bank, because the latter too did not respond to the increased demand for liquidity. Jude did mention this in some memos, but maybe he did not put the attack on both central banks together. And maybe he did. I might have missed some of his memos. But I am very sure that he did raise the liquidity issue also with respect to Japan.

Q. Within the context of these suppositions, I have another question. Jude has developed a schema where the "Thais first injected liquidity into the banking system in order to keep the baht tied to the dollar. Thai banks, having no first line borrowers with up-front collateral, pushed the reserves to the second tier of borrowers who would put it into bricks and mortar, hoping the market would keep expanding." This statement would seem to imply that the Thais were "pushing" money into the hands of individuals not really competent at putting that money to the "best" uses.

A. What Jude says, is that the Thais tried to compensate for the lack of international liquidity with baht liquidity. But the fact that you increase the money supply, does not create either increased real demand for it (so prices will be adjusted), or new investment opportunities. So this money goes into stock markets or real estate, where people think that they can get out easily when others catch up. That's why, if I recall Jude also wrote in one of his memos that if the Thais would have done this combined with diminished taxation, simplified regulations, part of the increased baht liquidity would have been absorbed in lasting ventures. This is because the lower taxes enhance incentives and would lead to increased demand for the baht (relative to other currencies).

Q. This is entirely possible, but what hard evidence is there to substantiate this supposition? Looking at the baht M2, for example, it would seem to me that people with capital, much like our real estate crisis in the Northeast in the U.S., kept leveraging themselves until the market was saturated and overbuilt. In essence, where does the "second tier" borrower concept come from?

A. There are always people who get into markets later in the game: herd instinct. I think that this is really what Jude is referring to.

Q. Do you think it applies to the situation in Thailand?

A. The "herd instinct" is international.

Q. Next, according to Jude, in order to keep the baht from depreciating, "the Bank of Thailand had to drain reserves from its banking system and became strapped...the banks could not lend to enterprises that would have occupied the bricks and mortar, built in the previous three years. The debtors had no choice but to turn these projects over to the bank and walk away." However, isn't it possible within this context that prospective business people who might have occupied the malls or condominium office space said, in  essence, "I can't possibly locate a business in this mall...There are two malls within walking distance...There are just too many malls!"

A. Yes, the better businessmen would have said that. But you know there is the saying: "Don't confuse brains with a bull market."

Q. In other words, was it the dearth of loans or the fact that reasonable business people recognized the glut and held back from business commitments of their own accord. I see the Thai problem in this light, massive overbuilding and rampant speculation. There was simply too much supply created, far more golf courses, condominium complexes, hotel rooms and malls than could be turned into profitable business ventures or productively occupied.

A. Yes, and there is no contradiction. To do that, bank officers gave loans too easily.

Q. Jude would probably answer that these problems were symptoms of the systemic crisis arising out of our Fed's lack of awareness concerning our monetary policies and their effect on the rest of the world, but quite frankly, I find myself struggling to make this link.

A. It's more complex than what he is saying. Here is the sequence Jude has in mind (but you really have to double check this with him): If the Fed or Japan's central bank reacted and kept their currencies firmly linked to the approximately $350 gold price (with a small margin of error around it), the Thai central bank would not have been forced to increase baht liquidity. Once it did, it's like the genie out of the bottle, and the bank could not control how the increased liquidity was spent. For, while there was increased demand for dollar liquidity, there was no increased demand for baht liquidity. By supplying the unwanted bahts, the demand for it collapsed. Hope this makes it clearer. But please, do check with Jude. [Dr. Brenner is exactly right...JW]

Q. [From Steven Piraino] In your lecture, you indicated that an exchange rate depends on the capital flows between two countries. Do I understand you correctly?

A. No, what I meant is rather simple: First, recall my "Numeraire" lecture, or Jude's various lectures on the gold standard. When you do have such a standard, then currency values do not depend on capital flows. Nobody will even bother to look at those flows, just as you do not look how much is flowing to and out of California from the rest of the United States; But today we do not have that. So take the Canadian dollar. The demand today for this currency around the world depends on what people buy and expect to buy from Canada. If Canada lowered taxes significantly, more would be invested in Canada (more capital will flow in), more talented people would be retained in and attracted to Canada, and more will be produced in Canada relative to the rest of the world. So the demand for Canadian dollars goes up. That's all I meant. Of course, you are right: If there are no fiscal changes, and monetary authorities just play with money supplies, then obviously, if the money supply goes up, there will be inflation and devaluation. To avoid that you want to sterilize. I know that textbooks are full of models in which nothing happens, but governments want to impose an inflationary tax out of the blue, and then you are in the world described by your questions.

But I was talking about something different: how you look at monetary policy in a world in which there are significant changes in taxation? What happens if there are significant changes in the demand for one currency relative to another (because of, say, expectations of devaluations or expectations of diminished taxes and regulations? Those models which shape your questions, cannot give answers to these questions, and now you can, I hope, better see the main point in the "numeraire" lecture. Monetary authorities should use market prices as signals to know what happens to the demand for liquidity of one currency relative to another.

* * * * *

As you see, the Q&A is a bit more economic than political, but I think it should help deepen your understanding of the issues raised. We will get back on the political beat next week, with a guest lecture from Ibn Khaldun, who comes back to us from the 14th century to give us some insights on what is happening in the world today.