Price Adjustments Jude Wanniski November 20, 1998

Supply Side University Lesson #11

Memo To: Website Students
From: Jude Wanniski
Re: Price adjustments

In our lesson last week on exchange rates, I tried to drive home the concept that an exchange rate really is a price. The price of an orange is two apples. The price of an apple is half an orange. So too is the price of a dollar in Japan about 120 yen. The price of a dollar in Germany is 1.65 Deutschemark. The price of a dollar in Mexico is 10 pesos. Or if you are offering apples for dollars, the price or exchange rate will be the same in Japan, Germany and Mexico, ceterisparibus. This is the Latin term for "everything else being equal.11 Because it is extremely rare that, ceteris paribus, prices of apples in Japan, Germany and the United States almost will never be equal. In the U.S. market for apples, where there are more apples offered for dollars than anywhere else on earth, Japanese and German apple growers wouldn't even dream of offering their apples for dollars. An American apple grower has so many advantages over Japanese and German apple growers that he would be surprised if a single Japanese or German apple showed up for sale in his market. The biggest advantage is that the American's apples are close to the buyers of apples who will pay dollars.

Yes, a Japanese apple grower will have to pay a significant sum merely to ship apples to the United States, but another serious cost is in converting currencies and contracting in currencies. Even if a Japanese apple were competitive with an American apple when the cost of transport were added in, the cost of the currency exchange would make it prohibitive to export Japanese apples. If both the yen and the dollar were tied to gold, thereby eliminating the potential losses to the exporter or importer of the Japanese apples, most of this exchange cost would be eliminated. In a floating currency regime, somebody has to bear the risk that before the contract is completed the yen will be worth more in terms of dollars or less in terms of dollars. The apple exporter and the apple importer both are at risk when the contract is expressed in either currency and the cost of hedging against the potential exchange loss must be born by both parties. If there is trade in apples, it will be American apples going to Japan, because the basic U.S. cost of growing apples is so much lower than in Japan that the costs of carriage and exchange risk can be covered and the trade still be profitable.

When the United States went off the gold standard in 1971, taking the rest of the world with it into a floating regime, the supporters of a currency float pooh-poohed those who worried about the costs of hedging. Milton Friedman argued the changes in exchange rates between the dollar and yen and the dollar and D-Mark would be so small that the hedging costs would be trivial. As with so much of his theorizing on this account, Friedman assumed that there would be the same kind of automatic adjustments to trade and capital flows under floating regimes as there had been under a gold standard. In his study of the monetary history of the United States, he found that the velocity of money -- the demand for money — was constant, and it could thus be assumed that by controlling the supply of money you could determine prices and output. But when the dollar's link to gold at a fixed price was broken and became independent of each other, the demand for dollars declined relative to gold. The price of gold in dollars had to go up. The dollar's velocity increased, which meant that the same money stock could support more output at a given price level. If the monetary authority added still more money to the system, output would not necessarily go up, but prices would, and did. In the basic, undeniable monetarist equation: Money x Velocity = Prices x Transactions, what went wrong for Dr. Friedman was his failure to see that gold's link provided a value to the dollar that, when removed, would reduce the value of the dollar. I've concluded long ago that he did not see the market's insistence that gold be retained as the fundamental unit of account on which the dollar could stand as long as it remained its equal. Friedman's assumption was that if gold were demonetized it would lose value relative to the dollar. When silver was demonetized in 1873, it steadily lost value relative to gold and the dollar which was defined in terms of gold. This was because the world had become comfortable with a single unit of account, gold, instead of the inefficiencies inherent n a dual money. As silver was no longer held at an overvalued level, it became more affordable as an industrial commodity, particularly in the steadily expanding photography industry. In other words, as its monetary properties decreased, its industrial properties increased. It was then mined and refined not for use as monetary reserves but as a commodity cheap enough to be used up as fast as it was produced.

Tiese economic concepts are in some ways common to demand-side economic ideas, especially to Keynesian models that have always been ubious of the quantity theory of money that underpins modern lonetarism. Keynesians on the other hand share with monetarists the failure to recognize gold as the market's preferred unit of account. They will acknowledge that a central bank which pumps money into the economy at a great rate will cause a troubling inflation, but from their earliest days they have argued that a small amount of inflation is referable to no inflation or to deflation. A small inflation, say of 3% or 4% a year, will "grease the wheels of commerce," Keynesians equently argued, at least until inflation rates spiraled in the years after the dollar/gold link was severed. Here is a typical discussion of the issue in the 1951 edition, the second, of Paul Samuelson's Economics, (McGraw-Hill) which became the standard textbook in American colleges from its first edition in 1948:

An increase in prices is usually associated with an increase in employment. In mild inflation the wheels of industry are well lubricated and total output goes up. Private investment is brisk, and jobs plentiful. Thus a little inflation is usually to be preferred to a little deflation. The losses to fixed-income groups are usually less than the gains to the rest of the community. Even workers with relatively fixed wages are often better off because of improved employment opportunities and greater take-home pay; and a rise in interest rates on new securities may partly make up any losses to creditors.

In deflation, on the other hand, the growing unemployment of labor and capital causes the total of the community's well-being to be less, so that those few who gain receive much less benefit than those who lose. As a matter of fact, in deep depressions, almost everyone ~ including the creditor who is left with uncollectible debts — is likely to suffer.

The above remarks show conclusively why an increase in consumption or investment spending is a good thing in times of unemployment, even if there is some upward pressure on prices. When the economic system is suffering from acute deflation, it makes little sense to criticize public or private spending on the ground that this may be inflationary. Actually most of the increased spending will then go to increase production and create jobs. But the same reasoning shows that once fall employment and full plant capacity have been reached any further increases in spending must necessarily by completely wasted in "paper" price increases.

Note how Samuelson in this passage completely puts aside the value to an economy of having a fixed unit of account. The reason it "makes no sense" to criticize public or private spending because it may be inflationary tells us Samuelson has come to his conclusions by viewing the depression of the 1930s as an "acute deflation" when it was actually a contraction. It is important to remind ourselves when reading this material from the 1950s that the young Keynesians of the era still associated the depression with a failure of monetary policy due to the rigidity of the gold standard. Most of the errors in modern macro-economics, I believe, can be associated with this blind spot. In Chapter VII of The Way the World Works, I demonstrated that the stock market crash of 1929 was caused by the market discounting the likelihood of passage of the Smoot-Hawley Tariff Act in 1930. In his 1951 book, Samuelson notes that the entire economics profession opposed the tariff as being excessive, but it was not until my discovery in 1977 that the act itself was associated with the crash.

What does this have to do with prices? If the dollar/gold exchange rate remains constant, there can be no monetary effect on the general price level unless there is a sudden discovery of new sources of gold. The modest world-wide inflation attributed to the discovery of gold in California in 1849 — which is why the San Francisco football team is called the "Forty Niners" — was one such instance. And it too was temporary. Because the demand for gold did not match the increased supply, other gold sources that were marginal were abandoned until the purchasing power of gold was restored to its pre-1849 level. This is the reason why technological improvements in gold mining do not diminish its value as a monetary commodity. As some sources produce more gold, others are abandoned, keeping the supply equal to the demand.

When the United States is trading goods with the rest of the world, a sudden imposition of a higher general tariff wall around the United States will cause a decline in prices throughout the world. That's because if the United States is producing goods and services for trading purposes, not for sale in the domestic market, a sudden increase in the tariff on goods coming into the United States will cause demand for those goods to decline in the United States. Foreigners will not be able to sell as many as they had expected, which means they have a sudden surplus that can only be disposed of by a reduction of their prices, a distress sale, either here, or outside our tariff wall. Because the rest of the world did not earn what it expected because of the American tariff, it cannot buy the goods it expected to buy from the United States. Goods on our side of the tariff wall pile up on the docks and their producers have to cut the prices here at home in order to run down the surpluses. Even those producers who had not expected to export anything now find their domestic sales plunging because competitors are slashing prices here to dispose of goods no longer headed for foreign markets.

Economists like Samuelson understood this process when they denounced Smoot-Hawley as contributing to the contraction of trade in the 1930s. It is because they did not see it as having caused the collapse of equity prices on Wall Street in 1929 that they struggle with gold, having to assume that its rigidity as a standard of measure somehow combined with an inefficient stock market to produce the crash that eventually led to trade wars between the United States and Europe. Much of this confusion remains to the present day because of what I believe is failure in the economics profession to fUlly understand the way a monetary inflation or deflation works. In our recent guest lecture by Friedrich von Hayek, we saw how he admonished the profession for failing to see how a general increase in the price level occurs in a sequence. The failure is not because of a failure to see, but because of demands of the mathematical models, which are incapable of handling sequences that are different in every instance and in every country. It is simply assumed by the mathematical models that when the price level goes from A to B, the sequence is less important than the movement of aggregates.

In other words, when the dollar price of gold went to $140 from $35 between 1971 and 1973, the price of oil remained constant even as the prices of zinc and copper and other internationally traded commodities began to rise. The oil price jumped all at once, four-fold to $10 a barrel from $2.50, when the oil-producing countries of the Middle East saw the dollars they were getting were unable to purchase as much gold, copper, zinc, etc. The rise in the price of oil to importers like the United States then led to increased prices of domestic consumer goods and investment goods and a consequent rise in the cost of living. Workers demanded higher wages and senior citizens persuaded their congressmen to adjust Social Security benefits to the higher price level. All of this happened without any economists predicting the sequence of price increases in getting from A to B — although Robert Mundell and Art Laffer were alone in predicting B would eventually be the new general price level.

Although there is nothing I can find in the economic literature on the pace of adjustment from A to B during a monetary inflation ~ or from B to A in a deflation — it seems to me that the pace is more important than the sequence. If the price of gold doubles in the United States on one day and doubles in France on the same day and in Thailand on the same day and in Brazil on the same day — will A go to B in each country in the same time frame? The economics profession appears to assume the answer is yes, but that is because the record of history which roughly shows the same time frame is a record of a world anchored to gold. In the last 30 years, the experience has been quite different, with recorded inflation rates varying all over the lot after devaluations against gold. This is why I began to see a relationship between the gold price of a currency and its recent history of price stability. If a country like the United States has a recent history of price stability, it will also have a debt structure with longer maturities. If a country like Brazil has a recent history of price instability, it will have a debt structure of shorter maturities. Every country in a world of floating currencies will have different debt structures, as private contracts of all kinds almost always key off the value of their domestic currency. In Russia, today, many private contracts seem to key off the dollar or D-mark, the ruble being too unpredictable.

The reason a more mature debt structure slows the adjustment process is that almost all workers and enterprises in a national economy are trading domestic goods and services. If the dollar price of gold doubles when it has been constant for a long period of time, it has little immediate effect on wages, which are arranged in contracts of one-to-three years. The first prices that follow gold are internationally traded commodities priced on the spot market, and these do not double immediately because workers who are mining oil, zinc and copper or farming wheat, oats and corn are still tied to contracts and have limitations on what the market can bear in terms of price increases. If the average maturity of debt in the United States is 20 years, it will take at least that long to get from A to B, although most of the adjustment will come in the early years. Workers demand higher wages as the purchasing power of the dollar declines, but they get from A to B in several cycles, as contracts unwind throughout the American economy.

In Mexico, on the other hand, the experience with devaluation since 1976 has been so ingrained in the financial structure that price adjustments come much more quickly. In the first devaluation of 1976, when the peso went to $0.05 from $0.08, the adjustment process was relatively slow because the peso/dollar rate had been fixed for more than 20 years at 12 to the dollar. Debt maturities had lengthened as debtors and creditors became comfortable with the reliability of the peso purchasing power over time. In subsequent devaluations, the debt maturities shortened again and again because the population lost confidence in the integrity of the currency. Workers demanded pay increases immediately upon a dollar devaluation. The adjustment from A to B to C to D to E became shorter and shorter. In one surprise devaluation perhaps 15 or 20 years ago, I recall a story in the NYTimes of workers crowding into shopping malls in Mexico City the day after the announcement, buying anything they could get their hands on. One man bought three refrigerators at the pre-devaluation price. He told the Times reporter that he had no need for the refrigerators, but that he knew he could soon sell them for twice as much as he was paying.

When the peso devalued four years ago, to 7 from 3.5 to the dollar, there were no such crowds massed at the Mexico malls because the debt structure had matured in the previous six years of peso stability. Not long before the devaluation, the head of the Bank of Mexico proudly told me that the average maturity of government bonds had lengthened to five years from the three months at the beginning of the Carlos Salinas administration in 1988. This is why Mexico's economists now are confused at the their failure to predict near-term inflation rates. The peso now has gone to 10 to the dollar, but because of the dollar The peso now has gone to 10 to the dollar, but because of the dollar deflating against gold, there is not quite the need for A to triple to get to B. The economists are not taking into account the fact that the December 1994 devaluation is still unfolding even as the new devaluation has been laid atop the old one.

In the United States, the failure to understand that monetary deflation occurs in wage cycles seems to be the chief reason why Fed Chairman Alan Greenspan now appears to be comfortable with a gold price more than 20% below where it was two years ago. It will take several cycles for wages to come down to accommodate a B-to-A adjustment process. Because the process is gradual, owing to the maturities of debt structures here, and because the monetary deflation is offset by the promise of further tax cuts and budget surpluses, we may get to a new lower general price level without an economic recession for the country as a whole. For those parts of the economy that are tied to commodity prices, there is already recession.

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If there are any professional economists who are in this SSU lesson and know about material in the economic literature that bears upon the topic of the pace of price adjustment, please pass on the references. Anecdotal material is also appreciated and I'm sure some of our foreign-based students will be able to offer some.