Executive Summary: What will it take to end inflation? Not only a slowdown in the rate of increase of the general price level, but a stability that implies short-term interest rates of 1 1/2% and long-term rates of 3% or so. Amidst this summer's international monetary convulsions, with experts and politicians gasping over the hourly collapse of the dollar, the soaring price of gold, and the return of double-digit inflation, let's stand back and look at the big picture.
The Europeans are putting the final touches on a credible blueprint for moving control of the world's monetary system from Washington to Brussels; the Carter Administration is backstepping its way toward stabilizing the value of the dollar in terms of other currencies; and the body politic of the industrial world is learning that there are real costs to a falling currency, and little to fear from a strong one. The avenue that can take us to inflation's end may be before us.
A Political Inflation
In his recently published Memoirs, Richard Nixon allowed himself a pat on the back as he reminisced about the summer of 1971 and the Camp David meeting that shook the world. Yes, he says, Arthur Burns, chairman of the Federal Reserve Board, was a swell fellow with a "superior intellect." But... "This was to be one of the few cases in which I did not follow his recommendations. I decided to close the gold window and let the dollar float. As events unfolded, this decision turned out to be the best thing that came out of the whole economic program I announced on August 15, 1971."
President Nixon should have listened to Burns. The decision to "close the gold window and let the dollar float" (a statement that reveals Nixon's ignorance of just what he did do) was the worst economic move of his administration. Its destructive consequences remain with us in this summer of 1978. As the Dow Jones ticker informs us hourly of the collapse of the dollar against the currencies of Europe and Japan, the price of gold nuzzling $210, and U.S. price indexes back in double-digit advances, our understanding of it all must begin by fixing on that picture of Nixon cheerfully slamming shut the gold window. Only then can the micro-analyst, the investor, confidently track the minute-by-minute reports on the news ticker with an appreciation of the forces that move markets. We might then understand why the dollar has been falling even as the stock market has been rising, what is putting up the dollar price of gold and other metals and what will bring it down, and how U.S. politicians might grope their way to low interest rates — 1 1/2% short-term, 3% long term (levels attained already in Switzerland) — sometime in the 1980s.
Consider, first, the Nixon statement that he "let the dollar float." He clearly believes that the closing of the gold window was an act to free the dollar from its fixed relationships to other currencies. This idea could only have been put in his head by his economic advisers and the economics profession in general. Led by the University of Chicago's Milton Friedman, the profession in 1971 had reached a consensus that the dollar should "float", and there was thus scarcely a word of complaint from either monetarists or Keynesians, conservatives or liberals, that this was not a good thing for Nixon to do.
In fact, though, the United States had no responsibility — zero — under the terms of the 1944 Bretton Woods Agreement to fix or not fix exchange rates. The other nations of the world could, if they chose, fix their currencies to the U.S. dollar. Or they could float, or crawl, or slide against the dollar, as theCanadians, Germans, British and French did now and then. But the U.S. had only one responsibility: to maintain the value of the dollar relative to gold. The U.S. monetary authority would maintain a gold standard as its guide in the creation of money.
A gold standard? Wasn't that something that existed in the 19th century? And didn't President Roosevelt take the U.S. off gold in 1933 when he made it illegal for Americans to own gold bullion?
Not quite. A monetary standard is simply this: The Treasury agrees to buy or sell something of value at a fixed price measured in the currency it is creating. When that "something of value" is gold, the monetary authority is on a gold standard. For most of U.S. history, the U.S. Treasury bought and sold gold at $20.67 per ounce. A citizen of the United States, or a foreigner, or a foreign government could come to the Treasury with $20 and buy an ounce of gold, or show up with an ounce of gold and exchange it for $20 worth of coin or currency. With this arrangement, the general citizenry has control of money creation. The government could not create a single dollar in excess of the citizenry's requirements because one citizen would get that $1 and bring it to the Treasury, demanding one-twentieth of an ounce of gold. In this light, and in a very real sense, a monetary standard is a democratic institution, individuals "voting" with dollars for or against the monetary policies of the government.
In 1933, Roosevelt devalued the dollar against gold to $35 per ounce and ended the practice by which a citizen or foreign individual could come to the Treasury with currency or gold and ask that they be converted into one or the other. But this only partially ended "dollar convertibility". Foreign governments could still come to the Treasury with such demands. This meant that a U.S. citizen could still keep his monetary authority honest. The citizen, in 1960, could take his surplus $ 1, swap it with a German for 4 Deutschemarks. The German would take the $1 to the Bundesbank and get 4 Deutschemarks for it. And the Bundesbank would present the $l at the Treasury and get one-thirty-fifth of an-ounce of gold for it. There is, of course, a little extra work involved, but the U.S. monetary authority is still held to a standard by its citizens. More or less.
Less, of course, because the U.S. monetary authority and U.S. government could more easily try to outfox the citizenry. It did so by passing laws making it more difficult for citizens to invest abroad — capital controls. But dollars leaked out of the country anyway. The second, more effective method was to browbeat foreign governments into sitting on dollar hoards instead of converting surpluses into gold. As leaks continued, the price of gold in the private market inched above the official price, which meant that no government, anywhere, would turn loose an ounce of the gold in its reserve at the equivalent of $35 per ounce.
It all broke loose in 1971 when the Federal Reserve, spurred by the Nixon economic advisers and Chicago monetarists, pumped up the money supply with the idea that prosperity would ensue. Instead of prosperity, the world was choked with surplus dollars, and by early August the foreign central banks were telling Treasury they wanted gold. President Nixon said no and slammed shut the gold window. Now the American citizens had lost all effective control over money creation. The result was predictable.
Index of Wholesale Commodity Prices
United States 1800-1976
Year_____Index Year_____ Index Year_____Index Year_____Index Year_____Index
1800 102.2 1850 66.6 1900 64.8 1934 86.5 1972 267.0
1810 103.8 1860 73.8 1910 81.4 1945 122.4 1973 302.0
1820 84.1 1870 107.0 1920 178.7 1950 183.4 1974 359.0
1830 72.2 1880 79.4 1930 100.0 1960 212.6 1975 392.2
1840 75.3 1890 65.0 1933 76.2 1970 247.5 1976 410.2
Source: Roy W. Jastram, "The Golden Constant: The English and American Experience, 1560-1976", Wiley Interscience, New York, pp. 145-6.
For more than 130 years — as long as people in general (the market) could convert dollars directly into gold and vice versa — the general price level held within a narrow band. Only during periods of inconvertibility and war did the price level wander outside this band. The 1933 devaluation of the dollar triggered a year of double-digit inflation in the depth of the Depression. And, with only a few dozen governments able to convert dollars into gold at the U.S. Treasury, four decades of gradual decline in the dollar's value in terms of the general price level ensued.
When, in 1971, the power to determine the value of the dollar fell wholly into the hands of the few bureaucrats at the Federal Reserve, the dollar began its steep decline in value. That decline will not be arrested until the Federal Reserve is forced back to a monetary standard, an event that does not now seem imminent. But it is one we might imagine lies just over the horizon, with pressures from Europe and Japan ultimately leaving the United States little choice but to grope its way back to dollar convertibility.
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When the monetarists and Keynesians counseled Richard Nixon into snapping the dollar's last ties to a monetary standard, their theoretical arguments varied. But at bottom the notion was the same: Given a free hand to create money, the Fed would be able to bring economic prosperity. Keynesians argued that the dollar was "overvalued" relative to other currencies; devaluation was seen as a way of moving the U.S. economy along the Phillips Curve, trading more inflation for less unemployment. The monetarists argued that a steady increase in the money supply, whether the economy needed it or not, was the key to a productive, non-inflationary economy. Each theory required, for starters, an inconvertible dollar.
In the first few years after 1971, U.S. policymakers at least held out the possibility that as soon as the promised prosperity was in hand, and the U.S. dollar once again "competitive", there could be a return to convertibility. By 1976, as the following table indicates, the correlations between devaluation and economic well-being ran in exactly the opposite direction.
Exchange Rate Per Capita Income
Country Versus $US Constant $US
1970 1976 % Change 1970 1976 % Change
U.S. -- -- -- 4343 4843 +11.5
U.K. 2.396 1.806 -24.6 2028 1652 -18.5
W. Germany 3.646 2.518 +30.9 2762 4582 +65.9
Japan 358.1 296.5 +17.2 1523 2297 +50.8
France 5.529 4.779 +13.6 2578 3511 +36.2
Italy 627.1 832.3 -32.7 1583 1363 -13.9
Switzerland 4.310 2.499 +42.0 3188 5599 +79.6
Canada 1.044 .989 +5.6 3406 4791 +40.7
Source: International Financial Statistics
Politicians in the United States may be slow to figure out that a depreciating currency has a negative correlation with prosperity. In early August, President Carter told Business Week he thought the yen might be "undervalued." At 188 yen per dollar at the time, the yen had appreciated.by 47.5% against its 1970 value.
In Europe and Japan, though, the message has gotten across. U.S. trading partners no longer seem to fear, as they did in 1971, that a cheapening dollar would take business away from them. They see that the United States has become less, not more competitive as the dollar has declined relative to their currencies. As this realization has penetrated, the idea that their support of the dollar is crucial to their own economic well-being has withered.
The July 6 summit meeting in Bremen of the European Economic Community was an explicit message to the world marketplace that Europe will no longer be wagged by the U.S. dollar. The EEC will, instead, establish a European Monetary System on January 1, 1979 with membership open to anyone in the world, not only EEC members. The EEC members will chip in the equivalent of $20 billion in reserves, and act in competition with the International Monetary Fund as a lender. What makes the difference, though, is that the Europeans plan to issue gold-backed bonds, which means the unit-of-account will be tied to a gold monetary standard. Thus, instead of waiting around for a return to dollar convertibility, the Germans, French and Swiss will take the lead themselves in developing a world trading currency that holds its value.
The Carter Administration is alarmed at this play, as well it should be. But there is nothing it can do about it. Indeed, the Carter people have done everything possible to irritate the U.S. trading partners, thereby pushing them in this direction. Last year, it was Treasury Secretary Blumenthal "talking down the dollar."Then the incessant pressures on Japan by junior Treasury officials to stop supporting the dollar. Now, there is Fed Chairman G. William Miller's attempt to drive down interest rates with new money creation.
The only way the EEC can make this system work is if it absolutely forgets the dollar, and is prepared to let it slide as far as it may. Undersecretary of State Richard Cooper sees it happening, and July 12 said that the U.S. "would oppose exchange market intervention of a kind that would promote European exchange rate stabilization at the expense of the dollar market." But the matter has been taken out of his hands. If the EEC is determined to create a world trading currency that promises to maintain its value over time by hewing to a gold standard, world traders will flock to it, and in the process abandon the dollar.
This is what's happening in the financial markets, which do not have to wait until January 1 to make adjustments in the holding of currencies. Every day that passes makes it appear to the market that European and Japanese currencies will be holding their value relative to gold in the months and years ahead. So international traders, including the multinational corporations, switch out of dollars into these other currencies. The Wall Street Journal and the conventional Friedmanites seem to think the dollar slide is the result of excessive money creation; Chairman Miller could solve all by tightening up a bit. But it is the already existing dollar supply that is the problem, as the private market is substituting other currencies for dollars.
The unfolding events may be "bad" for the Carter inflationists, who have lost leadership on monetary policy to the Europeans in the same way they have lost leadership on fiscal/tax policy to the U.S. Congress. But all this bodes well for the U.S. economy, if the end result will be a return to dollar convertibility.
We can assume the Carter Administration will begin to move in this direction because the only alternative is to stand by and watch the dollar sink further in the international financial markets with a consequent impoverishment of the American economy relative to Europe and Japan. The Trilateral Commission ideologues around the President, including Cooper at State, may not admit the error inherent in their soft dollar policies. But Mr. Carter's support in the Business Roundtable and the New York banks will, one would think, sooner or later be jerked out from under him. The only way the Administration can stop the Europeans is by offering a world trading currency superior to anything they could design, i.e., a convertible dollar. Mr. Carter, in other words, may be dragged kicking and screaming toward an end of inflation.
What would be the ideal solution? In 1974, when he was a consultant to the U.S. Treasury, Prof. Arthur Laffer advised William Simon on a return to convertibility. The idea was instantly rejected, but it remains the best idea around. The United States now owns nine metric tons of gold, which at inflated prices gives it a nominal value in excess of $100 billion. Laffer recommends selling off eight tons of gold in the private market, and when one ton is left in the hoard. Treasury announces dollar convertibility at that price. That is, U.S. citizens can bring gold or dollars to the Treasury once again and have one converted to the other at a fixed price, the price being that which prevails after eight tons are sold off. Laffer figures the price would work out to around $45 or so, perhaps more. But the important thing is to get the people of the United States back in control of money creation. If the people have a firm enough grip on money creation, via an open gold window, there will be no more inflation. Once a citizen knows he or she can bring a U.S. dollar to the Treasury a year from now, five years from now or twenty years from now and receive in exchange one forty-fifth of an ounce of gold, all the monetary risk of holding a dollar evaporates. Interest rates would drop like a stone, to 1 1/2% short term and 3% or so long term.
The Europeans and Japanese would love it. Instead of having to go through the laborious, politically difficult process of supplanting the dollar with a jerry-rigged EEC unit-of-account, the world would flock back to the dollar. Exchange rates would be fixed, not by virtue of any explicit fixing by the United States, but because the rest of the world would want to tie to the dollar and enjoy the end of inflation.
Can we put a probability on this? The question is not really if, but when? As with everything else. President Carter may be capable of minor concessions, forced down this avenue in the same way he has been reversed on capital-gains taxes. Monetary policy may be tightened in response to a weak dollar; tighter reins may be put on the targets for growth in the money supply; and the price of gold may even be used as a proxy for inflationary pressures and a guide to monetary policies. But a complete resolution of the convertibility issue and a return to a dollar gold standard will almost certainly have to await the 1980s and a change of administration. In mid August of 1978, that probability seems very high.
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