The Volcker Myth
There is a common misconception regarding inflation, which says that there must be long and painful correction in order to stop it. Well, as Nathan Lewis points out, there might be an alternative…and it has something to do with our favorite yellow metal.
Gradually, people are becoming aware that we have an inflation problem, which seems to stretch around the world. Perhaps it is time to think about how to resolve it. Certainly a few coy remarks by some Federal Reserve representative aren’t going to be effective. If that were all it took, then nobody would ever have an inflation problem. You would just say, “we are concerned about inflation,” and it would disappear – poof! – like a cartoon genie.
Sorry: not quite so easy.
Inflation is childishly simple to understand, but economists like to remain confused. When a currency loses value, markets gradually adjust to reflect this new development. When the dollar’s value falls in half, things that cost $10 eventually cost $20, more or less. It’s no more complicated than that. The dollar’s decline is best measured against gold – for centuries considered a stable measure of value. The dollar is now worth about 1/900th of an ounce of gold, compared to about 1/350th on average during the 1980s and 1990s. You can do the math yourself and figure out what this means for prices going forward.
Conversely, if a currency remains stable – pegged to gold for example – then there is no inflation, whether an economy collapses (as in the early 1930s) or expands (as in the 1960s).
One of the reasons why inflation went on so long in the 1970s is that people imagined that stopping the inflation would be very painful. I call it the Volcker Myth: that “we need a recession so horrible that it breaks the back of inflation.” The power of this myth was so intense that, in effect, people tried their hardest to make it come true, and the 1982 recession was the result.
This myth continues today with the idea that there is a “tradeoff” between inflation and growth. Baloney. Inflation is bad for economies, and a stable currency is good. You can’t devalue yourself to prosperity. Nor can you recession yourself to a sound currency.
Ronald Reagan took a different view. If inflation is bad for an economy – this had been fairly well proven by 1980 – then certainly stopping inflation must be good, right? Reagan’s plan was to put the dollar back on the gold standard in 1981, and also to cut taxes dramatically. The combination of sound money and a hefty tax cut would create lower interest rates and an economic boom.
If sound money and lower taxes are good for an economy – and they most certainly are – then the result should be a better economy, not a worse one.
This idea has been proven out many times since 1980, particularly in the former Soviet sphere. Over the past eight years or so, one country after another has stabilized their currencies and implemented amazing “flat tax” programs. Russia led the way with its 13% income tax in 2000. The result has been a tremendous economic advancement, with falling interest rates and expanding finance. Many of these countries are experiencing their biggest economic boom since before World War I.
Unfortunately, Reagan’s plan was a little too sunny for the American imagination circa 1980. For the election that year, Reagan recorded television commercials promising a gold standard, but they were never broadcast. Instead, the Fed undertook the “Monetarist experiment” in which short-term interest rates went as high as 18%. Instead of cutting taxes right away, the tax-cut plan was delayed until 1983, watered down, and phased in over years. Tax cuts might have got in the way of the plan to have “a recession so horrible that it breaks the back of inflation.”
Economists these days are madly, insanely, pathologically fascinated by interest rate manipulation. They believe that, with a sufficiently high short-term interest rate target, inflation can be resolved. This rarely works. To solve the worsening inflation, in September 1973 Fed Chairman Arthur Burns went to an average Fed funds rate of 10.78%. It was a flop – the dollar kept falling in value until late 1974. It was a flop in the long term as well, with inflation worsening until the early 1980s. Often, these high interest rate targets effectively cripple the economy, the currency falls even more, and inflation gets worse. Many Asian government found this out the hard way in 1997 and 1998, until they learned to ignore the IMF’s bad advice.
Low interest rates don’t work. High interest rates don’t work. The Monetarist experiment stopped the 1970s devaluation trend, but it produced such chaos and mayhem that it too was abandoned in 1982, after only three years.
The solution to inflation isn’t a recession. The solution is not high interest rates. Reagan had the right idea: peg the currency to gold, and slash taxes to rev up the economy. The Russian 13% flat tax plan would do just fine. With this combo, the U.S. economy could have the best economic boom since the last time the U.S. enjoyed a gold standard and a big tax cut, which was 1964-1966.
Or, perhaps the Russian or Chinese governments will discover the high road to economic success – a gold standard and low taxes – leaving the U.S. to destroy itself with cheap-money solutions.
Eventually, central bankers are likely to respond to worsening inflation with rate hikes. The rate hikes will likely cause economic stress, but fail to solve the inflation problem. At this point, the central bankers will blame everything under the sun for the mysterious “stagflation,” except themselves. It will become apparent that the central bankers are much better at producing excuses than solutions. Then the central bankers will be replaced.
That is the point where the Reagan of the future will be able to step to the forefront. Cut taxes. Peg the currency to gold. Enjoy the results.
for The Daily Reckoning
July 2, 2008
Nathan Lewis is the author of Gold: the Once and Future Money, published by Agora Publishing and J. Wiley in 2007. It is now available in five languages.
He runs an investment fund in New York.
Today, we’ll keep it short and sweet.
The Dow managed only a piddling 32-point rise yesterday; still no recovery from last week’s big losses.
Oil rose another $1.30 – to close over $141. Gold jumped $16; it will now cost you $944 to buy an ounce.
“Caught between a fragile economy and banking system and rising inflation,” writes James Saft, “Bernanke and other Fed policy makers seem to have arrived on a strategy of jawboning the dollar higher and inflation lower.
“But talk is only effective if your audience judges that you have the means and willingness to follow through.”
Based on the last few days’ trading results, Team Bernanke might as well have kept their mouths shut. Gold and oil are acting as though they expect higher rates of inflation, not lower rates. And the dollar loses value daily – though it still has not collapsed completely.
The last part of that phrase might be worth a thought or two. The dollar has fallen against other major currencies. Against the euro, for example, it is worth barely half what it was at its high, which was reached shortly after the euro was launched 10 years ago. Against gold, it is worth only about a third of what it was worth 10 years ago. And against oil…the loss has been even greater – it’s down about 80%.
Yet, the dollar still hasn’t “collapsed.”
To give you an idea of what a collapse looks like, we look out the window. The English housing market seemed to defy the California trendsetters. As U.S. houses fell in value, U.K. prices stubbornly held up.
“It’s a small island,” explained the analysts. “We have a lot of immigration from overseas,” they went on. “We like owning our own houses,” was the verdict. Said a woman in the office when we enquired: “Housing always goes up in Britain.”
It goes up until it goes down. Now, it is going down, say the London papers. And the house builders are collapsing. Comes news this morning that the U.K.’s largest house-builder, Taylor Wimpey, was cut in half yesterday after it failed to raise the money it was looking for. This morning, the shares are still falling.
Another English builder has already collapsed. Its shares are selling for less than one times trailing earnings.
You want to see collapse? Just look at what has happened to Wall Street this year. In the last 6 months, Citigroup has lost 43% of its value. Merrill Lynch is down 40%. And Lehman Bros. has fallen 68%. The Wall Street Journal says banking stocks are beginning to look like the dotcoms in 2000. The big question is whether these are just temporary corrections – caused by panic over subprime losses and a credit crunch. Or whether it is a case of another dotcom-style bubble popping; if so, the Wall Street firms have further to fall and will not recover for many, many years.
But, back to the dollar.
In the vaults of various central banks around the world lies $4.8 trillion worth of foreign currency reserves – the fruit of selling oil and widgets, mainly to U.S. consumers. And like oranges or papayas…these dollars have a limited shelf life.
We have not been invited to peek into these vaults, but we have no doubt what we would find: huge stacks of green money, with the faces of dead U.S. presidents on the notes. Americans have been the world’s biggest spenders of the last 20 years. Naturally, it is their money that makes up the bulk of those foreign currency reserves. It is their money, too, that now poses the biggest problem – not only for the people who shipped it overseas, but also for those who have it in their vaults.
By our very rough calculation the total of these reserves will hit $5 trillion before the end of this calendar year. Then, we will be talking about real money. But that is the trouble; we are not really talking about real money at all, are we?
We should have said: $5 trillion is a lot of money; too bad it isn’t real. These are dollars, remember, the faith-based currency. The same dollars that have lost approximately 97% of their value over the last hundred years…and, according to the statisticians on the government payroll…now loses value at about 4% per year.
If we take the government’s number goons at their word, and presume that the entire $5 trillion were invested in 91-day U.S. Treasury bills, currently yielding 1.63%, the holders of all this dough are losing about $120 billion per year. The fruit is starting to smell a little rich, in other words.
But it could be a lot worse. If the euro, gold, oil, or commodities rise sharply, foreign dollar holders will feel like chumps. A few may give up on the dollar and dump it on the world market in large quantities. This could cause a sudden drop in the value of the greenback…leading other holders to rush for the exits. The dollar’s collapse would bring down the whole post-’71 monetary system…and pitch the world into a much more serious problem.
Already, many dollar holders are getting itchy. Many are looking to lighten up their loads. Some are trading dollars for food…
(“Hoarding nations drive food costs ever higher,” says the New York Times.)
A few have helped recapitalize the banks. And Abu Dhabi just traded $900 million for the Empire State Building. Only about $4.7 trillion left to go.
By comparison, the entire world’s stock of gold – above ground – is only worth about $4.2 trillion.
*** What the candidates will never tell you…
As we keep saying, democracy is fine, as long as you don’t take it seriously. The candidates for the White House job are eager to show voters that they are patriotic, religious and right-thinking men. What they don’t want to do is trouble the voters with real problems.
What kind of problems?
In our view, there are three major challenges facing the United States.
1) The country is going broke.
2) The military is out of control.
3) Standards of living are falling.
What? You haven’t heard the Democrats mention these things? How about the Republicans? Nope…?
As to the first, the country is going into a recession with its finances in the worst shape ever. In fact, if you believe Eli Broad, founder of Kaufman & Broad, the big building firm, this is the worst period in U.S. economic life since World War II. In his entire life, he says he’s never seen anything like it. And he’s 75 years old.
But here, we’re not talking about the economy itself. We do that every day. Here we’re referring to public finances.
Typically, in a recession, the government tries to “lean into the wind” to counterbalance the effect of an economic slowdown. Business stops investing so much. Consumers stop spending so much. The government – according to classic Keynesian economics – tries to take up the slack by spending more.
But where does it get the money? The feds already have a deficit of about $500 billion. And a “financing gap” of $57 trillion. In the coming recession, predicts Bill Gross of the PIMCO fund, the federal deficit will go to $1 trillion. Obama will likely be the next president. He’ll be tagged with the first TRILLION DOLLAR DEFICIT. But what can he do?
Obama says he’s going to cut spending. But every economist in the nation is going to tell him not to do it – not during a recession. It will only make the recession worse, they’ll say. Instead, they’ll urge him to spend more money. They’ll remind him that the Japanese used fiscal stimulus on a massive scale – equal to 10% of GDP – and it still wasn’t enough to light a fire under their economy. A similar fiscal stimulant in the United States would mean a deficit of $1.7 trillion!
Our old friend John Mauldin is sure we will “muddle through” somehow. “We always do,” he says. And it’s true; we muddle through most things. But a man does not muddle through a hanging; nor does an economy muddle through when its government goes broke.
More on these major problems tomorrow…
*** Starbucks says it will close 6,000 stores…and lay off 12,000 employees.
*** Yesterday, we reported that revenues were down at Nevada’s brothels. Today, The Wall Street Journal reports that revenues are down at the casinos too.
Yes, it is looking grimmer and grimmer.
The Daily Reckoning