- The Washington Times - Thursday, August 16, 2001

The emerging debate in Washington over the dollar's strength against foreign currencies is misplaced. It is the dollar's relative scarcity to gold that is crippling the domestic economy, with only side effects on our export industries.
The only solution is a devaluation of the dollar relative to gold, to $325 or so from $265. This can be easily accomplished by a presidential executive order. Or the problem can be solved by an agreement among the major central banks to inflate together in these same proportions.
What few professional economists understand is that the U.S. economy currently is ensnarled in a historically rare monetary deflation that would not be occurring if the U.S. Federal Reserve were required to supply all the dollars demanded by the world economy at a fixed gold price. As the most monetary of all commodities, gold remains the best error signal for the Fed's mistakes in supplying too much or too little liquidity to the banking system.
Unless a policy change takes place at the national level, we should not expect economic recovery anytime soon. Deflation forces prices and wages to fall just as monetary inflations require prices and wages to rise.
The deflation began in late 1996, when the market began gearing up for a bipartisan compromise to reduce the capital gains tax starting in 1997.
The prospect of a bigger economy generated a surge in the demand for dollar liquidity. When the Fed failed to meet that increased demand, the dollar's relative scarcity forced commodity prices down and the dollar up. In April 1997, we personally alerted Fed Chairman Alan Greenspan and then Deputy Treasury Secretary Lawrence Summers of the deflationary process unfolding.
They discounted the gold signal.
At first, the rising dollar supported much loftier equity prices, especially for firms that were heavy on commodity/energy inputs and information output. Lower tax rates, falling nominal interest rates and reverse tax bracket creep all increased the discounted present value of real-after tax real earnings — temporarily.
There were victims at the outset as well. In an inflation, commodity producers at first benefit, as they are internationally traded on the spot markets. Everyone else gets hit with the higher costs. In a deflation, it is the commodity producers who take the first hit, and they did in 1997-98.
The rising dollar caused the dollar pegs of emerging economies to snap, setting off the Asian, Brazilian and Russian economic meltdowns. Beginning in 1998, when oil prices hit $10 per barrel, oil producers for two years stopped investing, with no positive returns available. As a result, the global economic rebound of late 1999 occurred against the backdrop of diminished oil supplies, foreshadowing the high oil, energy and gas prices of 2000-2001.
As the deflationary process went unchecked, high oil prices confused the Fed into thinking inflation had returned, so it pushed interest rates up to slow the economy. Despite its six interest-rate cuts this year, the price of gold is only slightly higher than it was before the Fed began reducing rates. The value of the dollar on foreign exchange markets is higher, with sensitive commodity prices trading at 16-year lows.
Because forward-looking spot market prices do not need a "lag" to register a shift in the central bank's monetary stance, we can see there has been no monetary ease to date.
While some economic commentators and even Mr. Greenspan have recently cited fast money supply growth as evidence of easier monetary policy, the deflation confused them there as well. Monetary aggregates always have tended to grow faster when deflation expectations mount and economic agents hoard money. In a deflation, the velocity of money — its turnover rate — declines. Money sits idle as it appreciates against real goods and the velocity of the broad monetary aggregates now is falling at rates not seen since the deflationary recession of 1982 and the milder squeeze of 1985, when the dollar reached similar heights against foreign exchange.
On Jan. 7, during the transition, we advised senior officials of the incoming administration that their economic program to cut taxes would not end the deflation and that the Fed's interest-rate cuts would not work either. We knew they could not act on our advice until it became clear we were right, because there was such a broad consensus that conventional medicine would work. That point has now arrived, although the debate over what to do is still incorrectly focused on the dollar's value against the euro and the yen.
The way to achieve a stable domestic unit of account — one that is neither inflating or deflating — is to once again have the U.S. government fix the price of gold in dollars at a price that ends the current deflation.

Jude Wanniski is president of Polyconomics Inc., for which Michael Darda tracks monetary policy, bonds and foreign exchange.



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