Fighting the last monetary war

Posted: May 27, 2003 12:00 AM

While in Europe over the Memorial Day weekend, where we celebrated the liberation of Holland and the D-Day landing at Normandy, I noticed many newspaper headlines bemoaning the specter of deflation hanging over the European economy.

   In my opinion, recession, not deflation, is the problem. The price of gold in euros is bearing above its 10-year moving average, commodity prices are not falling and consumer prices remain above the European Union's target. Today, a euro's value relative to the dollar is $1.807. That is about the same as it was shortly after the euro's inception, when on Jan. 4, 1999, it set the record high against the dollar of $1.184.

   Unfortunately, the threat facing the European economy stems not from deflation but from recession driven by bad governmental policies.

   Tax rates are far too high, inflexible labor laws are counterproductive and the welfare state is stifling. Europe's economy did not grow in the first quarter of this year, and there is little evidence of revived growth.

   In the United States, Washington and Wall Street are also abuzz with talk of deflation and the so-called deteriorating dollar.

   In my opinion, deflation is not a problem today even though it was a severe problem between 1997 and 2001. During that time I tried to draw attention to the issue several times when deflation was causing enormous economic dislocations, both in the United States and abroad. In that time, the dollar appreciated by more than 45 percent, putting tremendous pressure on countries and industries with dollar-denominated debt. The recent 20 percent or so decline in the dollar's trade-weighted exchange rate since early 2002 is a sign that a readjustment is occurring that can help unwind many of the harmful effects of the previous episode of deflation induced by the Federal Reserve Board.

   It is important to note that money is not intrinsic wealth; it is a unit of account, a measure of value. Imagine if the bureau of weights and measures changed the 12-inch ruler on a daily basis -- 13 inches one day and 11 inches the next -- but on average the bureau promised to keep it 12 inches in length. That would be preposterous. A currency is a measure of value. It cannot lengthen one day and shrink the next. And, it isn't sufficient that it retain a constant value "on average." "On average" you wouldn't have to wear a winter coat in either Buffalo, N.Y., or Green Bay, Wis.

   The same holds true for the exchange rate value of the dollar. The exchange ratio between the dollar and other currencies is a function of what is happening in the economies of those other currencies and it is a function of how the Federal Reserve conducts monetary policy in the United States. We must never forget the Fed has monopoly power over the issuance of currency. Therefore, the Fed has a moral and fiduciary obligation to keep the value of the currency constant.

   The problem is, in a world of floating exchange rates the Fed has no reliable bench mark against which to judge whether it is maintaining a constant value of the dollar. All it has available are secondary indicators of the dollar's stability.

   By latching onto interest-rate targeting as the mechanism by which the Fed decides how many bonds to buy or sell, the Fed has mistaken cause for effect just as it did in the early 1980s when it latched onto adjusting the "quantity of money" as the means of conducting monetary policy. Of all the secondary indicators of dollar stability, only sensitive commodity prices, gold being the pre-eminent among them, are direct enough and understood well enough to serve well as a gauge by which the Fed can decide whether to buy or sell bonds and how much to expand or contract its portfolio of bonds.

   I believe Treasury Secretary John Snow understands very well the necessity of replacing the so-called "strong-dollar policy" with a "stable-dollar policy." After all, we don't want a rising dollar or a falling dollar; we want a stable dollar. As Snow observed, we want the currency to be a good store of value and a currency people are willing to hold over time.

   In order to ensure a stable dollar of constant value, it has long been my view that the Fed should announce that it intends to maintain a fixed dollar price of gold, or if gold is politically incorrect, then announce that it will maintain a fixed dollar price of an index of price-sensitive commodities. Then the Fed can conduct monetary policy in such magnitude as necessary, to hit that price rule instead of always fighting the last monetary war.