The True Gold Standard (Second Edition)
Previous: The Debate Has a History
Curiously enough, I had to be talked into joining LBMC as chief economist by our president, Jeff Bell. “You keep mumbling about dollar reserves and the flows of the dollar-reserve system,” Bell told me. “Well, if you’re right, and if policymakers won’t change the system, shouldn’t we be able to predict the result of policymakers’ actions even before they do?”
But, sitting in Kemp’s office for 10 years, I had received forecasts from all the major Wall Street brokerage houses. And that means from some of the savviest economists in the world. What I had concluded was that no one can forecast the economy. I was convinced that Rueff and Lehrman were right as a monetary policy. But forecasting was another matter. Also, I had a nagging feeling that if such an approach could work and be commercially viable, somebody else would have done it already.
But Jeff is a persistent fellow, and so I agreed at least to test the predictive power of the ideas. The first thing I tested was the ability of commodity prices, including the price of gold, to predict consumer and producer price inflation. I had to conclude that commodity prices cannot predict inflation – at least, not well enough for anyone to pay for the forecast. Commodity prices are either too coincident with broader measures of inflation to predict them, or else they’re all over the place (see Graphs 3 and 4, pp. 37-38).
So I developed what had been my basic policy insight – and here I drew on Mundell as well as Rueff – that the dollar-reserve system has been, if anything, more of a driving force in the world since 1971 than it was under Bretton Woods.
The predictive power of domestic money aggregates had failed, largely because of financial innovation and the shifts in demand among different currencies under floating exchange rates. Laffer and Mundell had originally tried to predict inflation under fixed exchange rates by adding up all the money supplies in different currencies no longer makes sense under floating exchange rates.
But, I reasoned, if the demand for any or all domestic credit aggregates was unstable, this was not necessarily true of the “final asset” (in this case, dollars) in which all these aggregates were ultimately payable. If that was the case, such a measure of “excess money” (I’ll explain the tern a bit later) might be predictive where others had failed.
Based on Rueff’s ideas, a logical way to test this hypothesis was to combine the dollar assets of foreign central banks with the U.S. monetary base – U.S. currency and bank reserves. I called this the World Dollar Base.
Lo and behold, the World Dollar Base had an amazing ability to predict U.S. inflation more than two years in advance. And it had done so for about 50 years – as long as the dollar had been the worlds’ chief reserve currency. Further research showed that this predictive value is even stronger in world markets for commodities, which are mostly dollar-based and answer most closely to the description of “tradable goods.” But when combined with more conventional factors, the World Dollar Base was also useful in predicting inflation of non-traded goods and services. And, I found, the World Dollar Base helped explain short-run fluctuations in economic growth, when combined with other important factors like marginal tax rates on capital and labor. (Of course, the level of output at any time mostly depends on the supplies of labor and capital, and technology.)
LBMC’s first monthly forecast predicted that “the CPI should rise 6-7% in the 12 months ending in mid-1990 (Economy Watch, November 1988, pp. 1-2). These predictions were outlined in three different articles in the Wall Street Journal in the course of 1989. And these are the predictions which Wanniski now disputes. In 1989 Polyconomics disputed whether the predicted events would happen; now Polyconomics disputes whether the predictions happened.
Having placed Wanniski’s disagreement in context, and having explained how LBMC got here, I’d like to explain exactly how LBMC’s approach differs from other economic schools and why the World Dollar Base “works”.
Next: Who Was Jacques Rueff?
The Rueffian Synthesis