Reply to Polyconomics - Part 5

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We can see from this how important it is to have a properly functioning monetary regime. Any unnecessary imbalance between the supply and demand for money—therefore, any unnecessary difference between total demand and total supply of goods – creates a lot of wear and tear on the economy, because all relative prices and all production plans in the economy must change before equilibrium is restored. And by that time there is a new disequilibrium to which the whole economy must adjust.

In Wanniski’s frictionless barter model, the only problem is that the disembodied “unit of account” in the minds of everyone has changed. This causes windfall gains or losses for debtors and creditors, and if the tax code is not indexed, leads to a tax increase. That does happen. But in the real world a malfunctioning monetary system also independently causes tremendous misallocation of resources and wear and tear on the real economy.

We can also see how unconstructive it is for people like Wanniski and Goldman to echo the hapless U.S. Treasury Secretary who informed everyone that “Inflation is caused by a number of factors that act together and interact in strange and mysterious ways.” Not surprisingly, this was the same fellow who presided over double-digit inflation. Inflation is caused by human beings known as government policy makers and central bankers, through a process which can be described and broadly predicted by other human beings – and even, with fairly simple reforms, prevente3d. But inflation will not be prevented if people listen to “experts” like Wanniski and Goldman who tell us that it is caused by mysterious forces of the universe.

Wanniski favors a version of the “price rule” which would have the Federal Reserve expand or contract the domestic money supply according to the behavior of an index of commodity prices. This is another “closed-economy” theory, because it does not contain any way of dealing with the influence on commodity prices from foreign dollar reserves. And as we have seen, it suffers the additional handicap that the full effect of excess money on commodity prices takes more than two years to develop.

Targeting the price of gold under the current monetary system is not the same as a gold standard. This is because, under a gold standard, the creation of money is directly tied to the gold market. The monetary authority keeps its money at parity with gold, by purchasing all gold supplied but not demanded, or by selling all gold demanded but not supplied, in the private gold market.

But under a “gold-price rule,” the central bank does not buy and sell gold; it buys and sells financial assets like Treasury securities. The money created in this way is not issued in response to anyone’s demand for such money; it is issued on the initiative of the central bank. And this new money must make its circuit all the way through the rest of the economy – first bidding up the price of financial assets and then forcing all producers in the economy to adjust their plans – before the fact that the money is not demanded is reflected in the price of gold; a process that takes a good two years. Because the process takes time, the central bank is always responding to the balance of supply and demand for money two years earlier. Moreover, the central bank will be unable to remove all the money it created as long as the government budget is in operating deficit. So the inflation is, in practical terms, irreversible.

There is a more sophisticated version of the “price rule,” associated with Manuel Johnson and Robert Keleher (formerly of the Federal Reserve). In this version, the Federal Reserve targets not only some index of commodity prices but also financial asset prices like the yield curve in the money market or the dollar exchange rate. This is a great improvement over a commodity-price rule, because it recognizes that excess money can show up first in the markets for domestic claims or foreign exchange. In effect, the proposal recognized that a truly “general” price level includes more than just goods and services – though it does not explain how much weight should be given to other prices.

But this version of the “price rules,” too, fails to take account of the excess money associated with foreign official dollar reserves. Such a “price rule” would not have prevented the first (and largest) wave of inflation that hit in 1973-74, which was created in 1970-72 when exchange rates were still fixed and commodity prices relatively stable – largely through the expansion of foreign dollar reserves.

Since changes in the World Dollar Base are to a large extent divorced from the supply of wealth, it is not surprising that the World Dollar Base has such a close correlation with inflation. Its ability to predict inflation with a high degree of success is anything but mysterious. Under the current monetary regime, a change in the World Dollar Base is almost a pure measure of monetary disequilibrium. Merely from the way most of it is created, we can predict with a high degree of probability that it is “excess money” that will result in inflation.

In Rueff’s words: “The preceding analysis proves the dictum of Ecclesiastes that ‘He that digest a pit shall fall into it.’ Once an inflationary situation has been allowed to develop, no human agency can avoid the consequences” (Age of Inflation, p. 19).

The irony is that the principals of LBMC may be the only inventors of a definition of money who think it should be abolished. If Lehrman or I were Treasury Under Secretary for Monetary Affairs, we would try to liquidate over half of the World Dollar Base – foreign official dollar reserves – and render the rest of it useless for predictions by making it convertible into gold. To apply the recent phrase to the World Dollar Base: first we could cut it off, and then we would kill it.



The World Dollar Base doesn’t explain everything that goes on in the economy. In fact, it really explains only one thing – inflation. But under the current monetary system, you need to know when that one thing is going to swamp everything else – for example, your plans to invest in zero-coupon bonds, or borrow to produce widgets. If policymakers ever reformed the monetary system, I would probably retire from forecasting, because our comparative advantage would be greatly diminished. Come to that, a lot of people would turn to producing new wealth from the task of helping others keep what they have.

The principals of LBMC have collectively spent several decades trying to bring about just such a policy change. Having been unsuccessful in this effort, however, we now find ourselves much in the position of Richard Cantillon in 18th century Paris. Cantillon explained to policymakers exactly why John Law’s paper-money scheme with the first central bank of France would fail; they ignored him, so Cantillon made a living speculating on the ups and downs of the system. Law hated him for it.

In this report, then, we have outlined the origin of Wanniski’s heartburn over LBMC’s largely successful predictions using the World Dollar Base. We have shown that the World Dollar Base, unnoticed until recently, has accurately predicted inflation for over 50 years. We have outlined the pertinent ideas of Jacques Rueff, which explain why these predictions “work.” We note that Rueff’s framework leaves room for what is true in supply-side economics. But Wanniski, it seems has no room for Rueff’s explanation of inflation, which LBMC has proven to be true.

If Wanniski is correct in thinking that the “Rueffian synthesis” is not compatible with “supply-side” economics, then he has just written the suicide note for his brand of supply-side economics. Either Wanniski must learn to bend his theories to accept reality, or Wanniski’s theories will be shattered by it. Reality won’t yield, any more than Samuel Johnson’s boulder.


Kathleen M. Packard, Publisher
Ralph J. Benko, Editor

In Memoriam
Professor Jacques Rueff

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