The Debate Has a History

Previous: The Rueffian Synthesis

The attack does have a great deal to do with a longstanding debate over monetary policy. The issues in the debate go back many decades; but the debate in question occurred among advisers to Jack Kemp between 1980 and 1988. One on side were Jude Wanniski, his former economist Alan Reynolds, and
Columbia University professor Robert A. Mundell; on the other side were Lewis Lehrman, Jeff Bell and myself – all currently principals of LBMC.

I’d like to begin with a brief outline of that debate, and then go on to discuss the ideas of Jacques Rueff, who strongly influenced the thinking of LBMC’s principals. This will explain exactly why the World Dollar Base “works.” But I think the discussion will also shed light on two things; how the economic debate of the 1970s and 1980s was left unresolved; and why the “supply-side” movement seems to be scattered on the hills like sheep without a shepherd.

Now, the essence of the “supply-side” approach to economic policy was that monetary and fiscal policy are inherently separable. The previous neo-Keynesian consensus had argued that both monetary and fiscal policy work in the same direction.

The idea that you can have a different “policy mix” is generally associated with Mundell. As explained by Wall Street Journal editor Robert Bartley: “To combat stagnation plus inflation, you needed two levers: tight money to curb inflation, and tax cuts to promote growth. … In a Keynesian world, of course, tight money would merely offset tax cuts; one would contract aggregate demand while the other expands it. The key was that supply-side tax cuts provided stimulus not by expanding aggregate demand – ‘putting money into people’s pockets’ – but by stimulating supply, by increasing incentives to work and invest.” (Introduction to The Way the World Works 1989 edition, pp/ x-xi).

However, those who agreed on tax-cutting often disagreed about monetary policy. Many of them agreed with Milton Friedman that “tight money” meant controlling the domestic money supply while allowing exchange rates to float. Others argued that this would not work, partly because under floating exchange rates the demand for domestic money is not stable. Instead, this group said, monetary policy ought to be governed by some kind of “price rule” – some mechanism by which the central bank supplies all money demanded at a fixed price. This “price rule” group included Wanniski, Mundell and the current principals of LBMC.

But those who advocated for a “price rule” disagreed about which price rule. And in this debate, there were many throwbacks to a debate carried on during the late 1950s and 1960s, as the Bretton Woods system was crumbling into dissolution. The debate was similar, because the issue was essentially the same.

Two economists – Jacques Rueff and Robert Triffin – had the distinction of correctly predicting, beginning around 1960, that the Bretton Woods system (then in its heyday) could not last. Under the Bretton Woods system, the United States alone maintained convertibility of the dollar into gold, while other nations kept their currencies convertible into dollars. Basing the international monetary system largely on the IOUs of one nation (the United States), Triffin and Rueff proved, was financing a gradual inflation despite a fixed gold price. The monetary IOSs of the United States to foreign central banks kept expanding, but the supply of new gold did not; because rising prices meant rising gold-mining costs, while the output price for gold was constant.

In effect, rising prices were signaling to the gold market (exactly as under a gold standard) that there was too much gold, when in fact the cause of the inflation was too many IOUs. This was not some policy glitch; it was inherent in the “reserve-currency” system itself. Triffin and Rueff predicted that the thing would have to break down. One way or another, the relentless fall in the purchasing power of gold would be reversed – either through a general price deflation (as in the 1930s, when the similar system based on the pound sterling collapsed), or else through a devaluation of the dollar, and of all currencies tied to the dollar, against gold.

To remove the problem, Triffin and Rueff agreed,  the international monetary system must be based, not on any single nation’s currency, like the dollar, but on a truly international money. But they disagreed about which.

Triffin argued in favor of a plan originally proposed in 1943 by John Maynard Keynes, which would have set up the International Monetary Fund as the world’s central bank. The IMF would issue its own world-wide currency, which all nations’ central banks, including the Federal Reserve, would be required to use to settle international accounts. All the central banks, in effect, would stand in the same subordinate relation to the new world central bank as a domestic commercial bank stands to its central bank. The original Keynes plan was rejected because of its inflationary potential, but Triffin suggested safeguards to reduce this danger.

Rueff, on the other hand, argued for a return to an international gold standard; the central banks of all nations would settle their accounts in gold, not the currency of any nation or of a world central bank. This, he argued, was a viable system with a proven record of price stability. And such a reform, he pointed out, would remove the defect that had caused both the breakdown of Bretton Woods and had permitted the deflationary collapse of the similar monetary system based on the pound sterling in the 1920s and early 1930s.

In the event, something else happened. Many other advocated “floating exchange rates,” so Bretton Woods was allowed to collapse, unleashing unprecedented world-wide inflation. Yet, against the expectations of many, the system that emerged, though one of flexible exchange rates, was still based primarily on the dollar.

Triffin’s and Rueff’s positions were represented among advisers to Jack Kemp. Lehrman and I, and later Jeff Bell, favored Rueff’s solution, for the same reasons. Mundell had long agreed with Triffin’s and Rueff’s analysis of Bretton Woods. He and Wanniski favored a variation of the Keynes plan, under which the IMF would issue a “gold SDR” (Keynes had called his monetary unit “bancor” – “bank gold”). However, believing that such a plan would be a political non-starter, they fell back on a revival of Bretton Woods. This may seem surprising, since Wanniski’s seminal 1975 article in The Public Interest, “The Mundell-Laffer Hypothesis,” was devoted mostly to explaining why Bretton Woods brok down and to advocating the “gold SDR.” (In that article, tax cuts are mentioned briefly, and the Laffer Curve is literally a footnote.) But in their view, the international gold standard would be a step backward in what they perceived as an inexorable monetary evolution, while revived Bretton Woods would leave the door open for a future world central bank.

A third variation on the “price rule” should also be mentioned. Some have argued that the Federal Reserve should “target” some commodity index or the price of gold. Wanniski argues (wrongly, in my view) that this would be equivalent to a gold standard.

I became interested in Rueff through Lehrman, whom I met shortly after joining Kemp’s staff at the start of 1979. Lehrman had known Rueff well, and was virtually alone in expounding his ideas. Lehrman had started republishing Rueff’s works through the Lehrman Institute, which was the hotbed of supply-side debate in the 1970s and early 1980s.

In 1980, Kemp asked me to draft a bill intended to restore Bretton Woods. I responded with a long memo based on Rueff’s analysis (as well as I understood it), explaining why that would not be a good idea. Many supply-siders among whom the memo was circulated were students of Laffer and Mundell, and most disagreed.

The monetary issue went into abeyance, because for the next few years tax and budget issues were more pressing policy problems. By 1985, however, especially after the Group of 5’s (later, Group of 7’s) Plaza Accord, international monetary reform was again salient. As Kemp’s staff economist, I was tasked to renew the discussion and find a compromise on the monetary issue among Kemp’s advisers. After a lot of debate, we hammered out a compromise proposal which involved a gold standard among the major central banks, but under which smaller nations could still use the dollar if they chose. However, Wanniski objected when Kemp began explaining the idea in Rueffian terms. He withdrew his agreement, and generally did his best (which is considerable) to persuade Kemp to avoid any specific proposals.

All this is why the supply-siders have always sounded an uncertain note on the monetary issue’ some supply-side tax-cutters are monetarists, and those who favor a “price rule” could not settle their differences.

In retrospect, it may seem strange or even amusing that a bunch of guys were sitting around debating the future of the international monetary system in cramped offices or Capitol Hill restaurants. But that’s the way a lot of the most important policy decisions are made. And in this case the issues at stake were important ones.

The debate over monetary reform among Kemp advisers would seem to have ended in 1988, when Bell, Mueller and Frank Cannon (and soon, Ralph Benko) left politics to start LMBC (originally BMC). We were joined by Lehrman as an active partner in 1990, after he left Morgan Stanley. This effectively left the monetary policy field to Wanniski.

The trouble, from Wanniski’s point of view, is that LBMC’s forecasting methods, and the World Dollar Base, grew directly out of Lehrman’s, Bells, and Mueller’s position in the earlier policy debate.

And if LBMC can predict the markets with the World Dollar Base, it strongly implies that Wanniski’s position on monetary policy was wrong.

For example, if monetary policy has its maximum effect on commodity prices more than two years later, then targeting commodity prices, while leaving other monetary institutions unchanged, would destabilize the economy – much like the 1979-82 experiment with targeting the domestic money supply.

Moreover, if increases in foreign dollar reserves are shown to be a cause of U.S. inflation, then a monetary system based on the dollar – which Wanniski has long advocated, if only faute de mieus -- will be inflationary and unstable.

The principals of LBMC have never been at pains to point this out, since we are no longer involved in trying to influence economic policy. Though we give our views when asked, we regard our business as one of predicting, not advocating. But Wanniski spends much of his time trying to influence economic policy, so the issue looms large with him.

Next: LBMC's Provenance


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

In Memoriam
Professor Jacques Rueff

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