The True Gold Standard (Second Edition)
In which LBMC’s approach receives a name, Wanniski is refuted, and the setbacks of the supply-side movement are explained.
In his Life of D. Johnson, James Boswell describes Samuel Johnson’s reaction to the theory of George Berkeley, Bishop of Coyne. Berkeley’s theory claimed to disprove the existence of the physical universe, on the grounds that it exists only as an idea in the mind.
“I observed,” Boswell recalls telling Johnson, “that though we are satisfied his doctrine is not true, it is impossible to refute it. I never shall forget the alacrity with which John answered, striking his foot with mighty force against a large stone, till he rebounded from it, – ‘I refute it thus.’”
Johnson’s answer came to mind when I read a recent attack upon LBMC and all its works by Jude Wanniski of Polyconomics, Inc. Along with his new economist, David Goldman, Wanniski undertakes to challenge LBMC’s contention that the World Dollar Base can be used to help predict inflation more than two years in advance – and that this is how LBMC was able to predict the inflation of 1989-90 and the recent recession.
Polyconomics’ argument boils down to this: “LBMC believes that auction prices on futures markets react to changes in liquidity with a two-year lag. Nothing like this has ever been argued in the history of economics; all schools of economics believe that auction markets react almost instantaneously to changes in liquidity.”
In other words, LBMC can’t be right, because that would be against the economic theories of Polyconomics, Inc. (We pass over the rather uncharacteristic appeal to “all schools of economics.”)
Samuel Johnson was right: if any theory is so foolish as to deny a fact, its disproof is not another theory, but the fact itself. Polyconomics claims that inflation cannot be predicted as long as two years in advance. But they offer no evidence. So the answer to Polyconomics is simple. We refute them thus.
Graph 1 shows the year-to-year inflation of food and energy commodities over the past 50 years, as measured by the fixed-weight index for personal consumption expenditures. The graph compares it with the year-to-year increase in the World Dollar Base a bit more than two years earlier. (Our methodology is discussed later on.)
The graph shows that every major commodity inflation was preceded by a commensurate expansion of the World Dollar Base.
The relationship with food and energy commodities is essentially similar whether one uses producer prices, consumer prices, or the CRB commodity futures index.
Graph 2 shows the relation between the World Dollar Base and overall personal consumption expenditure inflation. This relationship is not quite as close, because the pricing of labor and capital services differs somewhat from the pricing of natural resources (see “The Myth of Core Inflation,” LBMC Report, April 1990). However, the relationship is still a strong one. The World Dollar Base has a strong ability to predict changes in inflation, more than two years in advance.
“’Tis strange – but true, for truth is always strange; Stranger than fiction.”
The main purpose of this report is to explain in some detail why this relationship is casual, not accidental. LBMC began with a theory and found the evidence to support it, and not vice versa. This enabled LBMC to predict both the inflation of 1989-90 and the recent recession and recovery – not merely explain them after the fact.
Polyconomics raises many minor points, and I’ve prepared a detailed response to them. But I’ve relegated much of it to an appendix. This is because, while LBMC is willing to enter an argument, for Wanniski the thing is merely a quarrel. Those interested in the quarrel may be interested in the appendix. Those interested only in the facts and theory may perform an appendectomy and learn what they wish to know by reading this paper. The appendix, it turns out, is almost as long as the body to which it is appended. This is because the economic argument concerns “only” the meaning of macroeconomics, while the quarrel concerns the meaning of Wanniski.
Part of the mystery, it would seem, is why Wanniski demands a comparison between LBMC’s inflation and recession predictions and those of Polyconomics. At the start of 1989, Polyconomics confidently predicted that “U.S. Inflation is not expected to be any higher than last year, and is probably headed lower” (“The Outlook for 1989,” p. 1, emphasis in original). Polyconomics dismissed the surge of inflation that almost instantly followed as a fluke, and at the end of 1989 flatly stated that “neither recession nor inflation are imminent risks” (“How Bad Are Profits?” Sept. 18, 1989, p. 1).
With undiminished assurance, Wanniski now explains the recession as the inexorable result of the Tax Reform Act of 1986. Alan Reynolds, who made the earlier predictions as Polyconomics’ chief economist, says, “I blame this recession mostly on the war” (Wall Street Journal, July 5, 1991, p. A2).
One can nitpick any two-year forecast, including LBMC’s; but it’s clear that Wanniski is not doing so because Polyconomics had either a correct or cogent prediction to tout.
Wanniski’s attack, it turns out, has nothing to do with business competition. LBMC and Polyconomics are not even competitors (as is suggested by the fact that we have mutual clients). One of Wanniski’s endearing qualities, in my view, is that his business has always been an offshoot of his role as a political gadfly – not vice versa. As I point out in the appendix, for Wanniski to offer LBMC-type econometric forecasts would be like a mullah running a distillery.
Next: The Debate Has a History
The Rueffian Synthesis