The True Gold Standard (Second Edition)
The Rueffian Synthesis
Previous article: Reserve-Currency Inflation
To explain inflation in the United States, we need to include the increase in foreign official dollar reserves (dR); because this represents an excess supply of money which is prevented by foreign central-bank intervention from leaving the dollar market.
D – Q = dP = dM – dL +dR.
The change in official dollar reserves (dR) is “excess money.” In theory, we could think of it as equivalent either to increasing the money supply (M) or to reducing the demand for money (L). However, because the change in reserves works in the same direction as the money supply, and because it’s not always easy to think about a negative demand for money, LBMC treats foreign dollar reserves as if they were an addition to the money supply. The domestic monetary base (M) plus foreign dollar reserves (R) equals the World Dollar Base ($). So LBMC’s version of Rueff’s balance between total supply and total demand replaces dM with d$:
D – Q = dP = d$ -dL.
What this means (at least, at this level of abstraction) is that the “excess” World Dollar Base (d$ - dL) is not one cause of inflation in the dollar market – it is the only cause!
As for making this the basis of prediction, the question is whether we can measure the “excess” World Dollar Base. The answer, LBMC has found, is basically yes.
LBMC has its own proprietary method of measuring the World Dollar Base. But to know the “excess” World Dollar Base, we still need to know something about the demand for money (L).
According to Rueff, the demand for money should be directly proportional to the price level (P) and positively related to two other things: the volume of exchanges of non-monetary wealth (Q), and some residual “hoarding” factor (H) which is unrelated to P or Q. But according to Rueff, as an empirical matter this last factor should normally be insignificant. So if we ignore (H), we can approximate this by saying
L = kPQ
where K is a constant related the demand for money to the volume of transactions.
Graphs 1 and 2 were derived from the foregoing analysis. We took the increase in the World Dollar Base, as a percent of the initial dollar value of some measure of transactions. These proxies were total expenditures on food and energy commodities for Graph 1, and total personal consumption expenditures for Graph 2.
We compared this ratio – d$/PQ – with inflation (dP/P) for the same categories of goods, a bit more than two years later.
Graphs 1 and 2 show that LBMC has essentially confirmed Rueff’s theory of inflation: inflation can be explained as the result of a fairly well-defined excess supply of money over a fairly well-defined demand for money. But we have to take into account the dollar’s role as an official reserve currency.
The simplified approach used in Graphs 1 and 2 ignores two things: the demand for money that is not related to the state of the economy (H), and the change in the supply of goods (dQ) during the intervening two-plus years. What Graphs 1 and 2 show is that these two factors are not very important.
This is, in part, a vindication of Say’s Law, as restated by Rueff, against Keyne’s General Theory. The fact that the non-systematic factor (H) is relatively insignificant implies that apart from the inflationary process, unexplained variations in the demand for money have little impact in driving a wedge between total supply and total demand for goods. Or to repeat Rueff’s words, Say’s Law is “roughly correct” because “this residue is always limited, except during inflationary periods, relative to the portion of the demand which is provided by the supply.”
What may seem more surprising is that assuming perfect foresight about the change in the quantity of goods (dQ) during the intervening two years does not improve the forecast. Most of the “work” is done by the World Dollar Base, which makes it predictive by itself, even where proxies for PQ are not available (see Graph 3, for example). In fact, subtracting the actual change in supply of goods from the inflation forecast in Graphs 1 and 2 substantially worsens the forecast!
This is not because the further change in the total supply of goods doesn’t matter; rather, it’s because the economy’s process of adjusting to excess money takes time. So the change in supply of goods (dQ) matters for a time period different from the one we are observing – namely, for a following period, by which time this change in the supply of goods (dQ) is included in the total supply of goods (Q), and therefore is included in our measure of the “excess” World Dollar Base. (Perfect foresight about other factors would improve the forecast.)
The theory we have outlined assumes that the supply of goods (Q) or the subset of output (Y) is determined by factors independent of the money supply or the price level. This is true in the end; but as long as prices don’t adjust instantaneously to an excess money supply, it can’t be true during the period of adjustment. Before output prices adjust, excess money will lead to a temporary increase in output; but when output prices rise, as they must, the “real” value of money and claims is reduced, causing output to fall again. While causing fluctuations in output, merely creating more money cannot create any more wealth. The whole point of the excess money supply is that it represents demand for goods without any matching supply. In fact, by misallocating resources, the process of inflation reduces the efficiency of the economy and lowers output over time, on balance.
Next installment: LBMC's Growth Model
Previous: LBMC's Provenance
Wanniski is correct about one thing: LBMC’s approach is basically “Rueffian.” “Supply-side fiscalism” was named by Herbert Stein, an opponent. Mundells’ and Laffer’s “global monetarism” was named by Marina v.N. Whitman, an opponent. Upon consideration, LBMC accepts the name “Rueffian” from Wanniski.
Jacques Rueff is interesting today for a number of reasons. He was a good economic theorist because he was a practitioner of economic policy – and vice versa.
Trained in science and mathematics at the Ecole Polytechnique, Rueff devoted his first theoretical work to showing that the same scientific method applies to “moral” or “social” sciences like economics as to the physical sciences (Des Sciences Physiques aux Sciences Morales, 1922). In both cases, he pointed out, individual acts can be “indeterminate,” but the pattern of large numbers of individual acts can be predicted as a matter of probability. And so in economics no less than physics, as he later wrote, “A scientific theory is considered correct only if it makes forecasting possible.”
Rueff wrote two treatises on money. The first dealt with basic “static” principles (Theorie des Phenomenes Monetaires, 1927). He envisioned a second volume of monetary theory, dealing with “monetary dynamics.” But when published 18years later, it had turned into a general outline of economic society, with an analysis of different monetary, fiscal and regulatory regimes and a theory of economic policy as the application of incentives and disincentives (L’Ordre Social, 1945). The themes had become so fundamental and sweeping, I think, because European civilization had come to the brink, and the immediate task was to rebuild it. Later, Rueff also wrote a number of works applying his theories to the Bretton Woods system, including The Age of Inflation, The Monetary Sin of the West, and Balance of Payments. One of his last works was The Gods and the Kings, a meditation on the relation between the sciences and society, which returned to the theme of his first work.
This theoretical output would be enough for most men. But one reason Rueff’s theories are extraordinarily applicable in the real world is that he grappled for most of his life with the day-to-day problems of economic policy. Rueff was commissioned to determine the level at which the French franc should be stabilized in 1926, based on his pioneering studies in purchasing power parity: it was a success. Rueff also was the first to point out that the chronic unemployment in Great Britain in the 1920s was the result of both the exchange rate and the unemployment “dole” being fixed too high in relation to nominal wages. Rueff was later put in charge of the Bank of France’s sterling reserves in London, where he was able to analyze and correctly warn about the deflationary collapse of the sterling-exchange system if it were not fixed. In the 1930s, Rueff served both as Secretary of the Treasury and deputy head of the Bank of France. After the war, based on the theories developed in L’Ordre Social, he outlined plans to put the basket-case French republic on a sound footing – and was given the change to implement them, successfully, in 1958. As an advisor to de Gaulle, Rueff then outlined a reform of the Bretton Woods system that would have prevented the world-wide inflation of the 1970s and 1980s. Rueff ended his career as a judge at the World Court and a member of the French Academy. He died in 1978.
Jacques Rueff is particularly interesting to us in the United States today because, in the course of all this, he debated the men and ideas behind the three macro-economic schools which took part in the U.S. economic policy debates of the 1970s and 1980s. He crossed swords with Irving Fisher, the forerunner of the domestic monetarists, and personally debated John Maynard Keynes, whose followers dominated U.S. economic policy in the 195-0s and 1960s. And in doing so, Rueff had something interesting to say about Jean-Baptiste Say’s Law of Markets, which could be called the cornerstone of the third school, supply-side economics.
I’d like to describe Rueff’s analysis of each. (I want to apologize in advance to both the layman and the expert – to the layman, for using a few mathematical formulas; to the expert, because they greatly simplify a complicated subject.)
Jacques Rueff, a key figure in European economic circles from the 1930s until the 1970s, was, first and foremost, an empiricist: he believed that economic policy should be based on impartial analysis of the evidence. And that evidence – which he derived from pioneering, detailed statistical analysis – showed that the economy functioned in large part due to the equilibrating role of prices.
Thus, any attempt to intervene in the efficient functioning of the price mechanism, whether through the dole or through inflation, would undermine the economic – and social – order. As Christopher Chivvis, a researcher at RAND Corporation, shows in this lively and charming biography, this put Rueff squarely at odds with Keynes and other interventionists.
In the early 1920s, as a young scholar at the Institut de Politique de Paris, Rueff undertook a series of analyses of economic statistics, including a profound assessment of the causes of unemployment in Britain, which had risen from 2.5 percent in 1900 to 13 percent in 1921. Rueff found that the main cause of Britain’s unemployment was a failure of the labor market to adjust to changing external economic conditions – namely, the increasing competitiveness of textile manufacturers, shipbuilders and coal producers – which he attributed to the introduction of the dole in 1911. He published two papers on the topic, one in 1925 and another in 1931, which resulted in his principle of non-intervention in matters that would affect prices the loi Rueff.
The Rueffian Synthesis