Chapter 29
The Demise of the Global Price Rule
Abstract
If the United States and other countries abandon inflation targeting, their inflation will become more volatile and perhaps slightly higher. The implication for the rest of the world could be very damaging, especially for the smaller economies who fix their currencies to larger economies. By fixing to the US dollar and/or the Euro, other countries are effectively importing those monetary policies. Hong Kong is a prime example of what we are talking about. Our concerns for the rest of the world are twofold. First, we see the inflation rate rising and becoming more erratic in both the United States and the European Economic and Monetary Union (EMU), if the two regions’ central banks abandon their inflation targeting. Second, by forcing the rest of the world to float their currencies, the G-7 is in effect forcing the countries to decouple themselves from the stable inflation rate that both the United States and the EMU have enjoyed. The experience of the 1970s taught us that countries with depreciating currencies tend to have a higher inflation than the countries with the appreciating currencies, as well as being the subject of speculative attacks against their currencies.
Keywords
Bretton Woods
domestic price rule
global price rule
inflation rate
nonreserve currency country
reserve currency country
The 2009 G-7 meeting was an extraordinary meeting. The United States persuaded the world’s industrial powers to endorse flexible currency exchange rates. The move was clearly a jab at Japan and China, as well as a signal to the world that the G-7 countries were willing to engage in mercantilists beggar-thy-neighbor policies that could lead to the ratcheting up of the worldwide inflation rate. Some of these issues continue to this day. Then there are the central banks with inflation target mandates facing criticism that they are not doing enough to stimulate the local economy when nothing could be further from the truth. Keeping the inflation rate within the mandated target is the central bankers’ goal for the countries whose central banks have an inflation target or single mandate.
The experience of the 1970s showed us that an unhinged monetary policy accompanied by deliberate monetary devaluations only lead to inflation and does not have a long-term effect on a country’s trade balance. It was sad to see nations going down the wrong path. In the case of many developed economies, and in particular the European ones, the failure of the continent’s economies to reach a real GDP growth rate in the 2%–3% range cannot be attributed to monetary policy. Rather it was attributable to the euroesclerosis produced by a dirigiste economic policy with a Keynesian bent.
If the United States and other countries abandon inflation targeting, their inflation will become more volatile and perhaps slightly higher. The implication for the rest of the world could be very damaging especially for the smaller economies who fix their currencies to larger economies. By fixing to the US dollar and/or the Euro, other countries are effectively importing the monetary policies of the United States and the European Economic and Monetary Union (EMU). Hong Kong is a prime example of what we are talking about. Our concerns for the rest of the world are twofold. First, we see the inflation rate rising and becoming more erratic in both the United States and the EMU, if the two regions’ central banks abandon their inflation targeting. Second, by forcing the rest of the world to float their currencies, the G-7 was in effect forcing the countries to decouple themselves from the stable inflation rate that both the United States and the EMU have enjoyed. The experience of the 1970s taught us that countries with depreciating currencies tend to have a higher inflation than the countries with the appreciating currencies. We are not calling for double-digit inflation, we are just making the point that a higher inflation rate is not good for long-term fixed income securities.
The Elements of the Global Price Rule
The global price rule has two distinct components. One or more countries will in general adopt a domestic price rule. Operationally, the domestic price rule is quite simple. Whenever the domestic prices exceed those of a target range, the central bank will, through open market operations, remove domestic money from circulation. The central bank will sell bonds in the open market and receive cash in exchange. As we believe that inflation is too much money chasing too few goods, the reduction in the high-powered money circulating the economy should lower the domestic price level. During periods in which the price level falls below the target range, the central bank increases the amount of money circulating in the economy by buying bonds in the open market. As the government pays for the bonds by printing money, the higher quantity of money leads to an increase in the domestic price level.
The price rule adjustment mechanism is general enough to accommodate several variants. The one favored by us is based on the domestic Consumer Price Index (CPI), while another version focuses on the price of gold. Either way, the price rule provides for an automatic adjustment mechanism for increasing and reducing the money supply.
Other countries, if they choose to, could adopt the price rule of another country by simply fixing their exchange rate to that of the country whose price rule they want to adopt. To see this, consider the operating mechanism. Whenever the exchange rate depreciates, the satellite country’s central bank, that is, the nonreserve currency country, would have to reduce the quantity of domestic currency circulating. The lower quantity of domestic money will lead to an appreciation of the currency and eventually the currency would reach its target range.
Next, let’s assume an absence of transportation costs and/or trade restrictions in the economy. Under these idealized conditions, arbitrage insures that the dollar price of a given commodity is the same in the two localities. If the exchange rate remains fixed, it follows that the rate of price increases of the traded commodities has to be the same in the two economies. Alternatively stated, the inflation rate will be the same in the two economies.
The exchange rate is a simple way for a country to adopt another country’s monetary policy. In doing so, the country is importing the reserve currency country’s inflation rate. In the case of the reserve currency country, there are several choices for conducting its own monetary. The one we prefer, the domestic price rule, provides an automatic adjustment mechanism that keeps the underlying inflation rate within a specified target range.
What Could Go Wrong?
The domestic price rule is not immune to misinterpretations and misapplications. One particular case that concerns us is when the central bank accumulates a large reserve of the commodity used to implement the price rule. To show our concerns, let us consider the case where the central bank has no accumulated inventory of the commodity in question. Let’s also assume that all the central bank has is a printing press and a furnace. Then every time the prices get out of line, the central bank has to fire up the printing press or the furnace to bring the prices in line. In this case, the adjustment is automatic and instantaneous.
Next consider the case where the central bank has an accumulated inventory of the commodity in question. If we also assume that the central bank’s inventory is large enough to affect the market price, the question then is what happens when the currency value falls below the target price? We know that equilibrium is restored when the currency value is brought back in line with the target range. There are two ways this can be accomplished. The proper and sustainable way is to withdraw money from the system through an open market operation, like the one described earlier. However such a procedure may be interpreted as contractionary as the central bank would be withdrawing money from the system. For this reason, some politicians may prefer an alternative way to bring temporary equilibrium: selling part of the inventory of the commodity held by the central bank. Doing so will increase the supply of the commodity and thus lower its market price, thereby bringing the money price of the commodity back into the target range.
The problem with the second approach is that eventually the central bank will run out of reserves and as soon as it becomes clear that this is the case there may be a problem, a speculative attack will be mounted against the intervention mechanism. That is exactly what happened to the United States under Bretton Woods. The United States did not adjust its money supply to bring the price of gold back into equilibrium. Instead it chose to adjust the supply of gold in the market by selling gold. When it became clear that the United States did not have enough gold, other countries (like France under the leadership of Charles de Gaulle) began demanding payment in gold rather than in dollars. As the United States began depleting its reserves, instead of adjusting its monetary policy and reducing the money supply, the Fed ultimately refused to exchange the dollars for gold. The gold window was closed and there was no anchor or restraint to the US monetary policy. As the unhinging of the system progressed, so did the US inflation rate and interest rates. The rest of the world did not fare much better, especially the countries who embarked in a truly floating exchange rate. The inflation experience was, on average, worse than that of the United States. The spiraling inflation did not come to an end until the operating procedures of the Fed changed.
Under the leadership of Paul Volcker, the United States abandoned targeting the quantity of money and focused instead on a domestic price rule. Inflation began to decline and so did interest rates. The secular decline in inflation fueled a bull market in bonds that lasted over 20 years. Many of the emerging countries in the world also changed their operating procedures and targeted some of the major currencies in the world. In doing so, they adopted those countries’ inflation rates. Worldwide inflation declined as the price rule propagated among the world central banks.
Nonreserve Currency Issues
Monetary problems are not unique to the reserve currency countries. In many respects, the countries adopting an exchange rate rule also face similar issues. If they accumulate foreign exchange, they have to be careful of how they intervene in the foreign exchange market. If they use the reserves to maintain some independence within their domestic monetary policy, eventually the country will be subject to a speculative attack. If the central bank breaks, devaluation will ensue and domestic inflation will rise matching the amount of the devaluation. Examples of this abound. During the 1990s, the world experienced the Tequila Effect, the Asian Contagion, and the Russian crisis among others. All of these countries’ experiences showed that whenever the domestic central banks began tinkering with the domestic price rule, by spending the inflow of foreign exchange during the good times, they did not have enough to finance the outflow during the bad times. Eventually the speculative attacks on the currency broke the bank and the currencies were devalued, the inflation surged, and the countries experienced a significant setback.
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