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Last week, I mentioned that "the steering
wheel and brake pedal are disconnected," implying metaphorically that
the Fed can't really steer the monetary policy vehicle even if it guesses
correctly about what it should do next. This is not an inescapable condition.
The Fed, like other central banks, does not
control interest rates directly. What it, and they, do, specifically, is
adjust the amount of base money in existence. Base money consists of notes
and coins (typically about 90% of the total) and bank reserves (10%), which
are held electronically at the Fed. All monetary transactions are performed
with base money. There is no form of money besides base money. When you write
a check, what happens, exactly, is that your bank, Bank A, transfers bank
reserves (a form of base money) electronically (at the Fed) to the account of
Bank B, the bank of the recipient of the check. Much the same thing happens
when you use a credit card. Thus, while it may seem as if these sorts of
payment methods constitute a "type of money," in actuality your
bank makes the transaction using base money, and then adjusts the amount of
money that the bank owes you (deposits) or that you owe it (credit cards).
Presently, the Fed adjusts base money, on a
daily or even hourly basis, in accordance with an interest rate target.
Adding base money tends to depress short-term lending rates, and subtracting
base money tends to raise them, at least in the shortest term. In this way,
the short-term interest rate is maintained near the Fed's target.
Now, the Fed, and other central banks around
the world, are not supposed to do this. They were not created for this task.
Historically, base money was managed in accordance with the gold standard,
and central banks were intended to provide base money on a short-term
self-cancelling basis during episodes of systemic base money shortage,
which were normally signaled by short-term interest
rates in excess of 10%. Such conditions would be expected for only a few days
a year, if even that. However, the urge to fiddle with economies via
interest-rate manipulation proved to be overwhelming, so now we have central
banks which are fully devoted to interest-rate manipulation, as if something
worthwhile could be gained from it (not possible).
We were speaking, last week, specifically in
reference to inflation targeting. OK, let's imagine that the central bank
decides to guess that inflation two years from now will be unacceptably high,
and wishes to suppress/prevent such inflation. (Does this sound like
something that might happen soon? Oh, yes indeed!) What can the central bank
do? Well, the central bank can only do one thing, which is to increase or
decrease the base money supply. It doesn't have any other powers. The proper
thing to do, assuming that the central bank correctly diagnosed a situation
in which present currency value was too low, would be to reduce base money to
support currency value. This would be represented by an increase in the
currency's value vs. gold. I.e. a "fall in the gold price." What
the central bank would likely do, however, is increase its interest rate target.
Then what happens? The short answer is: nobody
knows. It's a chaotic system. Sometimes it works great (like Brazil
presently), and the currency soars higher. (It has helped that Brazil's
president Lula has been steadily lowering taxes.) Other times, it doesn't work
at all, or has the opposite effect. Like Brazil pre-2003.
To illustrate what I mean, let's take a
somewhat extreme example. Let's say the Fed, worried about future inflation,
tomorrow adopted a Brazilian-style interest rate target of 19%. Would the value
of the USD rise? Or would it fall, as such a policy would amount to economic
suicide for the U.S.'s debt-laden economy? If the USD fell as a result of
such a policy, the effect would be worse inflation. Thus, we would
have a collapsing economy and worsening inflation, i.e.
"stagflation". For one thing, higher short-term interest rates mean
that the opportunity cost of holding base money (notes and coins and bank
reserves), which doesn't pay interest, increases. Thus the demand for base
money declines, as people break open their piggy banks (metaphorically
speaking) and loan the money to banks (deposits) to earn interest. As the
demand for money declines, the value of money also has a tendency to decline,
which of course means more inflation. At the same time, super-low
interest rate targets are not a reliable method of avoiding deflation, i.e.,
lowering currency value. The Bank of Japan fooled around with low interest
rates for years, with hardly any discernible effect on Japan's horrible
monetary deflation. The opportunity cost of holding cash (interest) is low,
and the risk of depositing the money with banks rises (banks suffer from bad
loans in a deflation), so the demand for money may rise, which tends to cause
a rising currency and more deflation. Indeed, banks themselves
may wish to hold more non-interest bearing cash, i.e. bank reserves, as a
zero-percent return beats a negative return on loans that go bust. (This was
also true during the 1930s.) After much prodding mostly by foreign investors,
the BoJ finally adopted a rather timid
"quantitative" methodology (i.e. NOT an interest-rate target) which
finally produced exactly the effects promised, namely, the monetary reflation now being enjoyed there. It took way longer
than it had too, however.
If all this is confusing, the point is: the
steering wheel and brake pedal are disconnected. Even if the Fed correctly
analyzes the monetary state of the economy (and how often does that happen?),
the present interest-rate targeting system does not allow them to act
effectively on their insight. And if their analysis is wrong to begin with, wellä.
The correct method of reacting to inflation (a
currency value that is too low) is to reduce the supply of base money, thus
causing a rise in currency value, as noted in the currency/gold ratio. The
effect of this would normally be lower interest rates, as the threat of
investment loss via inflation is reduced. This process is not chaotic, it is
extremely reliable. The steering wheel and brake pedal are once again connected.
There is a "cost," however: the central bank is no longer allowed
to fool around with interest rates!
Thus we see that the correct methodology of a
central bank is the direct adjustment of base money, and the correct target
is stable currency value, traditionally represented by a stable currency/gold
ratio, i.e. a gold peg or gold standard. This has been tested for hundreds of
years and works just fine.
It is important to see just how similar a gold
standard and the present system are. Today, the Fed adds base money when the
short-term interest rate is above its target, and subtracts base money when
the short-term rate is below its target. This is an interest-rate peg. Under
a gold standard, the Fed adds base money when the currency's value is above its
gold parity target, and subtracts base money when it is below its gold parity
target. Virtually the same process. Vastly different outcomes.
So now that we have the steering wheel and
brake pedal properly connected, these question is: who is driving this thing?
A board of statisticians looking in the rear-view mirror (or guessing about
the future view in the rear-view mirror), or gold? Since our stance on the
matter is already clear, we'll leave George Bernard Shaw with the last word:
You have to choose between trusting the natural
stability of gold and the honesty and intelligence of members of the
government. With due respect for these gentlemen, I advise you, as long as
the capitalist system lasts, to vote for gold.
--George Bernard Shaw,
1928
I am bringing these topics up now because I
expect they will become more important over the next twelve months or so.
Indeed, if someone at the Fed reads this, perhaps the outcome will turn out
better than it would have otherwise. That might be a nice thing.
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street Journal
Asia, the Japan Times, Pravda, and other publications. He has appeared on
financial television in the United States,
Japan, and the Middle East. About the Book: Gold: The Once and Future
Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is available at
bookstores nationwide, from all major online booksellers, and direct from the
publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
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