The True Gold Standard (Second Edition)
The Rueffian Synthesis
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LBMC’s integrated approach to economic forecasting can fairly be called “the Rueffian synthesis.” It would be more modest to call it “a” Rueffian synthesis, since that would allow for other Rueffians who might conceivably quibble about our application of Rueff’s ideas. But it appears that, apart from LBMC, there are no other Rueffians in the world – even in Rueff’s native France – using Rueff’s ideas as a basis for economic prediction.
Next installment: Reply to Polyconomics
Previous: The Debate Has a History
Curiously enough, I had to be talked into joining LBMC as chief economist by our president, Jeff Bell. “You keep mumbling about dollar reserves and the flows of the dollar-reserve system,” Bell told me. “Well, if you’re right, and if policymakers won’t change the system, shouldn’t we be able to predict the result of policymakers’ actions even before they do?”
But, sitting in Kemp’s office for 10 years, I had received forecasts from all the major Wall Street brokerage houses. And that means from some of the savviest economists in the world. What I had concluded was that no one can forecast the economy. I was convinced that Rueff and Lehrman were right as a monetary policy. But forecasting was another matter. Also, I had a nagging feeling that if such an approach could work and be commercially viable, somebody else would have done it already.
But Jeff is a persistent fellow, and so I agreed at least to test the predictive power of the ideas. The first thing I tested was the ability of commodity prices, including the price of gold, to predict consumer and producer price inflation. I had to conclude that commodity prices cannot predict inflation – at least, not well enough for anyone to pay for the forecast. Commodity prices are either too coincident with broader measures of inflation to predict them, or else they’re all over the place (see Graphs 3 and 4, pp. 37-38).
So I developed what had been my basic policy insight – and here I drew on Mundell as well as Rueff – that the dollar-reserve system has been, if anything, more of a driving force in the world since 1971 than it was under Bretton Woods.
The predictive power of domestic money aggregates had failed, largely because of financial innovation and the shifts in demand among different currencies under floating exchange rates. Laffer and Mundell had originally tried to predict inflation under fixed exchange rates by adding up all the money supplies in different currencies no longer makes sense under floating exchange rates.
But, I reasoned, if the demand for any or all domestic credit aggregates was unstable, this was not necessarily true of the “final asset” (in this case, dollars) in which all these aggregates were ultimately payable. If that was the case, such a measure of “excess money” (I’ll explain the tern a bit later) might be predictive where others had failed.
Based on Rueff’s ideas, a logical way to test this hypothesis was to combine the dollar assets of foreign central banks with the U.S. monetary base – U.S. currency and bank reserves. I called this the World Dollar Base.
Lo and behold, the World Dollar Base had an amazing ability to predict U.S. inflation more than two years in advance. And it had done so for about 50 years – as long as the dollar had been the worlds’ chief reserve currency. Further research showed that this predictive value is even stronger in world markets for commodities, which are mostly dollar-based and answer most closely to the description of “tradable goods.” But when combined with more conventional factors, the World Dollar Base was also useful in predicting inflation of non-traded goods and services. And, I found, the World Dollar Base helped explain short-run fluctuations in economic growth, when combined with other important factors like marginal tax rates on capital and labor. (Of course, the level of output at any time mostly depends on the supplies of labor and capital, and technology.)
LBMC’s first monthly forecast predicted that “the CPI should rise 6-7% in the 12 months ending in mid-1990 (Economy Watch, November 1988, pp. 1-2). These predictions were outlined in three different articles in the Wall Street Journal in the course of 1989. And these are the predictions which Wanniski now disputes. In 1989 Polyconomics disputed whether the predicted events would happen; now Polyconomics disputes whether the predictions happened.
Having placed Wanniski’s disagreement in context, and having explained how LBMC got here, I’d like to explain exactly how LBMC’s approach differs from other economic schools and why the World Dollar Base “works”.
Next: Who Was Jacques Rueff?
Previous article: The Way the World Dollar Base Works
So far, we haven’t said much about what does cause the supply of goods (Q) to change.
In L’Ordre Social, Rueff constructs a theoretical model of the world economy. In it, output is the flow of goods and services produced by the stocks of labor and capital. His analysis includes the interaction of market prices and costs of production (net of taxation); markets for goods claims and foreign exchange, which are integrated through internal and external trade by purchasing power parity (and disparity), including transportation costs and tariffs, a monetary system which may be either gold-convertible or inconvertible, with or without reserve currencies, with or without adjustment lags (which produce overshooting effects in the price level and exchange rates); a theory of how economic policy operated through incentives and disincentives, including not only taxation but also price- and other regulation; alternate methods of financing budget spending (taxation, borrowing, monetization) and their effects – among other things.
While Rueff provides much of our theoretical framework, LBMC’s economic models are much, much simpler.
LBMS’s growth model tries to predict output (Y), a subset of the total supply of goods (Q). Output is determined by stocks of labor (L) and capital (K) – both of which incorporate knowledge and technology – modified by their respective utilization rates (UE and UTL). The equilibrium values of the capital and labor stocks are affected by the marginal tax rates on labor (MTRL) and capital (MTRK). For example, the formula for the tax on capital (MTRK) includes the personal income tax on dividends, the capital gains tax, and the corporate income tax on profits, which takes into account the present value of depreciation allowances.
In addition, there are temporary changes in the measured utilization rates of labor (UE) and capital (UTL) from monetary and budget policy. These effects are captured with a combination of the inflation-adjusted World Dollar Base (R$), interest rates (IR), and the inflation adjusted stock of Federal debt to the public (RFD). The effect is temporary because, as we have just seen, if an expansion of the real World Dollar Base causes output to rise, any inflation that results will later reduce the “real” World Dollar Base, and so cause output to fall. Our Growth Model specifically predicts industrial production, and derive a proxy for real GNP from industrial production.
The LBMC growth model, then, is a largely a model of government “policy shocks”: the level of output at any time is always determined mostly by the supplies of labor and capital; but changes in the quantity of services that existing labor and capital are willing to supply, and therefore changes in output around the trend, are usually dominated by adjustments to changes in monetary, tax, or budget policy.
The reason we spend much of our time answering questions about the World Dollar Base, then, is not that LBMC’s econometric models are based on one variable. Rather, it is because other forecasters use some or all of the same supply- or demand-side explanatory factors we use except for the World Dollar Base. As a result, much of the difference at any time between LBMC’s forecast and that of other forecasters can be traced to the fact that we include the World Dollar Base, while no one else does.
Next installment: A Rueffian Synthesis
Previous article: A Rueffian Synthesis
Having demonstrated that the World Dollar Base “works,” and having explained in detail why it works, we turn finally to answering Wanniski and Goldman.
Wanniski delegates most of the Polyconomics’ attack on LBMC to David Goldman. Strange to say, it is necessary to answer Wanniski and Goldman separately. This is because their arguments against LBMC’s monetary approach are not only different, but mutually exclusive.
Wanniski and Goldman agree on one thing: that, in Wanniski’s words, LBMC’s and Rueff’s monetary ideas are “a variation on the monetarist ‘demand model’ of Milton Friedman.” However, as we already saw, Rueff expressed the extent of his agreement with the monetarists’ conclusions by saying that they are “entirely wrong.”
The single point of agreement between Rueff and Friedman is that – as an empirical matter, not a necessity of theory – there can be some measure of money which is a stable function of something else. It turns out that Wanniski accepts this proposition, but Goldman does not.
Since Wanniski states in his cover letter that “the LBMC model proceeds from the weak side of Rueff’s monetary theory,” we are prepared for Goldman to enlighten us about what Rueff had to say. Exactly what was the weak side, and which the strong, of Rueff’s monetary theory?
We are surprised to find that – in what Wanniski bills as a debate about Rueff – Goldman does not mention Rueff. Friedman and Henry Kaufman, yes; Rueff not a peep. This is doubly off, since from earlier writings it would seem that Goldman is familiar with Rueff’s ideas.
Whatever his reasons, Goldman’s theoretical arguments are for this reason mostly irrelevant. The most interesting thing about Goldman’s objections is that they contradict Wanniski’s objections.
Goldman’s quarrel is with the crude version of the Quantity Theory of Money, which Rueff refuted. The trouble with the quantity theory, Goldman says – as if revealing a great secret – “is that the same quantity of money can support many different price levels, depending on how fast it moves from hand to hand”.
However, Wanniski has no problem with the Quantity Theory of Money as an analytical tool. When we open The Way the World Works, we find many statements like the following:
“The government now doubles the money supply. In the first instance, output remains the same, but the nominal value of output doubles to $200 as all individual prices in the economy double, the general price level in fact “doubling”.
Or again: “If there are ten apples in the economy and $10.00, each will trade for $1.00; if there are ten apples and $11.00, each apple must sell for $1.10 or someone in the economy will have $1.00 that will buy nothing”.
Wanniski’s seminal statement of supply-side ideas, “The Mundell-Laffer Hypothesis,” which appeared in The Public Interest in 1975 and was imported into The Way the World Works, is devoted almost entirely to an exposition of “global monetarism” – a term Wanniski himself has used for Laffer’s and Mundell’s monetary ideas.
In that article, Wanniski attempts to describe how a reserve currency like the dollar works, by imagining that New York issued currency which was used not only in New York but also for settling payments between the other 49 states:
“If 49 states are maintaining external balance by expanding or contracting their money supply, and New York is expanding the quantity of money to accommodate the system as a whole, then if New York expands too fast everyone in the system has too much money and there is a general inflation.”
Wanniski resembles Clause Rains in the famous scene in Casablanca where he says, “I am shocked – shocked! – to find gambling going on in this café! – as the croupier hands him his winnings.
Wanniski is shocked – shocked! – to find Monetarism going on – while he plies his readers with the crudest Quantity Theory and expounds the virtues of “global monetarism.”
Next installment: Reply to Polyconomics - Part 2
Previous article: Reply to Polyconomics - Part 1
If Wanniski does not object to the Quantity Theory as an analytical tool, when what is his problem? His objection is precisely to treating money as a commodity. That in his view, would violate Say’s Law – when in fact, as we have seen, it’s the only way to defend Say’s Law in a money economy.
The sharp either/or distinction between “supply-side” and “demand-side” economics, on which Wanniski places so much emphasis, is the subject of one of the murkiest chapters in Wanniski’s book. It is the distinction about which Wanniski most often quarrels. But it is based purely on Wanniski’s own confusion.
Mundell, whose ideas Wanniski purports to follow, does not see a sharp supply-side/demand-side distinction; for him it is a question of both/and, not either/or. That’s the whole idea of his “policy mix.” The following is typical of Mundell’s approach:
“Supply-side theory does not discard the valid Keynesian idea of balancing aggregate demand and supply at full employment, indeed that is a prime feature of our ‘voodoo’ school. But to this basically Keynesian insight we add the idea of using incentives to increase the ‘marginal efficiency of labor,’ if I may use that term. We need also to increase the marginal efficiency of capital. The real sinner in our economy is our obsolete tax structure, and raising taxes won’t make it any more holy.” (“Idle Resources, Easy Money, Hard Choices,” Manhattan Report on Economic Policy, Manhattan Institute, July 1982, p. 7).
Unlike Mundell, but like the classical economists, Wanniski does not in practice have a single theory of a money economy; he has two disconnected theories: a barter theory and a separate theory of money, which is a variation of the Quantity Theory.
Wanniski ordinarily speaks in terms of the barter model – with butchers and bakers exchanging their meat for bread and so forth. Occasionally, Wanniski will graft money onto his barter model as a unit of account that exists only in the minds of all economic agents – not as one of the goods that they exchange. This way of looking at things is not debilitating for certain purposes. But the barter theory cannot explain inflation, because it contains no money.
Wanniski fails to consider money as a commodity which is supplied and demanded, which has both a price and a cost of production, like any other commodity. To Wanniski, doing so is the very essence of the “demand model,” because it seems to him to violate Say’s Law. For this reason, any accurate description of a money economy is, in Wanniski’s view, a “demand model” – only barter theory can be a “supply model.”
At most, Wanniski will permit money to be a unit of account and a medium of exchange, but not a store of value. In reality of course, money must first be a store of value before anyone will use it as a unit of account or a medium of exchange.
“Once we come to understand the concept of money we automatically introduce a confusion into our understanding of the economy, forgetting that we only work in order to trade our labour supply for the supply of other workers. Instead, we come to think that we work for ‘money,’ and that money is the object of work,” Wanniski writes (The Way the World Works, p. 107).
This, he says, is exactly the error of the monetarists: “The electorate does not view money as a storehouse of value, i.e., a commodity that has worth beyond its usefulness as a medium of exchange. The electorate will exchange its labor for a precise quantity of money, that which it precisely needs to lubricate the wheel of commerce. It will not exchange its labor for money not needed for transactions. This, though, is the theory of the monetarists” (idem, p. 163).
Wanniski argues that the monetarists believe in “money illusion,” which he defines as follows: “Money illusion implicitly assumes that prices do not change as a result of the amount of money issued” (idem, p. 160). That is, he complains the monetarists don’t follow the Quantity Theory.
Wanniski accuses the monetarists of believing that an increase in the money supply will permanently increase real output. Citing Friedman, he says: “The monetarists argue that by increasing the supply of money, both Smith and Jones will want more – not as a medium of exchange, but as a storehouse of value, a form of wealth. In coming into the market and trading their labor for this incremental wealth, Smith and Jones increase the economy’s output. There is now more money in the system and the monetarists agree that prices will rise, so that Smith and Jones are back to where they began…. But at least the economy has gotten one transaction out of them, so that all of the increase in money has not gone exclusively into price increases, but has yielded a little output, too” (idem, p.163).
The monetarists say nothing of the sort: they argue that the money supply cannot have any permanent effect on output, only on prices. And they are right on this. During the period when the economy adjusts to excess money, there is a temporary up-and-down fluctuation in output, around a trend determined independently by supply factors; but Wanniski has only heard the “up,” not the “down.”
Wanniski’s confusion – which is the source of a goodly share of his anathemas – stems from the fact that he has not successfully worked out what Say’s Law means in an economy with money. Money can produce no temporary fluctuations in output in Wanniski’s barter theory, for the simple reason that there is no money for a barter economy to adjust to. This is why Wanniski tries to find fiscal explanations for monetary problems.
Wanniski has been sufficiently answered by the earlier discussion of Rueff’s restatement of Say’s Law. The interesting thing is that Goldman does not seem to have read Wanniski’s book.
Goldman tells us that “LBMC’s model is a variation on old-fashioned monetarism, which asserts that the price level varies with some measure of the quantity of money (M1 or M2), after a two-year lag.”
One of the main problems with that idea, Goldman explains, is that:
“An enormous amount of U.S. currency is held as a store of value or used as a circulating medium by countries with high inflation rates, or by tax evaders, drug traffickers, and so forth. About two-thirds of the $240 billion U.S. currency in circulation as of October 1990, is circulating abroad, according to Federal Reserve estimates. Federal Reserve Chairman Alan Greenspan estimates that $5 to $7 billion is circulating in just one South American country. It is hard to imagine what effect a stack of $50 bills under an Argentine or Bolivian mattress has on the world price level. (p. 2).
To summarize, then: Wanniski charges the monetarists with believing that “prices do not change as a result of the amount of money issued”; while Goldman indicts them for believing that “the price level varies with some measure of the quantity of money.”
Next installment: Reply to Polyconomics: Part 3
The Rueffian Synthesis