Paul Volcker, former Chairman of the Federal Reserve System, has written that “a nation’s exchange rate is the single most important price in its economy; it will influence the entire range of individual prices, imports and exports, and even the level of economic activity.” (Paul Volcker and Toyoo Gyohten, Changing Fortunes, Times Books, New York, 1992, page 232.) If “a nation’s exchange rate is the single most important price in its economy” one really has to be concerned that the United States has allowed the value of the dollar to decline so precipitously over the past six years or so. Volcker alludes to all kinds of things that can happen to the nation that lets its exchange rate decline, but he doesn’t even mention one other possibility, a situation that has arisen since he wrote the quotation presented above, and that is the situation, like the one that has arisen, in which a country’s assets become so cheap that foreign interests can acquire them at historically low prices.
It is important to see just how badly the U.S. dollar has declined in value to get some appreciation for the problem. From the year 2001 through the year 2007, the Dollar has declined at a compound rate of over 7% per year to the Euro. In terms of the British pound, the dollar has declined at a compound rate of over 5.5% per year. The same is true of an index of major currencies against the dollar as compiled by the Federal Reserve System. An index that includes a broader range of currencies produced by the Federal Reserve shows a more moderate rate of decline of about 3.3% per year. Although, whichever way you measure it, the U.S. dollar has not fared well in world markets during much of the Bush Administration.
These market results are important because they indicate how world financial markets are betting on relative rates of inflation in the different countries. If one works with what is called the Purchasing Power Parity [PPP] Theory for exchange rates in its pure form, one can argue that the change in any nation’s currency against the currency of another nation can be represented by the difference in the expected rates of inflation between the two countries. In this were the case, it could be argued that the difference in expected rates of inflation between the U.S. and England is in excess of 5.5 percentage points. That is, whatever the market expects the rate of inflation to be in England, they expect the rate of inflation in the United States to be 550-basis points higher.
Since the PPP Theory is not an exact theory, we cannot just extrapolate the figures presented above and apply them to differences in expected rates of inflation. However, we don’t need to do this. We can just argue that the differences presented above provide some ballpark ‘guesstimate of anticipated relative rates of inflation. If one argues in this way, the conclusion can be drawn that, whatever the real estimates are, participants in world markets believe that inflation in the United States is much worse than it is in other countries or areas in the world. If the differences were just 1% to say 1.5%, it could be argued that the differences were non-existent or too small to worry about since the PPP Theory was not exact. However, at the magnitudes that have existed over the past six years, the differences, I believe, cannot be ignored. Market participants believe that inflation is expected to be much worse in the United States than it is in other areas of the world! The only country that is not listening to this is the United States.
Why is this happening to the value of the U.S. dollar?
Let’s take a step back for a minute. At one time it was assumed that the U.S. government could run any kind of economic policy that it wanted and not have to pay for it to any degree in world financial markets. The reason for this was that the United States was a ‘big’ country and was not subject to the same pressures that ‘small’ countries were. Much of International Macroeconomic Theory relates to ‘small’ countries, but theorists and practioners, historically, have generally argued that because of its dominating size, the United States could act in a way that the ‘small’ countries of the would could not. They could get by doing what they wanted to do without much regard to international financial markets.
What happens to the ‘small’ countries when they try and do this? Well, they were kept in hand by that amorphous, unidentifiable, shady group of people called ‘international bankers.’ If a ‘small’ country conducted its fiscal policy in a way that ran substantial deficits (for that county) and did not have an independent central bank, thereby increasing the possibility that the inflation rate in the country would rise, these ‘international bankers’ would sell the currency of that country in the foreign exchange markets. The foreign exchange rate would decline, and then the government would have to back track and reduce or eliminate the deficit and make its central bank independent of the national government.
The argument was put forward that this clandestine band of ‘international bankers’ usurped the sovereignty of nations so that the nations could no longer run their own economic policies. During this time we saw leaders, like Francois Mitterrand of France, a militant socialist, back off from combating the ‘international bankers.’ They made their central banks independent of the government, and began to conduct a more conservative fiscal policy. For example, Mitterrand freed the central bank of France, making it independent of the national government. And, in the 1990s and the early 2000s, many other nations followed suit, making their central banks independent, and mandating inflation targets for the conduct of monetary policy. But, these were all ‘small’ countries.
Now we come to the United States. After balancing the Federal budget, the United States Government, under the leadership of President George W. Bush, created massive Federal deficits through the implementation of major tax cuts, and the expenses related to fighting a foreign war. In addition, the Federal Reserve System, led by Alan Greenspan, acted as a complacent component of the Federal Government and kept its target for the Federal Funds rate below 2% for over two years and at 1% for approximately a year during this time. In the past, the U.S. government could ignore the ‘international bankers.' But this is no longer the case. Just like any ‘small’ country in a similar situation, the international bankers’ began to sell dollars and continued to sell them as the large deficits persisted. Yet, the Federal Reserve seemed to ignore the decline. The result? The United States does not seem to be a ‘large’ country anymore. Globalization has come back to hit the United States.
Still the price indices produced in the United States do not reflect this perceived inflation…at least up to this time. But, there are those that believe these price indices understate the true rate of inflation. See, for example, the perceptive article “Inflation May Be Worse Than We Think” by David Ranson of H. C. Wainwright & Co. Furthermore, in the commodity markets, we see that wheat, oil and gold have all hit new highs. And, the Euro rose above $1.50 for the first time. Maybe the United States needs to put ideology aside and listen to what the market is telling us.
And, there is one piece of anecdotal evidence that maybe needs to be mentioned. In the early 1920s, John Maynard Keynes wrote about the ‘profit inflation’ that existed in England. This was a situation where profits had risen but the real wages of the worker had not. He was concerned with the restlessness in the country that had arisen due to the resulting redistribution of incomes. What I would like to point out is that all of the major candidates campaigning to become the Democratic nominee for President of the United States have taken an increasingly populist position on economic policy as the campaign has progressed. Ohio is a prime example of how this message has resonated with a fairly large portion of the population. The question therefore is: Has inflation really been a problem for the United States over the past several years? The magnitude of this inflation has not yet surfaced in the statistics, but it may have been experienced and felt by participants in the financial markets, and by workers and by households.