I’ve been warning about the deflationary implications of a broken credit-creation mechanism and a partially broken system of government credit (the PIIGS, American state and local governments). This is what I talked about Monday night on CNBC’s The Kudlow Report.
A small minority of other analysts have echoed such warnings, but none with the authority of Robert Mundell–in my view the greatest mind in economics of the post-World War II era. Here is a report in Monday’s Wall Street Journal (behind paywall):
Nobel Laureate Robert Mundell—says dollar weakness is not his main concern. Instead, he fears a return to recession later this year when QE2 ends and the dollar begins its inevitable rise. Deflation, not inflation, should be the greater concern. Avoiding the recession is simplicity itself: Just have the U.S. Treasury fix the exchange rate between the dollar and the euro.
Mr. Mundell’s surprising statement came at a March 22 conference in New York sponsored by the Manhattan Institute, The Wall Street Journal and the Ronald Reagan Presidential Foundation. His economic predictions carry great weight because, unlike most economists of his generation, he is often right. His analysis of international economics has revolutionized the field, making him the euro’s intellectual father and a primary adviser to China’s economic policy makers.
Nevertheless, with gold around $1,500 and oil above $100 a barrel, supply-siders are scratching their heads: How can he possibly see deflation ahead? How can dollar weakness not be the problem?
The key to Mr. Mundell’s view is that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. For example, when the dollar declines significantly against the world’s second-leading currency, the euro, commodity prices rise. This creates U.S. inflationary pressure. Conversely, when the dollar appreciates significantly against the euro, commodity prices fall, which leads to deflationary pressure.
From 2001-07, he argues, the dollar underwent a long, steady decline against the euro, tacitly encouraged by U.S. monetary authorities. In response to the dollar’s decline, investors diverted capital into inflation hedges, notably real estate, leading to the subprime bubble. By mid-2007, the real-estate bubble had burst. In response, the Fed reduced short-term interest rates rapidly, which lowered the dollar further. The subprime crisis was severe, but with looser money, the economy appeared to stabilize in the second quarter of 2008.
Only with great trepidation would I take issue with Prof. Mundell, but I believe that he underrates a factor that he was the first to identify in the economics literature: the fact that balance of payments deficits arise from differential savings rates among countries, which in turn arise from differential demographics. The Chinese, for example, were massive buyers of US securities, including mortgages, because the US was the only market offering sufficient investment instruments to satisfy China’s bottomless supply of savings. And the Chinese were saving half their income (an unprecedented level) because a rapidly-aging population restricted to one child per couple required a huge buildup of financial assets.
I am also less concerned about QE2, and more concerned about the fact that issuance of bonds linked to private credit risk is still down by half from the peak, while total loans and leases at US commercial banks continue to fall (forget the dead-cat bounce in C&I loans). This is an institutional breakdown; the Fed wants inflation and says so, but may not be able to get it, because the Fed’s largesse isn’t translated into lending to the private sector. That’s a Japan-style pushing-on-a-string problem. Even if the Fed stops buying Treasuries, there is huge demand for securities from the banks.
The markets, as I said Monday night, are oscillating between fear that the Fed might succeed, and fear that it might fail–thus the huge volatility in the price of inflation hedges.
Nevertheless, Mr. Mundell views QE2 as the wrong solution for the problem. Instead, the U.S. and Europe simply should coordinate exchange-rate policies to maintain an upper and lower limit on the euro price, say between $1.30 and $1.40. Over time, the band would be narrowed to a given rate. Further quantitative easing would be off the table.
With a fixed exchange rate, prices could move free from the scourge of sudden deflation and inflation, allowing investment horizons and planning timelines to expand along with production levels on both sides of the Atlantic. To supercharge the U.S. recovery, he also recommends permanently extending the Bush tax rates and lowering the corporate income tax rate to 15% from 35%.
Again, it seems presumptuous to disagree with the great man, who among other things is the intellectual father of the Euro. But the southern European fiscal crisis seems to prejudice the Euro as a lodestar for monetary policy. An agreement to stabilize the dollar against a group of Asian currencies, starting with a convertible Chinese yuan, would seem to make more sense. I’ve been advocating that since late 2008.
These quibbles aside, Robert Mundell’s deflation warning should be taken seriously. To reiterate: don’t sell your bonds, and don’t sell your gold. We have a gold bubble and a government debt bubble, and we don’t know which will pop first.