Those who oppose currencies being exchangeable into gold fall into two fallacies. Firstly, they assume that the supply of gold, being fixed, must also necessarily fix its value. Secondly, they don't appreciate that currency started out as a consumer good -- that is, it had intrinsic value -- and that until currency is restored to this role then we will have continuing currency problems. We will either have rampant inflation for a decade or two, or periods of prolonged deflation. In between, there are periods when the value of the government currencies is approximately right, but this is more by good luck than judgement, and they don't last long before we plunge one way or the other again.
The writer, Bill O'Rahilly, has touching faith in the ability of governments to engineer themselves out of economic difficulties and quotes Franklin Roosevelt's 40 per cent reduction of the dollar against gold in 1933-34 with approval. Yes, asO'Rahilly says, it certainly stimulated a stock market rally and, of course, being an investment banker, that's what he would like to happen right now. Unfortunately, though, Franklin Roosevelt's decision in the 30s did nothing at all in making enough money available for consumer demand, and unemployment continued much as before and was only relieved by the outbreak of WWII and the huge take-up of workers in the armaments and allied industries. I hope we don't have to wait for WWIII to lift America out of gradually worsening unemployment which is bound to affect all of us before too long.
KH
<<<< GOODBYE, YELLOW BRICK ROAD
Bill O'Rahilly
Seldom can we draw upon fiction and witchcraft to direct us through economic history. But in 1964, Henry Littlefield, a school teacher, published a study entitled "The Wizard of Oz: A Parable on Populism". In this essay he presented L. Frank Baum's, The Wizard of Oz, as an allegory for late 19th century America. His descrikption of this popular novel has echoes in today's US economy.
The story covers the1890s, during which the US endured grinding deflation. Farming communities in the west, represented by the Scarecrow, saw their incomes and asset values collapse and the real cost of debts rise. This benefited the bankers in the east -- in the guise of the Wicked Witch of the East. Throughout the period the gold standard was in operation, represented by the Yellow Brick Road. The supply of money was confined by the fixed availability of gold. According to Littlefield, Baum supported the Democratic pro-silver candidacy of the time and wove this theme into his tale. Dorothy was the US, Oz was gold, the Tin Man was industry and the Emerald City was Washington. Perhaps teh allegory was lost on Metro Goldwyn and Mayer -- or maybe they employed artistic licence for visual effect. But in Baums' original story, Dorothy did not have ruby shoes but silver ones, representing the silver campaign.
In a National Democratic Convention debate on monetary policy at the time, William .Jennings Bryan, a little-known Democrat, called for a move towards a
silver standard. Silver would, he said, provide a more abundant reserve against which banks could produce money and ultimately reflate the economy. Drastic times called for dramatic rhetoric. Bryan's manifesto earned him the Democratic presidential nomination that year as he electioneered: "You shall not press down upon the brow of labour this crown of thorns, you shall not crucify mankind upon a
cross of gold".
Victory eluded Bryan in the 1897 election and the gold standard remained. Not long after, discoveries of gold in the Klondike and the Yukon led to an increase in gold reserves, which had the same net effect on liquidity as moving to a silver standard -- the US economy eventually reflated.
The big mistake of policymakers in the 1890s was slavish adherence to the gold standard. Bryan's call for a break from the prevailing economic convention was too revolutionary to countenance. Indeed the gold standard remained for another 40 years. It again acted as a policy restraint after the 1927 crash, with more disastrous
consequences. This time here were no serendipitous discoveries of gold. The
consequence of policy inflexibility was the Depression of the 1930s.
Learning from the past, the Federal Reserve has already gone some way to embracing Bryan's school of thought by breaking with policy norms and deploying "pre-emptive and forceful" measures. The Fed maintains that it is easier to preventt deflation than cure it. If we consider International Monetary Fund studies of Japan in the early 1990s, it is clear that the onset of deflation can be insidious and can lead to unsuitable policies that at the time appear appropriate. This is why, despite signs of recovery, the Fed has continuously cut interest rates. Although current policies may stoke inflation in the future, the Fed would rather face inflation than deflation down the track.
In the deflationary arena, traditional relationships and systems become distorted. We can no longer rely on conventional policy responses to buoy economic growth. Hence interest rates have been reduced to their lowest levels in 50 years, the dollar has declined by 30 per cent against the euro and federal taxes have been cut by $350 billion. Though such measures are not unusual per se, the combination, speed and degree to which they have been invoked recently marks them as dramatic and unforeseen.
Exchange rate policy alone can be highly potent. Consider the effect that Franklin Roosevelt's 40 per cent reduction of the dollar against gold had in 1933-34. This depreciation led to a surge in money supply that precipitated an end to deflation in 1934 and sparked one of the most vigorous stock-market rallies in a century.
Some recent economic data indicate that the threat deflation is beginning to wane. But the Fed will probably maintain an accommodative stance until it is certain of that. During this transition period, we could see an outcome that echoes 1999, when the Fed told markets it would provide liquidity to protect financial systems against a possible slowdown induced by the "millennium bug" (Y2K). Ultimately, when it became evident that the advent of Y2K would pass without a ripple, this excess liquidity was sucked into markets and fuelled a bull run in equities. If observers today view the Fed as over-compensating against deflation, we could see a shift in liquidity from bonds and property to equities, prompting another Y2K-style bull run.
For the time being the Fed's goal is to ward off deflation if that means straying from the Yellow Brick Road of policy orthodoxy,so be it. Any unwelcome rise in the longer end of the yield curve will more than likely be countered by rhetoric to that effect from Fed members.
Much has changed since Baum wrote his tale. The Scarecrow's fields are full of genetically modified soya and the Tin Man has silicon components. Yet as before, the Good Witch in the Fed will endeavour to bring Dorothy safely back home to Aunt Em.
The writer is a Dublin-based investment banker
Financial Times 5 August 2003 >>>>
Keith Hudson, 6 Upper Camden Place, Bath, England
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