The following article was copied from Sinclair's website:
If Mr. Greenspan Walked His Talk
by Reuven Brenner
Financial observers seem mad with anticipation whether or not Mr. G. will or will not use the word "patience" in his discourse. Yet, at the same time, when Mr. G. does make some clear and substantial statements, even if he does not make their consequences explicit - there seems to be no reaction.
It happened again last week. Greenspan said that despite the fact that current account deficit reached 5% of GDP the dollar remains "close" to its long term, two decades average. His intention was probably to calm down financial markets, and suggest that the 5% deficit is not necessarily a threat to the value of the dollar, to world's financial stability, as some observers suggest, and it could stay at that level for a while. And suggest, may be implicitly, that the depreciation of the dollar is, may be, unrelated to the politics on an election year.
Two questions arise with what seem at first sight relatively precise, factual observation. One, what "average" was he referring to? Two: why is looking backward at an average of two decades relevant at all to infer anything about where monetary affairs are heading in the future? And why not look at one decade? Or, even better, may be, at four decades, or a century? Clarifying this statement about "the average" could be relevant if the pronouncement signals that monetary policy will be guided from now on by sticking to it, re-establishing the US dollar as a monetary anchor - independent of domestic politics. If this was the case, that would be an important message - if only Mr. G. would make his view explicit about the "average", and if his successors would be bound by this same target. One can only hope that in the next hearings about the Fed's monetary policy, some Senators would push relentlessly Mr. G. to make his point clear.
Let us address the second question first. For what type of data would a two-decade average be relevant? The last two decades saw great upheavals. Communism fell (late 1980s, early 1990s) - and, it first seemed that the idea that bureaucrats in a political capital would know how to price eggs, schools, healthcare, steel, and for the Fed to know what to do with interest rates, was weakened. As events since then showed - in India just last week, and with Central Banks mismanaging monetary policy continuously - these expectations were way off the mark.
During these two decades, China opened its doors, and India opened to business. Or, so it seemed until, with the re-election of a member of the Ghandi dynasty on May 12, markets plunged as members of her coalition party talked about central planning and more money being allocated by governments, rather than investors. Japan went into a slumber (around 1988, consequence of severely mismanaged monetary and fiscal policies), and is yet to wake up. Russia broke up, and has been fluctuating since. The European community expanded and the Euro appeared. Latin America seemed to be headed toward stability and even prosperity, but is now back with its customary patterns of coups, defaults and devaluation. There has been NAFTA. Some manufacturing business moved from the US to first Mexico, then China and other low-wage countries. Much of Africa mired in customary vicious tribal/political upheavals, with AIDS spreading. Add to these two wars in Iraq, radical, Fascist Islam and terrorism gathering force - on Western soil too, a West mired in misguided "everything is relative"-mindset. Why would any pattern over such two turbulent decades serve as guidance for this year?
And yet.
These two decades have not been entirely unprecedented. The world has seen such turbulent decades before, full of wars, technological breakthroughs, borders being redrawn in sand, though information traveled more slowly, and wasn't visual. Was there anything relatively stable during such periods of upheaval? There was, and, once again, let's quote Mr. G. himself emphasizing it in an earlier speech. He opened his December 19, 2002 speech before the Economic Club of New York with this statement:
"Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money."
In other words, it is quite possible to have a monetary standard over decades and even centuries, wars and political and technological upheavals notwithstanding. How can that be? In our "floating world," living with the utterly misunderstood idea of what anchoring monetary policy implies, let's take a step back and explain the simple mechanism behind such stability.
Say there are 1,000 good and services available or to be delivered in the future. If there were no monetary anchor, there would be 499,500 prices, as each good and service would be priced in relation to every other. However, if society chooses one commodity as a yardstick, there are 999 prices and that's it. This simple fact explains why every society since time immemorial agreed on such yardsticks, why cigarettes play this role in prisons - even prison-lands, such as countries under communism were. All that is needed is that the commodity society agrees upon is in relatively fixed supply. This happens to be the case of gold, and also of cigarettes, since prisoners have rights to fixed allocations per month.
The above simple calculation also shows why we face such explosion of trading in derivatives. With dozens of central banks mismanaging monetary policy, businesses buy insurance for certain price ranges (this is what derivatives are), to assure that they stay in their lines of business, rather than see their revenues and profits wiped out by exchange rate fluctuations. This calculation also explains part of the rationale behind the Euro. (The Euro should have long raised the question: if it is good for them, why eliminating floating isn't good for other parts of the world?)
The calculation also shows why being guided by price indices does not quite work. One can calculate a price index for the prices of the 1,000 goods and services. But for such index to serve as reliable guide for monetary policy not only must the goods and services stay relatively the same but the weights assigned to these goods and services must stay so too. Yet with innovations, relative prices fluctuating wildly, as do the weights. Also, it is difficult to interpret the change in price in one of the biggest components in the index (housing, or "rental equivalence," as technically called, which represents 30% of the Consumer price index in US and Canada. Europe's "harmonized price index" excludes dwelling). What fraction of the increase in housing prices is "investment," or "speculation", and what fraction is due to "consumption"? Little wonder that focus on price indices, as guides for monetary policy didn't work. Although in the G-10 countries price indices varied within narrow ranges over the last decade, exchange rates between these countries fluctuated in the +50% and -50% range.
These numbers bring us back to the first question, and Mr. Greenspan's "average" over the last two decades.
Since late 1986, the US dollar varied relative to G-10 (since the introduction of the Euro, G-6) in the + 20% and -20% range (relative to the average), and it is true that the dollar is now within the 10% range from this average. The movement of gold prices is almost perfectly correlated with the movement of the dollar relative to the trade weighted G-10 (G-6) index. When the dollar expected to go down relative to other currencies, gold goes up, and the contrary. This almost perfect correlation suggests that whether Central Bankers like it or not, gold represents a fraction of international monetary portfolios, and behaves as a substitute for the US dollar. It behaves as a "global currency" in the sense that when the dollar is expected to get stronger - as it did between 1997 and 2001, by 40% relative to the G-10 index - gold dropped by $100, about 30%. And the contrary: since 2001, gold went up by $100, or 40% (roughly back to its 1997 level), whereas the dollar dropped by about 30% relative to G-10. (Note: the reason percentages vary is that when price drops from $350 to $250 that represents about 30%. When price goes back to $350, that's 40%. That's why diagrams with growth rates mislead).
To summarize: the only things that were- and could be stable - during political tempests around the world, are monetary anchors (gold for the Western world, and silver for Mexico and China, when the latter was on the silver standard, actually using the Mexican silver dollar). They could be so when monetary policy was separated from politics, domestic or international, and served to anchor prices and long term contracts. Price indices cannot offer such guidance, and often can neither monetary rules, since demand for currencies fluctuates around the world, as does velocity. (Milton Friedman retracted his "monetary rule" view, as being too rigid, in an interview with Financial Times last summer). Now if only Mr. Greenspan would be forced to state that the Fed would stick to the "two decade average" and use changes in gold prices as signal to either absorb or add to the global US dollar liquidity, a measure of stability would be brought back to the world.
And Mr. G could re-claim his title as "Master of the Universe" - given prematurely few years back. Am not holding my breath, though. Traders in the trillion dollars per day "derivative business" would not like the above scenario one bit.
Reuven Brenner: CV
Reuven Brenner is President of R. Brenner Cons. Inc. and holds the Repap Chair at McGill's Faculty of Management. |
