Currency Chaos: Where Do We Go From Here?

I would strongly recommend you read the “Weekend Interview” published in the Wall Street Journal on Saturday. The interview is with Robert Mundell, 1999 Nobel prize-winning economist who teaches at Columbia University. Mundell has been referred to as the “father of the euro.” (http://online.wsj.com/article/SB10001424052748704361504575552481963474898.html?mod=WSJ_Opinion_LEADTop)

Let me just summarize some of the points Mundell makes in the interview because, I believe, that more people should be aware of them.

First, Mundell reflects a bit on history and states that the major event of the post-World War II period was the United States going off the gold standard in 1971 and letting the value of the dollar float. “The price of gold was fixed at $35 an ounce in 1934, but by the time the U. S. got through the Korean War, the Vietnam war, with all the associated secular inflation, the price level had gone up nearly three times.” The U. S. lost more than half its gold stock and had to get off the gold standard.

No one has suggested any system, gold or whatever, to stabilize prices since. And, the “secular inflation” has continued into the 21st century.

Second, the dominance of the United States and the dollar in the world economy, which began in the 1930s, has declined. “”To be fair, America’s position (in the international community) is not nearly as strong now.” But, Mundell doesn’t “think the U. S. has any ideas, they don’t have strong leadership on the international side. There hasn’t been anyone in the administration for a long time who really knows much about the international monetary system.”

Third, it is wrong to think that the world situation revolves around the United States versus China faceoff. “It’s a multilateral issue because the U. S. deficit is a multilateral issue that is connected with the international role of the dollar.” Mundell supports the suggestion of French President Nicolas Sarkozy that discussions should begin on reforming the world monetary system. But, he argues that the Europeans must play a very important part in any discussions because the dollar-euro relationship is so important in world financial markets. “The dollar and the euro together represent about 40% of the world economy.”

Fourth, the world currency system needs to be based on fixed exchange rates and not flexible ones. Mundell believes that almost all of the volatility in foreign exchange markets is “noise, unnecessary uncertainty.” World trade will be better off without having to deal with this “noise” because “it just confuses the ability to evaluate market prices.”

The argument against fixed exchange rates is that, in a world where capital flows freely between nations, a country cannot run an independent economic policy aimed at achieving things like full employment and price stability and still maintain a stable exchange rate. This argument is called “the Trilemma problem” of international economics: you can only achieve two of these goals; capital mobility; fixed exchange rates; and an independent governmental economic policy. (For more on this see my post, http://seekingalpha.com/article/227990-monetary-warfare-can-nations-have-independent-economic-policies.)

What about a country losing the ability to run an independent economic policy?

Mundell is asked the following question: “I suppose the Fed officials would argue that their mandate is to try to achieve stable prices and maximum levels of employments.”

The answer: “Well, it’s stupid. It’s just stupid.”

“The Fed is making a big mistake by ignoring movements in the price of the dollar, movements in the price of gold, in favor of inflation-targeting, which is a bad idea. The Fed has always had the wrong view about the dollar exchange rate; they think the exchange rate doesn’t matter. They don’t say that publically, but that is their view.”

Hence, the fifth point is that monetary and fiscal policy should not be conducted independently of what is going on in the rest of the world. A country, even the United States, cannot continue to inflate its currency without repercussions. The government cannot continuously ignore what is happening to the value of its currency. If a country does ignore what is happening to its exchange rate there will be consequences to pay down the road.

Sixth, “the price of gold is an index of inflationary expectations.” What is it reflecting? Mundell argues that a rise in the price of gold might indicate “that people see huge amounts of debt being accumulated and they expect more money to be pumped out.”

“Look what happened a couple weeks ago: The Fed started to say, we’ve got to print more money, inflate the economy a little bit. The dollar plummeted! (The price of gold rose!) You won’t get a change in the inflation index for months.” But, the decline in the exchange rate and the rise in the price of gold is a “first signal.”

Read the article.

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