Commentary

Theory vs. Reality

By Charles W. Kadlec. Mr. Kadlec, managing director of J. & W. Seligman & Co., an investment management firm, is author of "Dow 100,000: Fact or Fiction" (Prentice Hall, 1999).

An overly strong dollar is getting the blame for a weaker-than-expected U.S. economy and a raft of earnings disappointments. But the problem goes deeper. Monetary authorities all over the world are failing to provide predictable, stable monetary policy. This failure is evident in Turkey and Brazil, whose currencies are the latest to plummet on foreign-exchange markets, with currency turmoil now threatening to spread to Mexico and other developing countries. However, the root of the instability can be traced to the policies of the world's three key central banks: the Bank of Japan, the European Central Bank, and the U.S. Federal Reserve.

Policy Challenge

The Bush administration now faces its first international economic-policy challenge. Equity markets and income statements are forcing the issue today. Bond and foreign-exchange markets may put policy makers on the spot in weeks ahead.

Today, the three leading central banks of the world have each failed to provide monetary stability. The Bank of Japan now proclaims that it cannot stop the deflation that has dragged down that once vibrant economy and brought its banking system to the edge of insolvency. The ECB has yet to show that it has the wherewithal to stabilize the value of the euro. And the Federal Reserve's self-congratulatory public statement that it has reduced the Fed funds rate by 275 basis points in less than six months only underlines the fact that it kept interest rates too high, and monetary policy too tight, far too long. Moreover, the International Strategy and Investment Group reports that last year there were 153 instances of central banks hiking interest rates. In a head-spinning reversal, central banks so far this year have reduced rates at least 87 times.

The failure of central banking underlines the failure of current economic theory to provide a reliable guide to monetary policy. Just weeks ago, the financial media were reporting about the weakness of the yen and the euro relative to the dollar. Now, all we hear are complaints that the dollar had strengthened by more than 10% against both. Yet no one has specified how to tell whether the yen and euro are weak, or the dollar is strong. The math is the same. But the policy implications are as different as night and day: A weakening euro or yen indicates that the ECB or Bank of Japan should be tightening; a strengthening dollar indicates that the Fed should be easing.

Next, we are told that the strong dollar is slowing the U.S. economy. Based on that logic, countries with the weakest currencies should have the strongest economies. But countries with the weakest currencies, including Turkey and Indonesia, are among the world's weakest economies. Finally, conventional wisdom says that the currency of a country that is reducing interest rates should weaken, while the currency of a country that is increasing rates should strengthen. Once again, the opposite is occurring. The dollar is strengthening even as the Fed has cut interest rates, while the Brazilian real and Turkish lira have fallen dramatically, even as those countries increased rates dramatically in hopes of stabilizing their currencies.

The collision between theory and reality suggests a skeptical view of conventional theory is warranted. Take the notion that a central bank can reduce inflation by raising interest rates. However, lower inflation is associated with lower interest rates, not higher interest rates. So, how does a policy of raising interest rates lead to lower inflation? In fact, inflation last year accelerated even as the Fed was raising rates, and has begun to decelerate this year, even as the Fed reduced rates. Variable leads and lags are used to paper over this discrepancy. So, too, the notion that throwing people out of work and otherwise causing a shortfall in output reduces inflation. But a shortfall in output leads to increased price pressures, whereas abundance in output leads to lower inflationary pressures. A review of gasoline prices over the past year demonstrates this truism.

All of this would be laughable if it were not for the fact that monetary policy is one of the keys to economic growth and equity-market returns. One of the hallmarks of the periods of strong growth and above-average equity-market returns is an improvement in monetary stability. By contrast, periods of monetary instability have been associated with below-average growth and equity-market returns.

The key rationale for the current discretionary monetary system is that monetary authorities must have flexibility to manipulate policy in order to stabilize the economy. Yet that flexibility itself has become the source of economic and financial-market instability. Although we can applaud the Fed for aggressively lowering interest rates this year, we should not forget that as late as December, it held rates high, and monetary policy tight, in order to slow an economy it deemed too strong.

In addition, the lack of a predictable monetary stability has kept long-term interest rates extraordinarily high given that the U.S. is at peace and that the federal government will run budget surpluses as far as the eye can see. In 1964 -- in a period of above average growth, small deficits, and a Cold War burden -- the Fed funds rate was 3.5%, only 25 basis points below today's target rate. However, the prime rate was 4.5%, not today's 6.75%. Corporations at the bottom of the investment grade rankings could borrow long-term money at 4.8%, 3.2 percentage points below today's rates. The federal government could float 10-year bonds at 4.2%, instead of today's 5.2%. And families could finance the purchase of their homes with mortgage rates at 5.8% compared to more than 7% today. We can only imagine how much better the economy would perform with the restoration of such interest rates.

What produced those low, stable interest rates then was a monetary system based on a price rule. In the Bretton Woods era, the Fed was committed to targeting the price of gold. By maintaining a stable rate of exchange between the dollar and gold, monetary policy achieved its goal of providing a stable price environment and predictable monetary stability. Only when the Fed began to renege on this promise beginning in 1968 did long-term interest rates on government bonds begin to rise significantly above 5%. And, only after the link between the dollar and gold was severed on Aug. 15, 1971 -- today is the 30th anniversary of that decision by Richard Nixon -- did the world enter into the great inflation of the 1970s.

Necessary Step

Movement back toward an explicit price rule by the Fed may be a necessary step in restoring global monetary stability and above-average growth in the economy. Historically, the price rule of choice was fixing a currency's value in terms of gold. A gold standard is not intellectually fashionable today. However, the issue was reintroduced into the political realm by Jack Kemp's call for a gold standard in a recent article. What's important in this debate, however, is not gold, per se, but the need for a standard. A basket of commodities that includes gold could well provide a better proxy for the overall price level, and hence a better standard, than gold alone.

Markets have a way of pushing policy makers toward improving policy, or punishing them for their lack of ability or desire to do so. Once again, we are approaching a time when markets may test the best in the U.S., Japan and Europe to find a way to finish the last great piece of business from the Great Inflation of the '70s -- the restoration of a stable, predictable and global monetary system.