Wednesday, August 20, 2008

The Most Important Price in an Economy

In my post of August 18, 2008, I argued that neither of the presidential candidates had really staked out a well defined position as far as their economic vision was concerned. The pronouncements of the candidates, I wrote, were either too general or were bogged down in ‘wonkish’ minutia. As a consequence, an uncertainty has resulted that has left people and markets without direction and has fueled a greater volatility in prices.

Given this criticism, the question must be asked, “What is the basis for a sound economic vision?”

I believe that the foundation of a sound economic vision begins with the value of the United States dollar. I continually go back to the statement of Paul Volcker: “a nation’s exchange rate is the single most important price in the economy.” (Paul Volcker and Toyoo Gyohten, “Changing Fortunes: the World’s Money and the Threat to American Leadership, (New York: Times Books, 1992), p. 232.)

The reason the exchange rate is the single most important price in the economy is because it reflects the viewpoint of the rest of the world about how an economy is being managed relative to how other nations are managing their economies. In essence, the value of a country’s currency is related to relative rates of expected inflation…the expected inflation of the country in question relative to the expected inflation in other nations in the world.

And, it is expected inflation that is important, not actual inflation as measured by current price indices. Calculated measures of inflation do not always immediately capture what is going on in the world and, as a consequence, do not always pick up economic dislocations that will be reflected in prices at some time in the future.

For example, in the consumer price index, estimates are made of the rental price a home owner would pay for the housing services received from the owned home. These are not directly related to the prices that homes are being sold for. Thus, prices of houses may be rising at a very rapid rate while the estimated rental price of the housing services may be rising very slowly. Since the component of the consumer price index related to housing is quite large, the “measured” consumer price index may rise only modestly whereas the prices of housing might be rising quite rapidly. (Note: this, of course, relates to the situation several years ago and not right now.)

Furthermore, with all the Federal government debt being exported, the nations having investors that have purchased large amounts of this debt face a peculiar situation. Many of these nations have their currencies tied to the value of the United States dollar. The low interest rate policy in the United States has forced these countries to also maintain a low interest rate policy and this has resulted in higher rates of inflation in these countries. The inflation experienced in these countries is now finding its way back into the United States.

Thus, there are many ways that inflation or the possibility of inflation can work its way through the world economy without being captured in currently measured price indices. It would be silly for investors to wait for inflation to show up in the published price indices before they made their investment decisions. Investors must make decisions based on what they “expect” to happen. These inflationary expectations are therefore reflected in current market prices such as a nation’s exchange rate.

It can be strongly argued that if investors believe that a government is acting independently of the rest of the world and behaving in an imprudent and undisciplined manner they will sell the currency of that country and this will result in a decline in the value of that country’s currency. In essence, the market is reflecting the fact that this government is acting in a way that will cause higher relative rates of inflation in the future even thought the explicit evidence of this inflation is not present in currently measured figures.

This, I believe, is what has happened in to the United States dollar over the past six years or so. And, at the present time, no evidence has been given that the economic policy of the United States government has changed and there is little or no evidence that either of the presidential candidates will do anything to correct this situation. This is the cloud of uncertainty that is hanging over international financial markets at the present time. Until this position is clarified, uncertainty will remain and financial markets will remain quite volatile.

Of course, there is more to a vision of economic policy than that related to the nation’s exchange rate. But, the crux of such a policy is the trust that market participants place in the willingness of an administration to keep “expectations of inflation” under control. And, this goes backs to the basic fundamentals…fiscal discipline and conservative monetary management. For monetary policy to focus upon keeping inflation and inflationary expectations low, fiscal policy must be conducted in a way that does not put undue pressure on the conduct of the central bank. When deficits are too large the historical evidence suggests that sooner or later the monetary authorities will have to come in and “monetize” a substantial portion of the debt. This monetization of the debt is, of course, inflationary. Thus, even though a central bank may claim to be focused on keeping inflation low, a lack of fiscal discipline will be translated by market participants as potentially inflationary. Historically, the market participants have not been proven wrong.

Thus, fiscal discipline goes along with conservative monetary management. Again, no evidence has been forthcoming that either presidential candidate has advocated such control.

Economic growth is another facet of economic policy. However, the historical evidence shows that what is done to support long term economic growth is not directly connected with monetary policy or fiscal deficits. Loose monetary policy may spur on economic growth in the short run, but in the longer term, inflation created by fiscal deficits and loose monetary policy stifle initiative and innovation and lead to slower rates of economic expansion. Emphasis upon demand side stimulus (which tends to be inflationary over time) has not been the elixir for a dynamic and growing economy. What is needed is encouragement for a shift in the supply side of the economy. But, this will take an extended period of time.

I believe that a vision of future economic growth must be based upon three factors. First, organizations, both financial and non-financial, must stop focusing on financial methods as their key to performance and return to a focus on the products and services they produce as their strength. When the government emphasizes demand side policies, companies, unfortunately, seem to de-emphasize their “core competencies” and turn to financial leverage and added financial risk-taking as sources of exceptional performance.

Second, economic policy must support a “bottom-up” approach to economic creation and development. Real economic vitality comes about when entrepreneurial energy is released in an economy. Organizational conglomeration and size ultimately seem to primarily benefit the executives that build such giants. Why? Executive salaries, bonuses, and other benefits are related to size…because the system bases executive remuneration on comparables…and this has a cumulative effect that only encourages more inefficient mergers and efforts to achieve growth for growth’s sake. This area needs to be examined more thoroughly in order to create a supply side shift in aggregate economic performance.

Finally, in my view, the current world is a world of life-time education. To me, a safety-net begins by creating a world in which everyone, in a real sense, is trained for and participates in transition. The world is constantly changing. Major problems occur when people, companies, unions, and others want to “protect” people, companies, unions, and others from change. Government, at all levels, is going to have to play a role in creating this safety-net. But, the safety-net should begin and end with education…not just to start out…but throughout ones life.

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