SPEAKING FREELY The Fed and the nickel dollar By Wayne Jett
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When 1971 began, US$35 would buy an ounce of gold. By the end of that year, the
same amount of gold cost $70. In other words, the dollar had lost half its
purchasing power as measured by gold.
By the end of 1972, an ounce of gold cost $140, and the dollar had lost an
additional 50%. So the dollar at that time was worth a quarter of the dollar of
two years earlier.
The dollar's devaluation in 1971 was not announced by then-
president Richard Nixon or by the US Department of the Treasury. But the
devaluation was real, nonetheless. Just as real, in fact, as when the dollar
was officially devalued in 1934 by order of president Franklin Roosevelt from
$20.67 per ounce of gold to $35 per ounce.
During 2003, gold cost about $350 an ounce, 10 times the price at the outset of
1971. The 1971 dollar had shrunk to a dime (the colloquial US name for a
10-cent coin) - a major devaluation of the currency. Yet the US government has
not issued a single notice of devaluation during the 35 years since 1971. De
facto devaluation has occurred, even though it once required a direct order by
the president.
In 1973, the dollar's value was turned over to the Federal Reserve Board by
order of Nixon. The Fed, as it is called, has managed the dollar so that its
value "floats" in the market. By this approach, the Fed points to the market as
determining the dollar's value. The truth is, however, the dollar's value is
determined by the Fed's practices, not by the market.
The dollar is neither a commodity nor a product; its value is not determined by
the cost of production or by utility. Its supply can be changed at the Fed's
discretion, and demand for the dollar is often affected drastically by what the
Fed says and does.
Consider, for example, what has occurred since 2003, when $350 bought one ounce
of gold. In spring 2004, the Fed began spreading the word that its
interest-rate target for Federal Reserve funds would be raised. Since June
2004, the Fed has raised the Funds Rate target 16 times, from 1% to 5%. This
was done, most Fed observers say, to strengthen the dollar.
The rate hikes raised the interest payments made by consumers and by businesses
using commercial paper by $155 billion per year. This drain of working capital
from productive enterprises meant fewer resources available to hire people and
to make products.
This is the Fed's intent, since the Fed's theory is that higher unemployment
means fewer workers will demand higher wages that might push prices up. In
pursuing its rate-hiking regimen, the Fed conveyed a message to the economy -
month after month - that production and employment should be reduced.
But the Fed's rate hikes during this period have not strengthened the dollar.
Quite the opposite is the case. Today, one ounce of gold costs more than $700.
The dollar is no longer worth a dime compared with the 1971 dollar, as was the
case in 2003. In other words, today's dollar is a nickel's worth of the 1971
dollar. ("Nickel" is the US colloquialism for the 5-cent coin, which originally
was made of one part nickel and three parts copper.)
The dollar has lost half its value over the past three years; and with most of
the loss occurring within the past 10 months, the dollar's fall is getting
steeper. The Fed's theory and performance are failing badly.
Those who contend that the Fed is trying to make the dollar more valuable now
urge faster, larger hikes in interest rates. They say the Fed waited too long
to begin raising rates, and should be more aggressive. Others argue that a weak
dollar allows US exporters to sell more goods and services abroad. They speak
as if the Fed has been seeking that objective and is achieving it with the
weaker dollar.
Even with its new, plain-speaking chairman, Ben Bernanke, the Fed is not saying
whether it is trying to increase or to reduce the dollar's value. But
definitely the Fed is using a theoretical model that intends to reduce price
increases (ie, strengthen the dollar) by raising the level of unemployment. The
Fed calls it the Consensus New Keynesian Model, but in essence it is the
modified Phillips Curve model. The Phillips Curve, named after New Zealand-born
economist Alban William Phillips (1914-75), describes an inverse relationship
between inflation and unemployment; graphically, this appears as a curve
sloping downward and to the right, with inflation on the vertical axis and
unemployment on the horizontal axis.
This being the case, the Fed's theoretical model is most certainly invalid. The
dollar's instant purchasing power relative to gold is the lowest since 1980,
which was the dollar's worst year in history, despite two years of Funds Rate
hikes.
The Fed's rate hikes have weakened the dollar, along with economic growth, by
reducing demand for dollars to invest. That creates excess dollars the Fed does
nothing to drain. So the Fed itself is causing monetary inflation. This
explains the Fed's reputation for overshooting: rate hikes produce inflation
that chases rates higher.
Throughout history, gold has been an unerring measure of a currency's value.
The present high gold price means the dollar is worth very little now. General
prices will have to be adjusted higher in the next 10 years, probably more than
5% annually, if the dollar's value is not restored promptly.
In 1979, gold was at $280 an ounce and rising. Fed chairman Paul Volcker at the
time thought the circumstances were so bad he gave up trying to manipulate
interest rates to help the dollar. Unfortunately, Volcker chose an unwise
theory (monetarism) that made matters much worse.
This year, gold has touched $725 an ounce and is rising faster than in 1979.
Again, the Fed must abandon its interest-rate targeting. Time is of the
essence. This time the Fed should apply tried and proven classical principles
by targeting a value for the dollar as reflected by a price for gold. The Fed
can reach the target by selling its Treasury bonds to remove dollars from the
economy.
The target price should be between $375 and $450 an ounce, which would cause
the least price displacement in the economies of the United States and the rest
of the world. The precise gold-price target is not as important as the dollar's
stability. Lack of a floor under the dollar is what dropped the floor from
under stock and bond prices during the stock-market crash of 1987.
Wayne Jett is managing principal and chief economist of Classical Capital
LLC, a registered investment adviser in Pasadena, California.
(Copyright 2006 Wayne Jett. Used by permission.)
Speaking Freely is an Asia Times Online feature that allows guest writers to have
their say.
Please click hereif you are interested in contributing.
