Mundell: Deflation Risk for the Dollar (WSJ).

The following appeared in The WSJ on May 23, 2011.

Mundell: Deflation Risk for the Dollar
The Nobel winner says a stable dollar-euro rate is the best economic medicine.

By Sean Rushton

Conservative economists have been raising alarms for months about the Federal Reserve's second quantitative-easing program, QE2. They argue it has lowered the dollar's value, leading to higher oil and commodity prices—a precursor to broader, more damaging inflation.

Yet the man many of them regard as their monetary guru—supply-side economics pioneer and Nobel Laureate Robert Mundell—says dollar weakness is not his main concern. Instead, he fears a return to recession later this year when QE2 ends and the dollar begins its inevitable rise. Deflation, not inflation, should be the greater concern. Avoiding the recession is simplicity itself: Just have the U.S. Treasury fix the exchange rate between the dollar and the euro.

Mr. Mundell's surprising statement came at a March 22 conference in New York sponsored by the Manhattan Institute, The Wall Street Journal and the Ronald Reagan Presidential Foundation. His economic predictions carry great weight because, unlike most economists of his generation, he is often right. His analysis of international economics has revolutionized the field, making him the euro's intellectual father and a primary adviser to China's economic policy makers.

Nevertheless, with gold around $1,500 and oil above $100 a barrel, supply-siders are scratching their heads: How can he possibly see deflation ahead? How can dollar weakness not be the problem?

The key to Mr. Mundell's view is that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. For example, when the dollar declines significantly against the world's second-leading currency, the euro, commodity prices rise. This creates U.S. inflationary pressure. Conversely, when the dollar appreciates significantly against the euro, commodity prices fall, which leads to deflationary pressure.

From 2001-07, he argues, the dollar underwent a long, steady decline against the euro, tacitly encouraged by U.S. monetary authorities. In response to the dollar's decline, investors diverted capital into inflation hedges, notably real estate, leading to the subprime bubble. By mid-2007, the real-estate bubble had burst. In response, the Fed reduced short-term interest rates rapidly, which lowered the dollar further. The subprime crisis was severe, but with looser money, the economy appeared to stabilize in the second quarter of 2008.

Then, in summer 2008, the Fed committed what Mr. Mundell calls one of the worst mistakes in its history: In the middle of the subprime crunch—exacerbated by mark-to-market accounting rules that forced financial companies to cover short-term losses—the central bank paused in lowering the federal funds rate. In response, the dollar soared 30% against the euro in a matter of weeks. Dollar scarcity broke the economy's back, causing a serious economic contraction and crippling financial crisis.

In March 2009, the Fed woke up and enacted QE1, lowering the dollar against the euro, and signs of recovery soon appeared. But in November 2009, QE1 ended and the dollar soared against the euro once again, pushing the U.S. economy back toward recession. Last summer, the Fed initiated QE2, which lowered the value of the dollar, allowing a second leg of the recovery to take hold.

Nevertheless, Mr. Mundell views QE2 as the wrong solution for the problem. Instead, the U.S. and Europe simply should coordinate exchange-rate policies to maintain an upper and lower limit on the euro price, say between $1.30 and $1.40. Over time, the band would be narrowed to a given rate. Further quantitative easing would be off the table.

With a fixed exchange rate, prices could move free from the scourge of sudden deflation and inflation, allowing investment horizons and planning timelines to expand along with production levels on both sides of the Atlantic. To supercharge the U.S. recovery, he also recommends permanently extending the Bush tax rates and lowering the corporate income tax rate to 15% from 35%.

Above all, he made it clear that the volatile exchange rate is the responsibility of the U.S. Treasury, not the central bank. Without a breakthrough on exchange rates, he predicted another dollar appreciation following QE2, resulting in a return to recession and a worsening of the U.S. debt crisis. This would likely lead to a third round of quantitative easing, continuing the dysfunctional cycle.

Criticize the Fed all you like, Mr. Mundell says, but the key to recovery is to stabilize the dollar at a healthy level relative to the euro. Given his stellar track record, it's worth asking: Is anyone in Washington listening?

Mr. Rushton edits The Supply Side blog.

Monday update.

On Forbes, John Tamny rebuts Paul Krugman’s claim that the world in running out of resources.

The NY Sun notes Sarah Palin’s appreciation for gold and other commodities.

On The Kudlow Report, Art Laffer discusses Illinois’s big tax increase:



At Asia Times, David Goldman says banks are increasing their holdings of Treasuries.

The Financial Times reports prices are rising across the world (hat tip: Jerry Bowyer).

On Bloomberg, Caroline Baum explains Keynesianism’s flaws.

When Obama talks about “growing the economy,” one can see the ghost of John Maynard Keynes rising from the grave. Lord Keynes, who developed the theory without coining the phrase, generally returns at times of economic crisis to advise the current occupant of the White House on how to borrow and spend our way to prosperity. Spending revives the economy, which reduces government transfer payments (unemployment compensation, for example) and raises tax revenues, according to Keynes’s theory.

In other words, the spending pays for itself.

“How marvelous is the Keynesian world!” wrote Henry Hazlitt in “The Failure of the ‘New Economics:’ An Analysis of the Keynesian Fallacies.” “The more you spend the more you save. The more you eat your cake, the more cake you have.”

From Voxeu, Barry Eichengreen examines the future of the dollar.

Rebelyid discusses the successes of supply-side economics.

Thursday round up.

At The Washington Post, Fed Chairman Bernanke justifies yesterday’s decision to add $600 billion to the economy.

The NY Sun editorializes that the dollar’s value will predict the fate of the Boehner Republicans.

On The WSJ, Dan Henninger argues Republicans should focus on economic growth over spending cuts:




At Asia Times, David Goldman outlines why quantitative easing won’t work.

On NRO, Larry Kudlow suggests stopping bad ideas may be the best outcome of the Republican House.

The WSJ editorializes against quantatative easing:

The Fed first tried QE, as it's called, with $1.75 trillion of bond purchases starting in December 2008, but that was at the height of the financial panic when markets were frozen. The Fed's justification for this current round is that inflation is too low and growth too slow to reduce unemployment. The Fed promised to buy $600 billion in bonds for starters, and to keep buying until the rate of inflation rises, presumably above its 2% target.

This is a terribly risky strategy for what we expect will be little economic gain. The Fed hopes the policy will have the effect of reducing long-term interest rates by 25 to 50 basis points or more, but the 10-year Treasury bond is already near historic lows. Marginal business borrowers aren't worried about the price of money; they're worried about the vagaries of economic policy. QE2 only adds to this uncertainty, as the Fed expands its role into fiscal policy and credit allocation.

Meanwhile, Mr. Bernanke's monetary cowbell will flow into higher commodity prices and other assets, perhaps leading to more bubbles. It has already caused havoc around the world, as investors flee the dollar for other currencies. Dollar-bloc countries are already seeing an increase in their price levels and several are contemplating capital controls.

In The Financial Times, U.S. Rep. Paul Ryan (WI) emphasizes growth – including sound money.

On The Kudlow Report, Brian Wesbury sees the Fed funds rate as too low and likely to lead to inflation:




At Forbes, Steve Forbes suggests provisions to change in Obamacare.

From the Mises Institute, Austrian Robert Murphy challenges "60 Minutes" on taxes.

Australia’s you.com discusses the effect of tax rates on the Rolling Stones (H/T: Greg Mankiw):

The Stones are famously tax-averse. I broach the subject with Keith in Camp X-Ray, as he calls his backstage lair. There is incense in the air and Ronnie Wood drifts in and out--it is, in other words, a perfect venue for such a discussion. "The whole business thing is predicated a lot on the tax laws," says Keith, Marlboro in one hand, vodka and juice in the other. "It's why we rehearse in Canada and not in the U.S. A lot of our astute moves have been basically keeping up with tax laws, where to go, where not to put it. Whether to sit on it or not. We left England because we'd be paying 98 cents on the dollar. We left, and they lost out. No taxes at all. I don't want to screw anybody out of anything, least of all the governments that I work with. We put 30% in holding until we sort it out." No wonder Keith chooses to live not in London, or even New York City, but in Weston, Conn.

Of course, it wasn't just the taxman's pinch that forced the Rolling Stones to focus on the bottom line. They also got screwed by record labels. "In the early days you got paid absolutely nothing," recalls Jagger. "The only people who earned money were the Beatles because they sold so many records."

Wednesday items.

On NRO, Larry Kudlow suggests the negative yield on inflation-adjusted securities is signaling inflation.

Cato’s Dan Griswold rebuts myths about free trade.

On Carpe Diem, Mark J. Perry explains that current account deficits are balanced by capital account surpluses:


At Café Hayek, Don Boudreaux defends free trade.

On Forbes, Brian Wesbury and Robert Stein argue bullish investments have been more profitable than bearish.

On The Kudlow Report, Don Luskin debates the Fed’s feint towards lighter than expected monetary stimulus:



The WSJ notes that low-tax states have better economies than high-tax states.

On Townhall, Thomas Sowell recalls past tax cutting successes.

On NRO, Michael Tanner urges Republicans to focus on deep, painful spending cuts.

Weekend items.

At The WSJ, Andrew Bratson worries a rising yuan could derail China’s progress.

Larry Kudlow sees rising gold signaling inflation.

At The Kudlow Report, Stephen Moore debates tax cuts.



At New World Economics, Nathan Lewis examines the service economy.

Economist blogger Will Wilkinson suggests claims of rising inequality are exaggerated.

At The Washington Post, Neil Irwin advocates a dose of inflation to improve the economy.

From August, Steve Forbes speaks on tax reform.



George Will discusses Fidel Castro’s recent comments on the Cuban economic model's failure.

From 2000, Jude Wanniski analyzes how to help Cuba transition to a market economy.

Monday update.

In Forbes, John Tamny sees housing weakness as key to economic recovery.

At MarketWatch, Andy Xie argues loose money in the developed economies will raise inflation in emerging markets, which will then flow to developed economies.

Cato's Alan Reynolds rebuts the idea that inflation is impossible due to high unemployment.

In The WSJ, Hong Kong official Julia Yeung highlights China's steps towards yuan convertibility.

On Fox News, Todd Buchholz believes stimulus spending has damaged the economy.

At Big Government, Dan Mitchell critiques CBO's economic model for ignoring incentives.

At Bloomberg, Kevin Hassett suggests Keynesianism is the real voodoo economics.

NRO's Kevin Williamson questions whether the lack of an inverted yield curve mean the economy is recovering.

At Cafe Hayek, Don Boudreaux explains how higher Social Security taxes impact employment.

Wednesday articles.

Robert Mundell hopes the yuan's rise is modest.

In The WSJ, Steve Hanke argues it's good Greece can't devalue its currency, and that it should solve its problems with tax cuts.

Nathan Lewis made a similar argument a couple months back.

Larry Kudlow predicts slow growth but not a double dip recession.

Richard Rahn explains that Keynesian spending does not lead to prosperity.

Fred Thompson interviews The WSJ’s Stephen Moore on the failure of Keynesianism.

Monetarist Allan H. Meltzer explains why Obamanomics isn't working.

TNR's Jonathan Chait suggests supply-side economics means permanent tax cuts with every recession, eventually leading to zero tax revenue. He misses that if supply-side policies were followed consistently, there would be many fewer recessions and a lot more growth.

NYT columnist David Leonhardt sees 1937 all over again.

At Marginal Revolution, Tyler Cowen says Leonhardt is wrong because his analysis omits monetary policy. I would add that Leonhardt and Cowen omit tariff and tax policy.

Hip Hop Republican urges Republicans to embrace Jack Kemp's urban enterprise zones.

The NYT links Ireland's recession to its austerity program. But was it the spending cuts or the tax increases that really did it in?

Paul Krugman notes the bond market is not behaving like inflation is a concern.

Media Matters for America disputes the claim that tax cuts stimulate growth.

Monday round up.

In The WSJ, Steve Forbes refutes Hillary Clinton's claim that the rich don't pay their fair share.

Larry Kudlow suggests lower spending is the road to economic growth.

John Tamny sees government accountability as a one-way street.

Don Luskin translates the FOMC's latest report.

Terence Corcoran points to pressure on China to raise the yuan as protectionist.

In Forbes, Reihan Salam predicts a slow-growth decade.

A Crains columnist reports on an Art Laffer speech.

Russ Roberts claims Hayek is more relevant today than Keynes.

Ambrose Evans-Pritchard expects inflation.

Friday items.

Larry Kudlow considers the Tea Party's influence.

Cato's Dan Mitchell expresses disappointment in Britain's tax increase.

At National Affairs, R. Gregory Mankiw examines the Obama Administration's response to the recession.

From 1995, the Freeman offers a summary of supply-side economics.

Humorist Merle Hazzard sings about inflation vs. deflation.

Barry Ritholz suggests supply-siders aren't good economic forecasters.

Youtube features a tribute to the late Jack Kemp, in which he says:

Every generation faces choices: hope or despair; to plan for scarcity or to embrace the possibilities. Societies throughout history believed they had reached the frontiers of human accomplishment. But in every age, those who trusted that divine spark of imagination discovered that vastly greater horizons still lay ahead.

Paul Krugman wants the yuan to appreciate faster.

Gary Andres analyzes the gusher of U.S. debt.

Heritage's Brian Riedl argues spending not tax cuts are to blame for the deficit.

Thursday items.

The WSJ editorializes against capital controls in Asia.

David Goldman thinks small businesses are in trouble.

John Tamny predicts foreign blowback on U.S. companies for BP's treatment.

Michael Barone says spending cutters are popular with voters.

WSJ editorialists discuss the Fed’s easy money policy.

The McKinsey journal analyzes growth in Africa.

From the archive, here's Jude Wanniski on poverty in Africa.

Fiscal Times argues growth isn't enough to eliminate deficits.

At NRO's Corner, Andrew Stuttaford hopes Germany will abandon the euro.

Wednesday round up.

At redblueamerica.com, janmb misrepresents Jude Wanniski’s Two Santa Claus Theory. While Wanniski did argue Republicans should cut taxes in that article, he did not advocate they spend “like drunken sailors and put it all on the national credit card.”

Larry Kudlow argues (with Dan Mitchell's help) that government salaries are part of the reason for the debt crisis.

At Wainwright Economics, John Tamny says the wealth gap is irrelevant.

At themoneyillusion.com, Scott Sumner comments on Steve Hanke's recent item on Estonia and Greece.

The Washington Post expresses surprise that markets still are willing to buy 10-year U.S. Treasury bonds at a 3.3 percent interest rate.

Contrary to conventional wisdom, most supply-siders believe deficits have less to do with interest rates than does the dollar’s value. Larry Kudlow made that point earlier this year.

Therefore, this Bruce Bartlett quote is something of a surprise:

"You can talk about the deficit until you're blue in the face, but we'll only get political traction on meaningful deficit reduction when there is economic pain being caused by the deficit in the form of inflation or high interest rates or both," said Bruce Bartlett, a Treasury Department official in the George H.W. Bush administration who recently wrote an article predicting that the U.S. government will be downgraded in less than a decade.

As Bartlett surely knows, deficits lead to inflation only to the extent monetary authorities choose to devalue the dollar to reduce the debt burden. That's a dishonest course, the stealth equivalent of a default, and it's the opposite of what Alexander Hamilton did after the War of Independence, when he committed the U.S. to repay its large debts in gold-backed dollars. The U.S. similarly committed to repay its enormous World War II debts in gold-backed dollars, which it financed at two percent.

The question is, with gold having risen for nine years and now at $1200, why aren't interest rates higher? Is it the flood of savings from the world's soon-to-be-retired, desperate for safe investments? A central bank Ponzi scheme? The zero Fed Funds Rate? All of the above?

Comments welcome.

Wednesday articles.

Larry Kudlow sees a new tea-party Senate nucleus forming.

Former Dallas Federal Reserve President Bob McTeer says there can be no inflation because money supply is flat.

More than a decade ago, supply-sider Jude Wanniski pointed out that focusing solely on money supply was a mistake.

Art Laffer argues the low-tax environment of Texas helped it weather the recession.

As noted below, Dave Ranson recently wrote at The Wall Street Journal on the futility of raising taxes. Here’s a similar recent analysis from Nathan Lewis.

David Goldman analyzes the foreign financing of U.S. fiscal deficits.

Tuesday rundown.

Mary Anastasia O'Grady describes Venezuela's monetary mayhem (Google the article by title and you'll find the complete text).

At New World Economics, Nathan Lewis explains why high levels of capital investment are vital even in a service economy.

Larry Kudlow says gold signals an unstable dollar and stagflation.

Brian Wesbury and Robert Stein predict inflation.

The Pragmatic Capitalist sees deflation in the dollar's forex rise.

John Tamny argues that bailouts and currency devaluation will have dire outcomes.

Joseph Calhoun analyzes the Greek crisis.