Fed up - replacing the current US monetary system with one that limits inflation

National Review, Oct 10, 1994 by Lawrence A. Kudlow

The Fed has too much else on its mind to be bothered controlling inflation. But that can be changed.

Bretton Woods is really a metaphor for gold and price stability," said Jack Kemp as he launched an Empower America conference commemorating the fiftieth anniversary of the postwar global monetary pact. Indeed, John Maynard Keynes, one of the architects of the Bretton Woods agreement, told the House of Lords that it was "the exact opposite" of a return to the classical gold standard.

Kemp - the only prominent national politician who understands the complexities of monetary policy - stopped way short of calling for a full return to the Bretton Woods system, wherein the dollar was convertible to gold at $35 per ounce and all other currencies were pegged to the dollar.

Instead, Kemp, who is poised to announce a 1996 presidential bid immediately following this year's elections, is searching for a new approach that will promote economic growth by ensuring low inflation, and hence low interest rates, as far as the eye can reasonably see. Often accused of being a big-government conservative, Kemp knows full well that the power of government finance ministries and their central banks is dwarfed by the awesome power of global financial markets, driven by high-tech information processing, where daily dollar transaction flows total well over $1 trillion.

The subject of money is a timely one, as the U.S. economy again shows signs of rising inflation. The producer price index has increased at a 4.5 per cent annual rate over the past three months, after remaining flat for all of last year. The consumer price index rose at a 3.7 per cent annual rate for the three months ending in August, following a 2.7 per cent 1993 performance. Anticipating inflation, long-term Treasury-bond yields have moved up to 7.7 per cent, compared to 5.75 per cent nearly a year ago. The Eurodollar market expects short-term rates, which are now just under 5 per cent, to rise to 5.75 per cent in December and 6.5 per cent by next June. The overall stock-market averages have not advanced since early this year, and inside the market over 70 per cent of the S&P 500 listings have fallen at least 20 per cent from their highest level. Gold is again flirting with $400, and gold stocks are one of the hottest performing groups. Broad commodity indexes are very bearish on the inflation outlook: the Journal of Commerce index of raw materials has risen at a 25 per cent annual rate over the past six months, and the Dow-Jones spot index is up 24 per cent from a year ago.

A Wobbly Model

Once Again a bout of inflation threatens to disrupt the economy. However, a return to the old Bretton Woods system is not the answer. Bretton Woods' creators, Keynes and Harry Dexter White, both believed strongly in the benign intervention of government and would not have understood any better than Bill Clinton and his wrecking crew that next-century economics will be driven by market action, not government action. (Not long after the Bretton Woods conference, White committed suicide rather than face charges that he was a Communist spy.)

At the Empower America conference, former Reagan Treasury economist Paul Craig Roberts presented a critique of Bretton Woods, reminding participants that it permitted many fluctuations and crises, especially from France and England. The signatories relied on exchange controls and tariffs to prevent sporadic outflows. Countries whose currencies had been weakened by anti-growth tax and regulatory policies were constantly borrowing to support their currencies, then would periodically throw in the towel and devalue anyway. In effect, any country could withdraw from the system at any time, without penalty or sanction.

Meanwhile, Bretton Woods' other offspring, the IMF and the World Bank, were ruining the economies of Africa and Latin America. The twin banks also - by expanding paper money through the creation of special draw-ing rights (SDRs) and by a flood of new lending - helped to promote global inflation. What is more, the leading central banks, especially the U.S. Federal Reserve, never explicitly recognized the domestic-monetary-policy link to Bretton Woods, which was necessary to preserve the $35-per-ounce gold ratio or the foreign-currency peg to the dollar. Indeed, it was the U.S. that inflated its way off the system, ringing the death knell in 1971, when the gold window was formally closed.

In short, neither the U.S. Government nor any other was able to maintain the necessary discipline. Supporters of Bretton Woods ascribe the beginning of 1970s inflation to 1971, when President Nixon formally terminated the system. In reality, the beginning of the end came in the middle 1960s, when the Fed created new dollars at a very rapid rate. Federal Reserve credit (consisting mainly of the central bank's portfolio of U.S. Treasury securities and loans to member banks) which is the source of monetary-base dollar creation, increased at a 10.7 per cent yearly rate between 1963 and 1968, double the pace of the previous five years. In response to this inflationary money growth, gold that was trading freely in the London market moved up from $35 to $43 per ounce, a 23 per cent rise, which correctly heralded the coming inflation. So did long-term Treasury yields, which moved up from 4 1/4 per cent to 7 1/2 per cent between 1965 and 1970. The U.S. inflation rate, which averaged 1.6 per cent a year for the five years up to 1964, promptly moved to a 5.4 per cent annualized pace for the four years to 1970. All this occurred before the Bretton Woods system expired in 1971.