David Ranson and Penny Russell: Money meltdown

By David Ranson and Penny Russell
The Wall Street Journal
Thursday, July 5, 2007

Interest rates are on the rise in the Eurozone, Great Britain, and Japan, as well as in India and China. But the Federal Reserve has again elected to keep its target rate on hold despite repeated assertions that inflation risk is still its predominant concern. Are central banks abroad recognizing a threat that their American counterpart has yet to acknowledge?

The Fed seems to believe that inflation has something to do with "excessive" demand. Although it admits that inflation is already running at an unacceptable pace, the majority of its policy officials cling to the belief (or hope) that the U.S. economy is slowing down, alleviating the inflation threat. Both of these assumptions are inconsistent with historical evidence.

What's more, the recent rise in the euro and sterling relative to the dollar has obscured the fact that the world economy has embarked on another classic "run" on paper currencies that is driving inflation up everywhere. For several years now, as was the case in the 1970s, all the world's currencies have been depreciating relative to stable benchmarks such as gold. Since the end of 2001, these declines have ranged from 38% (in the case of the euro) to nearly 60% (in the case of the dollar).

Why then has the pace of consumer-price inflation to date been so much less noteworthy than the pace of currency depreciation against gold? The answer lies in the timing: Gold is a fast-moving leading indicator, whereas consumer-price indices are slow-moving indicators that lag far behind. We all learned in the period between 1975 and 1985 that consumer prices do eventually catch up. It is the size of the move in the gold price, rather than in the consumer price index, that is a true and timely indicator of the magnitude of the inflation problem.

In 1975 Yale economist Richard Cooper described the process that now appears to be driving world inflation as "a general loss of confidence in money, a psychological mood that can be transmitted across national boundaries ... [that will] lead individuals to try to convert their assets into physical form: goods or housing or real estate."

But why does this phenomenon break out at some times and not at others? Why is it sometimes local and sometimes global? History provides the answer. Following World War II, rapidly rising prices began to be accepted as an inevitable -- even "normal" -- fact of life. But in reality, up to and including the 19th century, significant inflation had been the exception rather than the rule. And when it did occur it was usually local rather than global. In the United States, for example, cumulative consumer-price inflation was zero from 1820 to 1913, just prior to World War I. In the United Kingdom, consumer prices were lower at the beginning of World War II than they had been in 1800. In England the prices of consumables rose at an average annual rate of less than 0.4% over the centuries-long run between 1210 and 1940.

Against this relatively stable background, inflation erupted when nations faced acute fiscal stress, particularly in times of all-out war. A government that lost a war of survival typically saw the value of its paper currency evaporate to zero. In the final stages of this process, hyperinflation and astronomical interest rates accompanied economic chaos. The defeated government either did not survive (such as the Confederacy in 1865) or had to be rescued from its currency crisis by the victors (as in Germany and Austria in 1923 and Germany and Japan after 1945). Even the winners of all-out wars, especially those that emerged seriously impoverished (such as Britain in 1945), resorted to currency devaluations and suffered high inflation as a result.

In all cases, inflation was related to the inability or unwillingness of the governing authorities to maintain a stable currency in times of war-related government spending and debt. Although we are not entirely at peace today, U.S. military activity is at nothing like the all-out scale from 1917-1918 or 1941-1945. So why are we having an inflation problem, and why is it global in scope? There are two culprits.

First, since 1971 no government has made an attempt to fix the gold value of its currency, and every political initiative that raises long-term government spending leaves the financial markets free to price currencies at a lower gold value. Depreciation of currencies relative to gold has become unpredictable, chronic, and planet-wide.

Second, the massive increase in the public-sector share of the economy that occurred in World War II (and was reinvigorated in the late 1960s) has become permanent. In place of war-related debt, public finance is now saddled with long-range government spending commitments, including burgeoning debt in the form of unfunded liabilities associated with national pensions and health insurance. The popular notion that inflation is the way politicians reduce public debt without formally abrogating it is not far from the truth. In a nutshell, inflation is a manifestation of looming government insolvency.

This problem vastly overshadows the federal budget deficits with which Washington is obsessed. The military costs of the "war on terror" and the Iraq conflict are mere addenda to a mountain of obligations, which financial markets are warning that the federal government can discharge only by inflating away.

Not that the other world economies are in any better fiscal shape than America's. In fact, throughout the 20th century, the United States has been a sort of lender of last resort. If we had not been on the scene in 1923, who else could have underwritten a new and viable currency for Weimar Germany? Though in recent times our allies in North America and Europe have been less warlike than we are, they long ago adopted much more generous social "safety nets" and thereby undermined their long-term solvency to an even greater degree than here.

Inflation was negative following the Civil War, when the price of gold fell back to its pre-war parity. Inflation was likewise low after World War I when the price of gold remained fixed. In contrast, inflation charged ahead after World War II as the market price of gold was permitted to rise. Broadly speaking, although a rise in the price of gold is a sufficient condition for consumer-price inflation, it is not entirely necessary. The shortages that occur in a widespread war (such as World War I) may be sufficient to push up the price level, despite price controls and adherence to the gold standard.

Inflation is not intrinsically global -- it is obvious that some countries experience more inflation than others. But currencies depreciating against gold across the board is a sign of worldwide inflation -- and it has begun to set off alarm bells in many major economic capitals. But in Washington, our own central bankers remain placidly confident that everything will turn out all right.

Unsustainable peacetime spending is a much slower process than the unsustainable war spending. Far from sudden death, currencies these days are facing death by a thousand cuts. The unfortunate result is that the current crisis of confidence in paper money goes largely undiagnosed by the bulk of economists and policy makers.

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Mr. Ranson and Ms. Russell are principals of H. C. Wainwright & Co. Economics.

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