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Peg to Gold, Cut Taxes

How to fix inflation & grow the economy? First beware the Volcker Myth...

PEOPLE ARE SLOWLY becoming aware that we have an inflation problem, writes Nathan Lewis for The Daily Reckoning – an inflation problem which seems to stretch around the world.

   Perhaps it is time to think about how to resolve it. But a few coy remarks by some Federal Reserve representatives aren't going to be effective. If that were all it took, then nobody would ever have an inflation problem.

   You would just say, "We are concerned about inflation" – echoing Ben Bernanke and Hank Paulson already this summer, and it would disappear – Poof! – like a cartoon genie.

   Sorry: not quite so easy. Inflation is in fact childishly simple to understand. But economists like to remain confused.

   When a currency loses value, markets gradually adjust to reflect this new development. When the Dollar's value falls in half, things that cost $10 eventually cost $20, more or less. It's no more complicated than that. The Dollar's decline, since it comes in the form of official government money, is best measured against something that's not official government currency – and so gold, for centuries considered a stable measure of value, offers a rigid yardstick.

   The Dollar is now worth about 1/900th of an ounce of gold, compared to about 1/350th on average during the 1980s and 1990s. You can do the maths yourself and figure out what this means for Dollar prices in the shops going forward. Conversely, if a currency remains stable – pegged to Gold, for example – then there can be no inflation of the money supply, whether an economy collapses (as in the early 1930s) or expands (as in the 1960s).

   One of the reasons why inflation went on so long in the 1970s is that people imagined that stopping the inflation would be very painful. I call it the Volcker Myth: that "we need a recession so horrible that it breaks the back of inflation." The power of this inflation myth was so intense, in effect, that people tried their hardest to make it come true, and the 1982 recession was the result.

   This inflation myth continues today with the idea that there is a "tradeoff" between inflation and growth. Baloney. Inflation is bad for economies, and a stable currency is good. You can't devalue yourself to prosperity. Nor can you recession yourself to a sound currency.

   Ronald Reagan took a different view. If inflation is bad for an economy – this had been fairly well proven by 1980 – then certainly stopping inflation must be good, right? Reagan's plan was to put the Dollar back on the gold standard in 1981, and also to cut taxes dramatically. The combination of sound money and a hefty tax cut would create lower interest rates and an economic boom.

   If sound money and lower taxes are good for an economy – and they most certainly are – then the result should be a better economy, not a worse one.

   This idea has been proven out many times since 1980, particularly in the former Soviet sphere. Over the past eight years or so, one country after another has stabilized their currencies and implemented amazing "flat tax" programs. Russia led the way with its 13% income tax in 2000. The result has been a tremendous economic advancement, with falling interest rates and expanding finance. Many of these countries are experiencing their biggest economic boom since before World War I.

   Unfortunately, Reagan's plan was a little too sunny for the American imagination circa 1980. For the election that year, Reagan recorded television commercials promising a gold standard, but they were never broadcast. Instead, the Fed undertook the "Monetarist experiment" in which short-term interest rates went as high as 18%. Instead of cutting taxes right away, the tax-cut plan was delayed until 1983, watered down, and phased in over years. Tax cuts might have got in the way of the plan to have "a recession so horrible that it breaks the back of inflation."

   Economists these days are madly, insanely, pathologically fascinated by interest-rate manipulation. They believe that, with a sufficiently high short-term interest rate target, inflation can be resolved. This rarely works. To solve the worsening inflation, in September 1973 Fed Chairman Arthur Burns went to an average Fed funds rate of 10.78%. It was a flop – the Dollar kept falling in value until late 1974. It was a flop in the long term as well, with inflation worsening until the early 1980s.

   Often, these high interest rate targets effectively cripple the economy, the currency falls even more, and inflation gets worse. Many Asian government found this out the hard way in 1997 and 1998, until they learned to ignore the IMF's bad advice.

   Low interest rates don't work either of course. But the Monetarist experiment stopped the 1970s devaluation trend only by producing such chaos and mayhem that it too was abandoned in 1982, after only three years.

   The solution to inflation isn't a recession. The solution is not high interest rates. Reagan had the right idea: peg the currency to Gold, and slash taxes to rev up the economy. The Russian 13% flat tax plan would do just fine. With this combo, the US economy could have the best economic boom since the last time the US enjoyed a gold standard and a big tax cut, which was 1964-1966.

   Or perhaps the Russian or Chinese governments will discover the high road to economic success – a gold standard and low taxes – leaving the US to destroy itself with cheap-money solutions.

   Eventually, central bankers are likely to respond to worsening inflation with rate hikes. The rate hikes will likely cause economic stress, but fail to solve the inflation problem. At this point, the central bankers will blame everything under the sun for the mysterious "stagflation", except themselves. It will become apparent that the central bankers are much better at producing excuses than solutions. Then the central bankers will be replaced.

   That is the point where the Reagan of the future will be able to step to the forefront. Cut taxes. Peg the currency to Gold. Enjoy the results.

Formerly a chief economist providing advice to institutional investors, Nathan Lewis now runs a private investing partnership in New York state. Published in the Financial Times, Asian Wall Street Journal, Huffington Post, Daily Yomiuri, The Daily Reckoning, Pravda, Forbes magazine, and by Dow Jones Newswires, he is also the author – with Addison Wiggin – of Gold: The Once and Future Money (John Wiley & Sons, 2007), as well as the essays and thoughts at New World Economics.

See the full archive of Nathan Lewis articles.

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