The Inflationary Adjustment Process
June 22, 2008
First, a currency falls in value. This is inflation. Then, markets adjust to the reality of this new currency value, via price adjustments. This is the inflationary price adjustment process, and it is well underway around the world now.
The decline in currency value is best shown by comparing the currency’s value to gold. Gold is the best measure of stable monetary value that we have, and in practice it works quite well. Over the past few years, the dollar has fallen against the euro, and the euro has risen against the dollar. These relative value changes are shown in the currency markets, but how have these currencies changed in absolute terms? If the dollar fell in value, but the euro was stable, we would expect to see inflationary pressures in the U.S., but not in Europe. In Europe, on balance, there would be competitive trade pressures due to the dollar’s devaluation, which would be labeled “deflationary” pressures but would actually be a result of inflation, namely the dollar devaluation. If the dollar was stable in value, but the euro rose, then we would expect to see deflationary pressures in Europe, but not so in the United States. This was the case in Japan after the yen rose from 250/dollar to around 120/dollar, after the Plaza Accord in 1985. Instead, we’re seeing inflationary pressures in the U.S., Europe, Japan, and indeed virtually every country on earth. This is evidence that all currencies have declined in value together, some a little more (the dollar) and some a little less (the euro). This is shown by the fact that all currencies have declined in value against gold.
Thus we see that gold once again serves as a stable measure of value. This is why gold standard systems work, and have worked for literally thousands of years.
Let’s say the dollar trades against the Mexican peso at 1:1. Let’s say there’s a Toyota truck manufactured in Oklahoma (but not in Mexico), that is for sale for $25,000 or 25,000 pesos. Then, the peso is devalued by 5x, so that it trades at five pesos to the dollar. Then, it would be reasonable to expect that the Toyota truck would soon sell for $25,000 and 125,000 pesos, as markets adjust to the new currency values. This price adjustment process might be relatively rapid, since there is no way to obtain the Toyota truck except to pay $25,000 for it, and to get $25,000 you need 125,000 pesos. (In practice, Toyota might sell the truck for less in Mexico and even take a loss to maintain market share, but you get the general idea.)
Now, let’s say that there’s a Toyota truck factory in Guadalajara, Mexico. Mexico devalues by 5x, so that the peso trades at 5:1. How might the price adjustment process work then? Since the Mexican workers’ salaries are also devalued along with the currency, the production cost of the truck declines. However, if there are imported components to the truck, then the peso prices of those would rise immediately. The factory (Mexican subsidiary of Toyota) might have debt denominated in pesos, which effectively disappear, reducing real costs. Depreciation reflects pre-devaluation prices. In short, the production cost of the truck would fall, so the factory could produce at a lower cost for some time. Thus, the peso price of the truck might rise to 50,000 pesos in the first year. However, over time, Mexican workers begin to agitate for higher wages to adjust for the fact that the currency they are paid in has been devalued. And, they might get a wage rise, because the factory can sell the truck for $25,000 or 125,000 pesos in the U.S., and make a big profit. Also, over time, fixed capital is replaced at post-devaluation prices. Eventually, prices reflect the reality of currency values, and the truck sells for 125,000 pesos and $25,000. However, in this case the adjustment process is longer, perhaps five years.
Now, consider a restaurant in Mexico City. Unlike the truck factory, the restaurant doesn’t sell its product in foreign markets. It doesn’t import materials from foreign markets. It is very much a domestic business. After the devaluation, the restaurant’s customers, ordinary Mexicans, can’t really pay more in nominal peso terms than they could before the devaluation. Maybe after the truck factory’s wages rise, the workers can spend a little more at the restaurant. Likewise, the restaurant can’t pay its workers and suppliers much more either, or it would not be profitable. So, the process of price adjustment for the restaurant, and its workers and suppliers, might be slower than that for the truck factory.
One thing you find in countries which experience chronic devaluation, like Mexico, is that people are very aware of the changes in currency values, and their implications. They know how the game is played. When they see the value of the peso drop from 1:1 to the dollar to 5:1, they immediately mark up sales prices. Workers immediately go to their employers and say “gimme 5x more pesos to make up for the currency devaluation.” They might not get their request, but they will make it. Suppliers immediately mark up their prices as much as they can. Thus, the price adjustment process is quick. In some countries, such as Turkey before 2001, where currency devaluation was essentially a constant affair, it is common to see prices adjusted to foreign exchange rates (the lira/euro rate in this case) on a daily basis.
Also, many small countries are heavily enmeshed in trade. The exports/GDP ratio might be 70%, compared to 10% for a large economy like the U.S. or Japan. In this case, both import and export prices would likely adjust to the currency devaluation immediately, which accelerates the whole price adjustment process.
Another thing you find in countries with a history of devaluation (which includes nearly all emerging market countries), is that contract lengths tend to be short. The last people who lent money for 10 years got screwed in the devaluation, getting paid back in a currency worth only 1/5th of its original value. Why take the chance? Debt maturities are short, often under two years. Likewise, other contracts such as leases, wage contracts or the like have provisions to adjust prices on short-term notice, or at the very least to be indexed to some government price statistic. All of this tends to speed up the price adjustment process.
In a country where currency devaluation is more unusual, often longer-term contracts are present. In the U.S., the 30yr fixed-rate mortgage is still the standard, while other countries use adjustable-rate mortgages almost exclusively. Likewise, whether formally or informally, other contracts such as wages or rent are expected to be relatively stable over time. What happens in a country like this in a devaluation? When the U.S. dollar is devalued by 5x, the U.S. truck factory worker doesn’t immediately demand a 5x increase in nominal wages. The truck manufacturer would like to increase the price by 5x, but they can’t, because their customers (the workers) haven’t enjoyed that kind of wage increase. Indeed, the workers’ needs haven’t increased that much themselves, as rent or mortgage payments haven’t gone up much either. The suppliers to the truck factory can’t put up their prices, because the truck maker hasn’t raised prices much yet. Thus, the suppliers’ workers won’t get wage increases either. The restaurant owner has a 10 year lease at a fixed rate, so he doesn’t have to put up his prices to reflect the increase in nominal rents post-devaluation until ten years have passed. The building owner doesn’t need to ask for more rent because his debts are also 10 year fixed-rate. Eventually, prices will reflect the decline in currency value, and the truck will sell for $125,000. However, this may take a long time. We see that the process of price adjustment can be different depending on the specifics of an economy.
I liken the price adjustment process to a large crowd of people who are shuffling from point A to point B while holding hands. We can imagine that the crowd would move slowly. The “holding hands” represents their relationships to each other. The worker would like to run point B (higher nominal wages reflecting devalution) immediately, but the worker has a relationship to the employer, who can’t raise wages until selling prices are also raised. The employer would like to run to point B (higher sellling prices reflecting devaluation), but can’t because the customers can’t afford it, and also the employer could be undercut on pricing by competitors whose own costs haven’t risen much yet. The competitors’ costs haven’t risen much yet because they have a 30yr lease at a fixed rate. Selling prices are raised a little bit, and then workers ask for a little higher wage, which allows them to pay a little more for things, so selling prices are increased a bit more, and so forth until everyone gets to point B eventually. Economist sometimes call this adjustment process the “wage-price spiral,” and have many pointless debates about whether prices are being “pushed by costs” or “pulled by wages.” It is all just part of the way that markets adjust to changes in currency value. There is never a risk of an inflationary “wage-price spiral” when currency values haven’t changed. (However, there is often real economic progress, which is accompanied by higher wages and higher prices. We are seeing this in China and Russia today.)
What happens when the dollar and peso are devalued by 5x together? Then the exchange rate remains 1:1 (you could say it is 5:5), but we would expect to see the truck sell eventually for $125,000 and 125,000 pesos. In this case, the foreign exchange rates wouldn’t change, so it would not be as evident to most people that currency values have changed. Thus, they would be less likely to act to adjust prices accordingly. The Mexican worker knows full well what to do when the peso drops to 5:1 from 1:1. Demand higher wages immediately! However, when both the dollar and peso decline together, it is not so obvious what to do. You could ask for higher wages … but then you would be less competitive against the U.S. workers, whose wages have also dropped. But corn prices have mysteriously risen by 5x, so let’s start complaining! The effects of currency devaluation are typically felt first in commodity prices, and over time, the pressure of increased prices there tends to catalyze the adjustment process throughout the economy. However, the process tends to be slower in this case. People aren’t quite sure what is going on. Why are oil prices rising? Is it a problem with production, or currency devaluation? Or both? After a while, they figure it out, and the adjustment process tends to accelerate. “Hey, this is all just monetary inflation! Let’s demand higher wages/prices/rents/yields to compensate.” Economists really hate it when people figure out that their currency has been devalued. That’s when they start pointing fingers at the central bank. That’s when the comfy economic effects of inflation — the artificial high of currency manipulation — start to wear off. Thus, the worst fear for economists and central bankers seems not to be inflation per se, but “inflationary psychology.”
Based on this theory, what would we expect to see today? Virtually all currencies have fallen against gold, so there would tend to be inflationary pressures in all economies. Check. Those economies which tend to adjust faster to currency devaluation (emerging markets) would tend to show more price rises. Check. “Inflationary psychology” is slowly kicking in, along with a tendency towards a “wage-price spiral.” Check.
Actually, many emerging market currencies have fallen less against gold than the dollar, so there is actually less inflation in the pipeline there than in the U.S. When prices rise faster, the adjustment process is over sooner. I am sure there will be an effort to blame emerging markets for inflation in the future, but actually emerging market central banks have been relatively more responsible than our own Federal Reserve.
Where is all this going? During the 1980s and 1990s, the U.S. dollar wobbled around but had an average value of about $350/oz. of gold. Today, it’s about $900/oz. That a 2.57:1 devaluation. Let’s round up and call that a 3:1 devaluation. Thus, we would expect prices to rise 200% from their 1990s levels to reflect this inflationary adjustment process. It’s already baked in the cake. However, this process will be quite slow. In reality, prices won’t rise exactly 200%. Some things will be cheaper in real terms. I would imagine computer hard disk space will get ever cheaper. Perhaps real wages will decline, as is typical during and after an inflation. Some things might be more expensive in real terms, and fossil fuels seem to be a good candidate for that. I suspect the dollar’s value will continue to decline, and that currencies around the world will also fall in value, though perhaps not so much as the dollar.
Gold remains the world’s best measure of monetary value. Just look at how much a currency’s value has declined against gold, and you will understand what is likely to turn up in headlines for the next few years.
You will also understand the ultimate solution to these problems: when a currency is pegged to gold, monetary inflation is not an issue. That’s why the British government was able to issue bonds at 3.5% and infinite maturity during the 18th and 19th centuries. No fiat currency, and certainly none of today’s central banks, has ever matched that kind of performance.
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Eventually, people are going to get so fed up enough with today’s monetary silliness, and the stupid explanations given by academic economists, that they will start to look for alternatives. The ultimate solution is, of course, a gold standard. It is the only solution that, historically, been permanent — which does not create still further problems which cause a search for new solutions. A few people have begun to pop up with comments on this theme.
Amity Shlaes (who read my book) appeared in the Wall Street Journal with an oped on June 5, called “Contracts as Good as Gold”.
Gene Epstein of Barron’s wrote a two-part series in February called “Greenspan was right: the Case For Gold”
Unfortunately, these opeds tend to suffer from the usual argle-bargle common today. It seems that nobody can talk about gold in plain terms.
Benn Steil is a “Senior Fellow and Director of International Economics at the Council on Foreign Relations in New York.” He gave a talk on gold and the gold standard called “Is the Dollar Doomed,” at a resource conference in May 2008.
Here is Joseph Salerno, an Austrian type, who turned up for an interview on CNN.
Here is Hossein Askari, a professor at George Washington University, and Noureddine Krichene, an economist with the Internationl Monetary Fund, to talk about a world currency linked to gold. Of course, nobody really needs a world currency, with a world central bank. I think the “gold” part is just a way to sell people on the world currency idea, which is a bad idea if you ask me. Gold is already the world’s currency, and anyone can participate in the world gold standard unilaterally. The fact that no government does so today doesn’t change that fact.
Judging by these offerings, I think there is still a learning process that needs to take place. A gold standard system set up by any of these people would likely run into problems, because I don’t think they understand the theory and operating mechanisms well. Mistakes would be made. Good intentions alone are not enough.
The crux of the matter is simplicity itself: gold is stable in value, so a currency pegged to gold is stable in value. The currency is pegged via some automatic base money supply adjustment process, much like a currency board operates. Everything else is complications and distractions.
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