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Consumer prices confuse the above definitions with commentary suggesting there’s inflation when they rise, and deflation when they fall. In truth, market prices are simply the intersection of supply and demand expressed in money. If you consider Say’s Law, which expresses the idea that one man essentially pays for another’s production with his own, a farmer could barter four cows for a sedan, should the dealer be so inclined; but the usual arrangement is to sell the cows for, say, $20,000 and buy a car with the money. Raising the cows and building the automobile is going to require the same amount of effort and material for considerable periods of time in this case.

Once you plug dollars into the trade, what we call price in everyday usage can change when the value of money does. This is where misunderstandings arise. When the dollar falls 10%, the price of the car is going to rise 10% at some point, so people will say it is more expensive even when it takes the same amount of time and material as before. This is something more and more Americans are becoming aware of as the dollar falls in the foreign exchange markets. An automobile manufactured overseas would be rising in price as fast as the dollar was falling. That may not be reflected in the selling price immediately, as companies try to hold market share, but it is obvious in the dollar’s relationship with the manufacturing country’s currency.

Inflation is controlled by monetary policy, which is usually a nation’s way of dealing with its own money. Fiscal policy, on the other hand, deals with non-monetary actions of government, such as spending and taxation. Over the millennia, a workable balance was struck using precious metals, gold and silver, which could be minted into coins of a specified weight and purity for ease of use.

In the nineteenth century paper money began to come into general use and caused people to examine its relationship to the precious metals they were used to using. It is, after all, far easier to use in commerce. At first, it was essentially a warehouse receipt and evolved from there using convertibility into the metals as a “money-back guarantee”: if you didn’t like the paper money, you could return it to the bank for gold or silver. The key move was really the founding of the Bank of England in 1694, which made the country’s finances transparent as Parliament received its creation as a concession from the king to fund his borrowing. With fiscal policy visible and a private-sector institution with essentially a monopoly on printing money, monetary policy entered the modern age. No sooner had this occurred than the wars against France intensified, culminating in the Napoleonic Wars ending at Waterloo in 1815. The latter were so severe that gold convertibility was suspended until 1821.

In any case, Britain had a better monetary reputation than France. As a result, it could borrow much more on the implied promise of returning to the gold standard. The policies during those wars did send prices much higher, and there was a period of recession as the government returned the price level to its prewar standard.

So, in some ways, things haven’t really changed all that much. The public is still trying to find a way to hang on to what it earns, and the central government has its own requirements. Linking money to an outside reference point, which became gold pretty much universally in the 1870’s, allowed both sides to see what was happening. If the issuer was too loose, people would bring their bills in for gold, and the monetary authority would lose some of its ability to issue money based on gold. That is the easy way to see what monetary and fiscal policy do. Today the Fed has linked the value of the dollar to interest rates, which means it ends up trying to control the economy rather than the value of money.

Instead of letting markets tackle what remains a small problem, Paulson has carved out what he deems “an appropriate role for government” to bring the private sector together in hopes of “achieving beneficial solutions for all parties involved.” What’s missed here is that if beneficial solutions actually exist, private interests very much driven by market signals would be the first to know what these are, and would act accordingly.

In describing his three-part plan to fix the alleged housing crisis, Paulson states that “we will need an aggressive, systematic approach to fast-track able borrowers into a refinance or mortgage modification.” He adds that this, part-three of his plan, will not “include spending taxpayer money on funding or subsidies for industry participants or homeowners.” Perhaps it won’t, but pity the poor shareholders who do pay taxes, and who will see their government craft another way to fleece them through reduced mortgage payouts in order to fix something that may have electoral implications in 2008. One can only wonder how many financially sound homeowners will “fast-track” themselves into what Paulson deems “mortgage modification;” all this with the blessing of the federal government.

Furthermore, taxpayers certainly fund Paulson’s Treasury along with the Department of Housing and Urban Development(HUD). Both entities got together to form HOPE NOW, which includes a nationwide letter campaign to inform mortgage holders of looming payment resets, HOPE NOW servicers trained to contact those with resets in their future, plus a 24-hour, toll-free number for homeowners to call that will “provide vital mortgage counseling in multiple languages.” Paulson adds that the Bush Administration has “requested funding for NeighborWorks America and other non-profit mortgage counseling operations,” not to mention the HUD-initiated “FHASecure” so that “an estimated 240,000 families can avoid foreclosure by refinancing their mortgages under the FHASecure plan.” So much for responsible taxpayers avoiding paying for the mistakes of others.

If we ignore the extra-constitutional nature of all of the above activity, governmental efforts to help the financially strapped might be a little less offensive if the federal government wasn’t already seriously immersed in the subsidization of those who’ve chosen homeownership. But in reality, homeowners already receive a tax deduction on the mortgage interest they pay, for the most part are able to sell their houses free of capital gains taxes, plus quasi-governmental agencies Fannie Mae and Freddie Mac provide a liquid market for the very mortgages that enable ownership to begin with. Paulson wrings his hands over the potential negative economic implications of a housing slowdown, but in concentrating on the “seen,” he ignores the “unseen;” particularly what the economy might look like if taxpayers weren’t forced to fund the “noble” intentions of politicians on both sides of the aisle when it comes to offering the dream of homeownership on the backs of others.

To talk about the “moral hazard” involved when it comes to the federal government protecting homebuyers from all manner of market uncertainty is at this point stating the obvious. Scarier perhaps are the long-term economic distortions that will reveal themselves thanks to a political class seemingly willing to do anything to prop up the housing market.

Memory says equity investors caught by a bear market earlier in this decade weren’t coddled as much, and as such, the message presently being sent to investors is to park cash in property as opposed to stocks. Innocuous at first, until we consider that tomorrow’s entrepreneurs are fully reliant on the savings of others. Simply put, capital invested in property is just that, as opposed to savings and investment that fund the various established firms and entrepreneurial concepts that employ us. If allegedly benevolent politicians make housing sacrosanct such that market uncertainty is a thing of the past, this will eventually materialize in tighter credit for the commercial entities in our midst that create real wealth.

In his speech on Monday, Henry Paulson said, “Nothing is worse than doing nothing.” That may be true in the private sector, but when the government seeks to do something, particularly with elections near, the citizenry should be wary.

As 2007 began, the Fed stopped injecting new funds into the economy as had been done throughout the period of consecutive hikes in the funds rate, and actually drained funds on net for the first half of the year. Difficulties in funding commercial paper rollovers became apparent to the Fed in August, prompting emergency injection of $39 billion in temporary funds. However, despite the Fed’s increase in those temporary funds to about $47 billion in November, the relief initially apparent in credit markets reversed and, in the last week of November, commercial paper again dried up as a source of capital for businesses, even to the point of sucking up and collapsing debt already existing and financed by paper due for rollover.

Former Governor Angell’s Proposal

On November 29, these concerns persuaded former Fed governor Wayne Angell to urge on CNBC’s Kudlow & Co. that the FOMC should cut the funds rate by a full 1% (100 basis points), and should couple that action with a firm public commitment to strengthen and stabilize the dollar. Angell’s prognosis was immediately echoed by Arthur B. Laffer and praised by CNBC’s Steve Liesman, who effused that he had favored such actions for weeks.

Angell’s shift from previous opposition to a further cut in the funds rate at the December FOMC meeting is significant in two primary respects. It tacitly acknowledges that Fed funds rate management is at fault for the credit strains now imperiling economic growth. More importantly, it acknowledges that the Fed is capable of cutting the funds rate sharply while still acting to strengthen and stabilize the dollar. This implies that the funds rate is not the valve that controls liquidity or the strength of the dollar, a conclusion I have expressed previously.

Free the Dollar from the Funds Rate

The important further implication is that the Fed need not manage domestic interest rates to manage the dollar. The fact that the Fed insists upon manipulating the funds rate despite the damage caused indicates other unstated purposes for its conduct.

Even Angell’s proposed cut of 1 percent in the funds rate on December 11 is unlikely to relieve credit market strains produced by the inverted yield curve. The yield curve probably would remain partially inverted, as the funds rate would be higher than the market judges overnight funds are worth. The overnight funds rate ought to be allowed to “float” to the level assigned by market judgment so banks and other lenders can begin again to provide the credit demanded by economic growth.

So long as the Fed continues to state an overnight funds rate “target,” the Fed will remain behind and out-of-step with the yield curve, producing credit strains that the market cannot always overcome. The Fed ought to free the markets to set the funds rate, then promptly announce, as Wayne Angell proposes, that the Fed will focus on strengthening, then stabilizing, the dollar’s value. ~

Angela runs a small provisions shop in the city. For her business, she has many financing needs from working capital to longer-term investments. Luckily there is a Micro Finance Institution nearby which she uses. Yet she only uses it to finance a part of her needs. For the remainder, she chooses to use the money-lender who charges a much higher rate, even though she could borrow more from the Micro Finance Institution. When asked why, she responds that she likes the money-lender’s “flexibility”, in that she can skip payments during the hardest weeks.

We feel these two examples illustrate how, despite years of stunning growth, Micro Finance Institutions still fulfil only a small fraction of the financial needs of the poor.

Being poor is not just about having too little income. It is about having insecure income. The income of the poor can vary dramatically from day to day, month to month, season to season. Contrast this with the single most salient fact of micro-finance: nearly all contracts are fixed in their repayment schedules. This mismatch between debt payments and income can create serious distortions. Are these distortions inevitable? The implicit presumption is that they are. Many good reasons have been articulated for using fixed debt contracts.

First, a flexible payment stream may generate many operational headaches. For instance, portfolio monitoring requires clear information on default status. It may be difficult (or impossible) to distinguish between someone exercising their flexibility and someone intending to default further. The faster that lenders deal with default, it is often believed, the better they are able to recover the loans. Furthermore, depending on how the flexibility was structured, it could cause confusion in the field. It is easier to train staff to collect equal and constant weekly payments. The flexibility should be such that staff can easily understand and implement it.

Second, cash management problems may arise. If clients experience correlated shocks (e.g., floods or droughts), they may (should!) use the flexibility to help smooth out those shocks. This has implications to the lender, if they are seeing a shortfall in repayment at the exact moments they want to have more cash on hand to lend to individuals.

Third, flexibility may put the lender at risk of loan-officer fraud. The loan officer, for instance, can claim that the client exercised their “flexibility” when in fact they repaid. Proper internal controls should be able to mitigate this risk, but it is an impediment nonetheless.

Lastly, varying contracts might weaken the repayment discipline of borrowers. Some argue that the key difference between debt programs and savings programs is that debt provides a commitment to make weekly payments, whereas with savings there is no such commitment. Thus this is one reason ROSCAs and chit funds exist, to provide individuals a commitment to save. If the debt requirement allows some flexibility, some fear this will erode the repayment discipline. Borrowers may forget which weeks to pay and which not, or find it hard to turn on and off the habit of putting money aside to pay the loan. Either way, the fear is that having a few weeks off will lead to lower repayment when the payments are required.

These costs of flexible contracts are often better articulated than the benefits. Yet qualitatively, the benefits could be huge.

First, rigid contracts may greatly constrain loan size. If I earn 50Rs some weeks and 550Rs other weeks, my debt capacity is not based on my average income of 300Rs but on the 50Rs that I can afford to pay in the bad weeks. As a result, borrowers with variable income and little means outside of money-lenders to smooth that variability will be given a debt capacity much lower than ideal.

Second, flexibility can actually save on loan-officer time. If every monsoon, we know clients have a tough time paying, might it not be more cost-effective to have lower or less frequent payments during that period rather than use valuable loan-officer time to chase down “delinquent” clients?

Third, the rigidity of contracts may effectively be keeping some lucrative borrowers from borrowing. Client retention is an issue for many Micro Finance Institutions. Perhaps many leave because they experience too many “close calls”, and then drop out in order to avoid going into default. Or perhaps out of this fear, they never join in the first place. Thus flexibility may increase client retention and help attract more clients. Ironically, these clients who leave, or never join, because of fear of default are dream clients for the Micro Finance Institution. They are clients of such strong integrity that they refuse to borrow for fear of defaulting.

Finally, flexible contracts may greatly increase the impact of the loan. Clients with rigid contracts may take actions which reduce the return on their investments. Owners of milk animals may under-feed during difficult times. Asset owners may sell off (productive) assets to repay debts. Flexibility would prevent the destruction of this value and could be as useful as the initial loan itself. Relatedly, this increased income could actually allow the Micro Finance Institution to further increase loan size.

Given these benefits, how can we practically implement flexibility in the current micro-finance structure? We give three examples, each highlighting a different element of flexibility.
First, we observe that flexibility can be pre-built into the contract. For example, the monsoon is a difficult time for everyone. Contracts could reflect this by reducing payments during this period in a pre-specified manner. Similarly, dairy farmers face two months a year without milk. Again, the contract could pre-specify a smaller loan during this period. Pre-specification of flexibility has many benefits. Notably, the client does not feel that they can negotiate down other payments. The flexibility is not after the fact. It is actually a “rigid” flexibility, with tightly delineated rules. As a result, it also eases concerns of MIS, cash management and loan-officer fraud.

Second, one could provide less rigid flexibility by pre-specifying a number of low payment periods, but not their timing. For example, one could give clients several tokens and tell them that each token can count for one weekly payment. In this way, the client agrees to a slightly higher payment each week in return for getting a few difficult weeks (of their own choosing) off. Again, the creation of a token ought to ease the logistical problems of MIS, cash management and fraud. Yet it still provides the borrower a great deal of flexibility.

Finally, consider a Micro Finance Institution which feels that their borrowers could handle loans that are 2,000Rs higher than they currently receive. Should they just increase the initial loan size? What if instead they told all borrowers that they would be eligible for a 2,000Rs second loan, at any point during the cycle? This second loan might actually help the client more than simply increasing the initial loan by 2,000Rs, since it gives the client a safety valve in case of emergencies.

Will these products work? Will operational hurdles prevent them from working? Will they erode repayment discipline and increase default? Or will they allow for much larger loan sizes and greater client income growth? We simply do not know. A common retort is that borrowers can use other sources of income or debt to fill in the gaps. This misses the basic point about the financial policy for the poor: these alternatives either do not exist or are very expensive. Why cede this important and potentially lucrative financial service without ever testing the waters? There is only way to know if microfinance can be more flexible: to test flexibility.

Much remains unknown in microfinance. We focus here on one issue in particular: the flexibility or rigidity of debt products. Nearly everyone feels they know how to structure a microfinance loan. Yet everyone differs on the answer. We label these as unknown not because nobody knows the answer but because we all “know” different answers. The goal of our research around the world, as with the Innovations for Poverty Action, the Financial Access Initiative, and the MIT Jameel Poverty Action Lab, is to bring about consensus about the circumstances under which different products and features and services are optimal for clients and institutions.

For a clue to the answer, consider Keynesian commentary published in Taipei Times authored by respected professor of economics at the University of California (Berkeley), J. Bradford DeLong. His commentary begins with this title and sub-title: “IS THE DOLLAR LEADING US INTO A DEPRESSION? A fallen greenback could mean economic turmoil, or … economic crisis. Economists are having trouble predicting the outcome because investors are not behaving rationally.” Psst, professor, your slip in respect for free markets is showing.

Those Pesky, Irrational Investors

At the outset, professor DeLong would benefit by honoring, as all economists should, the first rule of poker players: when all others at the table are acting irrationally, re-check your hole card. The fault may lie not in our investors, but in our economists.

DeLong observes that the falling dollar is causing “profound global macro-economic distress,” putting the world economy at risk. He posits that, if investors expect the dollar’s fall to continue, they will flee the currency, causing interest rates to soar and recession to follow. On the other hand, he reasons, if investors think the dollar will fall no more or even rise, interest rates can remain low and economic growth relatively robust. DeLong says so far there are “no signs” other than market volatility that investors think the dollar will continue to fall, and opines that this may be “wishful thinking” because the “… still-large current account deficit guarantees that the dollar will continue to fall.” (Emphasis added.) He shakes his head that he and fellow economists cannot understand why “typical investor[s] … have not taken steps to protect themselves … against the very likely US dollar decline in our future.”

Funny thing, though. On May 1, 2007, Fed chairman Ben S. Bernanke, in a speech enunciating the close relationship between open international trade and prosperity, said “the existence of a trade deficit or surplus, by itself, does not have any evident effect on the level of employment.” Bernanke emphasized that “… willingness to trade freely with the world is indeed an essential source of our prosperity.” These observations are at odds with DeLong’s view that the U. S. current account deficit guarantees the dollar’s continued fall and economic crisis. Current account deficits coexist with prosperity for long periods, portending calamity only in Keynesian theory.

The Problem Is Bad Policy

DeLong’s comments illustrate Keynesians’ approach to economic crises produced by their own policy. He observes the crisis and ponders why private parties fail to protect themselves from inevitable collapse.

Why not step back and examine the doctrine that produces dollar devaluation and a potentially cataclysmic outcome, rather than summarily dooming the public to live (or die) with that outcome? A continuously deteriorating dollar is not an inevitable result of the U. S. current account deficit, any more than was the overly strong dollar produced by the Federal Reserve during 1997-2002.

Relative to gold, the dollar is presently worth less than one-third of its 1999 value. The dollar’s extreme swings in value are caused by Fed operations. The FOMC manipulates domestic interest rates to assist price-fixing of bank credit costs. Simultaneously, the Fed issues instructions to the New York Fed’s open market desk to inject or drain liquidity without a guideline for the dollar’s value except foreign exchange rates. In 1997-2002, the Fed was far too stingy with liquidity, and in 2005-2007, too generous. In both periods, the Fed set credit costs too high, favoring banks.

Forex rates are dependent both on the dollar’s value and on the results of foreign central bank practices with their own currencies. Each foreign bank attempts to maintain parity with the dollar so as to remain competitive in the U. S. market, following a falling dollar downhill and a rising dollar uphill. Thus, forex rates are chaotic, unhelpful measures of the dollar’s health.

The Dollar’s Fall Was (And Is) Planned

The concern for a sharp fall in the dollar is real, considering current Fed practices that continue to weaken the currency. However, foreign capital continues to flow into the U. S. for an entirely rational reason, even considering existing Fed policy. No other currency presently enjoys national security capable of defending it from foreign aggressors. In that circumstance, any alternative currency can be attractive relative to the dollar only until the U. S. is no longer able or willing to defend it. This does not excuse bad U. S. monetary policy. Under present circumstances, which may be fleeting, national security pre-eminence overcomes flawed economic policy.

Reasoning that the current account deficit makes a weak dollar inevitable suggests that the weak dollar is intended – not accidental. Why? Because devalued currency is prescribed by DeLong and other Keynesians as the cure for current account deficits. Thus, a continuation of the dollar’s fall is “inevitable” only in the sense of inevitability the Fed will follow Keynesian advice. Economic calamity can result from debasement of the currency, but would be the fault of Keynesians at the helm rather than deficit in the current account.

The Solution is Monetary Policy Reform

Having already diagnosed the ailments of DeLong’s analysis, we have at hand the best remedy for the weak dollar. The twin scourges of severe credit strains and weak dollar can be relieved by dual responses. Credit strains are curable by floating the overnight funds rate to allow a normal yield curve, thereby enabling credit to flow to economic growth as determined by the market. Robust health can be restored to the dollar, eliminating inflation, if the Fed manages liquidity towards a stated gold price value for the dollar. This reformed U. S. monetary policy would delight every foreign user of dollars, including producers of all goods and commodities, as well as every investor in U. S. equities and bonds.

With such a positive outcome, we could stop worrying about the rationality of investors and economists, not to mention the looming economic turmoil and crisis Keynesians now foresee. ~

This seeming digression from our world of free‐floating currencies should remind us that the most important currencies were linked through gold in the nineteenth century, into WWI really. Even more interesting, they were not linked to each other in any official way. Britain was the biggest economic power of the time and simply agreed to redeem Bank of England notes, currency, for gold on demand. The U.S. Treasury did essentially the same thing, although silver came and went as money. It is vital for us to realize that a country could take a strong monetary position all by itself.

While gold was chosen for a lot of reasons, including a mistake by Sir Isaac Newton as Master of the Mint in valuing gold, the fact that England was willing to maintain convertibly no matter what, made London the world's financial headquarters in the nineteenth century. The decision to return to the gold standard after the Napoleonic Wars may not have been motivated by commercial and competitive concerns, but it certainly had powerful effects in that area. The lesson for us today has to be how England did that. Conventional wisdom in Washington seems to be that devaluing a currency is good for exports. In that case, Britain should not have been able to dominate international trade for a century the way she did.

London did become the center of finance because international investors felt comfortable that their money would be safe from depreciation there. Supposedly, every time there was a riot in Paris, more money flowed to England. The reason was the customer came first. Sound money and property rights led the development of the core capitalist concept of moving money from people who have it to those who don’t, but who do have a good idea. Property rights may be obvious, but a stable currency is essential to entrepreneurs who make long-term committments to commerical concepts.

In the U.S., British success showed up in the form of imported capital from London where the returns stateside were higher in what was and still may be a developing country. Rates were low in London, because the pound was stable, which made it easier for businesses during the Industrial Revolution to finance capital investment and improve productivity. That led to greater profits and money to invest in the U.S. Of course, the money invested in America created a trade deficit as imports from Britain became cheaper, and the "deficit" was balanced by the capital invested here.

What the British taught us is that we can have a stable currency, imports and exports, and impressive economic growth with the rising living standards it brings by treating investors of all kinds with respect. So, when you contemplate where the coffee you’re about to buy came from, remember that the cultivation, distribution and delivery of those beans was made possible by some fundamental monetary decisions made long ago, history that could teach us something even today.

For evidence of this, we can look to changes in the gold price itself in dollars, British pounds and euros since 2001. Many have suggested that Chinese and Indian demand for luxury baubles explains gold’s impressive rise in recent years, but when we look at gold in the aforementioned currencies, a different story emerges. While gold has risen 87 percent and 112 percent in euros and pounds since the summer of 2001, it has risen 192 percent in dollars. To gold watchers, and beyond that those who view inflation as monetary in nature, gold’s substantial rise in dollars is first-order evidence of an inflation in our midst.

By the spring of 2004 gold was bouncing around in the high $300/low $400 range, at which point an informal debate began among various free-market commentators about how this incipient inflation should be arrested. Though there was general agreement that the dollar’s fall (and gold’s rise) was alarming, there emerged quite a bit of controversy about what should be done to fix the problem.

Some argued that a rising Fed funds rate would arrest the dollar’s fall, some said the Fed need only sell assets from its portfolio to reduce the monetary base with an eye on the gold price amidst freely floating rates, and some said the monetary authorities need only make plain their unhappiness with the dollar’s direction in such a way that the markets themselves would reverse its fall. And while an even greater debate about the efficacy of rate targeting followed in recent years, there was still general agreement that the gold price signaled inflation; the notable exception being free-market economic commentator Jerry Bowyer.

To Bowyer, quiescent government measures of inflation such as the consumer price index (CPI) indicate that the gold signal lacks some of its past relevancy. Even with year-over-year CPI running at 3.5 percent (meaning the US price level would double in 20 years), Bowyer stands by his assertion that inflation at present is not a problem.

So while various gold types will occasionally mention the CPI compared to Bowyer’s frequent mentions, it’s not an indicator thought to be very useful. For one, as with all government measures of inflation and growth, the CPI has “rear-view mirror” qualities in that it only indicates what’s happened after the fact. Conversely, commodities such as gold, which are priced in the spot market in dollars, tell us in real time whether dollars are losing or gaining value.

As occasional gold advocate Alan Greenspan once noted in Congressional testimony, inflation strikes with a lag, so it’s necessary to utilize forward looking indicators such as gold, forex, and the yield curve. The dollar price of gold and the dollar’s value against foreign currencies are surely indicating inflation, while yields on Treasuries suggest a more optimistic outlook. Bowyer points to the latter to bolster his case, but then going back to the ‘70s, bond yields have frequently lagged gold and foreign exchange when pricing in the dollar’s direction.

Indeed, Treasury yields didn’t immediately adjust upward to dollar weakness in the aftermath of the breakdown of Bretton Woods. Furthermore, it took twenty years for yields to adjust downward once inflation was arrested beginning in the early ‘80s. And despite impressive dollar strength from 1997 to 2001, the latter never showed up in any material way in the yields of debt issued by the federal government. That Treasury yields seem sanguine today presumably speaks to market confidence that the Fed/Treasury are long-term credible when it comes to inflation.

Back to lagging government measures of inflation, in addition to timing issues, indices such as CPI track consumer prices without much acknowledgment of changes in the goods we buy. Bretton Woods Research’s chief economist Paul Hoffmeister has noted a recent announcement from General Mills that it will keep the price of its boxes of cereal steady, all the while reducing the amount of cereal in each box. Forbes publisher Steve Forbes recently wrote of the pastries sold at Starbucks, which while priced the same, are smaller than those sold in years past. Shades of the 1970s. When we consider the computer Bowyer uses to type out his polemics minimizing the gold message, surely the one he uses today has evolved in terms of power and speed relative to ones he’s used in the past. On a yearly basis computers become increasingly powerful and cheap for reasons other than the dollar’s direction, such as innovation in technology and methods of production.

But beyond the clear difficulty that government bureaucrats face in accounting for non-monetary changes that surely impact prices, the targeting of consumer prices is anathema to many free-market writers. Consumer prices are essential signals used by producers in judging what goods we like and dislike, so when the Fed targets a number Bowyer deems sound, it distorts the price signals that insure a smoothly running economy.

Bowyer mocks those who have and continue to assert that the U.S. CPI will eventually reflect substantial dollar weakness (as though 3.5 percent inflation isn’t already problematic…), but in wrapping himself in the worst kind of outcome bias, he ignores what’s happening around the world in countries that maintain a currency link to the dollar. Many free market types (including this one) applaud the process by which countries allow us to export our monetary policy to their less experienced central bankers, but evidence that all is not well on the inflation front abroad speaks to problems here. And the evidence shows up in the very CPI numbers that Bowyer elevates as sound indicators of inflation.

Qatar currently links its riyal to the dollar, and its most recent measure of CPI inflation came in at 13 percent. China has most famously tied the value of its yuan to the dollar, and despite a 12 percent rise in the yuan against the dollar since July of 2005, China just announced its highest inflation reading (7 percent) in eleven years. Some who might defend Bowyer against these examples would say that Qatar is booming due to oil wealth, and China due to its re-embrace of capitalism such that economic growth itself is the root cause of inflation in certain dollar-linked countries. If we forget that Japan experienced yearly non-inflationary growth of 20 percent during its reconstruction in the post-WWII gold standard years, Bowyer himself would remind readers that Phillips-Curve logic is bogus; something he did in an August NRO piece (Phillips Head Screw Drivers).

If he chooses to ignore the examples emanating from countries on an implicit dollar standard, surely Bowyer sees inflation as to some degree reflecting a decline in the monetary standard. And with oil a commodity whose price is set in world markets, its 216 percent rise in dollars (versus 105 and 130 percent in euros and pounds) since 2001 is once again suggesting a not-insignificant, inflationary decline in the value of the dollar.

Rather than address evidence that the U.S. CPI is flawed, or at the very least measured in goods particularly sticky in terms of price, Bowyer mocks what he deems “pretzel logic” on the part of stable-currency advocates. He does this all the while mis-reading what many gold types consider “tightness” on the part of our Federal Reserve. Tightness is not a number set by the Fed, but instead reveals itself irrespective of rates in the price of gold.

Still, if he chooses to de-emphasize the gold signal while concentrating on CPI and other more quiescent government measures of inflation, Bowyer might look at the anecdotal evidence. Inflationary episodes share certain characteristics that always seem to reveal themselves when a country’s currency is losing value. Much like the inflationary ‘70s when there was a flight to hard assets such as housing and art alongside suddenly “scarce” commodities, we’ve experienced much the same in recent years. And just as the weak dollar played a huge role in the failed presidencies of Nixon and Carter, so it weighs on President Bush.

The late Hall of Fame football coach Bill Walsh used to say that you could judge a quarterback’s performance by simply watching his footwork to the exclusion of everything else. With the benefit of hindsight, we can now say that the successful, popular presidencies since 1971 were those where the dollar resided in non-inflationary territory. Conversely, the weak-dollar presidents left with low approval ratings. If the economy were really as good, and free of inflation as he argues, would George W. Bush really be this unpopular?

With or without conversion to a gold-centric money model, Bowyer will continue to write important opinion pieces on the economic growth that results when taxes and inflation are low, and trade is free. Still, believer that he is that we should always be gaining wisdom from markets, he might begin to acknowledge market signals suggesting a not so sanguine inflation outlook; signals that might help explain the present malaise in the electorate.

The Fed’s TAF will open a small arena within which markets will be allowed to influence the pricing of credit from the Fed. Banks will be permitted to bid for credit, and bids will surely be well below the Fed’s current overnight funds rate, which is 4.25% after the reduction of December 11th. Assuming the Fed accepts market bids, perhaps banks will borrow funds for use in buying commercial paper and other debt instruments issued by business firms with good credit. This would be a good thing, as ongoing contraction in credit markets threatens a collapse in economic growth. Thankfully, the Fed noted this threat and moved to counter it.

Defining the Fed actions simultaneously identifies both the source of the problem and the inadequacy of the actions taken. A special auction for Fed credit is necessary because the Fed’s own funds rate is too high. The too-high funds rate prevents normal functioning of processes by which banks obtain funds at market rates and lend to others, and also at market rates adequate to cover risk and profit. To solve the problem, the Fed should drop its funds rate to a point on a normal yield curve (below market rates for short-term Treasury securities) or, much better yet, allow the market to set the overnight funds rate. Instead, the Fed proposes to conduct an auction of a limited amount of credit at a minimum bid rate. Categorically this is a half-measure inadequate to alleviate severe credit constrictions caused by the Fed funds rate itself.

Continued attempts to make manipulation of domestic interest rates the central focus of U. S. economic policy are indefensible. The funds rate fails to control rates at any other point on the yield curve, thus producing the “financial strains” so prominent in the Fed’s current thinking. Worse, even while credit markets have continued to function for larger firms during the past 18 months, high funds rates set by the Fed have penalized small businesses and consumers, draining capital and destroying jobs. Throughout this period, the dollar suffered from a weakened economy and lower demand for liquidity. Both influences reduced the dollar’s value when liquidity was not drained. Thus, funds rate manipulation causes economic contraction, inflation or both.

Public calls for the Fed to float the funds rate are growing louder. This week publisher and former presidential candidate Steve Forbes renewed his advice that markets should set the overnight funds rate. Arthur Laffer joined in that view. Two weeks ago, former Fed governor Wayne Angell recommended the Fed should proclaim its commitment to strengthen and stabilize the dollar by managing liquidity towards that end. Coupling these two actions – floating the funds rate and managing liquidity with a gold price target - would provide the complete remedy now lacking in Fed policy.

What few understand is that a market-set funds rate is not synonymous with flooding the economy with additional liquidity. The funds rate is not the valve to liquidity flows that it has been represented to be. A floating funds rate allows normal yield curve and credit flows, which means economic growth would be released from its present restraints. But liquidity would still be controlled by the Fed’s open market operations, which ought to be guided by commitment to stabilize the dollar at a strengthened level.

Fed chairman Ben S. Bernanke is mid-stride in performance that to date is uninspiring. He risks producing a collapsing dollar and serious recession during a presidential election year. Either would be bad for Americans, bad for global economies and bad for the prospects of one who aspires to a long tenure as Fed chairman.

Alternatively, by following the Angell-Forbes-Laffer path of free market interest rates and an honest dollar, Bernanke can become the most significant and successful chairman in Fed history, not to mention the pre-eminent central banker in the world. He would deserve the accolades, because market-based monetary policy would leave Americans and the world plenty to celebrate all around. ~

The problem here is that countries do not for the most part engage in trade. Individuals trade with other individuals, and once that reality is considered, the very notion of a deficit when it comes to the beneficial exchange of goods becomes ridiculous.

While the word brainwashing is perhaps too extravagant when applied to the notion of trade deficits, it could be said that readers of the mainstream media have been bombarded so consistently and so long about the major negatives of trade imbalances, that the debate is now settled. Our alleged trade imbalances will eventually destroy our economy.

The above idea makes for good headlines, but if we as individuals stop and think about how we go about our daily lives, we’ll quickly see that what has the media and many economists so hot and bothered is quite irrelevant. It is, because in the end, all trade must balance.

In my case, I run a trade surplus with Real Clear Holdings, my employer. At least a third of my surplus with my employer then goes to the federal government, the entity with which I run my largest trade deficit; though it’s sometimes hard to figure what I get in return from Washington.

With what’s left over, I run a variety of trade deficits, including a large one with a Safeway supermarket located in the Glover Park section of Washington, D.C. Unfortunately, as many customers of this Safeway are presently aware, it’s going through a partial re-model. As a result, many of the goods I would normally buy are not available thanks to the store’s reduced level of inventory.

If I were a country, economists and journalists would rejoice. Either because I can’t find much of what I used to buy, or because it’s not in stock due to the re-model, my trade deficit with Safeway has plummeted of late.

Am I better off? If we factor in that the goods I buy at Safeway tend to be healthier than my alternative choices, probably not. Economists would point to my falling Safeway deficit and say that I’m at least economically better off, but then my reduced trade deficit with Safeway has occurred alongside rising deficits with both Popeye’s Chicken and Domino’s Pizza. Whatever one thinks of my non-Safeway alternatives, I’m certainly worse off because at least at present, I can’t consume my surplus in the most optimal way.

In short, when we reduce trade to individual exchange, we see there can’t be deficits. We can only engage in deficit trading to the extent that we have a trade surplus elsewhere; usually with our employers, but sometimes with lenders and investors willing to curtail immediate consumption in order to capture a portion of the economic upside we offer.

The problem as always is that journalists and economists tend to look at trade through the prism of countries rather than individuals. Broken down to individuals, we can see that falling trade deficits, far from being good, are usually signals of our not being able to purchase what we want, or our not being able to attract the investment that we need.

Right now, the Social Security Trustees forecast the real long-term growth rate of the U.S. economy at about 2.0% per year. This is a reasonable projection of what current policies would yield. However, I believe that adoption of the FairTax would increase growth to at least 3.5%.

How significant is the difference between 2.0% and 3.5% real growth? Let’s look at the numbers over a 75-year period, the way the Social Security Trustees do.

Our economy would be almost three times larger in 2082 if we average 3.5% growth than it would be if growth averaged 2.0%. The “present value” of our GDP over the 75-year period would be more than 70% larger. The implications of this difference are staggering

For one thing, the financial problems of Social Security and Medicare, which seem overwhelming today, would simply disappear. For 2007, the combined costs of these programs will total about 7.5% of GDP. Under the Social Security Trustees’ GDP growth assumptions, these costs are projected to balloon to over 17.5% of GDP in 2082. However, if our GDP grows an average of 3.5% per year, the same projected real-dollar costs would total only about 6.0% of GDP—less than today.

Here’s another way to look at the potential impact of the FairTax. If you add our national debt to the projected (75-year) “unfunded obligations” of Social Security and Medicare, the Federal government is in a $48 trillion financial hole. However, assuming Federal revenues at their historic average of 18.5% of GDP, a real GDP growth rate of 3.5% would increase the present value of Federal revenues from about $138 trillion to about $236 trillion. This additional $98 trillion is enough to pay off all of our “debts” and pay for a tax cut equal to 3.9% of GDP.

Because higher economic growth has such a dramatic effect on the present value of Federal revenues, it is neither necessary nor desirable to implement the FairTax at its “static-revenue-neutral” tax rate of 23% (“inclusive” rate). A tax cut equal to 3.9% of GDP would bring the FairTax rate down to just over 18%. In fact, it would take a FairTax rate of only 13.4% to produce the same present value of Federal revenues with average real GDP growth of 3.5% as the 23% rate would yield if GDP growth averages 2.0%.

So, why would the FairTax produce a dramatic increase in GDP growth?

There is a reason why our economic system is called “capitalism”. It is capital investment—private capital investment—that makes our economy grow. This is clear from an examination of the “Produced Assets” numbers published by the Bureau of Economic Analysis (BEA). The ratio of real GDP to real “Produced Assets” (i.e., total invested capital) has been constant at 0.331 for the past 54 years. More capital investment yields higher GDP.

By eliminating all taxes on savings and investment, the FairTax would dramatically increase the profitability of business investment in the United States. It would make the U.S. the preferred location for manufacturing for export. It would make globalization work for, rather than against, American workers.

The FairTax would allow companies to reinvest all of their profits in growth. Raising capital is difficult and time-consuming for small companies, so many of them must limit their growth to what they can finance out of cash flow. The FairTax would not only permit these companies to reinvest the money they are now paying in taxes, it would also allow them to reinvest all of the money they are now spending on tax lawyers and accountants.

The impact of lower taxes on businesses can be dramatic. By cutting their corporate income tax rate from 40% to 12.5%, Ireland increased its average annual real economic growth rate from around 3% to more than 7%. The FairTax would reduce the U.S. corporate income tax rate from 35% to zero. It would also eliminate the “compliance costs” of this tax, which are estimated to be as burdensome as the tax itself.

There are those who claim that the FairTax is “regressive”—that it would benefit “the rich” at the expense of “the poor”. Yes, the FairTax would eliminate all taxes on capital. And yes, it is “the rich” who own most of the nation’s capital. However, there is a huge distinction between who owns the capital and what the capital actually is. It is also vital to understand who benefits from the capital that “the rich” own.

A young man starting out as an auto mechanic needs a very expensive set of tools. Tools are capital. If the young man borrows the money he needs to buy his tools, the tools (capital) will be owned by “the rich”. However, what the tools actually are is the capital that makes it possible for the young man to earn a decent living.

The economy as a whole gets a 33.1% annual return on invested capital. Most investment is made by, and owned by, “the rich”. However, “the rich” receive only 16% of the total return. Most of the benefit, 57%, goes to workers. Government (all levels) gets the remaining 27%. While the FairTax will make “the rich” richer, the vast majority of the economic benefits will go toward making the rest of America richer.

The U.S. economy averaged 3.72% per year real growth for the 75 years ending in 2006. There is no reason why we can’t average 3.5% for the next 75 years. We just need enough capital investment. The FairTax would give us that investment.

Political chaos has been Bin Laden's objective, and the Bhutto assassination is undoubtedly strategic. Not only does her absence in Pakistan's political process remove a powerful pro-Western sympathizer, but her death has spawned mass protests demanding Musharraf resign for inadequately protecting Bhutto. But as Mahmud al-Durrani, Pakistan's ambassador to the United States, said Thursday evening, no amount of security could protect her from a suicide bomber at the massive rallies she attracted. And further destabilizing the country, the Washington Times' Arnaud de Borchgrave reports that the tribal areas along the Afghanistan-Pakistan border are now under Al-Qaeda and Taliban control despite the Pakistan army's military campaign there during recent months, which has cost at least 1,000 soldiers lives and wounded 3,000.

The 100 basis point decline in the fed funds rate since September is not the likely cause for the continued decline in the dollar, which has been marked by foreign exchange weakness and rising gold. The Federal Reserve's rate cuts do not appear to be characteristic of loose monetary policy because money supply growth since September has been relatively tame, and thus very unlikely to be the cause of the dramatic 17% rise in gold that translates to a 17% decline in the real value of the dollar. Instead, the recent dollar weakness is likely the consequence of declining dollar demand primarily caused by new geopolitical uncertainties.