Beware of 'Peg the Dollar to the Euro' Proposals

In a cure for what is being forecast as a recession after the end of the Federal Reserve's latest targeted quantitative easing binge (QE2), Nobel Laureate Robert Mundell has proposed that the Treasury fix the exchange rate of the dollar to the euro. Mundell believes that a sure sharp rise in the dollar post-QE2 will lead to deflation in the U.S., and then recession. His prescription for this scenario is to stabilize currency exchange rates, given his view that exchange rates transmit inflation or deflation into economies by raising or lowering prices for imported items and commodities. By targeting a peg of the dollar to the euro, the world's two leading currencies, greater economic stability will be achieved.

I say that this is an absurd idea. Fixing the exchange rate of the dollar to the euro does not equate to currency stability. I also take issue with the dynamics that Mundell may be using in his argument: commodities don't always correlate with the eurodollar, so fixing the dollar to the euro won't necessarily affect commodity speculation and hot money flows across borders and back. The problem is with mismatched credit expansions and interest rate policies between borders - causing money to flow preferentially to the highest yielding opportunities at that moment. We have a very fluid and liquid global system now, and swing trading based on these mismatches in policies is quite obvious. We live in the realm of the carry trade, wherever it can be found.

Would an international gold standard help? Not if it isn't supported by a commitment to maintaining its stability, and I doubt that commitment exists at present. For one, it would mean credit could not expand or contract too drastically, and I do believe there are some highly placed who want such a turbulent environment. The other issue is interest rates, which are already monopolistically fixed by sovereign central banks - this is another control not likely to be easily ceded. A stable international gold (or hard money) standard and "free banking" are ideals for the distant future, and the benefits are worth continued extolment.

Japan's New Inflation

A few weeks ago Japan reported rising inflation, with the CPI gaining 0.3% and 0.6% YoY in March and April, after years of negative monthly CPI data. The headlines from major news outlets were indeed amusing: "Japan beats deflation for the first time in two years (BBC)," "Japan Ends 25 Months of Deflation in Victory Marred by Quake-Led Recession (Bloomberg)," and my personal favorite, "Why inflation is great news for Japan." Oh wait - that latter title is recycled from a myriad of similar news reports when inflation last surfaced in Japan in 2007/2008.

According to business/economic news media and Keynesians alike, inflation for Japan is good, while deflation is an anathema. Inflation means rising consumption, demand, loan growth and ultimately output, while deflation means falling consumption, demand, credit contraction and deleveraging, and ultimately falling output. Except the dynamics aren't that simple and settled.

Japan's persistent YoY deflation since 1995 is arguably the result of years of debt deleveraging from the '80s real estate and stock market boom-then-bust, but it is also the result of rising production and productivity [1], which has a positive effect on lowering overall consumer price levels, even when demand is increasing. One might call this "good deflation." Also overlooked is the fact that Japan's deflation was "low and stable," especially during the period 1998-2007, when the average annual YoY CPI deflation was -0.23% with a standard deviation of 0.49%. I find it contradictory that the bulk of economists (especially those residing at central banks) think that low and stable inflation is good (the "Great Moderation"), while apparently low and stable deflation is bad.

What Japan's experience with inflation proves is that rising prices can happen with falling output and productivity, or stagflation, a dirty word to garden-variety Keynesians. With the Yen recently strengthening against most major currencies, the Bank of Japan is limited in what it can do to weaken its currency, which in the past has been achieved though a plethora of quantitative easing measures. Japan has little choice but to continue to delever and fight off any potentially persistent high rates of inflation, should it arise.

[1] Japanese industrial production and labor productivity rose steadily from 1998-2007, aside from a break in the increase during the 2001 recession. CPI and production/productivity data for Japan were sourced from HERE.