True Inflation Is Currency Devaluation, and It Is a Cruel Blast to the Past
As for future stuff, it cannot be produced without investments in financial assets. The shift into tangibles thus prefigured a decline in production.
—Brian Domitrovic, Econoclasts: The Rebels Who Sparked the Supply-Side Revolution and Restored American Prosperity
If you wish to destroy a nation you must first corrupt its currency.
—Adam Fergusson, When Money Dies
The networks that televise the Super Bowl can command enormous rates for ads during the telecast. In 2001, the cost to air a thirty-second commercial was $2.1 million. By 2014, the rate had ballooned to four million dollars.1 The number speaks not just to the rising popularity of the NFL’s signature event, but also to the health of the various networks that bought the rights to the game over the years.
Still, by now you may have developed a bit of healthy skepticism about the price of anything in dollars. If I cut the length of the foot in half in order to be twelve feet tall, I’ll still be six feet tall. That’s how you should think of the dollar. While the dollar for most of American history had a fixed value in terms of gold, over the last four decades it has floated freely. Do those Super Bowl ad rates mean much?
At the end of January 2001, a dollar bought 1/264 of an ounce of gold. By Super Bowl Sunday in 2014, that same dollar was a shadow of its former self, buying only 1/1250 of an ounce.2 Most economists and pundits will tell you that there has been no inflation since 2000, and according to a Consumer Price Index that excludes the commodities most likely to signal monetary error, they may be right.
But the economic consequences of the dollar’s substantial decline over the last thirteen years demand attention, especially in light of America’s monetary experience since 1971. Devaluation of money is inflation, and the floating dollar’s forty-three year story is worth a brief review.
Watching ESPN one night, I was struck by a comment from Hall of Fame quarterback Steve Young. He said that he and the late Bill Walsh had come to the conclusion that a careful study of the quarterbacks’ footwork in a game film will invariably reveal who won and who lost. A keen and seasoned football eye would need to see only the quarterbacks’ movements from the ankles down—to the exclusion of everything else—to know the outcome of the game.
Likewise, if you were forced to live in a cave with no access to the outside world but were provided with just one economic indicator to follow the economy’s health, you’d want that indicator to be the dollar’s value in gold. As the 1980s Bundesbank president Otmar Emminger once asserted, “the dollar is the most important price in the world economy.”3 Yes, it is, and the most telling indicator of the dollar’s price is its price in gold. Supplied with this knowledge, a cave-dweller would have a pretty good sense of the United States’ economic health and that of the rest of the world.
When President Nixon made the fateful decision to sever the dollar’s link to gold in 1971, he wanted a weaker dollar. Presidents always get the dollar they desire. Unlinked to gold, the dollar began to fall as gold rose.
The financial writer John Brooks noted presciently in the New York Times that “the president and his advisers, in making their draconian move, did not understand what they were doing.”4 Agreed. It quickly became apparent that Nixon and his advisors had unleashed economic chaos. The prices of commodities that had historically been flat and nominally cheap (a barrel of oil at $2.30) eventually soared. There were no “oil shocks” in the early 1970s, but there were dollar shocks. From 1972 to 1973 alone, the price of a barrel of oil rose over 300 percent, meat prices were rising at an annual rate of 75 percent, and the price of a bushel of wheat rose over 240 percent.5
The Fed funds rate rose over 450 basis points from 1971 to 1973, but the housing market was undeterred. It is economically revealing that housing emerged as the top asset class during Nixon’s second term. Investors are always seeking the best return. When they put capital to work, they are buying future dollar income streams. But with the dollar in free fall, stock and bond income streams representing future wealth creation are not as attractive as they have been. So investors ask themselves a very blunt question: Why commit capital to future wealth creation if the returns will come in severely devalued dollars? In these circumstances, investment flows into the hard assets that are least vulnerable to devaluation—land, art, rare stamps, anything tangible. This is wealth that already exists. The migration of investments into existing wealth as a protection against dollar devaluation is a strong signal that production of wealth which does not yet exist will not be funded. Devaluation provokes a blast to the past, a boon for assets that the economy has already created.
The housing boom under Nixon was a troubling economic signal. The Austrian School economist Ludwig von Mises referred to the “flight to the real,” which occurs in periods of devaluation. Nixon’s monetary blunder made stock and bond markets unappealing, and housing and other hard assets were the beneficiaries. A house is tangible. You can live in it. In short, it is safe.
The problem with everyone’s pouring into housing is that it is consumption, like Vince Young’s three-hundred-thousand-dollar party. The purchase of a house will not make you more productive, it will not open up foreign markets, and it will not lead to cures for cancer. Investments in houses, land, art, and other tangibles is the equivalent of the prevent defense in football—a conservative strategy meant to avoid calamity. The problem is that economies need risk takers—entrepreneurs willing to try something new paired with intrepid investors willing to back new ideas that might deliver big returns (or not).
With the dollar in decline, investors went into prevent mode to protect their wealth from devaluation. Without aggressive investment in imaginative new ideas, Nixon’s economy sputtered badly, leaving him vulnerable to his political foes when Watergate erupted.
The dollar’s fall continued into Jimmy Carter’s presidency. Despite a sharp drop in the value of the dollar against gold and the Japanese yen throughout the 1970s, Carter’s Treasury secretary Michael Blumenthal intimated in a speech in June 1977 that the dollar was overvalued against the yen.6 This was a fairly explicit signal that President Carter wanted a weaker greenback, and the markets complied. Although gold was trading at roughly $140 an ounce7 when Carter entered office, it was at roughly $220 an ounce by 1979,8 and it hit $875 an ounce by January 1980.9
Unsurprisingly, “oil shocks” again accompanied the dollar’s fall. The price of a barrel of oil jumped 43 percent from 1975 to 1979. Yet those “shocks” were by no means global. Some countries chose not to mimic America’s currency devaluation. Over the same four years, a barrel rose only 1 percent in Deutschemarks and 7 percent in Japanese yen. In Swiss francs the cost of a barrel actually fell.10
In a decade marked by a declining dollar, stock market indices like the S&P 500 nearly flattened. Entrepreneurial enterprise dried up. There were three hundred high-tech start-ups in 1968, but none in 1976.11 Initial public offerings, which represent companies of the future, averaged twenty-eight per year from 1974 through 1978; by comparison, there were 953 in 1986 alone.12 High capital gains taxes were a big part of the problem, but dollar devaluation is very much a tax on investment. Remember that investors are buying future dollar income streams when they commit money to the stock market.
The investors who went into prevent mode did well enough. David Frum describes the 1970s this way: “If you had the nerve to borrow a lot of soggy cash, and then use it to buy hard assets—land, grain, metals, art, silver candlesticks, a book of Austro-Hungarian postage stamps—you could make a killing in the 1970s.” Frum further notes that when Forbes magazine “published its first list of the 400 richest Americans in 1982, 153 of them owed their fortunes to real estate or oil. (On the 1998 list, by contrast, only fifty-seven fortunes derived from real estate or oil.)”13
In his classic Wealth and Poverty, first published in 1981, George Gilder summed up the decade that had just ended: While “24 million investors in the stock markets were being buffeted by inflation and taxes, 46 million homeowners were leveraging their houses with mortgages, deducting the interest payments on their taxes, and earning higher real returns on their down payment equity than speculators in gold or foreign currencies.” Gilder also cited a 1978 Fortune magazine study that found that half the new multi-millionaires were in real estate.14 Oil was a good investment too. The Rolls-Royce dealership in oil-rich Midland, Texas, emerged as one of the brand’s most profitable dealerships in the world.15
You might think that the average American doesn’t follow the dollar, let alone the dollar’s price in terms of gold, and you’d be right. But the average American does follow the market’s price signals. During stock market booms there is plenty of conversation about stocks among regular people, but in the soggy-dollar ’70s the talk was about money made on housing and in the oil-patch. Americans reoriented their investments into the areas least vulnerable to devaluation. Oil, housing, and hard assets soared, while the stock market, which represents the funding of future wealth creation, flattened.
In the 1970s the American economy mimicked Michael Jordan’s move from basketball, where he was the best, to baseball, where he was not very good. The rush into housing was about getting by, not pursuing stunning advances in the human condition. The flood of investment into the American oil patch was the equivalent of LeBron James’s suspending his basketball career to play tight end. Rather than being content to import oil that others produced at a low profit margin and devoting our own energy and resources to high-margin technology businesses, we let oil signals, which were distorted by a falling dollar, lure us into low-margin work and investments.
The American fascination with housing consumption caused a capital shortage for businesses. A flat stock market and a malaise-ridden decade told the tale of the falling dollar’s damage. Fortunately, relief arrived in the person of Ronald Reagan.
For our purposes, the most important thing about Reagan’s 1980 campaign was his declaration, “No nation in history has ever survived fiat money, money that did not have precious metal backing.”16 As we learned with Nixon and Carter, presidents always get the dollar they want. The dollar fell to an all-time low in January 1980, when gold hit $875 an ounce, but the decline reversed itself. As Reagan’s victories in the Republican primaries started to accumulate, the price of gold fell as the dollar strengthened. Markets always price in the future, and the expectation of a new president who was explicit in his belief that unlinking the dollar from gold had been a mistake sent the dollar into a rally.
Under President Reagan, economic policy improved a great deal. Deregulation—already begun under President Carter—continued, the top marginal income tax rate was reduced from 70 percent to 28 percent, and the value of the dollar, reflected in the plummeting price of oil (ten dollars a barrel by 1986), was rising.17 While Reagan often erred when it came to free trade, getting three out of four of the basics of economic growth correct is not bad.
Early in his presidency, the economy fell into a major recession. But recessions are cleansing and necessary. Though undoubtedly painful in the short term, recessions indicate that an economy is on the mend. A recession is an economy’s cleansing itself of all the bad businesses, bad investments, and labor misallocations that brought on the trouble. That is why when government stays out of the way, recessions turn into impressive rebounds. The recession of the early ’80s was the equivalent of Michael Jordan’s ending his baseball flirtation and returning to championship form in basketball.
A stronger dollar made housing and energy less attractive to investors and revived their hope in future dollar income streams, so they returned to the stock market. With the president no longer talking down the dollar as Nixon and Carter had done (Gerald Ford’s presidency was too short to take into account for our purposes here), investors were finally comfortable about scrapping the prevent defense in favor of imaginative investing in future production and wealth creation. The IPO market that had lain dormant in the ’70s quickly took off. While Reagan did not restore the dollar to its proper role as a stable measure of value defined in gold, a rising greenback throughout much of his presidency was a boon to the economy. In the booming 1980s, the S&P 500 soared 222 percent as the price of gold declined 52 percent.18 The decade-long dollar nightmare was over, and high-profit-margin companies like Microsoft and Cisco were again the beneficiaries of Americans’ investment.
George H. W. Bush’s presidential election was, in many ways, the electorate’s way of giving Reagan a third term. But where things get most interesting from an economic and monetary perspective is the presidency of Bill Clinton. In 1999, near the end of Clinton’s second term, the liberal historian Richard Reeves acknowledged, “Reagan, in fact, is still running the country. President Clinton is governing in his shadow, trying, not without some real success, to create a liberal garden under the conservative oak.”19
Clinton did raise income tax rates in 1993, but in taking the top marginal rate from 31 percent to 39.6 percent he was conceding that the days of 70 percent marginal rates were over. And Clinton actually cut the capital gains tax—the price of investment in new companies—from 28 percent to 20 percent in 1997.20 On trade policy, Clinton worked with Republicans to ratify the North American Free Trade Agreement, which liberalized trade between the United States, Canada, and Mexico.21
Clinton was at his best on dollar policy. In Robert Rubin, who joined the cabinet in 1995, Clinton had a secretary of the Treasury who truly believed that a strong dollar was in America’s best interest. Rubin backed this belief with action, or better yet, inaction. As the economists Ronald I. McKinnon and Kenichi Ohno wrote approvingly in 1997, not once after Rubin’s arrival “did a responsible official in the American government complain that the dollar was too high.”22 Presidents always get the dollar they want, and as the Clinton administration was fairly explicit about its desire for a strong dollar, the greenback and the economy took off.
Even conservatives applauded Clinton’s dollar policy. Inflation—by definition a devaluation of the dollar—is a cruel blow to investments that have already been made. The free-market economist Lawrence Kudlow happily acknowledged in 1996 that Clinton got it right with the dollar:
The single most significant, inter-galactic, extra-celestial, interplanetary, and spiritual force behind the global stock market rally is the decline of inflation to rates not seen in over thirty years. While many industrial nations, including the U.S., have imposed anti-growth and anti-saving tax increases in recent years, fiscal drag has been offset by a steady decline of inflation. Inflation is a tax on money, wealth creation, income, and work effort. Inflation is a devastating tax on savings. But low inflation is a tax-cut. By enhancing the value of financial assets, price stability rewards patient savers and investors. It is a stimulant to capital formation, new business start-ups and growth. Growth does not cause inflation, low inflation causes growth.23
In those eight sentences, Kudlow explained the Clinton boom. The importance of the administration’s support of the dollar from the mid-1990s on cannot be minimized. Many conservatives still suggest that Bill Clinton was simply lucky to be president during the rise of the internet. This is faulty thinking.
The internet boom was inseparable from Clinton’s dollar policies. Investors become defensive when money is falling in value, and they seek safety. But if they know their investments will not suffer erosion by devaluation, they become willing to take risks. The strong Clinton dollar was the low-entropy background for the high-entropy innovation that was occurring in Silicon Valley.
The dollar is the most important price in the world, and often its value drives the direction of global currencies. With the dollar strong, other currencies followed on the way to a global boom. I must repeat that money is nothing more than a unit of measure. In a perfect world, money is neither weak nor strong but only stable. So while the United States did not return to an invariable dollar during the Reagan-Bush-Clinton era, Nathan Lewis has observed that from 1982 to 2000, “the dollar’s value was crudely stable vs. gold around $350/oz.”24
From that stability came an economic boom. During the 1980s and ’90s, the tax penalty imposed on work fell, the tax of government spending was lighter, regulation was less intrusive, freedom to trade was expanded, and the dollar was strong and stable. These are the basic necessities for economic growth. The stock market rally that began in the ’80s continued into the ’90s, and the S&P 500 rose 314 percent in the latter decade.25
So what happened? How did such a wildly prosperous economy sink into slower growth, flat stock markets, and financial crisis in the 2000s? Why has the richest nation on the planet seemingly lost its economic confidence?
Just as Steve Young and Bill Walsh would look at the quarterbacks’ footwork, we can look at the dollar. Presidents get the dollar they want, and with the election of George W. Bush in 2000, weak-dollar policies came into favor to the misfortune of the United States and the world. Treasury secretaries are mouthpieces for the dollar, and that is why they are coached so heavily about what they utter. What they say can move the dollar. Bush’s first Treasury secretary, Paul O’Neill, announced that a strong dollar was not a priority. His successor, John Snow, continued this lurch toward cheap money, asking at a G-8 meeting in 2007, “What’s wrong with a weak dollar?”26
The Bush administration imposed tariffs on foreign steel, softwood lumber, and shrimp. Carter (and, it must be said, Reagan) had perennially complained about the weak Japanese yen, and George W. Bush followed suit by complaining about a weak Chinese yuan. This was an explicit signal that the administration wanted a weak dollar, and markets predictably complied. No investor is going to fight a president who has control over Federal Reserve appointments. And whatever your opinion about the wars in Afghanistan and Iraq, war and good money are not always correlated.
And so the dollar began to decline. It bought 1/266 of an ounce of gold when Bush was inaugurated in 2001, and by July 2008 it bought 1/940 of an ounce.27 The price of oil during this period predictably soared, eventually reaching an all-time high of $145 per barrel. It had been as low as ten dollars a barrel in 1998 and twenty-five dollars a barrel in 2001. These were not “oil shocks,” but dollar shocks. In dollar terms, the price of a barrel rose 459 percent. Measured in other currencies, oil was still spiking, though not as much. In Swiss francs, a barrel had risen 216 percent, and it was up 198 percent in euros.28
Commodities are priced every second of the day in markets around the world. They are priced in dollars, and with the dollar’s fall against gold, it was not just oil that was spiking. Odd headlines—“States battle rise in copper thefts”29 and “Copper: Hot loot for some thieves”30—pointed to the problem. When the copper in a penny became more valuable than the penny itself, one congressman floated a bill to overturn a U.S. Treasury ban on melting pennies.31 It was the slow-growth 1970s all over again. The wealth of yesterday became more attractive than the wealth of tomorrow, which is funded in the stock market.
Stocks did move up in the early years of the Bush administration, but the gains were not what investors had grown accustomed to in the 1980s and ’90s. Google’s IPO was the only notable one. As Bloomberg reported in May 2008, “Take away ExxonMobil Corp, Chevron Corp. and ConocoPhillips and profits at U.S. companies are the worst in at least a decade.”32
Around this time, oil-patch states such as Texas and North Dakota were the recipients of an influx of people chasing an oil boom that was driven by a weak dollar. Harvard graduates were earning less money out of college than graduates of the South Dakota School of Mines & Technology.33 It’s true that brilliant engineering advances like fracking and horizontal drilling opened up vast reserves of previously unattainable oil and natural gas. But oil is plentiful at the market price around the world. In rushing headlong back into energy’s relatively low profit margins, Americans were repeating the 1970s, when lower-margin economic activity gained at the expense of work that was far more profitable. A Michael Jordan basketball economy had once again become a Michael Jordan baseball economy.
And just as they did in the ’70s, Americans started speculating in housing. It offered better returns than the stock market, and you can live in a house. The rush into housing was as bad an economic signal in the 2000s as it had been in the 1970s. As Adam Smith wrote in The Wealth of Nations,
Though a house, therefore, may yield a revenue to its proprietor, and thereby serve in the function of a capital to him, it cannot yield any to the public, nor serve in the function of a capital to it, and the revenue of the whole of the people can never be in the smallest degree increased by it.34
Housing is about consumption of wealth, but investment in wealth that does not yet exist is what makes the economy grow.
What caused the flood of investment into housing? The answer popular on the Left is that banking deregulation drove it. The favorite answer on the Right seems to be that Alan Greenspan’s decision to cut the Fed funds rate to 1 percent in 2003 made money easy and fed the boom. Others point to Fannie Mae, Freddie Mac, and the income tax deduction for mortgage interest payments. Let’s look at each of these arguments.
The deregulation explanation simply doesn’t hold water. John Allison points out, “Financial services is a very highly regulated industry, probably the most regulated industry in the world.”35 Banking came under even more regulation in the 2000s, including Sarbanes-Oxley and the Patriot Act.
Some on the left blame the near-total repeal of the Depression-era Glass-Steagall regulations, which separated securities services from commercial banking. This explanation is no more accurate than the argument about deregulation. Hybrid banks and investment banks were the healthiest financial institutions in 2008. They were the ones asked to acquire a failed Bear Stearns (J. P. Morgan), the failed Merrill Lynch (Bank of America), and the failed Wachovia (Wells Fargo). But the most important problem with this explanation is painfully obvious: banks ran into trouble not because of their exposure to investment banking services or because of underwriting or because of dealing in securities (which banks are still prohibited from doing).36 They imploded because of mortgage lending and exposure to mortgages, and the partial repeal of Glass-Steagall had nothing to do with that. As Gregory Zuckerman has pointed out, federal regulators encouraged the mortgage madness.37 Regulators are always the last to see problems. If they weren’t, they wouldn’t be regulators but billionaire speculators shorting the shares of errant banks.
The argument that a low Fed funds rate caused the rush into housing fails because it presumes that artificially low interest rates represent “easy money.” That’s like saying that if the government decreed that Ferraris would cost only ten thousand dollars then everyone could go out and buy a Ferrari. There wouldn’t be any Ferraris to buy because the Ferrari company couldn’t afford to make them if it had to sell them at that price. Likewise, low interest rates drove a lot of savers out of the market.
Furthermore, as we saw when we looked at regulation, John Paulson ultimately made billions betting against the housing house of cards. The employee who initially brought the lucrative trade idea to him, Paolo Pellegrini, had carefully studied interest rates and home prices. In tracking interest rates over the decades, he “concluded that they had little impact on house prices.”38
Housing soared in the 1970s when interest rates were sky-high. Looking back on the housing boom of that earlier decade, George Gilder writes:
What happened was that citizens speculated on their homes. . . . Not only did their houses tend to rise in value about 20 percent faster than the price index, but with their small equity exposure they could gain higher percentage returns than all but the most phenomenally lucky shareholders.39
What about Fannie Mae and Freddie Mac and the mortgage interest deduction? All three should have been abolished a long time ago. The last thing government should ever do is subsidize consumption of any market good, particularly one that makes people less mobile. Alexis de Tocqueville observed in the nineteenth century that Americans are “restless amid abundance.”40 Government subsidies of housing consumption give people an incentive to remain stationary, whereas, historically, they have moved all over the country in search of the best job opportunities. Stationary citizens are easy to tax (this may explain why government is so eager to subsidize housing), and they can’t pursue jobs elsewhere when the opportunity beckons.
More to the point, the view that Fannie, Freddie, and the mortgage interest deduction caused the housing boom ignores its global nature. Housing soared in Great Britain without a Fannie Mae or Freddie Mac and despite the abolition of the British mortgage interest deduction in the 1980s.41 In Canada, it is difficult to attain a home mortgage, yet housing boomed there as well. Blaming the low Fed funds rate is unsatisfactory because interest rates were higher around the world.
So what caused the migration of investment into housing? If you paid careful attention to my discussion of the 1970s, you already know. The rest of the world mimicked our weak dollar policies, and when money is devalued, housing is always one of the safer places to go. History is simply littered with instances of investors seeking shelter in housing amid periods of monetary devaluation. Housing is the classic inflation hedge. In When Money Dies, a tragic account of the collapse of the mark in post–World War I Germany, Adam Fergusson writes, “Anyone who was alive to the realities of inflation could safeguard himself against losses in paper currency by buying assets which would maintain their value: houses, real estate, manufactured goods, raw materials and so forth.”42
Looking at the British pound’s decline in the 1970s, David Smith writes in The Rise and Fall of Monetarism that the sector “which investors chose above all others was property development.”43 And a Bank of England quarterly bulletin observed, “There was [in the 1970s] no other general area of economic activity which seemed to offer as good a prospective rate of return to an entrepreneur as property development.”44
In his classic history of the Federal Reserve, Secrets of the Temple, William Greider asserts that the economy of the Carter years “particularly benefited the broad middle class of families that owned their own homes.”45 Housing is a relatively safe investment, one that holds its value better than stocks do when money is in decline.
A global housing boom occurred during the Bush years because the dollar was in free fall. That fall, moreover, caused a run on paper currencies all around the world. Housing, oil, and real estate drove the 1970s economy when the dollar sank, and a return to 1970s-style dollar policy during George W. Bush’s presidency generated a similar result.
Remember, when the dollar is weak, there is a tendency to migrate toward the tangible, to wealth that already exists. Investors go to their prevent defense. When money is stable or strong, investors do not worry as much about their investments’ being eroded by inflation, so they are intrepid.
The truth about the 2000s is that if we defined inflation the way it has always been defined—a decline in the value of money—there would be a broad acknowledgement that we had suffered a serious bout of inflation, a bout from which we are still suffering. Inflation, far from being the result of strong economic growth, is the ultimate growth retardant. Inflation, as Brian Domitrovic said, is the process whereby investment goes into tangibles such as housing instead of into the stocks and bonds that will lead to new wealth creation. The economic weakness of so much of the 2000s is all the evidence of inflation we need. Like a quarterback’s footwork, the dollar price of gold tells the tale.
The next question is why the moderation of the housing rush in 2008 caused a financial crisis. The answer is it didn’t, as we’ll see in the next chapter.