This morning Dr. Arthur Laffer continues his break with most of the other classical/supply-side economists. Dr. Laffer says inflation is nowhere in sight and the Fed is doing a "stellar" job. We can all agree with Dr. Laffer that growth does not cause inflation, the Philips Curve is (or should be) dead, and that economic growth today is stronger than most observers believe. Dr. Laffer is a national hero, who helped launch the U.S. to world economic leadership and, maybe more importantly, exported his low-tax ideas to a world in desperate need of capitalism. We are all benefiting from this global transformation that he and his mentor Robert Mundell envisioned. We continue to be somewhat flummoxed, however, over Dr. Laffer's views on monetary policy, which seem to contradict many of his earlier teachings.
Dr. Laffer's model appears to:
-- completely decouple commodity prices from Federal Reserve policy.
-- completely decouple the foreign exchange value of the dollar from Fed policy.
-- link the dollar's forex value exclusively to U.S. fiscal policy.
-- link commodity prices exclusively to economic growth and also fluctuations in the dollar "unrelated" to monetary policy.
In Dr. Laffer's model, the Fed appears to be a mostly impotent, almost meaningless entity.
-- Dr. Laffer says the dollar's strength between 1996 and 2002 resulted from the great economic policies of Presidents Clinton and Bush 43. But Bush 43's good economic policy didn't begin until the tax cut of 2003, which is when the dollar began its fall. Bush 43's great fiscal policy thus corresponds not with the strong dollar Laffer would predict but a weak dollar instead.
-- Dr. Laffer says the dollar weakening of 1985-1993 was due to the "end of the Reagan era and George Bush's and Bill Clinton's original tax increases." But the dollar weakening that began in late 1985 was a direct, concerted, and public effort of the Plaza Accord, and the weakening began before the tax reform of 1986, which was the most relevant fiscal event of that era.
-- Dr. Laffer grounds his benign inflation call almost entirely in what he sees as modest growth of the monetary base. But he does not appear to take into account rising velocity.
-- Dr. Laffer says expected inflation gleaned from TIPS bonds is the best predictor of inflation, but in fact TIPS have not been very good at all at predicting inflation.
-- IF...Growth = High Commodity Prices...AND...Growth = Strong Dollar...THEN...High Commodity Prices = Strong Dollar. But we all know this is almost never the case, and it's not the case now by a long shot.
-- For example, how do you explain the distinct periods of
> (1) the late 1990s when we had strong growth, a very strong dollar, and very low commodity prices; and
> (2) today when we have strong growth, a weak dollar, and very high commodity prices?
The difference, one can only conclude, is monetary policy. Likewise, in the early to mid-1980s, we had strong growth and a strengthening dollar. In the mid- to late 1980s, we had strong growth and a weakening dollar. The explicit difference was monetary policy.
-- Dr. Laffer then turns around and agrees with us that high commodity prices are determined partly -- or "exacerbated" in his term -- by a weak dollar. But he steadfastly denies that either has anything to do with the Fed. This after the Fed has just engaged in some four years of an explicitly "accomodative" monetary policy. Moreover, this accomodation was transmitted to China via the dollar-yuan currency link. So any extra commodity demand coming from China since 2003 has been in large part a result of a weak dollar supercharging an already fast-growing Chinese economy. And so we're right back where we started -- the Fed.
As former German banker Otmar Emminger said in 1985, the value of the dollar is "the most important price in the world economy." I don't see how we can ignore, let alone repudiate, this key theoretical tenet and practical guide.
- Bret Swanson