CPI at 7%? Bet Your Reserve Dollar
The "surprise" jump in producer and consumer price inflation is not a surprise when you understand the political and economic logic of using one nation's domestic currency -- the U.S. dollar -- as international money. Domestically oriented analysts have been fooled because U.S. inflation responds to the world-wide supply of dollars, not just those in the U.S.</br></br>The Bush administration fervently hopes the latest figures are just an aberration. Such arguments must be used with caution. (The Carter administration used to tell us that if you took away food, energy and housing, the underlying rate of inflation was only 9%.) True, the price of crude oil jumped more than $5 a barrel from November to January. But analysts knew what oil prices were, and they were still surprised. Moreover, oil prices fell sharply for most of 1988 without a fall in the inflation rate. Everything points to a broader acceleration of inflation.</br></br>While some point to rising wages or energy costs, the main cause of the current inflation is the past expansion of what my forecasting firm calls the "world dollar base" -- the stock of high-powered money (currency plus bank reserves) in the U.S., plus the dollars held by foreign central banks. The world dollar base is key because the world operates on a kind of "dollar standard." Other currencies are no longer pegged to the dollar. But most currencies, including the Japanese yen and West German mark, are backed with dollars, as currencies once were backed by gold reserves. The dollar shared this role with gold under the Bretton Woods monetary system of 1944-71. But since 1971, the dollar has been the unchallenged "reserve currency," even with somewhat greater use of the yen and the mark by small countries.</br></br>This change had an important, but overlooked, consequence for the U.S. "twin deficits": budget and trade. Under the dollar standard -- as under a gold standard -- the rest of the world must consume and invest less than its income in order to acquire reserves (sought for reasons I shall note). In economic jargon, this is called running an overall "balance-of-payments surplus." It's analogous to the fact that to put more cash in your wallet, you must pay out less than you earn, beg or borrow.</br></br>But it's different for the reserve-currency country. If other countries increase their dollar reserves, the U.S. must pay out more than it receives -- run a chronic "balance-of-payments deficit." To get a rough idea of the difference, imagine that everyone carried your personal checks around in his wallet instead of money. You wouldn't need to carry any cash -- just your checkbook. And with so many of your checks floating around permanently uncashed, you would always have a fat checking-account balance at your disposal, far beyond what you had saved.