In theory. The problem is that in practice, the Fed is far less able to control the economy than it was twenty years ago. There are billions of dollars sloshing around outside the banking system (some of which have even found their way to places like Russia and Argentina). What’s more, today a lot of people are holding money that used to be counted as checking or savings deposits in mutual funds. Oh yes, and let’s not forget booming credit, which in effect creates a money supply of its own. INTEREST RATES
Money, like everything else in the economy, has a price. Beginning in the late 1970s and lasting right through the 1980s, that price was high. Home mortgages carried double-digit rates, and borrowing on a credit card routinely cost about 19 percent. The Vietnam War, wage and price controls in the early 1970s, the quadrupling of oil prices, a flabby Fed, and a ballooning budget deficit had all done their part to push prices up—including the price of money.
Eventually, though, a tougher Fed and a sluggish economy brought down inflation, which allowed interest rates to fall. By 1993, some rates were at their lowest levels in thirty years. And to everyone’s surprise, they were even lower ten years later. This is at least partly because of the huge U.S. trade deficit. Foreign central banks and investors now hold much of the United States’ debt. Because their interest rates tend to be even lower than ours, they take the dollars we send them in exchange for record amounts of imported goods and send the dollars back to the United States, in effect recycling them, in order to take advantage of our interest rates.
It’s an awkward word, for sure. Simply put, disinflation occurs when prices rise, but at a slower rate than they did before. So what was so significant about it? First off, it was a big and welcome change from the 1970s and early 1980s, when rising prices (and wages that didn’t keep pace) eroded incomes, and consumers faced sticker shock every time they went shopping. Disinflation, and continuous low rates of inflation—say 2 percent to 3 percent a year—provide greater certainty and stability and allow economic activity to proceed at a steadier pace. (Though folks who expect to earn 10 percent on their certificates of deposit aren’t necessarily happier.)
In the 1970s, galloping inflation was our biggest problem. In the 1980s, we were obsessed with the budget and trade deficits. The 1990s shaped up as the decade of disinflation and price increases have been very moderate ever since. First, both the Fed and the financial markets will work hard to push interest rates higher if prices start rising. That, in turn, will immediately dampen animal spirits and lower the inflation threat. Second, the U.S. recession of 2001 made it harder for manufacturers to raise prices, and the slow recovery has kept price increases tame. But the stiffest curb on inflation comes from the growth in world trade. Read on. GLOBAL COMPETITION
The bulk of economic theory, and our understanding of how economies actually work, is based on the assumption that most nations are largely closed—that is, self-sufficient in the production of most goods and services, open to trade only at the margin. In the real world, however, trade across borders has been going on for centuries. And in recent decades, with the growing sophistication of technology, communications, and transport, it’s become easier and cheaper for more people in more places to make and ship goods and provide services. The value of world trade, in real or after-inflation terms, has grown 6.5 percent a year since 1950. For every $100 billion more in goods that are traded around the world, growth is pushed about $10–20 billion higher than it otherwise would be, economists say.
Free trade, or relatively free trade, unencumbered by stiff tariffs or quotas, is responsible for this heady growth. That sounds positive and, for the world as a whole, it is. New workers and consumers join the global community as trade increases—witness the way millions of Chinese have gotten rich, thanks to China’s adoption of decidedly uncommunist economic policies. Consumers in industrialized nations like the United States can obtain goods that are cheaper than those made at home, and that should improve living standards. But that benefit is not uppermost in the minds of workers in the United States, say, who lost their jobs because U.S. manufacturers decided to set up shop in Taiwan or Mexico and produce the same goods more cheaply there.
Today Americans are more and more aware of an alphabet soup of trade and economic relationships, from APEC and ASEAN to NAFTA and the WTO (see “Dead-Letter Department,” page 407). All these groups spin an elaborate web of relationships on which future growth will be based, often within loose confederations of nations. Are these relationships progrowth? Definitely But they also guarantee that economies are anything but closed. So long as trade continues to grow, wages and prices in relatively wealthy countries will be under downward pressure. And that means that global competition keeps the inflation threat low. FLOATING CURRENCIES AND THE GOLD STANDARD
All that trade is being financed with U.S. dollars, Japanese yen, the E.U.’s euro, and a whole lot of other currencies. Every day the value of those currencies vis-à-vis each other shifts—or “floats”—according to supply and demand on foreign-exchange markets, and in recent years there’ve been some mighty big swings as economic policies change and speculators and investors make big bets.
Businessmen and tourists complain about the uncertainty that accompanies floating rates, but there’s little alternative. Once upon a time, back in the 1960s (and for almost a century before), foreign-exchange rates were rigidly fixed—and only occasionally repegged—and major currencies such as the dollar were valued in terms of gold. (By this standard, gold was worth $35 an ounce, and dollars could be turned in for gold.) This setup supposedly lent stability to the world trading system and ensured that currencies possessed real, not inflated, value. But currency and investment flows across borders became so enormous in the late 1960s and early 1970s that the system (known as Bretton Woods, after the New Hampshire town where it was devised following World War II) unraveled. In 1971, Nixon took the United States off the gold standard.
Today there are still people who hanker for a gold standard. Gold, the argument goes, has intrinsic value, while paper does not. But advocates of a return to the gold standard are like octogenarians who reminisce about the good old days, forgetting about gas lamps and outhouses. The mechanistic inflexibility of the gold standard is what forced us to go off it. Floating rates allow these corrections to occur continually and with relative calm. The system may not be perfect, or even comprehensible, but it looks as though it’s here to stay.