Looking for Inflation in All the Wrong Places
(Prof. Steve Hanke, October 2, 2022)
Transcript available below
About the speaker
Steve H. Hanke is a professor of applied economics and founder and co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at the Johns Hopkins University.
Hanke is a senior fellow at the Cato Institute in Washington, D.C., a senior fellow at the Independent Institute in Oakland, California, a senior adviser at the Renmin University of China’s International Monetary Research Institute in Beijing, and a special counselor to the Center for Financial Stability in New York. Hanke is also a contributing editor at Central Banking in London and a contributor at National Review. In addition, Hanke is a member of the charter council of the Society for Economic Measurement and of the Euromoney Country Risk’s experts panel.
In the past, Hanke taught economics at the Colorado School of Mines and at the University of California, Berkeley. He served as a member of the Governor’s Council of Economic Advisers in Maryland from 1976 to 1977, as a senior economist on President Reagan’s Council of Economic Advisers from 1981 to 1982, and as a senior adviser to the Joint Economic Committee of the U.S. Congress from 1984 to 1988. Hanke served as a state counselor to both the Republic of Lithuania from 1994 to 1996 and the Republic of Montenegro from 1999 to 2003. He was also an adviser to the presidents of Bulgaria from 1997 to 2002, Venezuela from 1995 to 1996, and Indonesia in 1998. He played an important role in establishing new currency regimes in Argentina, Estonia, Bulgaria, Bosnia‐Herzegovina, Ecuador, Lithuania, and Montenegro. Hanke has also held senior appointments in the governments of many other countries, including Albania, Kazakhstan, the United Arab Emirates, and Yugoslavia.
Hanke is a well‐known currency and commodity trader. Currently, he serves as chairman of the supervisory board of Advanced Metallurgical Group N.V. in Amsterdam and chairman emeritus of the Friedberg Mercantile Group Inc. in Toronto. During the 1990s, he served as president of Toronto Trust Argentina in Buenos Aires, the world’s best‐performing emerging market mutual fund in 1995.
Hanke’s most recent books are Currency Boards: Volume 1. Theory and Policy (2020), Currency Boards: Volume 2. Studies on Selected European Countries (2020), Currency Boards for Developing Countries: A Handbook (2021), Public Debt Sustainability: International Perspectives (2022), and The Hong Kong Linked Rate Mechanism: Monetary Lessons for Economic Development (2022).
Robert R. Reilly:
Hello, I am Robert Reilly, director of the Westminster Institute. Today, we are extremely delighted to welcome for the first time Professor Steve Hanke, who is a professor of applied economics and founder and co-director of the Institute for Applied Economics, Global Health, and the Study of Business Enterprise at the Johns Hopkins University in Baltimore. He is also a senior fellow at the Cato Institute in Washington D.C., a senior fellow at the Independent Institute in Oakland, California, a senior advisor at the Renmin University of China’s International Monetary Research Institute in Beijing, and a special counselor to the Center for Financial Stability in New York.
Steve is also a contributing editor at Central Banking in London and a contributor at National Review. In addition, Dr. Hanke is a member of the charter council of the Society for Economic Measurement and of the Euromoney Country Risk’s experts panel. He served as a senior economist on President Reagan’s Council of Economic Advisers in 1981-82, and as a senior advisor to the Joint Economic Committee of the U.S. Congress in ’84 to ’88.
Dr. Hanke served as a state counselor to both the Republic of Lithuania in ’94 to ’96 and the Republic of Montenegro in ’99 to 2003. He was also an advisor to the Presidents of Bulgaria in ’97 to 2002, Venezuela in 1995 to ’96, in Indonesia in 1998. He played an important role in establishing new currency regimes in Argentina, Estonia, Bulgaria, Bosnia-Herzegovina, Ecuador, Lithuania, and Montenegro.
He has too many honorary doctorate degrees to name, and he has received likewise multiple honors and a knighthood. His most recent books include the five he wrote during or since 2020. For instance, Currency Boards: Volume 1. Theory and Policy and Public Debt Sustainability: International Perspectives. Today, Dr. Hanke is joining us to discuss: “Looking for Inflation in All the Wrong Places.” Steve, welcome to the Westminster Institute.
Great to be with you, Robert.
Robert R. Reilly:
So who is looking for inflation, and if they are looking in the wrong places, what are the wrong places to look for it? And therefore, you can also tell us what are the right ones?
Well, all the wrong places are everything you read about in the newspaper or everything you hear coming out of Washington D.C., whether it is the Congress, the White House, or the Federal Reserve, which is our central bank. What happened in the United States is that COVID hit in early 2020, and in a panic the federal government started spending a lot of money, and most of that was financed by the Federal Reserve expanding the money supply.
In other words, the U.S. Treasury was issuing bonds to finance the deficit that had been created by the spending, excessive spending, and those bonds were being bought by the central bank, the Federal Reserve. And when they buy the bonds, they credit the government, and that actually creates money. I mean, if you will, running the printing press.
So they were expanding the money supply. They had been expanding it since February of 2020 about three times faster than the rate that would be consistent with the Fed hitting its two percent inflation target, and that excess money creation is why we have a very high rate of inflation that is running the headline inflation. The consumer price index numbers are at 8.3 percent right now in the United States, so that is why we have inflation. It is too much money, but all the wrong places.
The Wrong Places
Now the Fed and the government do not want us looking and fingering the government spending and financing of that with Federal Reserve money. They do not want us looking at that. They want us looking at [what]? What have we been reading about?
Number one, remember Bob, this was all going to be a temporary thing. It was going to blow over in a few months, and after COVID settled down, and we would not have inflation. Well, it has been two and a half years and we have a lot of inflation, and that inflation was caused by excess money. We know that because John Greenwood and I, using the quantity theory of money about a year ago, a little over a year ago, in the Wall Street Journal we said that the inflation would end up being six percent and maybe as high as nine percent. We hit the target, and the target was hit because we were using the quantity theory of money. We were looking for inflation in the right place, and that is excess growth of the money supply.
So the officials, what do they tell us? They tell us, oh, it is temporary. It is going to blow over as soon as COVID settles down. It is the supply chain. Remember we went through the supply chains, that that was causing the inflation? Then we went through oil prices were going up, then we really were getting absurd, saying Putin was causing the inflation, and on and on you go with excuses, but they never mentioned the money supply, and they do not want to mention the money supply because if they did, the noose would go around the neck of the Federal Reserve. That is why they do not want us looking at the money supply.
Money Supply and Central Bank Policy
And to give you an idea about this, Bob, Jerome Powell is the chairman of the Federal Reserve, and in testimony in February of 2021 here is what he had to say about the growth in the money supply measured by what they call M2. He said, “The growth of M2 does not really have important implications for the economic outlook.” And then just this past month at the Cato Institute, in a question-and-answer period, he tripled down on this thing. He said, “For really many years now monetary aggregates do not play an important role in our formulation of policy.”
Another quote: “Changes in monetary aggregates have not had a consistent reliable relationship. They have not been a good predictor of the economy or inflation.” He also said, “Monetary aggregates do not play an important role in our formulation of policy, and we do not think they are generally a good way to think about policy or inflation.” So here is the head of a central bank, producing money, and he is telling us money is not important.
This is all complete nonsense, by the way. If you look at one of my favorite studies, actually Warren Weber did this at the Minneapolis Federal Reserve in a publication in 2001. He looked at the rate of growth in the money supply and the rate of inflation in 110 countries, so he had essentially every major country in the world, and he found that there was a one-to-one relationship. If the money supply goes up by one, the inflation goes up by one, that is what it means. He had a perfect fit between changes in the money supply and inflation.
And we all know this, and we have known it since really the 16th century when the quantity theory of money first arose. And ever since then, most economists adopt or embrace the quantity theory of money in one form or another, but this Federal Reserve has said no, it is useless.
Now, all the central banks, by the way, around the world have gotten on this bandwagon. If you listen to the Bank of England, you will see the same thing. Christine Lagarde the head of the ECB, the European Central Bank, says the same thing. Look at supply chains, look at oil, look at Putin, look at everything but the money supply, so that is how we got the inflation. It is all about the money supply.
Robert R. Reilly:
Steve, one way you make this crystal clear is through your bathtub analogy. Just to step back for a moment, could you talk us through that?
Yeah, let us talk about the bathtub because the first step is going to be how we got this inflation and where we looked for the inflation, and we look in the bathtub, the monetary bathtub. So we have had money coming into the bathtub through the spigot since February of 2020, and that has increased the money supply going into the tub by a little over 40 percent in two and a half years.
Now, what happens once the money gets into the tub? Well, some drains out naturally because the economy is growing, and to accommodate that economic growth, you need money, so some of it drains out the economic growth drain. And then the second drain is the demand for money. As people become wealthier and their incomes increase, they demand to hold more money, so that is another drain that drains some out of the bathtub.
But if you look at everything that has gone in, and the amount that has drained out, only about 50 percent of that 40 to 41 percent increase that has gone into the tub has actually drained out, so you have got a lot of money left in the tub, and that is excess money.
Inflation Overflow Valve
Now, where does that go? That goes out what I call the inflation overflow valve, and that is why we have, number one inflation now. And by the way, it does not come out of the overflow valve immediately, Bob. There is a lag of 12 to 24 months, maybe even in some cases a little longer than 24 months, that takes the excess money going out the valve to actually get into the economy and create inflation.
So this gets to where we are going, going forward. And John Greenwood and I collaborate and work on this bathtub thing pretty intensively, and Greenwood and I forecasted, as I said, not only a year ago correctly where we would be now, using the quantity theory of money in the bathtub, but by the end of this year we will still be at six to eight percent year over year.
The annual inflation rate in December, which is coming up pretty soon, will be six to eight percent, and in 2023 the excess will still be coming out of the overflow. And that inflation rate we think will be around five percent on an annual basis by the end of 2023, going into 2024. So that is kind of the inflation in the bathtub analogy and so forth.
The Fed is Flying Blind
The point now, however, is that the Fed, that is not looking at the money supply, all of a sudden, is panicked because, of course, the public’s number one problem and anxiety concerns inflation. The public does not like this, so the Fed has pivoted, and they said, well, we are going to kill inflation now. We have got inflation. We were not able to anticipate it. We do not know where it came from, according to them, but we have it. And now, even though they are flying blind, they are not looking at the money supply, somehow, they are going to increase interest rates, reduce the size of the balance sheet at the Federal Reserve, and kill inflation.
A Recession in 2023
Well, if you look at what has been happening the last six months, the money supply essentially has not grown at all, and that is before they have even started tightening the screws. So this means what, if the money supply is not growing? You have a recession right around the corner. So we have had six months now with essentially no growth in the money supply and the high rate of inflation Greenwood and I anticipate that we will see a recession, maybe a whopper, in 2023 next year if the Fed does not start putting the money supply in its dashboard and paying attention to the growth in the money supply. They should be growing the money supply at about four to six percent per year. Now it is growing at zero percent. It was growing almost 25 percent early in 2020.
Do Not Slam on the Brakes
Robert R. Reilly:
Well, if there is this huge overhang of excess money, why would they need to grow the money supply at six percent? Wouldn’t that simply add to the inflationary problem?
Well, no, it would not, and it would not for the following reason. Current economic activity and current demand, those two drains, current economic activity, current demand for money, need to be fed with current injections of money into the system. And what is the amount that would be consistent with an inflation target of two percent? I said four to six percent. It is really closer to six percent, but I would err now, since they are trying to slowly get inflation under control, to have it growing at around four percent.
And if they did that, then the excess dissipates over time and gradually, by the time we get into 2024, we will hit the two percent inflation target, but you do not want to slam on the brakes completely and too hard or you will not be accommodating with the excess that is in the tub. That is coming out by the way, that is pretty much earmarked, Bob, for inflation. The excess really is earmarked for inflation. It is not earmarked to facilitate current economic activity or current demand growth for money.
So the ideal thing – you say, well, what would you do, Hanke? Number one, they have to admit that money causes inflation, changes in the money supply cause changes in the Consumer Price Index, that is point number one. They have canceled that. They have to put that on their altimeter, and so that they are not flying blind. Right now, they are flying in an airplane with an altimeter. It does not have anything on it, and the only thing on it that counts in a central bank is the money supply, so they have to get the altimeter with the money supply on it. They have to fly with that around four percent, and if they do that, the inflation will gradually come down and work itself out of the system by 2024.
Interest Rates and the Money Supply
Robert R. Reilly:
Well, what so many of the governors of the board, the Federal Reserve board, seem to be saying is that our tool to fight inflation is raising interest rates, which as we know were kept pretty much near zero for so many years. And now at their meetings they are jumping it up by 75 points, and they intend to do more. They generally talk about this as the only tool in their toolbox. Now, what is the effect so far of their having raised rates, and what will be the effect if they are continuing to do it? Is that the engine of this whopper of a recession you say may take place?
Well, this is a good question, Bob. Let me quote Milton Friedman on this, Milton Friedman, who is really the kind of contemporary dean if you will of the quantity theory of money. Friedman, and I am quoting, said, “Monetary policy is not about interest rates. It is about the quantity of money,” so that gets to your question. We do not know what the linkage is between changes in interest rates and changes in the money supply. It is a very fuzzy kind of picture.
Sometimes we have had episodes where they have increased interest rates a lot in the United States, and it has not changed the money supply very much, and it has not even really slowed down the economy very much. Other times they have increased the interest rates, and boom, we have a sharp reduction in the money supply and a sharp reduction in economic activity.
It is the money supply that counts, and this linkage and focus on the interest rates is the wrong place to look. We said looking for inflation in all the wrong places, that is how we started, and we said wrong place, supply chain, that is the wrong place, oil prices, that is the wrong place, Putin, that is the wrong place, and so forth. Controlling the money supply by interest rates alone is looking in a way at the wrong place.
They really have the wrong thing on the altimeter. They do not have the money supply. They do have interest rates. They are looking at that, and they are also talking about what they call quantitative tightening, that is another thing, and that is reducing the size of the balance sheet of the Federal Reserve. Instead of buying bonds and creating more new money, they will let the bonds that they have mature, and in that way shrink. They will not be selling the bonds that they have, that would obviously shrink the money supply. They will just let them mature, and that will slowly shrink their balance sheet and the money supply, also.
Robert R. Reilly:
How is this like and how is it unlike what happened in the United States in the late ‘70s and early ‘80s when Paul Volcker was the chairman of the Federal Reserve? I remember moving to Washington, D.C. to work in the Reagan Administration, and I bought a house in early 1981, and I was paying 16 percent on the mortgage. It was quite a startling time. To a certain extent, doesn’t it look like the Fed now is doing what Volcker did then?
No, this is a very good question because the Fed in the late 70s had produced a lot of excess money. Rhere was a lot of excess money in the monetary bathtub. We had very high inflation and we had, actually, what they call stagflation. The economy was not growing, and we had a lot of inflation, so Volcker was appointed by Carter in 1979.
Then when Reagan came in, Reagan gave Volcker the green light. He said look, we want to kill inflation, that is one thing that we are after in the new Reagan administration, which of course, I was in there with you at that time, as you recall, those early days with President Reagan. Volcker was a monetarist. He used the quantity theory of money. He had the money supply on his altimeter, and that is what he was watching, and he was trying to reduce the growth rate of the money supply and with that kill inflation, which he did, in fact.
Now, Powell claims that he wants to be another Volcker, but he is not because he is not looking at the money supply. He is not a monetarist. He is not looking at the quantity theory of money. He and Volker are complete opposites because Volcker was not flying blind. He was flying the Fed airplane and he had the money supply on the altimeter.
That is not the case with Powell. He is flying the plane blind. He does not have the money supply in the altimeter. That is the problem, and I think if they keep up with what they are doing, no growth in the money supply or maybe they will even bring it so far down it will be negative, we are going to have a whopper of recession next year. That is the danger, and when you are flying blind, it is dangerous.
Robert R. Reilly:
On the other hand, Steve, Volker raised interest rates, and unlike the scenario you described where you let the excess money supply gradually flow out, there was a very sharp recession, [which] people would say [was] as a result of what he did.
Well, there actually were two, and let me explain that [because] this is a very important point. There were actually two recessions in Reagan’s first term, as you will recall, and what happened? Volcker had the right idea, monetarism, money on the dashboard, and the problem was the altimeter. The measurements they had for money were inaccurate. He thought that he was lowering the growth rate and the money supply just right. In fact, he was lowering it excessively, but he did not know it.
There was a group of researchers in the research department at the Federal Reserve who actually knew this, but Volcker was not given the proper information, so this was a calibration, a measurement of the money supply, that was misleading and misleading Volcker. Volcker was in principle doing exactly the right thing, he just did not know when he looked at the altimeter that he was actually flying at a lot lower level than the altimeter was registering.
The Relationship between Fiscal and Monetary Policy
Robert R. Reilly:
Steve, can we talk about the relationship between fiscal policy and monetary policy? It seems that the Fed has moved in lockstep with the excessive deficits that successive administrations, whether Republican or Democratic, have run.
Yes, this confuses a lot of people. And let us start by making the important point that the fiscal deficits do not cause inflation, and you can run fiscal deficits with stable inflation, no increasing in inflation, and you do that by selling the bonds that are required to finance that deficit to the general public. So they sell them to Steve Hanke and Bob Reilly, and what happens? We send the Treasury money. They give us a bond in exchange, and the money supply has not changed. The money supply has not changed, and money supply changes are what cause inflation to change.
Now, look at what they did in the post-COVID period. The deficit increased. The Treasury issued bonds, but it did not sell them to the general public, it sold them to the Federal Reserve. And the Federal Reserve literally creates money. They credit the government’s account when they buy those bonds, and that increases the money supply. And by the way, Bob, about 90 percent, or a little over 90 percent, of the post-COVID fiscal deficit was financed by the Federal Reserve. Most of the bonds that were sold to finance the federal deficit were actually sold to the Federal Reserve, and that is why they talk about the balance sheet expanding at the Federal Reserve.
Well, that is why, they were buying a lot of bonds, and so the asset side of the balance sheet grew enormously, and of course, they did that expansion by issuing credit to the government and creating money.
Robert R. Reilly:
The size of these deficits was so enormous. Could the public market absorb [them]?
Oh, the public market would have absorbed them, but let us go through what would have happened. To do that and sell bonds to you and me, that takes money out of our pocket, okay, so that takes money out of the system. And that is one reason, by the way, why you do not get inflation. They give us a bond, but we have to pay for it, and our checking account goes down. And checking accounts count as money, so the money supply decreases. That is one aspect.
The other aspect, to entice us to buy the bonds they are probably going to have to pay higher interest rates. Well, they do not want to do that. They wanted a free lunch, basically, but there is no free lunch with government deficits because either the interest rates are going to go up if they sell all the bonds to finance a deficit to the general public, or if they sell those bonds to the Fed, money is created, and inflation goes up.
By the way, over time interest rates always follow inflation, so even with that second option, by creating more money by selling the bonds to the Fed, creating inflation. Eventually, interest rates are going to go up anyway because as we see right now, interest rates follow inflation. They do not lead inflation, they follow inflation.
Why are Central Banks Getting this Wrong?
Robert R. Reilly:
Steve, from your vast experience in other countries as well as your analysis within the United States, it would seem that the relationships about which you are speaking are sort of undeniable, that they are well established. They were not when Milton Friedman introduced them, but over the years they have been. Why [is it that] not only is the United States living in a state of denial regarding this, but so are so many other countries?
The big reason comes back to what I kind of alluded to initially, and that is the Federal Reserve does not want to take any responsibility for inflation because inflation is bad. The public does not like inflation, and if the public can put their finger on who is causing the inflation, that is a real problem for whoever is fingered.
And the Fed does not want money to be mentioned at all, and the reason why is they are the ones responsible for the money supply, so they would like to take that off the table. If they can do that, they never will be fingered as a causal factor in the thing, so that is why this new song sheet has been produced in which all the central bankers are saying look for inflation in all the wrong places.
Holding the Federal Reserve Accountable
Robert R. Reilly:
Okay, let’s say you could finger the Fed, and everyone generally understood they are the ones who are responsible for this. It is independent. How do you hold the Fed accountable?
Well, you hold them accountable because the governors and the chairman are up for appointment, as you know. It is an independent institution, but in a way that is kind of a fiction because there is pressure put on the central bank from the Congress and also from the White House, so it is not like they are operating completely in a vacuum, and ultimately, they have terms. They are not appointed like the Supreme Court Justices for life. If they want to keep their job, they better be satisfying Capitol Hill as well as the White House. So there is really kind of a connection. They are responsible in the sense that there are term limits.
Robert R. Reilly:
Well, which means everyone is complicit in this.
Oh, yeah, it is a great Washington game that is being played now. You have the White House saying exactly the same thing. I mean the President, by the way, President Biden to show you how bad this is, he actually said – this was right before he was elected – he said, “Milton Friedman is not running the show anymore.” That is a quote, and why did he say that? He wanted to cancel the quantity theory of money. He wanted to cancel this notion that the money supply changes will change the rate of inflation in the economy.
And why did he do that? He bought into this idea of what they call modern monetary theory, and modern monetary theory basically says you can print as much money as you want, and as long as you are issuing debt in the same denomination as the money you are creating, no inflation will occur. And oh, if it does occur, they say oh, you can tinker around with fiscal policy then and tamp down the inflation.
It is a screwball idea, but it went around Washington, and it was not just the leftwingers. Bernie Sanders bought into this very big, by the way. He was a big promoter of modern monetary theory, but it went around Capitol Hill. It was convenient. It went around the White House circles. It was convenient.
And it is clear it even infected the Federal Reserve because the Federal Reserve has gone out of its way, Bob, to cancel the quantity theory of money, cancel anyone associated with it, namely, Milton Friedman, so that is the way Washington works. They want to spend like drunken sailors, and they want to say it is some exogenous thing that they have no control over, Putin, or supply chains, or COVID, or you name it, that is causing it, not them.
Robert R. Reilly:
I remember when Biden said that, and I also remember the sense of general euphoria that the deficit could be increased, that we can keep passing bills for subsidies or anything which we like because inflation has not really risen. And it was most likely for the reason you pointed out, that is the lag time. Well, now the lag time is over, and we are really being hit.
But the curious thing is as you have also already explained, no one seems to wish to learn from this.
Kinds of Changes in Prices
And the reason they do not is it is very clear what happens is that the narrative you see in the financial press is a thousand stories about supply chains, not so much about Putin anymore, but oil prices. And by the way, let me give you an example just to get this oil thing out of the picture.
You have two different kinds of changes in prices. You have what they call changes in relative prices, some prices go up, some prices go down, all the time, prices are moving all over the place, so that is changes in relative prices. And if the oil price goes up a lot, that is a relative increase in the price of oil compared to other things that we buy, cars, or groceries, or houses, or what have you.
The price level measured by the Consumer Price Index is an aggregate, that is not a relative price change. That is the level of everything going up or everything going down, and there are over 300 items in the Consumer Price Index, for example. It is a big basket with a lot of stuff in it. Inside the basket, there is a lot of relative price stuff moving around.
Now, let’s go back to the 1970s. We had two oil crises in the 1970s. One, we had the Arab oil embargo in 1973, and then we had a second oil crisis in 1979. The first one in Japan hit everybody, by the way. Everybody buys oil, and Japan does not produce any oil, they are buying it all on the international market, so whatever the international price is, that is the price Japan is obviously paying.
So in the first Arab oil embargo in 1973, the Bank of Japan decided that to cushion the shocks so to speak they would accommodate it by increasing the money supply. And what happened? They got inflation. Inflation went up, and everybody in Japan was saying that inflation increases because oil prices are going up.
Now, the second crisis in 1979, the Bank of Japan wised up and they said we are not going to accommodate this price increase. People will have to pay more. We are not increasing the money supply. And as a result, they did not get an increase in inflation, so that is back to the quantity theory of money. It is a quantity of money in the economy that allows the aggregate basket to go up, go down, stay the same.
These relative price changes fool people because, of course, when they go to the gas pump every week to fill their car, they know what the gas price is, and they go to the grocery store a couple of times a week, so they see the grocery prices going up. But there are all kinds of other prices, and if the money supply does not change, Bob, and you are required to spend a lot more money on gasoline because oil prices are up, you will not have as much money to spend on other stuff, and those prices will tend to sink, and the overall index stays the same.
The Consumer Price Index, in that hypothetical example that I just gave you, would not change very much. You would be spending a lot more on gasoline, less on food, and so forth, and that would be under the condition where the money supply was not changing.
Dollar as the Reserve Currency
Robert R. Reilly:
Steve, could we talk a bit about the international repercussions of what we could call the irresponsible physical and monetary policies of the United States, because the dollar is the reserve currency in the world. What has that done?
The dollar is very strong right now, by the way. It is as strong as it is almost at a record strength level against the Euro, for example, and the dollar is the most important currency in the world. The Euro is the second most important, so the dollar-Euro exchange rate is, in fact, the most important price in the world. And the dollar is almost at parity now, the dollar-euro exchange rate.
The dollar is very strong, so what this does – and the question is why? Well, there are two things. People say, well, the Federal Reserve started increasing interest rates a little faster than the European Central Bank and other central banks, and since you can earn more interest now in the dollar relative to these other currencies, the dollar tends to go up. I think that is true, that is a factor.
The big thing going on is the war with Russia, and the dollar is the international currency, and it is viewed as a safe haven. It is geographically a long way from the war zone, I mean it is an ocean away from the continent where the war is being fought.
And whenever a war is being fought on the continent, there is kind of a gradient going away from the war. As you go further and further away from the war, currencies further away become stronger, and with the U.S. dollar being the international currency, of course, this is a big deal. So the war is really, I think, one of the main factors driving the dollar up.
Now, you say, well, what does this do to other [currencies] internationally? Well, it makes it tough on other countries that have seen big depreciations in their currencies because most of those countries issue their debt in U.S. dollars, so they have to pay their debt off by earning dollars, and that means if they have had a depreciated currency, well, it takes a lot more of those depreciated units of currency to get a dollar than it did before, so the burden of the debt becomes very onerous on a lot of developing countries, by the way, this is a real problem, because their currencies are all half-baked.[If] you go to Latin America, those [nation states] are classic cases where you get huge currency depreciations, but you also get them in all kinds of other developing countries. [If you] go through Africa, all of their currencies are way down against the U.S. dollar. The debt burdens are much higher, and when their currencies depreciate against the dollar, they tend to import quite a bit of inflation, so they have big inflation problems just because of the depreciation. The international implication is kind of nasty. When the dollar gets strong, and these other currencies go down, their debt burdens go up and their inflation problems are pretty onerous.
Weaponization of the Dollar
Robert R. Reilly:
Steve, the last big issue I would like to hear your opinion on is what some people call the weaponization of the dollar, that the United States, having all the power that holding the reserve currency gives them, is using it to punish its political enemies through sanctions or through seizing their foreign reserves as has been the case with Russia and sanctions placed on other countries as you well know. Could you comment on the danger?
Yes, let me make two comments, two general comments. One is that as you know, Bob, I am a classical liberal, a free trader, so in principle, in principle I am against sanctions. Just I am for free trade. I am against sanctions, so that is a principle.
As a practical matter, if you look at the scholarly literature on sanctions, they never work. There is a big literature on sanctions. They always fail to accomplish their stated goal, and their stated goal is to damage whoever is being targeted, whether it is an individual or a nation state, and they usually end up creating what is called a rally around the flag effect. If you sanction a country or a leader of a country, which means, in fact, you are going to war with them because sanctions are a means of going to war, you tend to get the locals rallying around that targeted individual.
And look at North Korea, look at Venezuela, look at Russia. Has sanctions ever changed the behavior in those countries? No, they have created a rally around the flag effect, and you, in fact, keep those leaders in power. And you do damage their economies. There is no question about that, but you create a lot of negative unintended consequences that are that are even worse in terms of blowback on those who impose the sanctions on the targeted enemy.
And just look at what is happening in Europe. Sanctions against Russia are damaging Russia. They are literally destroying Europe, so they are a fool’s game. They are a stupid thing, a dumb thing. Anyone who has ever studied sanctions knows that they do not work.
Now, let me tell you about one example. This was in the Trump Administration. One Sunday afternoon, Secretary Pompeo called me, Secretary of State Pompeo that is, he had had it pre-arranged. His staff had called me before, a few hours before, and said could the Secretary speak to you about sanctions on Hong Kong. They were contemplating putting financial sanctions on Hong Kong, and Pompeo wanted to do this. We talked for about 35 minutes. He was for putting sanctions on to punish China for what China had been doing, interfering with Democratic processes in Hong Kong among other things.
I was adamantly opposed for the two reasons that I just gave you. In principle and in practice, they do not work, and there was a third thing, and that is weaponizing the dollar itself, because Hong Kong produces the Hong Kong dollar, but they do it with a currency board system, and the Hong Kong dollar trades at a fixed exchange rate of $7.8 Hong Kong dollar for one US dollar. And the Hong Kong dollars are backed 100 percent by U.S. dollar reserves. That means that the Hong Kong dollar is a clone of the U.S. dollar. It is the same thing as a U.S. dollar.
Now, the one reason I was against any freezing of assets or sanctions on Hong Kong [is] we would be taking [property]. We would be weaponizing the dollar and we would be taking property. This is exactly what we did with Russia, by the way. We froze their reserves, but I was totally against this, and that was a Sunday afternoon.[On] Monday morning, Pompeo, the President of the United States, Secretary of Treasury Mnuchin, and several others met, and they decided they would not impose sanctions on Hong Kong. I got a call from the White House. The call was basically, Hanke, you won, we are not putting sanctions on Hong Kong.
And the weaponization, by the way, has a long-term, I think long-term, very dangerous [set of consequences]. Weaponizing the dollar, like if they would have sanctioned Hong Kong, or if they did sanction and freeze those assets and interfere with the Swift payment system for Russia, this will eventually come back to haunt the U.S. because other countries will not view the U.S. dollar as being safe. And if they do not view it as being safe, they will go to some other substitute.
Now, eventually, this has not happened yet, and I do not know if it will happen, but it could happen, if the U.S. is not the international currency, people say oh, who cares, you know, we are in the United States. Who cares about that? It allows the U.S to borrow money cheaply, that is why we [have] run a trade deficit every year since 1975 in the United States. How do we finance that? How can we do this forever, run a trade deficit? We do it because the dollar is an international currency and people are willing to send capital to the United States. And they do that because the U.S. dollar has not been weaponized. It is safe. They get a good return, etc. etc., so that international currency status of the United States dollar is very important to U.S citizens because it allows us to do what? It allows us to consume a lot more than we make.
Robert R. Reilly:
Well, it seems that there are measures afoot, particularly on the part of China and Russia to come up with an alternate payment system, and the Saudis I think have agreed to use one of those payment systems. Turkey has agreed to pay Russia in Rubles.
This is kind of the camel’s nose under the tent problem. If you weaponize your currency, you are asking for trouble, and how big the trouble will be, I do not know, but you are inviting substitutes to come in. And you put your finger on it, Bob, about Russia and China. China has been working on this for quite some time, by the way.
And the only reason, by the way, that China has not really been able to compete [with] the Yuan [against] the U.S. dollar is that the Yuan is not convertible in international markets. It basically can be used in China. It is not like the U.S. dollar.
The U.S. dollar you can take any place in the world and exchange it for whatever the local currency is, or most people are just happy to get dollars, anyway. You go to Latin America or most developing countries, and you ride in a taxi, and ask the guy what the price is, and ask him if he wants dollars. He will say oh, yeah, I will take dollars anytime.
Inflation and Recession Outside of the United States
Robert R. Reilly:
Just a closing question, Steve, you said we may be in for a whopper of a recession because of the way the Federal Reserve has handled this situation. What about Europe? And of course, Great Britain is experiencing a very high rate of inflation. There is inflation in the European countries. They are getting exactly the kind of blowback that you are describing from the sanctions on Russia in the enormous rise in energy costs and the jeopardy that is placing on their economies, which rely on gas to function. Are they in for a whopper there, also?
Yes, I think they are in for a whopper kind of for different reasons than the United States. You put your finger on it. It is a sanctions blowback, [which] is disrupting the economies tremendously in Europe. I think people are not aware of what is going on. They are really in bad shape, particularly in Germany. Germany is kind of the epicenter of things. Germany is going through a tremendous transformation and hardships, so Europe is going to be in trouble.
The United Kingdom is in big trouble, but the United Kingdom, like Europe, are in a war with Russia. The blowback is huge on both of those places. Now, let me mention something you just reminded me of. There are places in the world where there is not inflation, and the reason there is not inflation is because the central banks have not produced excess money.
In Japan, the inflation rate is three percent per year. The Bank of Japan has not done what they did in the United States. They have not produced excess money. In Switzerland, the inflation rate is 3.4 percent. They have not produced excess money. China which follows the Milton Friedman quantity theory of money very carefully, [has little inflation]. 2.5 percent is the inflation rate in China, so that proves my point.
We are ending by allowing me to really drive home this idea that it is the quantity of money that creates inflation. Inflation is not a global problem, it is a local problem, and that is another thing that the central bankers in Europe, England, and the United States have spread, this idea that it is somehow a global problem. And the reason why they want to point the finger in the wrong place for the cause of inflation somehow, it is a global thing going on.
No, it is not a global thing. Japan, Switzerland, and China are just three examples I am giving you where they have low inflation rates. Look at the economies that are doing well, by the way, when you look at the sanctions thing. We have got Vietnam doing pretty well now, we have got Saudi Arabia doing pretty well now, we have got Japan doing pretty well now, and we have got Indonesia doing pretty well now. And I think I mentioned India. Why? Because they are all buying cheap Russian oil.
This gets to the sanctions thing. There is always a workaround with sanctions. They just do not work, Bob, that is the practical side of the thing. They do not work. They create a lot of unintended costs and consequences, and they are a stupid policy to be imposing, but the United States now for some time – actually, this started with George W. Bush. This is all a bipartisan thing, by the way. All these bad policies are [bipartisan]. The sanctions are completely bipartisan, and they are stupid. They are for losers.
Hanke Annual Misery Index
Robert R. Reilly:
Well speaking of losers, Steve, you issue the Hanke annual misery index, and I presume you will be putting out the new one as we come to the close of this year. Can you just comment on your misery index in these closing moments?
Okay, let me let me just say I will keep it very, very simple. The idea of the misery index actually was something that an economist, a very clever economist named Arthur Okun, devised. He was a member of the President’s Council of Economic Advisors with Lyndon Johnson. And President Johnson kept saying, you know, all these statistics, Art, I cannot keep track of it all. Are we doing better or worse? I really do not know what is going on. It is hard to follow.
Art said look, I am going to devise something that you can put [on] a card in your pocket. It is easy to follow. It will be the misery index, and the misery index, the simple one that he gave Johnson, was the inflation rate plus the unemployment rate. Those two things added together were the misery index at the time. And if unemployment goes up or inflation goes up, the misery index goes up, and that is bad and Johnson was clever enough – of course, you do not need to be a rocket scientist to figure out whether it is good or bad with the misery index going up or down, and so that is the idea.
Now, I have expanded it a little bit, and now we have the unemployment rate plus the inflation rate plus the borrowing rate, the interest you mentioned you were paying on your mortgage in 1981, 16 percent. Well, that would have been a bad number to go in the misery index. That would have increased Hanke’s misery index.
And then you subtract. There is one good that I put in the misery index now. The fourth element is the real rate of growth in the GDP, so if the economy is growing pretty fast, you subtract that from the first three negatives that you are adding together, and you come up with a Hanke misery index. So we will be producing that, and I hope I will share that with you and the folks at Westminster when it comes out. And it looks to me like it is going to be pretty bad this year because of inflation. It is the inflation.
What is in the misery index? Inflation, that is going up, the borrowing rate, interest rates are going up, okay, and the unemployment rates more or less staying. It is going up in a lot of countries. In the U.S., it is staying about the same. And then the last thing that is good that you are subtracting from those three bads is the growth rate in the economy, and the growth rate in the economy is going down. And as I say, even next year we will probably end up in a recession next year, so it could be negative.
Robert R. Reilly:
Well, I am afraid we are out of time, and I would like to thank Steve Hanke, professor of Economics at Johns Hopkins University in Baltimore for joining us today to discuss: Looking for Inflation in All the Wrong Places. I invite members of our audience to go to the Westminster Institute site or to our YouTube channel to see the other videos that we have on offer, a recent one on the energy crisis in Europe and its causes, programs on China, Taiwan, Japan, and the Middle East. Thank you for joining us today. I am Robert Reilly.