Executive Summary: The inclusion of a "gold plank" in the Republican platform, which reflects Ronald Reagan's willingness to devote monetary policy solely to maintaining price stability, has legitimatized serious discussion about dollar convertibility. The failure of Keynesian and Monetarist monetary experiments in the 1970s has begun to humble anti-gold dogmatists who are shifting toward accommodation. An "eventual" return is admitted. But a solid Reagan victory could lead to a swift monetary reform that would trigger a major bull market in bonds as well as extending a Reagan bull market in stocks. The Reagan campaign, though, has stumbled badly in August, reflecting the continued absence of a dominant campaign strategist. Pressures on the campaign are likely to force the required correction. The Carter-Reagan debates and the paid media war still will determine the election's outcome.
The Politics of Gold
Ultimately, inflation is a decline in the value of the dollar, the monetary standard. Until the decade of the 1970s, monetary policy was automatically linked to the overriding objective of maintaining a stable dollar value. The severing of the dollar's link with real commodities in the 1960s and 1970s, in order to pursue economic goals other than dollar stability, has unleashed hyperinflationary forces at home and monetary disorder abroad, without bringing any of the desired economic benefits. One of the most urgent tasks in the period ahead will be the restoration of a dependable monetary standard — that is, an end to inflation.
This is the "gold plank" of the 1980 Republican Party platform, unanimously approved by the 25-member subcommittee on fiscal and monetary affairs chaired by Delaware's Senator William Roth. The word "gold" was not specifically mentioned, although the subcommittee was conscious of the implications of the language of the plank, only because the political foundation had not yet been laid. In the primaries, Ronald Reagan had campaigned specifically on the pledge that monetary policy would only be employed to maintain price stability, insofar as he could ultimately influence the policy of the Federal Reserve. This stand in itself is of profound importance for it rejects the argument and belief of the demand-management theorists that monetary policy should also be used to combat recession. It was this belief that brought Keynesians and Monetarists together in an assault on gold that culminated in President Nixon's closing of the gold window in August, 1971.
The Keynesian argument at the time was that the fixed exchange-rate regime of the Bretton Woods system was penalizing the U.S. economy, specifically that the U.S. dollar had become overvalued relative to the Japanese yen and the Deutschemark. It was argued that if only the U.S. could devalue the dollar relative to these currencies it would enjoy economic expansion. Devaluation would mean fewer imports and greater exports, it was argued, and this would translate into more jobs and industrial activity. But under Bretton Woods, the United States had no power to influence the dollar's exchange rates with foreign currencies. The agreement was that the United States would maintain the dollar/gold exchange rate at $35 per ounce. Foreign central banks would be responsible for maintaining their currency exchange rates with the U.S. dollar, not concerning themselves with the price of gold, for there would be no need to do so. If Japan maintains the yen/dollar rate and the U.S. maintains the dollar/gold rate, the yen/gold rate is maintained automatically.
In order to achieve their policy objectives, the Keynesians had to devalue the dollar relative to gold and at the same time persuade foreign central banks to maintain the old implied currency/ gold ratio. That is, according to this theory the U.S. economy could be stimulated via devaluation to gold only if all other countries agreed not to maintain parity to the dollar. Otherwise, the same export/import relationships would hold at a higher general price level for everyone. Treasury Secretary John Connally was persuaded of this view by the theorists and hammered through the Smithsonian Agreement of December, 1971. The dollar/gold and foreign currency/dollar rates were changed to achieve a 13 percent average dollar devaluation against the other currencies.
To the monetarists, this was an uninteresting theory. But they joined forces with the Keynesians because of a wholly different theory. The monetarists also argued that monetary policy could be used to combat recession, but this could not be achieved if the monetary authority remained bound to maintaining the dollar/gold price at any rate. The Federal Reserve had to be free to manage the quantity of money according to the monetarist formulae. That is, the Fed can only follow one rule at a time, a quantity rule or a price rule. To follow Milton Friedman's quantity rule, the monetarist objective was an end to the dollar/gold price altogether. The dollar, they said, must "float" against the price of gold and thus against other currencies.
Where John Connally had achieved the Keynesian objective, George Shultz achieved the monetarist objective, presiding over the formal severing of the U.S. Bretton Woods obligation to maintain a dollar/gold price. Shultz, and William Simon after him at Treasury, took the cues from Professor Friedman. The floating of the dollar was applauded by Keynesians in the belief that it would free domestic demand-management from international constraints. The vision was of money-supply increases bringing down interest rates as opposed to money-supply increases being used by Americans to buy imports, which would then result in foreign claims on U.S. gold. The leading Keynesian in Congress, Chairman Henry Reuss of the House Banking Committee, predicted that with gold no longer having a role as a monetary asset, its dollar price would fall to about $6.
A decade ago, the classical economists forecast what the GOP platform now concludes; that the experiment with an "independent" monetary policy would unleash an inflation without bringing any of the desired economic benefits. Indeed, in 1969, Robert Mundell of Columbia University not only forecast that the experiment with dollar inconvertibility would soon begin, but that the global experience would prove so unsatisfactory that by 1980 it would end.
In the classical, supply-side model, individuals produce in order to consume; their objective is to produce both for current consumption and for future consumption. For current consumption, they require a medium of exchange that holds its value in order for trade with other producers to be facilitated, with no windfall losses or gains to either. For future consumption, they need a unit of account that holds its value over time. That is, the baker produces ten loaves, consumes eight and saves two. To save the two, he must translate them into a financial asset that can be translated back into two loaves next week, next year, or two decades hence, when he will retire. If the financial asset's unit of account does not hold its value, the two loaves become one, and eventually a slice. Observing the process, the baker's incentive to produce for future consumption erodes and he produces less. Or, he seeks to translate his loaves into less efficient assets that are not denominated in the shrinking unit of account: gold, for one. In the supply-side model, monetary policy should be employed solely to maintain the unit of account. Fiscal policy is the instrument designated to increase the efficiency and the productivity of the economy.
To the classical economists, the Bretton Woods system failed simply because its managers failed to understand that monetary policy alone was the instrument required to maintain the dollar price of gold, and through this process the prices of all other commodities. Instead, policymakers were led to believe that monetary policy could be employed to expand the domestic economy, and fiscal policy — tariffs or quotas — employed to maintain the dollar/gold ratio. (Americans would buy fewer foreign goods; therefore, foreigners would have fewer dollar claims on the U.S. gold stocks.)
There is one key piece to the puzzle that became available in the latter part of the decade that was not available at its opening: A classical explanation of the triggering cause of the Great Depression. The Depression, after all spawned the Keynesian and Monetarist schools, each of which put forward a hypothesis that it was trigged by a demand shock. The Keynesians argued that its causes were social, a maldistribution of income that produced an insufficiency of purchasing power in the pockets of the masses; the remedy was deficit finance of collective demand and income redistribution via taxation. To the Monetarists, the problem was insufficient bank liquidity from 1929 to 1933, which should have been remedied by going off gold to permit fiat money creation. In 1977, classical economists could put forward the hypothesis that it was a supply shock that triggered the Depression: the Smoot-Hawley Tariff Act of 1930, which cleared its chief legislative hurdle in the Senate in October, 1929. Consistent with this hypothesis is the contraction of the money supply by one third as an effect of the shock to production, not its cause. The hypothesis that maintenance of the dollar/gold ratio caused the Depression, which has ever since been used to give gold a bad name, has at the very least been challenged; at most, discredited.
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This review is important to the understanding of the politics of gold in September, 1980 and beyond. While most of the world believes a return to dollar convertibility impossible in the foreseeable future, the possibility of a swift return exists should Reagan win a solid victory in November. The primary reason is the widespread recognition that the experiment with a non-defined, floating dollar has failed to produce the promised benefits.
Just as important is the fact that only a handful of people stand in the way, and they are visibly wilting. Mundell points out that change which seems incredibly difficult in foresight often seems easily accomplished with hindsight. His example is the founding of the Bank of England in 1694, which had been thought impossible to accomplish "until King William III did it simply with a stroke of his pen." Arthur Laffer's example is especially relevant: Through the 1960s and into the spring of 1971, even the most ardent advocates of an inconvertible dollar confessed that they did not expect it to happen, and then there was the stroke of Nixon's pen.
The key people standing in the way of restoring dollar convertibility are the policymakers who took credit for it at the time: George Shultz, with pride of authorship, and William Simon, without; Henry Reuss, who assumed all the credit on the legislative end; John Connally, to a lesser degree because he participated only in the first phase. The other policymakers of the era were either passive, doing what they wrere told without emotional commitment (Nixon) or skeptical at the very outset, giving way to the political imperative (Arthur Burns and Paul Volcker). The others standing in the w7ay are only the Keynesians, broadly speaking, because no single Keynesian economist of stature invested emotional capital in the idea, and Milton Friedman. This is the entire cutting edge of the anti-gold contingent.
And what would happen if Milton Friedman began an accommodation to gold? Would Shultz and Simon remain steadfast in opposition? What would happen if the Keynesians, through economists of stature, began an accommodation? Would Henry Reuss remain steadfast? As it is, George Shultz told the Washington Post on July 31 that a return to gold is "not workable" and Henry Reuss in the House of Representatives on July 30 called the Republican plank "a sleazy seduction by one of the most noxious interest groups going — an eccentric cabal of newsletter writers, calamity peddlers, speculators, dealers and hoarders". Alan Greenspan, who played no role in the experiment, told the Post he sees a return to a gold link, but not until inflation is brought under control. (The supply-side model continues to elude Greenspan.)
There is, though, cracking at the theoretical level. In August, the Brookings Institution released the 10th anniversary issue of its Papers on Economic Activity. Brookings, a Keynesian outpost, gave the lead role in reviewing the economics of the 1970s to James Tobin of Yale, which suggests that the Keynesians consider Tobin their leading political economist. And here is Tobin with a startling admission:
In August 1971 the United States abrogated the Bretton Woods agreement, made the dollar inconvertible into gold, and forced other major countries to appreciate their currencies against the dollar. These steps led in 1973 to abandonment of pegged exchange rates in favor of "dirty" floating. But the new regime did not in the end fulfill the hope, long nurtured by economists, that floating would relax the international constraints on domestic policies.1
What of Milton Friedman? Clearly he has been struggling in the last few years with his experiment. Here, first, is the confident Friedman, in his presidential address to the American Economic Association on December 29, 1967, explaining why monetary policy should move to a quantity rule instead of a price rule:
Of the three guides listed (exchange rates, price and quantity), the price level is clearly the most important in its own right. Other things the same, it would be much the best of the alternatives — as many distinguished economists have urged in the past. But other things are not the same. The link between the policy actions of the monetary authority and the price level, while unquestionably present, is more indirect than the link between the policy actions of the authority and any of the several monetary totals. Moreover, monetary action takes a longer time to affect the price level than to affect the monetary totals and both the time lag and the magnitude of effect vary with circumstances. As a result, we cannot predict at all accurately just what effect a monetary action will have on the price level and, equally important, just when it will have that effect. Attempting to control directly the price level is therefore likely to make monetary policy itself a source of economic disturbance because of false stops and starts. Perhaps, as our understanding of monetary phenomena advances, the situation will change. But at the present stage of our understanding, the longer way around seems the surer way to our objective. Accordingly, I believe that a monetary total is the best currently available immediate guide or criterion for monetary policy — and I believe that it matters much less which particular total is chosen than that one be chosen.2
In 1973, when the monetary authorities finally broke away from the price rule of the fixed dollar/ gold ratio, Friedman had won his quantity rule, the "longer", but "surer way to our objective". Here he is, more than a dozen years later and seven years into the experiment, writing in Newsweek of July 14, 1980. Entitled "Monetary Overkill," it is a scalding criticism of Paul Volcker for having permitted the recession:
The Fed has again overreacted — from February to May 1980, Mj-B has actually declined at a 5 percent annual rate. We need steadiness, not these wide swings. Some variation from month to month in monetary growth is unavoidable. However, the Fed has the power and the knowledge to keep monetary growth far steadier than it has been. It has lacked only the will.3
The implications of Friedman's critique are astounding. The Fed, he is saying, lacked the will to print money fast enough between February and May 1980, with the prime rate and the Consumer Price Index pushing 20 percent, the dollar price of gold exceeding $630 per ounce. His monetarist followers remained silent. On the following day, the Roth subcommittee of the GOP platform committee unanimously accepted the gold plank, an event that surely shocked the monetarist school. Look what happened:
On January 29, Lindley H. Clark, Jr., of The Wall Street Journal who is the dean of monetarists in the financial press, could write the following:
As this column said in 1972, the recent speculative frenzy in gold should have underlined once again the "foolishness of trying to carve out for gold....a dominant role in the international monetary setup". As Nobel Prize economists Milton Friedman has often remarked, "You might as well base your monetary system on porkbellies."4
On August 11, after digesting the news from the GOP convention, Lindley Clark wrote:
The Republicans aren't at all precise about what they want, but it's a safe assumption that they won't be satisfied with a mere return to the situation that prevailed in, say, 1960. Presumably they would prefer something more like a true gold standard, of the sort that prevailed before the Depression.
A lot of nice things can be said about a gold standard, and many of them are said by the University of Rochester's Robert Barro in "U.S. Inflation and the Choice of Monetary Standard..."
For one thing, Americans are comfortable with a gold or silver standard, and don't knock the virtues of comfort. Until the 1970s U.S. money usually had a link to one or the other metal or both; the exceptions typically involved war and could be seen as temporary.
Gold was a monetary anchor that gave Americans confidence in paper dollars. A true gold standard would control the issuance of paper money, since anyone could demand a certain amount of gold in exchange for his paper. Even the watered-down gold standard of the postwar years exercised some influence over money-creation, since foreigners could — and did — show up at the gold window."5
Clark does go on to suggest all that is needed is a "monetary anchor." Milton Friedman's proposal for a Constitutional Amendment that would limit money creation to a minimum of 3 percent and a maximum of 5 percent per year, he suggests, would do just as well as an "anchor". The classical economists, of course, reject the idea that the supply of money can be fixed without an regard for the demand for money. Still, Mr. Clark's positive observations about gold as monetary anchor, reflecting the views of other monetarists as well, hints that accommodations are in the wind from Friedman himself. Nor would that be difficult for him. His argument have always centered on politics rather than economics, mainly that governments do not have the will to submit to the discipline of a gold standard. Given the disillusion over attempts to regulate the quantity of dollars instead of the price of dollars in real goods, it no longer seen a matter of will at all, but simply of method. And pork bellies will not do as the method. Says Mundell:
Only a few commodities could serve as the basis for solving the final asset problem. But only one asset, gold, is now practical. Central banks now hold about a billion ounces of gold, worth some large fraction of a trillion dollars. Fixing the price of silver or platinum would not solve the inflation problem, which has its heart in the relation between the supply of dollars and the price of gold. Gold is unique because of the central bank hoards. It is only when both the supply of dollars and the price of gold are fixed or controlled that the inflationary movement can be stopped. The solution therefore is to fix the dollar price of gold, reestablishing dollar convertibility. This single action stems the source of world inflation. If there were no insoluble political programs, a modernized gold system would be the natural solution.6
The political problems, though, are not so insoluble. They really stem only from those who have a stake in the experiment of the 1970s, and who argue only that things would be worse with gold. But in the face of persistent double-digit inflation, recession, and the threat of international monetary disorder, those arguments seem less convincing than ever. A recent exchange at an economics symposium sponsored by the Securities Groups at New York's Hotel Pierre captured much of the flavor of the current debate. Panelist Edward M. Bernstein was asked what would happen if the United States made the dollar convertible at a price fixed by the market, as Laffer has proposed. Bernstein, who was an economist with the American delegation to Bretton Woods in 1944 and who urged floating in 1973, said it would be impossible to make the dollar convertible at this time.
The situation is too volatile, he said, with perhaps 150 million ounces of gold in private hands.
Eugene Birnbaum of The Securities Group asked him what would the holders of private gold do as they saw the United States guaranteeing convertibility, and what would happen to inflation?
Bernstein said, well, it would stop the inflation. But so many people would present gold and ask for dollars that the government would have to print many more dollars to accommodate the purchases, and this would reignite the inflation!
Birnbaum persisted. Wouldn't the individuals buying dollars with gold do so because of a belief that dollar assets would appreciate more rapidly than gold — and they would invest those dollars in financial assets?
Why, yes, said Bernstein, "There would be an inflation of financial assets!"
Exactly. With the dollar as good as gold, the demand for dollars would soar. Investors would crowd into the bond market, which would feel the bulk of the bullishness. Heightened confidence in the possibilities for economic growth would enhance the value of stocks as well, extending our Reagan bull market scenario.7
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But what has happened to the Reagan Bull Market? Why has the Reagan campaign stumbled so badly in August, which, in line with our scenario, has but the bears back on top on Wall Street? The answer is simply that the absence of a dominant political strategist since the departure of John Sears, in February, is finally hurting. Reagan coasted home to the GOP nomination on the Sears' strategy. And the absence of a dominant strategist will not be felt until there is a crisis, a crisis which now is unfolding because of the instability of the campaign's committee system. Currently, the campaign is under the collective leadership of William Casey, Edwin Meese II, Bill Timmons, Richard Wirthlin, Lyn Nofziger, and Stuart Spencer. That means there is no individual with the responsibility and authority to match wits with President Carter's manager, Bob Strauss.
In hindsight, the designation of William Casey as Sears' replacement was a serious error. Casey's shortcomings have been known for months, but the anti-Sears cabal that installed him has so far been unwilling to give up the power Casey's presence gives them. Meanwhile, his presence prevents the emergence of a single dominant strategist, an individual who would take charge and responsibility. When a committee decides, responsibility is diffused. Who scheduled Reagan on a foreign policy track after the GOP convention? No one individual. Who is responsible for sending George Bush to China? Nobody. Who is responsible for the lackluster television spots produced for the homestretch? Nobody. Who is negotiating with Strauss over the format of the debates? Everybody and nobody.
The assumption is that pressure brings change, and that until late August the Reagan lead was so large that pressure, and change, was not in the cards. Now it is. There is ample time for a shakedown, the submergence of Casey and emergency of somebody with authority to match wits with Strauss, make new media spots, plan the debates, and be in position to react to whatever comes out of Jimmy Carter's sleeve in October. If the Reagan bull market is to resume, it will be up to Reagan to do it.
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1 James Tobin, "Stabilization Policy Ten Years After", Brookings Institution Papers on Economic Activity, George Perry, editor, p. 22.
2 Milton Friedman, "The Role of Monetary Policy", American Economic Review, March, 1968, p. 15
3 Milton Friedman, "Monetary Overkill", Newsweek Magazine, July 14, 1980, p. 62.
4 Lindley H. Clark, Jr., The Wall Street Journal, Speaking of Business Section, January 29, 1980.
5 Lindley H. Clark, Jr., The Wall Street Journal, Speaking of Business Section, August 11, 1980.
6 Robert A. Mundell, "Gold: The 'Final Asset' Problem and its Resolution", H.C. Wainwright & Co. Economics, February 27, 1980, p. 11.
7 Jude Wanniski, "The Reagan Bull Market", A.B. Laffer Associates, August 1, 1980.