The Big Gold Question Jude Wanniski February 2, 2001

I had the following exchange with a client, Dick Gould of Greenwood Capital, and believe it is worth a broadcast to all of you:

Q. Interesting piece on the 50 bp cut. But isn’t gold really a partial reflection of dollar strength or weakness? One would need to look at it relative to all currencies to see with clarity the deflationary bias...which I agree seems to be there. Maybe it spread like a virus from Japan.

A. As the most monetary of all commodities, gold is the proxy for the rest of the universe of prices. It is a signal of INCIPIENT inflation or INCIPIENT deflation when it moves in one direction or the other from an optimum level. In other words, its movement is a reflection of the Fed’s daily errors in failing to supply the precise amount of liquidity the market is asking for. As it declined from $380 or so, it was in that way signaling Fed errors in not supplying the liquidity the market was demanding. The fact that the Fed chose not to worry about that signal does not make gold any less an error signal. It is what lets us see things more clearly than Alan Greenspan has since 1997. Now it is at $269 and represents a real problem, as the economy has had to adjust to economic activity with a reduced liquidity supply. The dollar economy has to squeeze itself into a “suit” of prices that is several sizes too small for it. In my framework, the dollar is only strong or weak relative to gold. The yen also is strong or weak relative to gold. The dollar/yen exchange rate represents the intersection of those two values. We did not import deflation from Japan. Greenspan & Co. did it all by themselves. No other country has the power to change the dollar/gold rate. The Fed has a monopoly on the creation or destruction of dollar liquidity.

Q. But what gold level is "equilibrium"? Would you take gold after it started to float freely decades ago and index it forward by the inflation rate to arrive at a level (presumably higher) to figure out whether or not we are in a deflationary or inflationary mode?

A. This is the Big Question, one that has divided supply-siders for the last 30 years. The optimum gold price, to me, is one that perfectly balances the interests of dollar debtors and dollar creditors. It is impossible to put any kind of exact weighting to debtors and creditors because there are billions of contracts in dollars, made at different moments over the last 30 years, with varying maturities. We have to take a stab at the answer by concentrating on maturities, which differ from one country to another and change as time rolls on. The average price of gold over the last decade is something like $350. The average over the last five years is $320. At $265, I believe we are clearly in a deflationary range, one that requires painful adjustment. Profits and nominal wages have to be pulled in that direction as dollar prices adjust to a level suggested by that gold price. The pain and strain of the adjustment by the overall economy can be ameliorated by a more efficient tax structure, i.e., one that reduces or eliminates unnecessary tax rates. But inside the overall economy, the debtors hurt by the deflation may not be the same individuals or enterprises who are benefited by the lower tax rates.

There are those who say the gold price has no meaning in this realm, that it is just another commodity with no monetary significance. This was the argument being made before Nixon de-linked the dollar to gold in 1971. Without gold’s use as a reserve asset, “propped up” by the government guarantee at $35 an ounce, it was argued gold would fall to $7 per ounce. Instead, it doubled in a matter of months to $70 an ounce. In 1973, Bob Mundell made a famous $1.00 bet with Milton Friedman that gold would hit $200 per ounce in 1974. Friedman had argued that gold’s monetary value was no better than that of pork bellies. Gold hit $200 that year.

It was in this period that I became persuaded by Bob Mundell’s arguments that gold was the most important commodity as a monetary signal for whether too much or too little liquidity was being supplied by the central bank. If gold doubled, it would take the general price level many years to double, but the process would begin immediately. So too, if the price of gold declined, it would be followed by a general decline in the general price level, adjusting to the new nominal value of the paper unit of account. When I say the process would begin immediately, I mean an increase in the dollar price of gold would immediately put upward pressure on the price of oil, which is fungible, internationally traded, and like gold, will not spoil with time. When the oil price goes up, it then pushes up other prices, because energy is an important input to the production of practically all consumer goods and capital goods. If the price of gold only rises from some optimum level by a tiny amount, the inflation it transmits will not be visible. Or, if it goes up by tiny amounts every day, the inflation it transmits gradually accumulates, but we then notice, looking back, that prices have risen.

In the deflation of the 1980s, when the Reagan tax cuts caused an increase in the demand for dollar liquidity that the Volcker Fed then refused to supply it, the price of gold fell sharply, to $300 from $600, and the price of oil followed. We did not see a decline in the consumer price index, though, because other prices, including wages (the price of labor), were still climbing in order to catch up with the huge rise in the gold price from $35 to $300, during the preceding decade. We wrote several papers at the time explaining why we were in a deflation, even though the CPI was still inching up. The economists at the time, who did not understand any of what they had wrought, instead came up with the term “disinflation.” And the government began separating out oil and food from “core inflation,” as if this was going to tell us any more of what was happening to the economy.

The disagreement I have had with Mundell in recent years is that he seems to believe gold is of less importance than it was when it was signaling a rise in the general price level (inflation). He continues to write theoretical papers on why an optimum world monetary system should include fixity between the dollar/euro/yen and gold. But he thinks that without such an international agreement on how to maintain fixity, gold’s relevance is less certain. I have told him that I am more Mundellian than he is, because I learned all about the relevance of gold in an inflationary era and believe it is no less relevant in a deflationary era. This difference is enough to divide the important supply-side intellectuals. The Wall Street Journal editorial page relies on Mundell, not me, so there is no push for an end to the deflation at the WSJ. Who is right? Only time can decide such things. If gold climbs over $300, as Mundell believed it would with an aggressive lowering of the funds rate, we will be out of the woods on deflation. Otherwise, the Fed will have to change its operating mechanism and actually target gold. That will not happen unless the WSJ begins a campaign to do so. If gold stays at $265 and there is no downward pressure on the general price level, including pressure on nominal equity prices, I will have to say I was wrong.