Thinking about Deflation IX Jude Wanniski August 6, 1998

Some weeks ago I had lunch with several men I’d never met before, one of them CEO of a major American corporation. They asked me about the Asian crisis and in the course of my response I said the crisis would not have occurred if our government had been on a gold standard. The CEO scoffed at the idea, as if it were the most absurd thing he had ever heard. Instead of arguing, I asked him to tell us what he thought a gold standard was. Of course he hadn’t the slightest idea, but knew it was something that was obsolete and should not be part of any serious discussion of the economy as it affected his bottom line. I softened him by noting there is not one member of Congress of the 535 who knows what a gold standard is, including the handful who think they know. If you have attended classes in economics in American colleges and universities in the past half century, you will not have learned what a gold standard is, or you would have been taught it is something that it is not.

For hundreds of years before economics was overtaken by mathematicians, economists knew what a gold standard was. Gold was the only commodity that did not fluctuate in value, which meant it was perfect to serve as the proxy for all other commodities. Its value derives from that function, which evolved through a trial-and-error process that has lasted several thousand years. Markets continue to tell us gold will have the same real value in the future as it has in the present. Its future price in dollars is the current price plus a premium reflecting the time value of money. “Gold,” Karl Marx wrote in Das Kapital, “is the commodity money par excellence.” What he meant was that in a universe without paper money, gold is the best commodity to employ as the definition of money, because money is most efficient when its value is constant. In the paperless universe of prices, of apples and oranges, bread and wine, some commodity must serve as the unit of account, against which all other commodities are valued, now and in the future. It is much too inefficient to go to market and ask: How many oranges does it take to buy that apple? How many loaves of bread to buy that apple? How much wine to buy that apple? If we have one commodity that has a constant value, it enables the shopper to ask: How much gold to buy that apple? How much gold to buy that orange? The shopper can then know the exchange rate between the apple and the orange by using gold as the standard accounting unit. Shoppers for government bonds from one country to another do that every day.

That’s a gold standard, and it works as well now as it always has. In April 1982, when we were in our last serious monetary deflation, I wrote a Polyconomics essay, “Deflation.” In it I argued that the world remains on a gold standard. This, even though the governments of the world are managing their national monies almost as if gold’s value had dissolved in 1973 when Milton Friedman persuaded Richard Nixon that gold’s value as a monetary commodity was equivalent to that of pork bellies. How does this private gold standard work? A NYTimes editor a few days ago scoffed at me the same way the Fortune 500 CEO scoffed at lunch. “Nobody thinks of gold when they are making contracts! None of the central banks talk about the importance of gold!!” My response was that there are very few adults on the planet who have not heard about gold and its relative value to apples and oranges, bread and wine, in their communities or villages. That is, even the poorest people have a conception of gold as a standard of measure. What about the richest and smartest people? If you were considering a loan of $1 million to an apple producer, would you be satisfied with output of a million apples as collateral? With an apple at $1, it is in the ballpark. An ounce of gold will buy roughly 300 apples and roughly $300. But suppose you knew an ounce of gold five years from now would buy 3000 apples? Would you lend the million dollars? Not unless you were paid an extremely high rate of interest, as the dollar would be only worth a tenth as much at the maturity of the loan.

Almost nobody consciously thinks of gold when buying a loaf of bread or a bottle of wine -- or a car or a house. But they would if pondering a $200,000 house with gold at $300 if gold were suddenly to plunge to $35. They would pick up the general smell of falling prices. What a great convenience it is to have buyers and sellers of goods and services knowing the relative terms of trade in gold, which is real, as opposed to a “dollar,” which can be worth anything. The convenience is most evident in economies that are experiencing hyper-inflation. Then it is clear to ordinary people as well as the sophisticates that when the government has supplied more liquidity than the economy demands -- or fails to drain liquidity when it is no longer in demand -- the gold price rises immediately and all other prices follow in gold’s train very quickly. This is because of the Law of One Price, which is another way of saying that commodities have roughly the same exchange rates over time. If an orange exchanges for an apple in 1900, it will also exchange at that rate in 2000. With technological advance, the apple/orange exchange rate remains the same, but real wages rise. There is no monetary inflation.

When the Federal Reserve supplies one dollar of liquidity over and above dollar demand, the party holding that extra dollar will use it to buy a dollar’s worth of gold. He had been holding a bill or a bond paying interest, and when he is forced to hold a non-interest bearing dollar instead, he prefers to hold gold, which pays no interest either, but which more likely will hold its value than the dollar. This occurs in the spot market. In the market of contracts, which involve the future, the gold price is transmitted up or down as a reflection of central bank errors. No other commodity moves up or down as quickly as gold. In a deflation, or decline in the gold price, the individual most effected by the error by the Fed is the person who borrowed dollars at the higher gold price with plans to sell gold to pay the debt. He now must sell more gold to acquire more dollars. If the lender holds gold as collateral and the gold price falls below the value of the collateral, the borrower may simply walk away from the debt.

When the dollar gold price rises or falls, it does so because of myriad global reasons bearing on demand for dollars. It is hopeless to conjecture why -- nor is there a need to know -- if the intent is to eliminate all risks of inflation or deflation, to remove all monetary risk from the economy. It is up to the Federal Reserve to add or subtract liquidity to prevent the gold price from moving. If it does not, the private gold standard immediately punishes the U.S. economy by inflating or deflating -- damaging creditors at the margin in the former case, debtors at the margin in the latter case. If the gold price rises, then the Law of One Price inexorably moves other prices in the universe in the same direction. It does so until the entire constellation of prices reaches equilibrium at the higher dollar/gold price. There is no difference when the dollar gold price moves down. All prices must adjust to the new equilibrium. The exchange rates might be slightly different, though, because of variations in tax policies at the new general price level.

Finally, real estate prices for an entire economy must also adjust to a new gold price, but it is improper to think of property in Manhattan or Tokyo “inflating” when the gold price is fixed or falling. Every ounce of gold is the same as every other ounce, while every square foot of land on the planet is different from every other square foot. Land parcels can rise in deflations and fall in inflations for reasons having nothing to do with the management of money. In his congressional testimony last month, Fed Chairman Alan Greenspan erred in his definitions of inflation and deflation even as he expressed a “nostalgia” for the gold standard. He does not see it, but the market is on a gold standard and has been throughout his Fed tenure. He has the power to make the world economy much more efficient by making use of the gold signal, but as long as he does not accept it as the only inflation signal, he will make the kinds of errors that caused the Asian collapse and still are nibbling away at Wall Street and the U.S. economy.