Could Gold Make a Comeback? Jude Wanniski March 14, 2000

To: SSU Students
From: Jude Wanniski
Re: Guest Lecture: Could Gold Make a Comeback?

I've invited our newest Nobel Laureate in economics, Columbia University's Robert A. Mundell, to be our guest lecturer for this lesson. It is in fact a lecture he delivered almost exactly three years ago, on March 12, 1997, at St. Vincent College, Letrobe, Pa. It is entitled "The International Monetary System in the 21st Century: Could Gold Make a Comeback?" The primary value of this lesson is Mundell's knowledge of monetary history, as you will see. It is worth its weight in....

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Out of respect for Philip M. McKenna, the founder and president of the Gold Standard League, I am going to emphasize gold in the title of my lecture. What will be the character of the international monetary system in the next century and how will gold intersect with it? This subject may strike modern audiences as a strange topic, but I can assure you that, back in the 1960s, when people were deliberating about the future of the international monetary system, gold figured importantly in the discussions. Even today, the importance of gold in the international monetary system is reflected in the fact that it is today the only commodity held as reserve by the monetary authorities, and it constitutes the largest component after dollars in the total reserves of the international monetary system.

It is true that gold today suffers from persistent attacks on it in the press and it is fair to say that there is still a conspiracy of silence on it among international monetary officials. The competing asset, the SDR or Special Drawing Right, was a "facility" or "reserve asset" created by the members of the IMF in 1968 as a substitute for gold. It was initially given a gold guarantee by members of the Group of Ten, which would have made it extremely valuable today; however, its gold guarantee was stripped away in the early 1970s when the price of gold soared, and ever since the SDR has floundered as an important component in the international monetary system. Later in the 1970s, when the Second Amendment to the Articles of Agreement, which endorsed managed flexible exchange rates, was enacted, it was decided to emphasize the SDR as an asset and de-emphasize gold; to further this end both the IMF and the US Treasury sold part of their gold holdings. The other countries, however, held onto their gold and experienced as a result reaped huge (if unrealized) capital gains when the price of gold soared in the late 1970s. Since that time a few countries (notably Holland, Belgium and Canada) have sold gold to help finance large budget deficits, but by and large the total gold holdings of all central banks and international monetary authorities today is not very different--at about 1 billion ounces--from what it was before the international monetary system broke up in 1973. Despite attempts to demonetize it, gold has kept much of its allure to the public and monetary officials; despite attempts to promote it, the SDR has remained, like the Susan B. Anthony silver dollar, a wallflower in the monetary system.

Gold's Mystique

We certainly have to examine gold's link to the monetary system, but not in any sense of any mystique; some of that has now been shed from the yellow metal. There was much talk in the 1970s of banalizing gold, stripping it of its mystique and luster and regarding gold as a commodity like any other commodity. But it was not really successful. Even when the price of gold soared above $850 an ounce, central bankers held onto it as if their lives or careers depended on it.

It is useful to reflect on the mystique of gold. Historically, it has been far from a banal subject. From the beginning of civilization, gold was such an attractive metal that it was coveted as an object of beauty and quickly monopolized by the upper classes. It soon found its way into the palaces and temples that controlled the autocracies of the ancient world. Many of the early empires used gold as reserves for their banking systems with exchanges being effected by means of clay notes and seals convertible--at least nominally--into one or both of the precious metals.

The introduction of overvalued coinage provided a strong economic motive for the cultivation of a mystique. From its very beginning, probably in Lydia in the 7th century B.C., coinage was overvalued; one could say that was its very purpose. The earliest coins of the Lydian kings were made of electrum (from the Greek word meaning amber), an alloy of gold and silver.

We mustn't be misled by the textbook fiction that coins were first struck to guarantee the weight, and therefore the value, of the earliest coins. There is no point stamping the weight on a lump of electrum metal if the fineness of the alloy is neither known nor constant; in fact the electrum coins from the early hoards varied widely in fineness. The earliest coins were not the natural electrum found in the beds of the Patroclus River near Sardis, but artificial electrum made by a metallurgical technique that had been pioneered by the Egyptians over a thousand years earlier and which was well known to such monarchs of the Mernmad line like Gyges, Alyattes and Croesus. The conventional wisdom that these Oriental despots stamped the coins to confirm their weight and thus provide a convenience for their subjects, is sheer nonsense. The stamp meant that the coins passed ad talum--by their face value--equal to 1/3 of a stater (the word meant "standard").

The earliest function of coinage was therefore profit. Coinage not only helped to market the electrum found in the Patroclus but the markup on them generated a substantial profit, helping these kings to achieve their dynasty's ambition of extending the Lydian Empire throughout Asia Minor. Accepted at face value as if they had a high gold content, the Lydian staters started out with a high proportion of gold but got progressively smaller, increasing the markup and the revenue for the fiscal authorities.

Coins cannot of course remain overvalued in a free market. Gyges and his successors were no libertarians. Overvalued coinage implies artificial scarcity, a monopoly and government control. Without exception in the ancient world, the gold and silver mines were controlled by the government. This was the basis for all the doctrines that would later evolve around gold: the assertion of mines royal, regalian rights, treasure trove, suppression of private, episcopal and baronial mints, the trial of the pix, and the regulation of the standard. To sell their coins and create the mystique, a full panoply of devices was called upon. Religious symbols helped to reinforce the mystique. Whether the symbol was called Marduk, Baal, Osiris, Zeus, Athena or Apollo, or Jupiter or Juno, or St. John the Baptist, its purpose was the same; the latter symbol made the florin the most famous coin of the Middle Ages. The gods changed but the principles stayed the same! Just look at the Masonic hocus-pocus that still remains on our dollar bills! "In God We Trust" introduced on our dollar bills in 1862 when their gold backing was dropped.

The Lack of an International Monetary System

When the international monetary system was linked to gold, the latter managed the interdependence of the currency system, established an anchor for fixed exchange rates and stabilized inflation. When the gold standard broke down, these valuable functions were no longer performed and the world moved into a regime of permanent inflation. The present international monetary system neither manages the interdependence of currencies nor stabilizes prices. Instead of relying on the equilibrium produced by automaticity, the superpower has to resort to "bashing" its trading partners which it treats as enemies.

After the revolution in East Europe and the collapse of the Evil Empire, we suddenly had tens of new countries entering the international monetary system, all with new currencies or new needs for currency policies. What monetary system should Managing-Director Michel Camdessus of the International Monetary Fund have recommended to these new countries? The answer would have been obvious before 1971: they should each stabilize their currencies to the anchored dollar or one of the other currencies that was stable vis-a-vis the dollar anchored to gold. Fixing exchange rates to the dollar bloc, which encompassed most of the world economy, would have given the new transition countries the relatively stable price level of the western countries.

I now want to point out a very important contribution made by the IMF between its opening in 1946 and 1971. The Fund gave countries a coherent philosophy of macroeconomic management based on the rudder of fixed exchange rates. A great deal is now left in the hands of national monetary leaders. To be sure, a country can move fix its currency to one of the major currencies, such as the dollar. In practice, such a move requires an act of great leadership; the stabilization plan involving fixed exchange rates implemented in Argentina by Domingo Cavallo illustrates how rare that quality is. In the period of fixed rates before 1971, great leadership was not required because there was a system to which most countries adhered and the IMF had a package of techniques available to implement it.

Originally established to defend and manage the anchored dollar system of fixed exchange rates, the IMF lost its sense of purpose as guardian of the international monetary system after 1971 and especially after 1973, the year the international monetary system was scrapped for flexible exchange rates. The Fund was then shifted from its role at the center of the international monetary system to a new role of ad hoc macroeconomic consultant and debt monitor, functions that might well have been provided by the private sector. When the challenge of the transition countries arose, the Fund had no coherent system for monetary stabilization to offer and the transitions were, almost without exception, bungled. The debâcle of the transition countries is confirmed by the fact that not one of the countries, at the end of 1996, had recovered to the level of output from which the transitions began, and with only one or two exceptions, inflation remains at two-digit rates. Recovery from the end of the Cold War has been far more disruptive than recovery from the end of the most devastating hot war in history.

An international monetary system in the strict sense of the world does not presently exist. Every country has it own system. Most people do not understand how unusual the system is. For thousands of years countries have anchored their currencies to one of the precious metals or to another currency. But in the quarter century since the international monetary system broke down, countries have been on their own, a phenomenon that has no historical precedent in the cooperative game known as the international monetary system.

Economic theorists know that the interdependence of the international monetary system stems from the fact that balances of payment are connected together. If one country has a balance of payments surplus, the rest of the world has a balance of payments deficit. If one country has a balance of trade surplus, the rest of the world has a balance of trade deficit. So one country's movement toward a surplus or deficit automatically affects other countries. This has an influence on the exchange rate system. In a world of n countries with n currencies, there are n-1 independent exchange rates. Every country can not fix exchange rates. There would be too many fixed exchange rates. There is one degree of freedom, giving rise to what theorists called the redundancy problem. The role of that extra degree of freedom was to maintain a stable price level, or in the case of the gold standard, to maintain the price of gold.

On paper, a collection of nearly 200 countries with individual currencies and flexible exchange rates would appear to result in incredible confusion. In practice, however, the system is not so bad. There is an important coherence in the world financial structure due to the configuration of powers in the world economy and the special role played by the currency of the superpower. When one country is a supereconomy, its currency often fulfills many of the functions of an international money, a subject to which we now turn.

A Theory of Superpower Influence

Historically, whenever there has been a superpower in the world, the currency of the superpower plays a central role in the international monetary system. This has been as true for the Babylonian shekel, the Persian daric, the Greek tetradrachma, the Macedonian stater, the Roman denarius, the Islamic dinar, the Italian ducat, the Spanish doubloon and the French livre as it has for the more familiar pounds sterling of the 19th century and the dollar of the 20th century. The superpower typically has a veto over the international monetary system and because it benefits from the international use of its currency, its interest is usually in vetoing any kind of global collaboration that would replace its own currency with an independent international currency.

In the 1870s, the United States and France were campaigning for international monetary reform in the sense of an international return to bimetallism and the development of a standard international unit of account. Which country was saying no? It was Britain, the leading world power in the 19th century. As top power, or at least "first among equals," Britain always said no to international monetary reform, no to an alternative to the pound as a unit of account and the sterling bill as the most important means of payment. But when Britain's star faded and America's rose, the positions were reversed, with Britain wanting international monetary reform and the United States, the new superpower, rejecting it.

At the world gold conference in 1933, France wanted international monetary reform. France wanted the United States and Britain to go back to fixing of the price of gold. President Roosevelt said no, and the dollar continued to float until, unilaterally, the U.S. devalued the dollar, raising the price of gold from $20.67 per ounce to $35. The United States did not want to move back to an international monetary system, except under terms that gave it leadership.

At Bretton Woods in 1944, President Roosevelt told Treasury Secretary Henry Morgenthau to make plans for an international currency after the war. Economists remember that Harry Dexter White and the staff at the US Treasury made a plan that involved the creation of a world currency to be called the unitas. Keynes, in London, made a comparable plan for reform that included a world currency called bancor. When the British delegation came over for the Bretton Woods conference, it kept bringing up the question of a world currency, but the Americans now had second thoughts and kept silent. Thus academic internationalist idealism fell prey to economic national self-interest. As a result the enlightened superpower backed away not only from Keynes' bancor plan, but from its own unitas plan. Bretton Woods did not create a new international monetary system; it kept the system that had been in place since 1934.

It is inappropriate to speak of a "Bretton Woods system." The conference at Bretton Woods, New Hampshire, in 1944 did not create a new international monetary system. Rather, it created two new international institutions, the IMF and the World Bank, were set up to manage international interdependence in the international financial system and provide a supranational veneer for the anchored dollar standard. As Joan Robinson once said, shrewdly: the IMF is "an episode in the history of the dollar."

Price Stability and Gold

The 20th century has not been a very satisfactory century from the standpoint of price stability. If we measure the magnitude of inflations both the product of its rate and the total value of commodities affected by it, we can be sure that more inflation has been created since 1914 than in all preceding millennia put together. Note that the starting date of the great inflations, 1914, begins with both the opening of World War I in Europe and the opening of the doors of the Federal Reserve System in the United States. Of the two events, the latter has been more culpable.

In some respects, the period of inflation could be better dated from 1934. It is true that the price level doubled during World War I. But in two steps, the price level of 1914 was restored. The deflation of the 1920-1 recession brought the index of the price level, based on 1914 = 100, down to 130, and the deflation of the great depression of 1930-34 brought it the rest of the way back to the pre-war equilibrium level.

Before 1914, price levels based on gold were remarkably stable over the long run. In 1977, Roy W. Jastram published an excellent study, called The Golden Constant, and followed it up with a second book in 1982 called Silver: The Restless Metal. In these books, he developed figures for the price level based on the wholesale price index in Britain from the 1500s to the present, and for the U.S. from 1800. England's data provided a very consistent series of prices over four centuries.

From 1560 to 1914, England's price index remained fairly constant. There were waves of gentle inflation and deflation but they tended to cancel out. World War I brought inflation followed by post-war deflation, and, with the onset of the great depression, Britain went off gold. From that time forward, Britain lost the monetary discipline it had since the time of Alfred the Great. The inflations since Britain left gold in 1931 and especially since the breakup of the anchored dollar system in 1971 have been the highest in Britain's history, higher by several orders of magnitude. In the quarter century after 1971, Britain's price level rose 7.5 times! Over this period, Britain lost its centuries-old reputation for monetary stability and the pound ceased to be a leading international currency.

Like the pound, most currencies lost their gold base in the 1930s, thus removing an important convertibility constraint on money supplies. Nevertheless, until 1971, the system did preserve an indirect link to gold through fixed exchange rates with the anchored dollar. It was the severing of the link to gold in 1971 and the movement to flexible exchange rates in 1973 that removed the constraint on monetary expansion. The price level of what had become the mainstream of the world economy was now in the hands of the Federal Reserve System, the greatest engine of inflation every created. Because there was no other international money, the Fed could now pump out billions and billions of dollars that would be taken up and used as reserves by the rest of the world. Not only that, but US government Treasury bills and bonds became a new form of international money. Dollars became the reserves of new international banks producing money in the Eurodollar market and other offshore outlets for international money.

The newly elastic international monetary supply was now made to order to accommodate the supply shock of the oil price spike at the end of 1973. The quadrupling of oil prices created deficits in Europe and Japan which were financed by Eurodollar credits, in turn fed by US monetary expansion. The Fed argued that its policy was not inflationary because the money supply in the United States did not rise unduly. The fact is that it had been exported to build the base for inflation abroad. As I showed in an article published in 1971, it is the world, not the national dollar base, that governs inflation.