Taxes, Money and the Asian Crisis
Jude Wanniski
December 8, 2000


We continue our discussion of the interaction between money and gold this week with another case study, the Asian Crisis of 1997. The following is an op-ed I wrote for the WSJournal editorial page on January 7, 1998. It describes all the elements that went into the Asian Crisis and mentions the fall in the price of oil and other commodities, which I then said produced “an early euphoria among consumers.” The essay, entitled “The Optimum Price of Gold,” is as relevant today as it was then; the recommendations made almost three years ago were ignored. It is admittedly not an easy read for newspaper readers, because it contains so many variables to juggle, and I suspect very few readers stuck with the op-ed all the way through. It is, though, the kind of piece students of supply-side economics should appreciate, as the ideas you are learning at SSU can be applied to real life. Note the price of gold was below $290 as I worried about the deflation it would create. Today it is below $280 and the consumer euphoria has dissolved with higher energy prices -- the result of two years downtime in the energy industry when prices of oil were at the bottom.

* * *

By Jude Wanniski
The Wall Street Journal
January 7, 1998

The $100-an-ounce decline in the price of gold in the past 14 months has persuaded conventional wisdom that gold has lost its lustre as a monetary asset. The sale in this period of 12 million ounces of gold by central banks -- out of holdings of 1.1 billion ounces -- has been part of that story. Those of us who believe the world is moving toward an international monetary reform that has gold as its center have the opposite view: Gold has once again superbly demonstrated its ability to foreshadow changes in the general price level.

The precious metal has been doing this for thousands of years. It did not stop when, in 1967-71, the United States abandoned in stages its 1944 pledge at Bretton Woods, N.H., to maintain the price at $35 per ounce. When the link was broken and the dollar “floated,” the dollar/gold price quadrupled to $140 by 1973. The worst inflation in U.S. history soon followed, as the Canadian supply-side economist Robert Mundell at Columbia University had predicted.

Modern central banking and the use of government debt as money has eliminated gold’s utility as a medium of exchange and sharply reduced its role as a store of value. Its surviving monetary function is to provide the Federal Reserve, which has the task of determining how much money to create from day to day, a precise signal of money demand.

Stabilize Gold’s Price

If, from an optimum given point, the dollar/gold price rises, it is a signal that there is surplus liquidity in the banking system. The Fed should then withdraw this surplus. It does so by selling interest-bearing bonds from its portfolio for the cash and bank reserves that pay no interest. If the Fed does this, it will tend to stabilize the gold price. On the other hand, if the Fed fails to withdraw this “liquid” debt, the process we know as inflation is initiated. The banks will be forced to apply the liquidity to risky transactions.

Should the gold price decline from that same optimum point, it signals a shortage of liquidity in the banking system. A shortage means the market is trying to finance sound transactions, but cannot. Now the Fed should buy bonds from the banks, supplying the needed liquidity. Otherwise, transactions that should be financed will not take place, initiating the process of economic decline called deflation. The Great Depression of the 1930s should properly be called a contraction, not a deflation, because it was caused by errors of tax and tariff policies, not of central banks.

Throughout modern history, governments have frequently suspended the use of gold in order to finance wars, which are inherently risky enterprises. After wars, governments have always returned to gold to take advantage of its utility as a monetary signal. In doing so, they must face the problem of returning at the optimum price, which is not easy because it is a subjective decision. A lower price benefits creditors as debtors must pay back dollars worth more in real terms. A higher price benefits debtors at the expense of creditors.

During the “greenback” financing of the Civil War, the dollar/gold price floated to $40 from the pre-war fixed price of $20.67. After the war, the creditors who dominated the Republican Party won the argument. They insisted on restoring the pre-war price, but at least allowed the six years up to 1879 for the debtors to adjust to the crushing burden this placed on them. Wheat, corn and wages had all doubled with gold, and the deflation forced a halving of these prices.

After the Napoleonic wars, during which the sterling price of gold had floated up by 40%, restoration of gold at the pre-war price produced a sharp, quick recession that led to a populist revolt against war taxes. Britain also left gold at the end of WWI to finance its war debts with cheap money. The sterling price of gold floated up 30%. In 1925, Winston Churchill’s Tories restored the pre-war parity in another boon to creditors that forced a sharp, quick recessionary adjustment.

These examples all pale next to the dollar deflation of the last 30 years. From $35, gold floated as high as $850 in 1980 as the Fed ignored its signals and created liquidity with reckless abandon. When the Reagan tax cuts increased the demand for liquidity which the Fed refused to supply, in early 1982 gold fell to $300 from its 1980 average of $600. The deflation produced the worst recession since the 1930s. The savings-and-loan industry, which had deployed the surplus liquidity of the 1970s in ever-riskier loans, collapsed under the deflation’s weight.

Today gold is below $290, after having spent the years 1981 to 1996 in a range of $340 to $400. With this decline, gold has again shown that it can forecast deflationary pain. The worst has been felt in Southeast Asia, where the central banks added gobs of liquidity to the market in order to keep their currencies tied to the dollar in 1993-96. Why? The 1993 Clinton tax increase had caused a decline in the demand for dollar liquidity. When the Fed did not mop up the surplus, gold rose 10% in dollars, from $350 to around $385. The Asian banks were forced to push their reserves into uncollateralized bricks and mortar.

Alas, when the markets here began to discount the tax cut enacted last summer, demand for dollar liquidity rose, but the Fed, again falling back to Phillips Curve thinking, was worried about rapid growth causing inflation. In refusing to supply the liquidity demanded, the Fed not only wiped out the 10%. It also initiated a new deflation, taking gold past the $350 -- which I believe is its optimal price -- because it appears to roughly balance the interests of debtors and creditors -- to below $300. In order to deflate with the dollar, the Asian central banks had to withdraw liquidity from the banks and all that surplus brick and mortar, or rather the shaky loans made to finance them, came crashing down. The economies now suffer further under the austerity strictures laid down by the International Monetary Fund.

For the Asians, clearly the optimum dollar/gold price to which they pegged is not optimal now. Nor is it optimal for Japan, which is valiantly trying to keep the yen close to the dollar in order to satisfy the Clinton administration and is crushing yen debtors in a ghastly recession.

Is a price lower than $300 optimal for the United States? So far, the answer isn’t obvious. It is at a level we have not experienced since 1979, which suggests the general price level will have to decline in order to equilibrate with gold. However, the capital gains tax was cut and it is unlikely we will see federal tax increases anytime soon, so it may be that an adjustment to this low level can be managed without any net pain to the economy. As usual, oil and commodity prices have followed gold down, producing an early euphoria among consumers. As a second effect, a falling price level inevitably puts pressure on nominal wages.

There is no arguing that it does favor creditors over debtors, though. This is fine as long as you are a net creditor. In any case, an economy strengthened by the capital formation invited by the lower capgains tax enables debtors to pay heavier debts. The nation’s biggest debtor, the federal government, also bears the heaviest burden. As measured in ounces of gold, the national debt is 25% higher than it was a year ago.

A Monetary Guide

The gains to be had for the whole world in formally stabilizing the dollar price of gold are so great that if we just get it as some point between $300 and $400, the adjustments would not be terribly unpleasant to anyone, even if the price were not exactly optimal. If $350 were chosen, as Jack Kemp recommended prior to gold’s decline this year, the Fed would target gold instead of interest rates as it works to eliminate inflation and deflation from the financial system. It would simply buy more bonds from the banks to provide more liquidity when gold approached $345, and sell bonds, mopping up surplus liquidity, as it approached $355.

Once anchored in this fashion, the U.S. dollar would provide a reliable monetary guide to all other national currencies. The global financial maelstroms of the last 30 years would give way to a new century of calm, of the kind the Bank of England provided the world in the Pax Britannica of the 19th century.