Gold as a Constant
Jude Wanniski
August 15, 1997


Supply-Side Summer School Economics Lesson #9

Memo To: Website students
From: Jude Wanniski
Re: Gold as a constant

[Steven Piraino, by e-mail, has tried a number of times with questions on why gold? This time he digs hard enough to make me understand that he wants the basis for my assumption that gold is a constant, when it seems to be so wobbly. Also, left over from last week’s question period was one from Russ Whiting, about Milton Friedman’s 1994 book, Money Mischief. I’d said I would find it hard to believe that Friedman would say bimetallism may be better than monometalism, but that if he did, it would confirm my argument that he sees little value in money as a unit of account. I got the book this week and, lo and behold, Friedman is worse than I thought on this critical issue! The book actually is worth getting, in paperback, from Amazon. There are a great many topics he deals with in the book that we could kick around in future lessons. It would be a good way to demonstrate how fouled up a brilliant man can get by starting from a wrong assumption.]

Q: I contend that there is no reliable constant. Measured against the CPI, which is itself flawed, the dollar has been stabler the past few years than gold. To blindly assume that the CPI is constant, of course, would be as intellectually lazy as assuming dollars are constant, or gold for that matter.  However, it is not my contention that you are intellectually lazy. I simply do not know the reasoning or evidence which lead you to believe in the stability of gold as a unit of account.

A: My reading of history is that there were only two metals which competed for the favor of world commerce as a unit of account, and that gold won that competition in the 19th century. From the 1870s, when most of the world went on gold, leaving silver behind, gold has had no competition as a monetary commodity. Gold won the competition probably because it is more difficult to find than silver. In 1792, when Alexander Hamilton put the U.S. on the gold standard, he included silver as a metal that would have equal standing, at the market ratio of 15 ounces of silver to one of gold. This was the European practice. Hamilton did, though, caution that the rate would have to be changed as the supply of silver or gold in the world produced different market ratios. When the rate soon went to 15.5, as silver became more abundant, people paid their debts and taxes in silver rather than gold. This was in accord with Gresham’s Law -- that bad money drives good money out of circulation. Of course, people will always choose to pay their debts and taxes with money that is less valuable, hoarding that which is more valuable. At the end of the Napoleonic wars, England came back on gold in 1816, but dropped silver and bimetallism. Except for a burst of new gold from California in 1849, which brought the ratio back to 15, silver discovery and production turned out to respond more readily to new technology, and the ratio was at 16 when the U.S. went back on gold in 1873, following the Civil War greenback era.

In 1873, France and the other industrial countries that had stuck with gold and silver joined the United States in dropping silver, but there was no distress in France, as there had not been in England when it dropped silver. The distinct problem in the United States was that during the Civil War greenback period, gold had floated to $40 an ounce. When the U.S. returned to gold, between 1873 and 1879, at $20.67 an ounce, the debtor class was put through a horrendous deflation. Had the United States returned to a bimetallic system at 16 to 1, as Milton Friedman argues should have been done in his 1994 book, Money Mischief, dollar debtors would have been able to pay with cheap silver and the ratio would have remained near 16 to 1. As it was, when the U.S. and France went strictly to gold in 1873, the price of silver dropped steadily, and by 1896 was at a 30-to-1 ratio. 

In Money Mischief, Friedman confronts the 1886 argument of J. Laurence Laughlin that “The act of 1873 was a piece of good fortune, which saved the financial credit and protected the honor of the State. It is a work of legislation for which we can not now be too grateful.” Friedman’s argument is that “the retention of bimetallism at 16 to 1 as the legal monetary standard would have greatly reduced the subsequent deflation in the United States and would have avoided the monetary and political agitation and uncertainty that the deflation produced. To a lesser extent, this would also have reduced the deflation in the rest of the world.” 

Friedman’s argument is extremely weak, in that the deflation doubled the burden of debts by bringing gold back to $20.67 from more than $40 in 1865. That 100% increase in the amount of wheat or corn a farmer would have to grow to pay his debts in gold dollars would not have felt much lighter if he has to pay with silver at 16-to-1 instead of 15.5. Of course, as the ratio changed to 30-to-1 by 1896, it would have been a terrific deal for farmers. But Friedman insists the rate would have stayed at 16-to-1. Perhaps it would have, but the United States would then have been the only country with two units of account. Indeed, the book reveals that Friedman has become hopelessly confused about monetary policy since his monetarist quantity theory failed utterly when tried in the 1970s, bringing the United States and world economy to the brink of ruin when Fed Chairman Paul Volcker and Treasury Secretary Donald Regan finally called a halt to the experiment in the summer of 1982. 

It is interesting to note that India and China, alone in the world, remained on a silver standard when they should have gone to gold along with the rest of the world. The silver/gold ratio kept climbing after 1900 and stands now at roughly 73 to 1. As a result, China and India experienced 20th century inflations well before other nations, setting them back in the global competition. China is making up for lost time now, but on her 50th anniversary of independence, India remains as confused as Milton Friedman and the London School of Economics about monetary policy.

It is history itself that determines the world money, by the same kind of trial and error process that led it to choose English as the international language. The dollar tried to compete against gold, which the monetarists assured us would work if only we followed the calculations of Professor Friedman and his students. It was the dollar that proved too wobbly, gold the constant. We say gold is constant only as an assumption, for without an assumption we can have no train of logic on which to build a monetary system. In the same way, we say the North Star is a constant, a fixed point, although we know even Polaris has a slight wobble to it. 

Your probing question about gold as a constant comes out of the same kind of confusion that we find in Milton Friedman’s assumption about the function of money itself. It was Professor Bob Mundell who taught me that there are at least three roles that money plays -- one as a medium of exchange, one as a store of value, one as a unit of account. That is, a “dollar” can be used to buy something with: I made bread and you make wine and we exchange through the medium of the currency. A dollar can also be held as a claim on something of value. It also serves as a unit of account, which gives everyone producing and exchanging in the marketplace a conceptual yardstick by which to evaluate all the opportunities of working, consuming, saving and investing. 

In Friedman’s universe, money’s roles are limited to the first two -- as a medium of exchange and a store of value. He will use the term “unit of account” here and there, but never as a major function of money and certainly never as its primary function. This is where he goes wrong from the beginning. To Friedman, inflation is always a monetary phenomenon, which occurs when too much money chases too few goods. In Mundell’s classical model, inflation is a decline in the monetary standard -- in other words, trouble in the unit of account. Karl Marx, who was after all a classical economist, noted that gold was “the money, par excellence.” In context, he pointed out that market prices would be cited in terms of ounces of gold in villages all across Europe, even though nobody in the village had any. The common understanding of the unit of account enabled them to transact in whatever medium was available -- smaller coins, paper or written IOUs. It has been my observation since first understanding what I’d learned from Mundell and Marx that there is nothing a government can give its people that will be more beneficial to its economic needs than a unit of account that maintains its integrity over time. 

When we ask if the dollar or gold is a superior medium of exchange, we can’t say that under any and all circumstances gold is better. In most cases it is not, because, for spot transactions, the convenience of paper is far greater than specie. Gold is only better for you as a medium of exchange when you find yourself having to meet an obligation that can be cleared in gold or paper, and at that moment gold has less value than paper. In the same way, the dollar is superior to gold as a store of value when we are entering a period of deflation, in which the scarcer dollar buys more gold. Given Friedman’s definition of money, it is not at all clear that gold has an advantage over the paper dollar, as long as the quantity of dollars in supply is no greater than the quantity of goods in production. 

In the Mundellian world, money’s chief function is as a unit of account, and in that regard, there is no contest between gold and anything else we can think of. There was a time when silver gave gold a run for its money -- to coin a phrase -- but as we saw earlier in this lesson, it lost that race. At the time Milton Friedman helped persuade President Richard Nixon that the dollar would be better off delinked to gold the jury was out on which would prove better as “money.” Friedman scoffed that gold was now a commodity no different than pork bellies. It was even assumed by some that the dollar price of gold would plummet once gold was demonetized, as silver did in 1873. Chairman Henry Reuss of the Joint Economic Committee of Congress predicted gold would fall to $7 an ounce! Instead, it quickly doubled to $70. On P. 192 of Money Mischief, Friedman summarizes his quantity theory, which clearly has no room for money as an accounting unit:

If the quantity of goods and services available for purchase -- output, for short -- were to increase as rapidly as the quantity of money, prices would tend to be stable. Prices might even fall gradually as higher incomes led people to want to hold a larger fraction of their wealth in the form of money. Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.

Bullfeathers! After the monstrous failure of the experiment in Friedman’s quantity theory, there is no proposition in economics that is less “well established.” There are no clear correlation between the quantity of money and quantity of output, no matter how one defines “quantity” or “money” or “output.” This is an extraordinary embarrassment to the economics profession, which not only joined with Friedman in blowing up the dollar’s connection to gold, the unit of account, but also celebrated Friedman and his monetarism with a Nobel Prize. The only thing they really don’t like about his model is that the most important role of money is as a store of value -- wealth. In the neo-Keynesian model, which is still taught everywhere that monetarism is no longer taught, there is -- surprise, surprise -- no value attributed to money’s role as a unit of account. The Europeans are still trying to erect a Euro monetary system around the proposition that money’s primary role is as a medium of exchange, which elevates the importance of income over wealth. Unless they fix the Euro to gold, or to a dollar that is fixed to gold, they will never succeed. 

Inflation occurs when the dollar or any other paper currency loses value relative to gold. Deflation occurs when a currency gains in value relative to gold. In Switzerland of 1974, when the central bank was maintaining the Swiss franc’s value relative to gold, the money supply was increasing at a 30% annual rate and the Swiss industrialists were screaming that they couldn’t sell anything on the export market. In other words, production was falling and the money supply was exploding -- and inflation was so low that interest rates were negligible in francs and negative for dollar deposits. Here in 1980, the gold price was going through the roof and so were interest rates, yet the money supply the Fed was targeting in accordance with monetarist principles did not show any growth. During the period of dollar stabilization against gold, which began in earnest in early 1986 with gold at $350, the money supply has exploded while production has been so-so and the inflation rate in decline. In each case, the monetarists will say there is an explanation of why the correlations are all wrong. Those who assume gold as a constant, as a unit of account, will always find monetary inflations and deflations following gold up and down, with lags varying according to the maturities of debt in the economies involved.