Midterm January 1998:
Supply-Side University Q&A
Memo To: Students of SSU
From: Jude Wanniski
Re: Midterm Q&A
Our recent discussion of the monetary signals being emitted by the gold price has generated considerable feedback, mostly in the form of questions seeking further clarification about the metal's monetary properties. This is a representative sampling of the recent exchanges. Below is a directory:
• Why Gold (S. Piraino)
• Inflation Under Bretton Woods fR. SibH
• Post-WWII Changes in the Business Cycle fR. Sibi)
• Gold Standard by Executive Order (G. Tilghman)
• "Capital" Usage (G. Tilghman)
• Inflation Expectations and the Gold Price (D. Luskin)
• Currency Sterilization (M. Unger)
• Critique of Jude's WSJOp-ed (www.mises.org)
• The Fed: Optimum Gold Price Operations (F. Gehrke)
• Banks and Government Bonds (F. Gehrke)
• Treasury Auctions and Bond Purchases by the Fed (F. Gehrke)
Q: (Steven Piraino) I accept your argument that gold was chosen by a historical process as the best money, and I can believe that gold is better than any other single commodity as a unit of account.
However, is its fixity the result of some "magical property" or was it just a chance event (i.e., people just happened to never change their valuations of gold)?
Polyconomics says gold does indeed have a magical property: it is a fixed unit of labor. It takes the same amount of effort to bring it to market as it ever did or ever will. The implication is that something embodying a fixed amount of raw labor must have a fixed price.
David Gitlitz, however, says marginal utility determines price, not raw labor. I understand this. If gold's marginal utility is fixed over time, it will purchase the same amount in goods and services 2000 years from now as it does today.
Here is the state of my current knowledge:
1. Gold is a fixed unit of raw labor.
2. Marginal utility determines price.
3. Something with a fixed amount of marginal utility must have a fixed price.
I DO NOT UNDERSTAND HOW GOLD'S "UNIT OF LABOR" PROPERTY GIVES IT THE FIXED MARGINAL UTILITY NECESSARY FOR IT TO HAVE A FIXED PRICE.
A: When we find gold being used as money in ancient history, we can assume that the sorting out process had already progressed to the point where contiguous peoples had eliminated competing commodities. On isolated islands, we can find people using other devices to serve as a numeraire, so they could equate a fish and an melon and a thatched hut to a unit of labor. But now that we are all contiguous, gold is everywhere. Its last competing numeraire was silver, but that fell in 1873.
Gold is the only commodity that has unlimited utility, because it converts into everything else with equal efficiency. As David Gitlitz puts it, gold is the only commodity that does not have a declining marginal utility. Call it the Midas Factor. There is, of course, always the chance that something will occur to upset gold's unique quality of being the only proxy for everything else in the universe of goods and services. Chances are it will not happen in my lifetime, so I will let you worry about that.
Inflation Under Bretton Woods
Q: (Robert Sibi) When the U.S. had the dollar linked to gold at $35 an ounce under the Bretton Woods system, we had inflation under those years. Historically, it was unprecedented. Was the reason for this because of the Roosevelt devaluation in which gold was raised to $35 from $20.67?
A: You are exactly right. The 1934 change in the gold price came after several decades (from 1879) at $20.67 and it would have taken more than a decade to change the general price level by the 59% of the devaluation, as all long-term contracts would have to unwind during the adjustment process. The process began immediately as prices began moving up in 1935, but the war intervened, deferring much of the inflation to the postwar era. Try and think through why it takes so long for other prices to catch up with a change in the gold price — given the idea that contracts have to unwind. Then think through the process of a gold-price decline and deflation.
Post-WWH Changes in the Business Cycle
Q: (Robert Sibi) Another interesting post-war event that has taken place is the change in the business cycle. The growth is much slower and the recessions are a lot less extreme than before WWIL Keynesian demand-siders claim this is because of the chronic budget deficits that have resulted. I doubt that you agree with this. What is your explanation for this event?
A: The only extreme recession the United States experienced prior to WWn was the Great Depression. Earlier economic declines were mild by comparison. The post-WWI recession was due to an abrupt end to the war, as the government suspended contracts and left war tax rates at high levels to pay down the war debt. The recession of the 1870s was the result of a monetary deflation, as the government decided to return to a gold standard at the pre-Civil War rate of $20.67 an ounce from the $40 level where the greenback had floated. The period from WWII has been punctuated by several mild recessions, but from 1967, the serious economic decline that drove down real wages and living standards was masked by the monetary inflation.
Gold Standard by Executive Order
Q: (George Tilghman) Two questions. First: In your 1981 client letter entitled "The Mundell-Zijlstra Option," you sketch how the transition to a gold standard could start: "the President (would) ask his Treasury Secretary to stabilize the dollar price of gold on international markets. Treasury has the authority to do so." You say, "There would be some difficulty in stabilizing at $450 if the Fed were determined to undermine the process." Is this still your preferred method for going about a transition to gold today? Would not such an act be received by the Fed as a threat to its autonomy and might it not join with Congress in opposing the move if it did not understand the benefits of a gold standard? In other words, could any administration be assured that it would succeed in the transition if it wanted to try? Also, in practice, would the Treasury be buying and selling bonds to manipulate the price of gold as the Fed would do? If so, the Fed's opposition would take the form of offsetting open market activity, right?
A: It's really not possible to formally re-establish the link between the dollar and gold without a President who is willing to do it. In 1982, Ronald Reagan would have loved the opportunity, but the forces of chaos around him talked him out of it. There is no question that if President Clinton woke up tomorrow and wanted to fix gold at some reasonable price, i.e., 10% of one side or the other of $350, there would be support from a lot of Republicans. It is far more likely that it would occur with a President who has a mandate to do so. Imagine Jack Kemp or Steve Forbes or Dan Quayle promising to refix if elected in 2000, by executive order, and then getting elected. It would happen on Day One. If we assume good things will happen on the financial markets, the necessary legislative details would follow immediately. Remember that the Fed is composed of bureaucrats who serve at the discretion of the government. If the government orders the Fed to conduct monetary policy in a certain way, the members have to do so or resign. The Treasury, by the way, has no power to manipulate the price of gold through bond sales. Only the Fed can monetize debt, which is the one known way to manipulate the dollar/gold price. In other words, Treasury cannot create liquidity, it can only shift it from one place to another.
Q: Second: You have often described an individual's capital as his surplus of time, energy and talent. I have found this difficult to get hold of. In trying, I think of an individual having built up a positive net worth by having consumed less than he earned in the past. This is his capital. As this capital accumulation occurs, the individual's assets take a form which will earn him a return. He lends money at an interest rate or takes an equity stake in return for a piece of the profit should the investment work out. If an equity investment goes bad, capital is extinguished. This means that the remaining quantity of the individual's capital is no longer equal to an accounting of what his surplus of time, energy and talent was in the past. Am I close?
A: Little George Tilghman consumed capital until he got to a certain age. Prior to that age, he had a shortage of time, energy and talent, but his parents and community of relatives, friends and neighbors had sufficient surplus to compensate little George for his deficit. At some point, you will have developed sufficient time, energy and talent to fulfill all your own needs, and have a surplus that can be invested in others. If you make an unwise investment of that surplus, the part that involves time and energy will be extinguished, but the part that involves talent should at least have increased in a positive return in experience. Say you marry unwisely. That's a bad investment of your time, energy and talent. You won't make the same mistake twice. When I talk about "capital" in the macroeconomic sense, I'm referring to capital in aggregate. Capital formation occurs when the financial system is equipped to bring together those who have a deficit in time, energy and capital with those who have a surplus. When it happens in a family, the financing occurs through barter, human experience at its most basic level. When we have the whole world involved, six billion souls, it gets vastly more complicated. But the more we can match up surplus time, energy and talent with worthy deficits, the better off humankind will be.
Inflation Expectations and the Gold Price
Q: (Don Luskin) My question is about the "right price" for gold, not in a particular inflationary environment but in a particular inflation-risk environment. Could not the price of gold fall NOT because of monetary deflation, but because of a fall in the expected RISK or inflationary CHANGES? (Or at least in part? This is not meant as an apologia for the Fed in light of the current gold price collapse).
A: The answer is NO! Remember the price of something is its exchange rate. What will it exchange for? How much is that apple? One orange. The price of an apple is an orange. How much is that apple in hours of work sweeping floors? Ten minutes. The price of one hour of sweeping floors is six apples. These are real prices. If I were to tell you that the price of an apple is 100 baht in Thailand or 10 francs in France, you would be able to infer that if an apple costs $1 here, it probably has an equivalent value in Thailand and France, which would suggest a baht is worth about a penny and a franc about ten cents. You can only make that inference because apples can be traded fairly easily around the world. You can't make that inference if you were told a square foot of office space in downtown Tokyo rents for 10,000 or 100,000 yen. Real estate is not fungible. Every square foot on earth is different than every other square foot.
Paper currencies are not real, in the sense that the denominations of paper money are meaningless unless they are attached to something that is palpable and tradable. If I offer you 6,000 Russian rubles for your fine camera, you would laugh, having recently noted that the ruble trades at 6,000 to the dollar. But wait, didn't the government announce that it was going to take three zeroes off its ruble notes, in effect making each ruble worth 1000 times more in terms of the government's debt? That means the offer of 6,000 for your camera is not $1, but $1,000, a better deal. You had best take the offer now, though, because the deal may not look so good a month from now, if the ruble devalues from 6 to the dollar to 12 to the dollar. That means you would only be getting $500 for your camera. But wait, suppose the ruble price of gold declines in the next month, while the dollar price of gold rises. If gold is 1800 rubles an ounce today and $300 an ounce today, and a month from now gold is 1200 rubles and $400 an ounce, then an offer of 6000 rubles for your camera is really one you should grab. You will be getting five ounces of gold, which you will be able to convert into $2000 in cash!
Once your head starts hurting with all the possibilities of changes in the value of things as the paper money floats one way or another, you begin to realize the value gold provides as a constant. Its value as a guide to incipient inflation or deflation does not change in a deflationary environment or in an inflationary environment. It is the floating paper or "fiat" money that rises or falls in PRICE, while its VALUE as a unit of measure declines no matter what the direction of change from its gold exchange rate. A yardstick that is 36 inches maintains its value no matter if it is being used to build a doghouse or a skyscraper. A yardstick that changes to 37 inches or 35 inches from day to day loses value.
Q: (Michael J. Unger) What are the differences between a sterilized/non-sterilized currency market intervention?
A: If the Treasury department wishes to support the dollar relative to a foreign currency or a foreign currency relative to the dollar, it asks the Federal Reserve to conduct the operations. The Fed does so at its international desk. For example, it could buy dollars with yen assets it holds in its portfolio. This momentarily strengthens the dollar relative to the yen. The Fed, though, is an independent central bank. The Treasury cannot force it to do anything that will affect domestic monetary policy, which is what the purchase of dollars with yen would do unless that operation were sterilized. That is, an intervention on behalf of the Treasury would cause a decline of dollar liquidity in the domestic banking system. To maintain its independence, the Fed then buys bonds from the commercial banks with the dollars it has purchased with yen. The liquidity effect is zero, because the foreign intervention has been sterilized. I once suggested the practice was totally useless, the equivalent of two men in a rowboat, one drilling holes in the bottom to let water in, the other with a bucket bailing it out. There is some small effect, in that some speculators may get caught with the momentary strengthening of the dollar against the yen. Other, wiser speculators would cash in by betting on the momentary change, if they know there is no meaningful change in liquidity positions being contemplated. The bank agents who conduct these multiple operations for the government and the Fed enjoy making the fees from the trades. It's a nice piece of business. The same effect could be had, for all practical purposes, by having the Treasury Secretary announce that we would like the dollar stronger than the yen. Unless that announcement were followed by the Fed subtracting net dollar liquidity or the Bank of Japan adding yen liquidity, the water in the glass would settle down after having been shaken a bit. Robert Mundell once described the process of currency sterilization as the equivalent of "dry sex."
Critique of Jude's WSJ Op-Ed
Q: The following commentary, circulated through the von Mises website (www.mises.org) came to me this week from several students who had gotten it. I treat it as a question:
In today's WALL STREET JOURNAL (January 7, 1998), supply-sider Jude Wanniski argues that the dramatic decline in the price of gold reflects an increase in the demand for cash that is not being accommodated by the Federal Reserve. Unless we want deflation—which the JOURNAL editorial page wrongly theorizes would be a terrible thing—the Fed needs to adopt a looser monetary policy.
Ignored in his analysis is the fact that the price of gold does not necessarily function as a monetary crystal ball, and neither does the Fed any longer possess the means of strictly managing monetary aggregates. A gold price rule of the sort supply-siders favor is more unworkable than ever. On the international fiat dollar standard, the future of domestic interest rates and inflation depend on the behavior of dollar-holding foreign central banks.
Yet in today's monetary climate, as Llewellyn H. Rockwell, Jr., argues in today's JOURNAL OF COMMERCE, everyone seems to agree that there are deep flaws with the "dirty float" system of exchange-rate management. The real question is what should replace it: fixed rates, perfectly floating rates, or an international gold standard.
Among the three, only the pure gold standard addresses the root of the Asian currency debacle, namely the tendency of foreign central banks to generate domestic economic bubbles through interest-rate manipulation using dollar reserves as a base, as well as the willingness of the U.S. Treasury, the Fed, and the IMF to bail out the governments and banks that hold these bonds once trouble arrives.
"The world monetary system," writes Rockwell, needs an anchor that is not subject to political manipulation, an anchor that the gold standard provided and can provide again. Gold restrains governments and lending institutions just as today's monetary system makes the world safe for bad credit risks the world over.
"But can we return to a gold standard? It's either that or suffer ever more bailouts, currency upheavals, and political controls on markets. It's no surprise, as even Alan Greenspan once pointed out, that the biggest enthusiasts of something-for-nothing economics are also the most outspoken opponents of gold."
A: The commentary from the von Mises website does not seem to understand that what I proposed in the WSJ op-ed of January 7 is an international gold standard, essentially of the kind the private Bank of England followed for several centuries. There is no discussion in my essay about "strictly managing monetary aggregate," and in fact I wholly agree that it is impossible to manage monetary aggregates. The key to the von Mises critique appears to be in this sentence: "On the international fiat dollar standard, the future of domestic interest rates and inflation depend on the behavior of dollar-holding foreign central banks." Let me address this critique point by point:
1. I did not say the decline in gold reflects an increase in the demand for cash. I said it reflects an increase in the supply of liquidity, which includes cash and bank reserves — the two forms of government debt that do not pay interest.
2. Why do you think it is wrong to say deflation is bad? Von Mises thinks it is bad.
3. Why do you say the price of gold has no forecasting significance? Von Mises thought it did. A rise in the price of gold in a country's currency always and everywhere has been followed by inflation. Except, of course, if the price is simply rising after a steep decline.
4. Where did I say the Fed ever possessed the means to strictly manage monetary aggregates? I don't believe in quantity rules. That is monetarism.
5. Why do you think that "A gold price rule of the sort supply-siders favor is more unworkable than ever?" Please support the assertion.
6. You say that "On the international fiat dollar standard, the future of domestic interest rates and inflation depend on the behavior of dollar-holding foreign central banks." That's true, of course, unless our domestic open-market desk sterilized all foreign injections of dollar liquidity by mopping them up with bonds. Which is what happens now anyway.
7. You say that "The real question is what should replace it: fixed rates, perfectly floating rates, or an international gold standard." I never said I favored fixed rates -- except to fix the dollar/gold rate, which is the one essential feature of a gold standard. Floating rates are of course the problem. An international gold standard is what I have proposed, although I argue that we establish the standard, and allow every other country to decide whether or not they wish to be part of our system. If we have the power to establish the VCR as the international videotape system, and Albania wants to stay on the Betamax, well too bad for them.
8. You say that "Among the three, only the pure gold standard addresses the root of the Asian currency debacle, namely the tendency of foreign central banks to generate domestic economic bubbles through interest-rate manipulation using dollar reserves as a base, as well as the willingness of the U.S. Treasury, the Fed, and the IMF to bail out the governments and banks that hold these bonds once trouble arrives." I described in my WSJ op-ed how the bubble formed when Asian central banks were forced to inflate when the dollar price of gold rose, then had to deflate when the dollar price of gold fell. That is the only "bubble mechanism" I see. Describe to me the mechanism you say exists, but which you do not describe, except for a "tendency of foreign central banks to... etc."
9. "The world monetary system," writes Rockwell, needs an anchor that is not subject to political manipulation." I agree. The anchor I describe would only be subject to political manipulation if another President came along and decided to uproot the anchor by fiat. There's no power that can prevent that from happening but the votes of an informed electorate.
The Fed: Optimum Gold Price Operations
Q: (Forrest Gehrke) Three excellent, basic questions from Forrest. First: You recommend a price of gold around $350. Yesterday the price was $282. For the Fed to inject enough dollars to raise liquidity to a level sufficient to bring the price of gold up to the level you think necessary, how many billions worth of bonds would they have to buy? Where does the Fed get those dollars? Do they simply print them?
A: The amount of bonds the Fed would have to buy to get gold to $350 may be a very small number or a very large number. It pays to remember that all prices are based on expectations. If you expect the price of apples to rise, you buy now. If you expect the price to fall, you wait. Inventories of apples expand and contract according to these expectations. Thus, it depends on market perceptions of where the Fed wants the price to be. If the market were suddenly told that the Fed wanted gold at $350, dollar liquidity would splash into the market from every corner of the earth. This is because people holding it in the belief that it will become even more scarce relative to gold will sell more gold for dollars and hold the dollars. Banks who hold dollar reserves will try to get more people to borrow them, but people worried that gold and other prices of goods will fall further will be reluctant to borrow now and have to pay back more valuable dollars later. If the Fed announces that it would like gold to climb to $350, but follow with a sale of bonds that makes dollars even more scarce, the markets would be confused, but generally will react to what the Fed does more than what it says. By adding liquidity in a sustained way, the Fed causes the markets to sense a bidding up of prices, as dollars become more available relative to gold. In other words, it might take only a trivial amount of fresh liquidity to get the price soaring. In 1982, when the Fed monetized $3 billion in Mexican peso bonds, the gold price leaped from the $330 level in the spring to more than $500 on Labor Day. It was almost all expectations. The Fed "gets its dollars" because Congress in 1934 allowed it to buy U.S. government bonds from the banks with blank checks, the process by which debt is "monetized." The "money" is first seen as notations in the bank ledgers as dollar reserves. If people wish cash, the bank will buy paper notes and coins from the Mint, writing checks against those balances in reserve.
Banks and Government Bonds
Q: (Gehrke Question Two) Do the banks have that many bonds in their inventory? If they do, why? Is there some legal requirement that banks keep a specified level of bonds in their inventory?
A: There are a small number of specified banks that are privileged to trade in government bonds as "primary dealers." They earn the fees in buying and selling from the Fed as there are additions and subtractions from liquidity. All other banks hold government bonds because they are interest-earning assets that are safe and liquid.
Treasury Auctions and Federal Reserve Bond Purchases
Q: (Gehrke Question Three) I read that the Treasury holds auctions for bonds. How do these auctions interact with policies the Fed is trying to carry out? It would seem the Treasury is counteracting the trend the Fed is trying to carry out if the Fed is buying bonds from the banks.
A: There is for all practical purposes no conflict between the Fed's buying bonds and the Treasury selling them. The Treasury can only issue bonds that bear interest, at a rate determined by the auction. Treasury cannot create "money," as it could prior to the Federal Reserve Act of 1913. Only the Fed can do that, as it has a monopoly over the blank check book given it by Congress. Treasury bond sales are not inflationary, no matter how many congressmen think so. This is because while the Fed can create liquidity, Treasury can only move it around. Treasury bond sales can only have an inflationary effect if they grow so large and the funds spent are so misused that the market begins to suspect that the government will have to devalue the dollar. Devaluation is another way of saying the government will default on a fraction of its debt. A government defaults on all of its debt when it goes out of business, as with the Confederate States of America or Germany after both wars. In World War n, the government issued a gigantic amount of bonds, but the Fed monetized only enough to supply liquidity demands that kept gold at $35. There was no inflation. The postwar economists who wrote the history of the period insisted there was no inflation because of wage and price controls — and that interest rates were low because "they were pegged" at 2% in an accord between the Treasury and the Fed. This is all nonsense, as the following half century has demonstrated. Interest rates on 20-year bonds cannot be "pegged" at 2% if the government is not pegging gold at a fixed rate by managing the supply of liquidity around that rate. The entire war debt was financed at 2% long-term interest rates. At the end of the war, the publicly held national debt, if I recall correctly, was about 125% of national output. The publicly held national debt today is more like 75% of national output, but the market will not finance it at 2% because there is no commitment to maintain its purchasing power in gold, apples or anything else.
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I have to tell the class that I am extremely pleased with the way we are developing. In addition to the questions posed at SSU, there are many being kicked around on our Bulletin Board. I'm especially happy to see so many young students come into the discussion with interesting questions that others might be hesitant to ask. To tell you the truth, in almost every session I have to call friends and associates to help me answer these basic questions.
The new semester next week has been promised as a course in the political side of political economy. It is something new for me as well as for the class and I'm not sure how it will develop. I'll need your help with lots of good questions about the mechanisms of the political marketplace.