Four Questions about Money Jude Wanniski July 17, 1998

Memo To: Supply-Side Students, Summer Break
From: Jude Wanniski
Re: Four Questions

Q-1: Although you've touched on these themes in several places, I wonder if you could outline some of the "social" effects that might arise from a gold standard/low taxes/referendum sort of political economy. s For example, the left shrieks that eliminating capital gains taxes will amount to a giant tax cut for the rich. They have a point -- there's in some sense a limited amount of equity capital, for example, and those that are wealthy will tend to be able to acquire more of it than those that are not. Wouldn't there be a concentration of ownership in the hands of a few wealthy people, creating a sort of Victorian capitalism, with a soot-stained lower class and a decadent, aristocratic leisure class funded by the dividends of industrial enterprises set up by their grandfathers? I wonder how this open-society vision agrees with basic liberal ideals of a narrow income spread and broad middle class.

A-1: Rich people do not benefit from a lower capital gains tax unless they put their wealth at risk, by making an investment in an asset with a low capital value in the hopes it will gain in value. A zero tax on capital gains only benefits those people who have successfully put after-tax ordinary income at risk. A high tax on capital gains discourages people who have wealth from risking it on people who have no wealth. A zero capital gains tax does benefit the rich, but only after they have become rich. It does not benefit the rich who refuse to risk their wealth on those at the bottom of the pile, who can't possibly rise in the socio-economic pyramid unless there are people willing to bet on them. That is, to get from the bottom up, you must have access to capital. The kind of capitalism that invests only in low-risk enterprise is what you see in Japan, where a successful corporation invests in other successful corporations, in order to diversify its portfolio. A gold standard is part of the equation because it lowers the risks people of wealth have in investing in people who have ideas, youth, energy and no capital. It is argued that the people of Japan are not entrepreneurial, but I don't think that's true. For the last half century, the tax system has given enormous benefits to corporations and great punishments to start-up enterprises that might challenge the big corporations. As the twig is bent, so it grows.

Q-2:I have some trouble connecting your view of currencies, in which the central bank is basically the sole player, and the view of the currency markets which I see every day. Most market players seem to treat currencies like stocks, with the currencies of "good" countries rising and "bad" countries falling as capital moves in an out on the whims of traders reacting to the silliest comments from government officials. The gold markets seem to be the same way, with lots of speculation about sales of gold by central banks, production levels in Zimbabwe, etc.

A-2: The central banker is the sole player in the creation of base money. By that I mean non-interest bearing debt of the government — any government. If the Fed creates $1 billion in base money, it means the government is only responsible for that $1 billion. It is not responsible for the several billion that are created on top of that original base. The base is critical because the central bank, if operating properly, will allow it to expand only if the demand for base money exceeds the supply. The bank can tell this if it observes the price of gold declining in its '' currency. The "money supply" that exists in addition to the base are not related to the currency as a unit of account. It is money created by the private banks, using the currency as the accounting unit. This "money" has no inflationary or deflationary consequences because it cannot increase or decrease the price of gold, which only the central bank controls. It is created for private transactors who need it to facilitate a trade, with the bank acting as the intermediary. A million widgets exchange for two million gidgets. The contract is in dollars. When the  exchange is made, the dollars disappear. You can see that there are no inflationary consequences as there is no permanent excess in the supply of liquidity. What you see from your vantage point is trading in these dollars and yen, which sit atop the monetary base of the United States and Japan. The exchange rate at any given moment is the dollar's gold price relative to the yen's gold price. It's our yardstick in competition with their meter stick. If we keep our yardstick 36 inches long and not allow it to waver, to 37 or 35, we will have a stronger economy than Japan's, which allows its meter stick to go to 110 cm, then to 80. The more stable the unit against gold, the more reliable it is to private transactors who are exchanging widgets and gidgets.

Q-3: Some people have criticized the Fed's clinging to the gold standard because they say it kept the Fed from providing liquidity to sound banks  that were experiencing a sudden rush on deposits at the onset of the Depression. I believe you said that the Fed was for some reason not allowed to provide liquidity at that time, but in any case is there any conflict between the gold standard and the Fed's capacity to prevent a banking run by acting as lender of last resort? In a Von Mises overview, it also said that Von Mises thought there shouldn't be a lender to provide funds in the case of a banking run. Do you agree with this?

A-3: By "clinging" to the gold standard in the 1930fs, we kept our yardstick at 36 inches while all other measuring units in the world were fluctuating. The Fed provided liquidity to sound banks everywhere, through its discount window. The bank failures were as the result of the economy shrinking by one third, due to the fiscal shocks of the Smoot-Hawley Tariff Act and Hoover tax increases. For a bank to get liquidity from the Fed required the bank to give in exchange eligible paper, i.e., collateral. If a bank went to the Fed with a mortgage on property that was now worth less than the mortgage, the paper was not eligible. The Fed was not required to give something for nothing, or SI000 in cash for paper that could not find a buyer at S500.

Von Mises did not say there should not be a lender of last resort. He said the central bank should not be required to provide something for nothing. His argument is with the monetarists who think the Depression could have been avoided if the Fed had "printed more money," i.e., bought interest bearing US bonds from the private banks in exchange for non-interest bearing cash and bank reserves. Von Mises would point out that there was no demand in the market for cash and bank reserves, except from Bonnie and Clyde, who got what they wanted without collateral.

Q-4: You've shown quite well, I think, how the central bank has infinite power to manage the "supply" of a currency (I use the quotes because the situation seems only analogous to a market). Properly wielded, this power allows the central bank to move a currency wherever it wishes, or alternately, to pin it to a stable point. However, it seems like few central banks are using this power in any sort of sensible way. In the absence of rational moves on the "supply" side, the "demand" side, which is to say the debt or currency markets, seems to have a lot of influence on the value of the currency. You've mentioned in several notes, for example, how tax cuts/hikes increased or decreased demand for a currency. Can you lay out in an organized manner what sort of "demand"-side actions influence a currency? If a currency reaches a certain gold price, is the effect (inflationary or deflationary) the same whether the move occurred through a "demand"-spurred move or a "supply"-spurred move?

For example, the "Big Bang" in Japan will allow Japanese financial institutions to invest a great deal of money overseas in search of higher returns. Superficially, this would seem to decrease demand for yen,  pushing the yen lower against gold. If enough money flowed out to push the yen to ¥44,600, would this have the same effect as if the BOJ pumped money into the economy to relieve deflationary pressure? Would the increased demand for dollars increase deflationary pressure in the U.S.?

A4: This is an extremely interesting question, one I can't remember coming to me in this fashion. My answer should help clear up several issues. The simple answer is that you can never tell for sure in advance how a supply-side move or a demand-side move will effect the demand for money. A 10% income tax cut might cause an increase in the demand for money or it might cause a decrease in the demand for money. The only way you could predict in advance which it will be is if you know where the tax rate is on the Laffer Curve — the point of diminishing returns. The mass of people in the marketplace make those judgements one at a time, and the net result of a 10% income tax cut will then show up as upward or downward pressure on the price of gold.

The most, most, most important point here is that the only thing we have that helps us answer these complex questions is our assumption that the masses of people on the earth use gold as the basic unit of account, the anchor for all other economic variables. This is why I call it the Golden Polaris, at least one fixed point in the economic firmament. When I see the price of gold rising in terms of dollars, the possibilities of why it is happening are myriad. Sometimes the connection seems so obvious to me that I can confidently predict which way the price of gold will go. When the income tax is 25% or higher, an increase will usually mean a decrease in the demand for liquidity. Theoretically, if the 25% rate applies only at extremely high incomes, a further increase will have no effect on the demand for liquidity.

What is a "demand-spurred move"? Demand-side economists use the same policy levers as supply-side economists. A Keynesian says we should cut taxes to put more money into people's pockets, so they can increase their consumer demand and spur the economy onward. When an economy is stagnant, they call this "pump priming." A supply-sider may recommend the exact same tax cut, but on the grounds that the higher rate is discouraging economic activity, acting as a barrier to trade or investment in trading activities. Whatever the reason, if the government cuts the rate, it will have the effect of increasing or decreasing the demand for liquidity. One or the other. The only way you can tell which is if there is an incipient increase or decrease in the price of gold. This is the wonderful thing about gold. It enables government to alter policy of all kinds in response to the wishes of the people, yet at the end of the day, the central bank can adjust monetary policy to keep the unit of account constant, by buying or selling bonds from its portfolio. Remember SSU students, the central bank's primary responsibility is to manage the mixture of interest-bearing debt and  non-interest bearing debt. It may never be able to manage it to perfection, but it can come as close as possible by telling the market for debt instruments that it will use gold as its constant target. The mass of people in the market then get exactly the amount of "money" it wants, with no surplus of non-interest-bearing debt. In this way, gold is the most democratic of all monetary policies. This is why ordinary people love a gold standard, because it never cheats them. The elites, who know how to make money in a floating currency world, often with inside information or brilliant insight, do not like gold, because it eliminates the possibility of accumulating wealth at the expense of the masses.

Your question about Japan's "Big Bang" errs in assuming that it would result in a decline in a demand for yen. Quite the contrary, the reform of the financial system will increase the efficiency of the economy. Regulatory barriers now in place that prevent the free flow of capital will be lifted, which is the equivalent of a cut in tax rates that are unnecessarily high. Anything that increases a barrier between two transactors in the economy — thus discouraging the transaction — reduces the need of the two transactors for liquidity. They put their hands in their pockets and go home.

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