Supply Side University Lesson #4
Memo To: SSU Students
From: Jude Wanniski
Re: Finding the right gold price
On January 7 of this year, I wrote an op-ed article for The Wall Street Journal, entitled "The Optimum Price of Gold." In it, I noted that Professor Robert Mundell of Columbia University, the prime mover of modern supply-side economics, was saying at the time that any dollar gold price between $300 and $400 could be fixed and sustained. My position was not inconsistent in suggesting that the optimum price was $350 or close to it. Mundell really was saying the pain of adjustment to a fixed gold price would be bearable within the limits of $300 or $400, although he clearly meant the pain would be greatest at the extremes. When I wrote the WSJournal article, the price was $290. It more or less has remained below the lower "pain threshold" ever since.
The fact that there has been a great deal of pain in the financial world since I wrote the piece is of course no surprise to me or to Mundell. Almost everyone else who is supposed to know economics or finance has been professing surprise at the convulsions and chaos we have experienced up and down and sideways. That's because they don't know there is an optimum gold price. For most of the experts on Wall Street and in the financial press, the reasons for the turbulence have to do solely with "bad investment decisions by white adult males," a la Long Term Capital Management, or "bad loans" by "yellow adult males who are crony capitalists." Or because of psychological "bubbles" that led masses of people to act irrationally.
In the first three lessons this semester, we have covered the reasons why gold is still the most monetary of commodities. When dollar inflation occurs, the process begins with a rise in the dollar price of gold when the central bank supplies more liquidity to its member banks than they are demanding, All other prices sooner or later follow until they are consistent with the higher gold price. And so with deflation, as the dollar price of gold is the first commodity to decline when the central bank withholds liquidity that is being demanded.
In this lesson, we consider what the price of gold should be if we were going to fix it in the near future. This becomes more than a theoretical exercise if you consider that the world next year may be forced to a single, fixed currency in order to get through the Y2K computer chaos. Only gold could resolve the sovereignty problems that would otherwise prevent agreement. Jack Kemp has urged President Clinton to call an international monetary conference along the lines of the 1944 Bretton Woods conference to devise a global monetary system. I'm assuming there will be one because the political consequences of ignoring the problem would be immense. I'm reminded that Kemp and Mundell in 1983 co-authored A Monetary Agenda For World Growth, as the proceedings of a Washington conference that dealt with this issue.
Fixing the gold price at Bretton Woods posed little difficulty to the participating nations, because the United States had maintained the dollar's convertibility among foreign central banks at $35 per ounce even after making it illegal for U.S. citizens to own gold for investment purposes in 1934. That is, the Treasury accepted gold bullion for dollars from the allied powers at the $35 rate and sold bullion to them via their central banks on demand at that rate. There was an attempt at Bretton Woods to substitute a bi-metalic system, with the dollar fixed to gold and silver at some composite rate. The United States and UK prevailed in keeping gold alone as a monetary metal and retaining the $35 dollar/gold exchange rate. There thus was no political "pain of adjustment" involved in setting a gold price at that level, although there the general price level in dollars still had to "catch up" with $35 gold after the war ended. That is, after President Franklin Roosevelt devalued the dollar in 1934, to $35 from $20.67, it took more than 20 years for the general price level to completely adjust to the new gold price. Most economists attributed the post-war price inflation to "pent-up consumer demand," but price inflation cannot occur without being preceded by a devaluation of a currency against gold. Half of the adjustment to $35 had taken place by the time of Bretton Woods, because of the government's price controls and because long-term contracts that had been made prior to the devaluation at the old gold price still were unwinding.
The unwinding of contracts between debtors and creditors, lessors and lessees, management and labor, is what "the pain of adjustment" is all about. Jones signs a 25-year lease on office space or a dining establishment, agreeing to pay $2000 a month when the price of gold is $200 an ounce. Then the gold price changes to $400 an ounce, either because the government simply announces the devaluation, or the Fed mismatches liquidity supply to liquidity demand until the price runs up in the market. The people who rent the space do not feel the inflation for 25 years insofar as the rent is concerned. Their customers also benefit in that they can charge lower prices than their competitors because of the break they have on rental space. The pain of the inflation is felt by the creditor, who has no other choice but to swallow the loss over the quarter century. The owner of the property is not hurt as much as the creditor, who financed the real property prior to the inflation at market rates of interest that were undoubtedly very low, reflecting inflation expectations. The depositors in the credit institutions bore the brunt of the loss as their savings lost purchasing power.
Only as these contracts expire in little bits and pieces do they show up in the consumer price indices. They lag because the people who make up the warp and woof of the economy as producers and consumers, debtors and creditors, make their price adjustments slowly, as the longer maturing contracts play out. A doubling of the price of gold does not propel the carpenter to demand a doubling of his wage — unless he lives in a country experiencing hyperinflation, where a doubling of the gold price precedes a doubling of all prices by days or weeks. Which is why the CPI is worthless as an inflation indicator in a nation that has had a sustained period of stability in the gold price. In a country that has had a poor experience with inflation, nobody is foolish enough to offer a long lease or loan without provisions for inflation adjustments. Plus, the CPI is more accurate because it adjusts so quickly to the change in the gold price.
When I wrote the WSJournal article in January about the optimum gold price, I did not express disagreement with Mundell on his range of $300 to $400, instead citing my specific figure of $350. On a series going back to 1978, prior to its surge, the average monthly gold price is roughly $350. If we take a shorter series, to 1988, the average price is more like $363. This is why I've felt that there would be too much deflationary pain below $325. What's too much? When workers are forced to take pay cuts or smaller benefit packages, because there is a downward shift in the general price level, it is the ordinary people who feel the crush. They have acquired debts by collateralizing their labor at the higher rates, and can't meet their obligations on the way down. Below $325, the adjustment process would be too much for the political economy to handle.
Economists who have not thought about deflation as a phenomenon involving a change in the gold price are unable to understand why there seems to be no correlation in price changes when the dollar price of gold doubles and at the same time the Mexican price of gold doubles. The dollar/peso exchange rate remains the same. But because debt maturities are much shorter in Mexico, the price adjustment comes much more quickly. The general price level might double in Mexico over four years, taking eight or ten in the United States. How confusing to mathematical economists to find the dollar buying more in Mexico than in the U.S. That is because they do not relate the average maturity of contracts.
Prior to the great inflation of the last 30 years, economists could note the similarities of prices from one country to the next. There developed the concept of Purchasing Power Parities, or PPP, which demonstrated that a cup of coffee in Toledo would cost roughly the same as a cup of coffee in Amsterdam when the currency exchange rates were equilibrated. The PPPs got out of whack during the worst period of the financial turbulence of the 1980s — which was the legacy of Presidents Nixon, Ford and Carter and the economists who advised them. Countries with longer debt maturities and more stable gold prices in the local currency — Japan in particular — could buy much more with their money in terms of an ounce of gold than those whose debt maturities had shortened, with much higher gold prices — the United States, for one. In other words, the number of yen an ounce could buy would buy many more cups of coffee in the U.S. than the number of dollars an ounce of gold would buy. The PPP theories were blown to pieces. They will of course work much better after a sustained period of global price stability on a new gold standard.
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When supply-siders first began talking about refixing the gold price, Mundell was fairly casual about saying it could be fixed anywhere remotely near the going price on the market. This changed when gold soared in 1979 and 1980 to levels that were so high that the pain of adjustment at market levels would have crippled the creditor class. It was then he tried to bring in the remnants of PPP theory to surmise an optimum price. Arthur Laffer, who was engaged in these discussions about the best pegging price, had the idea of telling the market that the price would be pegged on a certain Tuesday at 4 p.m. EST six months hence. The market would then supposedly jostle around with debtors and creditors moving gold to an optimum level, which he thought always would be much lower than where it was at the moment. He still apparently believes gold belongs closer to $250 than to $350. Both methods seemed too apolitical, in the sense that they while they seemed economically correct, neither took into sufficient account the pain of adjustment.
It was when I became dissatisfied with these methods of discovery that I began to think about the time horizon of debtors and creditors and a balance that would be politically feasible. In other words, if the price were set too high or too low, it would be blown apart by political frictions, and the establishment would insist rates must continue to float. The establishment prefers floating exchange rates, because it has the political advantage over ordinary people who don't know how to defend themselves against monetary swings and can't make money out of the chaos.
There will be questions from the class about this lesson, I'm sure. A number have already been posed as a result of the last two lessons, which I will take up next week in a Q&A. So get your questions in soon. They may relate to the current monetary fluctuations.
We now show more than 700 registered students at SSU. We will soon be asking you to reaffirm your interest and attendance. Here is the op-ed I mentioned at the top of the lesson:
The Optimum Price of Gold
By Jude Wanniski
The Wall Street Journal January 7, 1998
The $100 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 12,000,000 ounces of gold by central banks — out of holdings of 1,100,000,000 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.
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 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 central bank errors.
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, 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 allowing 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. Sterling/gold floated up 30% and in 1925 the Tories and Winston Churchill 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, gold fell from its 1980 average of $600 to $300 in early 1982. The deflation produced the worst recession since the 1930s. The Savings&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 in 1993-96 added gobs of liquidity to the market in order to keep their currencies tied to the dollar. 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. 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 was worried of inflation signs caused by gold having climbed by 10% from the $350 level. 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 where I believe it is optimal — 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 came crashing down on them. The economies 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 was not optimal where it is 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 gold 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. At a second effect, it 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.
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 at 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 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.
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