Supply-Side University Lesson #8
Memo To: Website Students of SSU
From: Jude Wanniski
Re: The Numeraire
I originally had not planned to devote this entire semester to monetary policy and money, but because we are in such a rare period of history -- with a true monetary deflation unfolding around us — it seems practical to continue our lessons in this realm. This week, I'm reaching back to last year's fall semester for a lesson on the concept of money that takes us beyond the term "unit of account." In a global deflation, "unit of account" is not quite the term we need to cover the world. In a world of floating currencies, each currency is a unit of account within its own sphere, but how do we tie together these variable standards of measure, unless we have a numeraire. In the Bretton-Woods system, in which the dollar was defined as 1/3 5th of an ounce of gold, and each other currency was defined as some fraction or multiple of a dollar, the unit of account in each country was the national currency; the numeraire directly or indirectly common to all was gold. In a floating system, the accounting unit is different from one country to the next. The numeraire remains gold — the one monetary vehicle that enables us to see which currencies are inflating and which are deflating.
It is my assertion, for whatever it is worth, that the term numeraire nost properly applies to a unit of labor. This is certainly not original on ny part, but is inferred from my reading of the classical economists, especially Karl Marx. The following is from Capital, quoted in Essential Works of Socialism, pp. 63-65, ed. by Irving Howe, (Holt, Rinehart and Winston, 1970), an interesting volume for you to peruse for a nice smattering on socialism:
The mystical character of commodities does not originate...in their use-value. Just as little does it proceed from the nature of the determining factors of value. For, in the first place, however varied the useful kinds of labour, or productive activities, may be, it is a physiological fact, that they are the functions of the human organism and that each such function, whatever may be its nature or form, is essentially the expenditure of human brain, nerves, muscles, and so on. Secondly, with regard to that which forms the groundwork for the quantitative determination of value, namely the duration of the expenditure, or the quantity of labor, it is quite clear that there is a palpable difference between its quantity and quality. In all states of society, the labour time that it costs to produce the means of subsistence must necessarily be an object of interest to mankind, though not of equal interest in different stages of development. And lastly, from the moment that men in any way work for one another, their labour assumes a social form.
Whence, then, arises the enigmatical character of the product of labour, so soon as it assumes the form of commodities? Clearly from this form itself. The equality of all sorts of human labour is expressed objectively by their products all being equal values; the measure of the expenditure of labour power by the duration of that expenditure, takes the form of the quantity of value of the products of labour; and finally, the mutual relations of the producers, within which the social character of their labour affirms itself, take the form of a social relation between the products.... What, first of all, practically concerns producers when they make an exchange is the question, how much of some other product they get for their own? In what proportions are the products exchangeable? When these proportions have, by custom, attained a certain stability, they appear to result from the nature of the products, so that, for instance, one ton of iron and two ounces of gold appear as naturally to be of equal value as a pound of gold and a pound of iron in spite of their different physical and chemical qualities appear to be of equal weight. The character of having value, when once impressed upon products, obtains fixity only by reason of their acting and reacting upon each other as quantities of value.
These observations by Marx help explain his belief that "Gold is the commodity money par excellence." When we know the value of gold money and agree upon it in relation to other values, we can then triangulate into other relative commodity values. If we know one ton of iron equals two ounces of gold, we can relate one ton of iron and 700 loaves of bread or 300 chickens and one ton of iron or two ounces of gold. Marx could observe that in the marketplace, everything for sale or trade was priced infractions or multiples of gold ounces, even though no gold ever changed hands. Over the centuries, new goods never seen before came into the marketplace, including autos, radios, telephones, heart transplants, etc. Each in turn established its value relative to the numeraire. Even today, when no unit of account officially is defined as a specified weight of gold, the market uses gold as the numeraire to triangulate the relative value of real things, as opposed to paper money that floats without definition. And the numeraire remains identified not with capital, but with labor.
Why is this argument important? I think because it nails down the importance of having a fixed unit of account. As long as gold is mixed up with capital and labor, it opens logical discussion to the idea that gold will hold back progress. If gold is simply tied to labor, then it cannot hold back progress. An ounce of gold today will buy 10 haircuts in Tokyo, 30 haircuts in New York, and 300 haircuts in Lagos or Calcutta. A man with a pair of scissors is like a man with a shovel looking for gold. The scissors and shovel are capital, it is true, but they are minimal considerations that can be ignored. In a country that is totally starved of capital, only labor exists, and in that country one man will pick up scissors to cut hair and the other will pick up the shovel and head for the hills. In the time it takes for a thousand barbers to cut 300,000 heads of hair, a thousand miners will produce a thousand ounces of gold, which can exchange for 300,000 haircuts.
It is important that gold be seen as this elemental unit of measure, at least in its role as the most monetary of all commodities. The several billion transactors on earth need a common starting point, from which to measure their value in terms of capital in combination with labor. You cannot measure two media with the same standard of measure — you cannot measure a length and a liquid with the same ruler. The use of gold as numeraire is critical to people as they go about their daily lives. It is not enough for them to know the price of everything in dollars, the official unit of account, when that unit varies from day to day relative to gold, which people have used for millennia to calibrate relative values.
Gold has been the best proxy for all goods and services offered for exchange in the market universe for most of human history — because it does best the job of serving as a unit of account. This function does not involve trust, except in the sense that the world marketplace trusts that gold will hold its value over time better than paper currencies or other competing commodities. At that level, it involves spot prices, which represent units of labor, not capital. If I make bread and you make wine, and one bottle exchanges for one loaf, they can both be priced in terms of gold, for purposes of making the exchange. It may take you all day to make a loaf and take me only an hour. You may be using a lot more capital than I am. Still, the basic loaf exchanges for a basic bottle and a basic weight of gold. Over the millennia, new commodities are added into the galaxy, but instead of gold seeming to lose its edge as the best proxy for all, it becomes even better. Prof. Milton Friedman thought for a while that the dollar would be better managed according to his scientific principles, but he was defeated thoroughly, as Prof. Robert Mundell predicted would be the case.
The issue is confused by those who argue gold has not maintained its purchasing power since the 16th century, because it could not buy a tv set back then, and now it can. An ounce of gold today can buy as many loaves of bread or bottles of wine as it could 2000 years ago, as long as we agree the bread and wine is made by labor, in the most basic way, as opposed to being made in high-tech bakeries and vineyards. Silver, which once was competitive, is no longer, as for thousands of years silver and gold ran neck-and-neck, at around 15 to 1, but since silver's role as a monetary commodity essentially ended in 1873, it now takes 80 ounces of silver to buy the basic loaves and bottles that gold still buys.
This doesn't happen by magic. The golden constant is constant because the basic unit of labor remains constant. A man can dig the same size hole today that he could 2000 years ago, in the same amount of time. Because he cannot eat gold or use it as shelter or clothing or transportation or watching the evening news, he only takes enough of it out of the ground to maintain its value as a unit of account. When he takes out one ounce too many, there is an incipient inflation. When he takes out an ounce too few, there is an incipient deflation. By tying our paper monetary system to this highly perfect gold market, we get the most efficient money — for all its functions.
The most persistent question that arises about a return to a gold standard concerns the amount of gold available in a growing economy. If we make gold the money, is not economic growth going to be limited to the amount of gold we can dig out of the ground? With only several hundred million people on earth, maybe that was okay, but now with 6 billion and counting, are we not tying ourselves down to a glacial rate of growth? The answer is that we only use gold as the numeraire, because we cannot have an efficient world monetary system without one. A numeraire is like a yardstick, a unit of measure that is fixed in time and space, the length of a man's stride. The amount of things you can measure is not limited by the number of yardsticks you can make. The amount of economic growth the world can have is not limited by the numeraire. Because every country in the world uses non-interest-bearing government debt as its money — its unit of account, its medium of exchange, and its store of value — as long as it keeps the supply of debt that pays no interest equal to the demand for that "money" at a constant value to the numeraire, there can be rapid growth with no increase at all in gold stocks. We can measure a doghouse and the World Trade center with the same yardstick.
The arguments against a gold numeraire in the same way would insist that the world could be swamped with too much gold if the Soviet Union or South Africa decided to mine gold like crazy and dump it on the world markets in exchange for dollars at a guaranteed fixed price. But if they supplied one more ounce of gold than was required to maintain the numeraire, the central banks would add liquidity to prevent the gold price from falling due to its excess supply. Follow what would happen: The Russians direct their gold miners to dig up another 10 million ounces of gold in calendar 1998. We assume they are doing this because the United States is guaranteeing $350 per ounce, and the Russians want to get the $3.5 billion for the 10 million ounces. If they dug up 10 million ounces and sold them into the open market they might assume the gold price would fall and they would get much less than $3.5 billion. In the event, the dollar price of gold would be depressed to the bottom range of the "gold points." That is, a $350 peg would mean we might buy gold at $345 and sell gold at $355. The actual operating mechanism would mean we would add liquidity when gold got to $345.01, to avoid having to actually buy the gold. The Russians would keep selling until all their gold was in private hands, having realized the lowest possible price.
The Russians now have $3.45 billion in dollars. What do they do with it? It is not likely they will buy U.S. Treasury bonds, because if they did, they would get the interest-bearing bonds and the U.S. Treasury would have the dollars. Instead of having to issue $3.45 billion in bonds to refinance the national debt, the Treasury has the cash. All that has happened is that Russian gold miners have worked like crazy, they have not been paid, and their government has U.S. government bonds. That's why this scenario does not work. If the Russians have $3.45 billion in cash for their gold, they will want to spend it on things they can buy for dollars. Say they decide to buy wheat from our farmers. They give the farmers the money and they get the wheat, which means the dollar price of wheat climbs on the world market. The farmers get the wheat, and have the surplus dollar liquidity the Fed produced to prevent gold from breaking below $345. The best buy on the world market is gold at $345.01, which the farmers buy until it reaches $354.99. (The farmers may buy something other than gold, but eventually the surplus liquidity will come to buy gold.) At that point, the Fed will sell bonds into the open market until the surplus liquidity has been absorbed.
If you stand back and examine the transaction, the United States has gotten the best of the deal. It bought gold for $345 from the Russians and sold it for $355. Our central bank produced surplus liquidity and then extinguished it, with not the slightest tremor to the dollar. American farmers sold the equivalent of $3.45 billion in wheat for $3.55 billion in gold. The Russians have the wheat, but they must sell the wheat for rubles in order to pay the gold miners for mining the gold.
This scenario is precise, seamless. It is exactly why only noodlehead governments would even think of trying it. It is why the Amsterdam banks could maintain a gold standard in the 17th century, why the Bank of England could take over in the early 18th century, and why the United States could take it in 1913, at the outbreak of war in Europe. The only reason the United States left gold is because the Federal Reserve was creating liquidity in 1971 in an attempt to lower interest rates and expand the economy. They did so even as foreign central banks, which were collecting that surplus liquidity in Europe, were asking for gold in exchange. The Fed simply ignored the gold signal, on the advice of President Richard Nixon's Keynesian economists who did not fathom what they were doing.
Why has mankind selected gold as the numeraire over the course of civilized history? Because of its several physical characteristics. It is first of all a precious metal — a tiny, tiny fraction of the earth's surface. All the gold mined in the history of the world would not be sufficient to build more than half the Washington Monument. It is also soft, which means it is useful as money, because it could be easily divided into fragments of different weights. It is also dense, which means it is portable, taking up very little space in comparison to its weight. As a store of value, it was better than just about anything else, because it could be easily hidden or transported. It is durable, lasting millennia without being altered by chemical change, by rust, by weathering. Hit a diamond with a hammer and it is worthless. Hit a gold bar and it will change its shape a bit. And it is not so scarce as to be found only in selected places. Civilized man could find this rare commodity just about everywhere, on all continents, which meant that it would be recognized as a commodity of value throughout the world. There are a host of other reasons that have been given on why nothing else but gold will do as the numeraire. These are the most common.
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At the time we posted the lesson on the Numeraire, October 24, 1997, the monetary deflation was underway, toppling one market after another in Asia. My use of the term "Asian Flu" soon came into vogue. It is only because we understood gold's role as Numeraire that we could see the deflationary dollar/gold price causing such turmoil. Here is the client letter we sent the previous day in 1997. We were all alone at the time in our analysis. A year later, we've been joined by a few others who now appreciate the continuing importance of gold, but the people who count and are in a position to alter the continuing effects of the deflation still resist the idea — Alan Greenspan among them.
October 23, 1997
THE ASIAN FLU
The 25% collapse of Hong Kong’s Hang Seng index this week in part reflects a harsh discounting of the recession that looms throughout the Southeast Asian economy, although the action in the currency futures market clearly indicates the heavy betting is on devaluation of the HK dollar. When overnight interest rates hit 150%, as they are now, we should soon know whether the fever breaks or the patient expires. What began as the sniffles in Bangkok has turned into a widespread influenza that threatens the financial structure of all of Asia. There is not a doctor anywhere in sight, either at our U.S. Treasury Department, at the International Monetary Fund, or at the Federal Reserve, who seems to know how to arrest its spread. There are literally hundreds of billions of credits and debits in the network of the global economy, with Europe’s weak link traveling through the London/Hong Kong nexus. Our weakest link is the Japanese economy, where old fashioned Keynesians at the Finance Ministry and Bank of Japan are combating recession with an insanely deflationary monetary policy of close to zero interest rates and tax increases designed to balance the budget. Meanwhile, the witchdoctors of the IMF are running amok in the region, demanding tax increases and “free floats” in exchange for cash.
If the decision about the Hong Kong dollar is going to be made in Beijing, we would of course hope that it would be to defend the currency to the last yuan. There are ample monetary reserves in Hong Kong and China to do this as long as it takes to persuade the markets that there will be no devaluation. We continue to believe the geopolitical consequences of devaluation would be so great, to Hong Kong and China, that they are unacceptable. Once the market sees there is nothing up Beijing’s sleeve, interest rates will plummet and the Hang Seng will soar, having survived at least this test of its resolve. Michael Kurtz points out that there is actually a codicil in Hong Kong’s Basic Law that promises a pegged currency, and that its credibility as a financial center would be smashed if it abandoned the dollar peg -- without at least repegging to gold or the mainland yuan at equivalent rates. Kurtz believes local money is betting the peg will be maintained with high interest rates, and the financial and property stocks that comprise the greatest part of the Hang Seng have been clobbered because they are interest-rate sensitive. There should be no one who suffers a capital loss by holding a currency that is now under the sovereign cloak of the Chinese government.
China cut its domestic interest rates last night in order to goose its economy, where the growth rate is floundering below 8%. The last thing it needs is to be pulled into a currency devaluation against the U.S. dollar, at a time when the U.S. Congress is already wondering why their trade surplus with us is at record highs. We remind you that the Chinese revolution of 1949 was in reaction to the hyperinflation of the Kuomintang government, with Mao Tse-tung coming to power promising to end the inflation. The Communists made every economic mistake imaginable trying to make communism work, but they never inflated. Their intent now is to build world confidence in their currency in order to create a global market for their government bonds, a goal that would be severely set back if they allowed their currency or Hong Kong’s to devalue.
We remain fairly isolated in our argument that the major culprit behind this Asian flu is the Federal Reserve, which must be thought of as the world’s central bank. By allowing the dollar gold price to rise in 1994 to $385 from $350, where it had hovered since 1985, the Fed introduced a mini-inflation that Alan Greenspan & Co. tried to beat back with higher interest rates and a weaker economy. The gold price decline, to $320 from $385, began a year ago as the demand for dollars picked up in expectation of a stronger economy and was not met by an increase in dollar liquidity. Our economy survived this minor deflation because of the success of the budget deal and the long-awaited cut in capital gains tax. Thailand caught a cold, though, because of its currency’s link to the dollar. It inflated with the dollar’s in 1994-96. It made the further mistake of imposing capital controls in 1995 on the advice of MIT’s Paul Krugman, who warned against “hot money” flowing into their stock market. When the dollar deflated this year, Thailand was the weakest of the Southeast Asia countries and the logical place for speculators to hammer. When its currency fell, the speculators moved on to the other countries of the region, just as they attempted to make a killing in Argentina after the killing they made in Mexico.
There was no Domingo Cavallo in Kuala Lumpur or Jakarta when the speculators arrived to test the ringgit and rupiah, and these currencies quickly fell. The Philippine peso and Korean won followed, then joined by the Taiwan dollar -- helpless individually against the onslaught and with no clear leader to rally them jointly. They could have arrested their declines simply to match the dollar deflation, but once the IMF began circulating with its bag of poison, the bad colds became serious and life-threatening. How appropriate that former U.S. Treasury Secretary Bill Simon this morning writes on the WSJournal’s editorial page, calling for an end to the IMF.
It is too easy, though, to potshot the IMF at this point, when Alan Greenspan and Treasury Secretary Bob Rubin should be on the hotseat. Instead, they are hiding in the weeds, pretending all that bad stuff going on over there in Asia is the result of bad loans by bad bankers. Greenspan will argue that these countries want to have it both ways, desiring the dollar peg for currency stability, but also wanting a cheaper currency to spur exports. This is not what’s happening, though. Greenspan knows the Asians are suffering because they put faith in the dollar and his conduct of monetary policy. He also knows the $320 gold price is bad for us and bad for them, and should be lifted back to $350 by liquidity additions to the banking system. This would instantly relieve pressure on the Hong Kong dollar and the rest of Southeast Asia, China and Japan. If the dollar weakens against gold by even this small amount, the relief that would be felt in Japan would be enormous, and we could soon see the Nikkei doing a hop, skip and jump over 20,000 from 17,000.
How do I know Greenspan knows all this? Well, he knows everything, especially these arguments, which he can’t dismiss because they are part of his entire belief system as he has tried to explain to Congress in the last decade. He knows any country that pegs to the dollar while we are not pegged to gold simply imports all our monetary mistakes. My guess is that Rubin does not understand what’s going on, unless Greenspan has been trying to tutor him. Two weeks ago, I went to Washington and met with Deputy Treasury Secretary Lawrence Summers for the sole purpose of giving him this analysis in person. Which I did, and I know he did not immediately see any holes in it. As long as everyone in the system knows someone else can be blamed for anything really, really bad that happens, they can hide in the weeds. President Clinton, who is either playing golf or pondering his prosecutors, I’m sure has no idea what’s up. He is getting briefed on China, we can be sure, as the President of China, Jiang Zemin, is coming Sunday for a summit. What perfect timing!