To: SSU Students
From: Jude Wanniski
Re: More Q&A on Gold
I keep planning to run another guest lecture in this semester’s focus on money and banking, but interesting questions continue to come in. So you have here another Q&A. The first question is from a prospective client in Texas who had read on another Internet site that the gold market might be being manipulated to keep the price low, in order to hide pent-up inflation from the eyes of gold-watchers. Here is how I responded:
JW: In the almost 30 years since I began watching the price of gold on a daily basis, I've heard dozens of stories about how it is being manipulated by private transactors, gold producers, or governments. They come from gold-watchers who do not understand central banking and how it operates -- or how central banks operate differently from one country to the next. If you do not understand that process and yet you see sudden swings up or down in gold’s price in dollars or in other currencies, it is natural to conjecture about forces being at work with the power to cause those swings.
My orientation begins with the fact that the dollar price of gold is a ratio of two ratios. In the numerator is the supply of dollars versus the demand for dollars and in the denominator is the supply of gold relative to the demand for gold. The biggest variable in the ratio of the two ratios is in the numerator, where the central bank is supplying dollar liquidity into a market which is in need of a certain amount of dollar liquidity. The smallest influence on the gold price is in the demand for gold relative to the supply of gold. This is because the stock of gold in the world is so large relative to its "flow," or use. A large portion of the stock of gold's 125,000 metric tons, perhaps a third, 40,000 metric tons, is held inert in the world's central banks, as monetary reserves. The world population increases its demand for gold for all purposes to only 2000 or 2500 metric tons per year.
If we were on a gold standard, the central bank of the United States would be required to keep the supply of liquidity equal to the demand for liquidity at a specific ratio of the two ratios. It has absolute control over the amount of liquidity being supplied, because the Fed can buy and sell bonds from its portfolio to add or subtract, right down to the penny. In other words, it can totally control the numerator. If it supplies too much liquidity, though, the marketplace will use the surplus to increase its demand for the species, thereby causing a change in the denominator. Indeed, the most important use for gold in the world is as a monetary commodity, to provide this kind of escape hatch for private citizens who try to protect themselves against governments that cheat them by pushing more money -- government debt that pays no interest -- on them than they desire.
To "manipulate" the dollar price of gold outside the numerator, then, requires some person or persons to gain control of the supply of gold, as the demand is almost totally determined by the numerator. How does one go about gaining control of the supply? If you have a gold mine that is feeding gold into the world economy -- and suddenly announce it is closing for the indefinite future -- you might have a temporary effect on the supply. But there are plenty of alternative sources which can step up their sales from inventory, as the price tends to rise. And others will step up their mining activity at the margin. The would-be manipulator would soon realize he is gaining nothing by keeping the mine closed and will re-open it. Actually, the would-be manipulator would realize before he closed the mine that the process would play out as I describe, and choose not to play that game.
Now if you really believe that the gold price is being manipulated, please describe the credible mechanism. I've been thinking about this for almost 30 years and for the life of me cannot imagine one that works in the real world.
Q: In his Washington Post column this week, Robert Samuelson makes the flat statement: “The country long ago left the gold standard, which caused the Great Depression.” I’d never seen this statement before. What is he talking about?
JW: Samuelson has been a supply-side adversary for more than 25 years, but he still does not know what a gold standard is and could not explain what he meant if you asked him. The fact that all demand-side economists oppose a gold-based monetary system enables him to make this kind of statement without naming a source, knowing he will not be called upon to explain himself. It is unusual to see the statement made so baldly, though, because a great many Ph.D. economists were taught, and believe, that the gold standard ended in 1913 and thus could not have caused the Great Depression. Other academic economists believe the pure “gold standard” ended in 1913, but the gold-based “dollar-exchange standard” continued until 1971, when President Richard Nixon broke the dollar/gold link. To classical supply-side economists, as long as the dollar is defined in terms of a specific weight of gold, and the government recognizes the dollar as legal tender at that weight, the dollar is as good as gold.
I’d guess that Samuelson’s source was a monetarist, i.e., a follower of Milton Friedman, who might say that the gold-based dollar-exchange standard “caused” the Great Depression because it prevented the Federal Reserve from devaluing the dollar when the official price was at $20.67 per ounce. The reasoning would have to be that we could have inflated our way out of the 1931-32 recession and it would not have become a Depression. Friedman himself would not make that argument publicly because he knows President Franklin Roosevelt, in a series of small steps, devalued the dollar in 1933-34, to $35 an ounce, on the advice of monetarists of that era who argued it would end the recession. Instead, it simply caused a gradual inflation that did push up nominal prices, but also increased income-tax thresholds through inflationary bracket creep. The recession got worse, not better. By remaining on a gold-based monetary standard for the dollar, although even at a devalued rate, Roosevelt was able to finance World War II at the extremely low interest rate of 2%.
If academic economists -- and journalists like Samuelson -- would accept my iron-clad thesis that the impending passage of the Smoot-Hawley Tariff Act caused the Wall Street Crash of 1929, they would be able to discard their now obsolete theories that either Federal Reserve monetary errors caused the Depression or that the Gold Standard did. There are some economists who now accept my Smoot-Hawley thesis but still insist the Fed compounded the problem by not adding enough “money supply” to the banking system, yet as hard as I have looked into the Fed’s behavior in that period, I can find no errors. Journalists like Robert Samuelson make statements as they do without making any serious attempt to understand the policy mechanisms that brought on the economic contraction of the 1930s.
Q: Another frequently expressed objection to the gold standard is the claim that "under the gold standard the country experienced frequent, severe financial panics, culminating in the Great Depression." While your position on the depression is well known, I'm not aware that you've discussed earlier financial panics, bank runs, etc., which many believe were worse than what we've experienced since.
JW: A gold-based monetary standard can only reduce the risk of monetary inflation or deflation. There have been bank runs here and in England under the gold standard because of the increased risk of war, when market participants consider the possibility that the government will suspend the gold standard and devalue the currency. Neither can a gold-based money eliminate the risks associated with domestic errors in tax or tariff policy or prevent shocks to commercial stability engendered by foreign changes in economic policies. The fact that Adam Smith and Karl Marx agreed that a gold-based monetary system is optimal should tell you how many areas of disagreement there can be when organizing economic systems for different countries and cultures.
Q: In Lesson #10, Prof. Robert Mundell argues that the United States is suited for a monetary policy that targets inflation, and that’s it. Now, there are three types of monetary systems that any country in the world can have: inflation targeting, monetary targeting, and exchange-rate targeting. The United States cannot peg its currency to a larger currency (exchange-rate targeting), as there is no currency larger in the world than the United State dollar. Also, the United States cannot use monetary targets while simultaneously changing the lever of the federal funds rate. So, Mundell is right by default, and the United States can only target inflation, because it cannot target other currencies nor other baskets of goods for aforementioned reasons. Is my reasoning correct?
JW: I’m afraid you did not understand. Mundell only is saying that if you target an exchange rate, you cannot also target the “money supply.” If the Federal Reserve were to target the euro or the yen, it would have to add or subtract liquidity in order to maintain a fixed dollar/euro or dollar/yen rate. This would mean the Fed would accept the monetary policies of either Europe or of Japan. It could not simultaneously manage the overnight fed funds rate. If the Fed were to manage the exchange rate between the dollar and gold, it would have to allow the “money supply” to rise or fall and it would have to permit the exchange rate between the dollar and the euro or yen to fluctuate. It would be up to the European Central Bank and the Bank of Japan to fix their currencies to the dollar or to gold. If the dollar were fixed to gold, it really would not matter which the euro and yen were fixed to, because Mundell would say a dollar-euro-yen-gold fixity is perfectly balanced and in equilibrium.
Q: If fixed exchange rates are clearly superior to floating exchange rates in providing economic stability and prosperity on a global scale, then why do so many economists consider floating-rate regimes to be superior? Put another way, on what basis do advocates of floating regimes believe that manipulating the monetary unit of account would be beneficial? Is it related to their emphasis on fostering “demand” in the economy through monetary means?
JW: Almost all the academic economists in the world today -- excepting some branches of the Austrian school -- look upon monetary policy as a tool by which the government can manage the national economy. Clearly, this is the consensus here in the United States, where neo-Keynesians and monetarists at the Federal Reserve set aside considerations of the dollar’s stability against gold or against foreign exchange. Instead, they try to guess at how high the interest rate they set should be in order to prevent wages from going up too fast or unemployment from falling too fast. I believe that any change in the dollar price of gold, up or down from some optimum rate, represents an error in central bank policy that subtracts from the national standard of living. In other words, Greenspan and his fellow central bankers have enormous power, but with it they can only make inflationary or deflationary errors. Greenspan has been acclaimed in the past because the errors have been small under his leadership. He is being more sharply criticized now because the errors have become more obvious with wider swings in the dollar/gold price and the concomitant effects on other commodity prices and financial assets.
Q: Mundell also writes, “Fixed exchange rates always work and only work when intervention in the foreign exchange market determines monetary policy.” Does Mundell mean here that a monetary policy must conduct monetary policy in both the foreign exchange and domestic market, and does he leave out the domestic aspect of monetary policy in this quote because it is already considered a given?
JW: This quote simply means that if the exchange rate between the dollar and the yen is going to be fixed, the monetary policies of the Fed and/or the BoJ must be devoted to maintaining the fixed rate in order to keep it fixed. If I were to ask Mundell if the dollar/yen rate could be fixed by having the Fed and the BoJ each maintain a fixed rate with gold, he would of course agree, although in a way it would seem to be at odds with the statement you quote. That is, if A (dollar) = B (gold), and B (gold) = C (yen), then A (dollar) = C (yen).
Q: Mundell’s use of the term intervention in the last question also threw me off as well. I always thought that a gold standard would ensure that amount of liquidity in any monetary system would be set by the private market, and not by the whims of central bankers. Perhaps Mundell uses the word “intervention” as a way to explain actions that are within a monetary framework. Am I just getting confused by semantics, or is there a larger issue here?
JW: It is confusing because here Mundell is talking about fixed exchange rates without the use of gold, in which case one central bank or the other has to ultimately intervene in the foreign-exchange market to add or subtract liquidity to maintain the rate. If it subtracts liquidity in the forex market but “sterilizes” the intervention by adding it back in its domestic market, the fixed rate will not hold.
Q: You wrote the following to describe monetary conditions in both the United States and Switzerland in the 1970s: “In 1973, we formally floated and the Swiss remained tied to gold. This little country was suddenly the only country in the world where you could draw up international contracts without having to buy insurance against inflation or deflation (hedging). The problem was that the franc became so much in demand that Swiss export industry could no longer compete -- in pharmaceuticals, chocolate or cuckoo clocks. Mundell pointed out to me that a small country could not be the only one with a gold currency unless it was willing to destroy all its domestic industry except banking. He said if the Swiss could have held out, everyone in the country would be working for a bank and nobody would be making cuckoo clocks. The POLITICAL strain was too much and the Swiss were forced to float the franc along with the other European currencies.” I’m sorry, but I still don't get it. How did the demand for the Swiss franc hurt their export industries?
JW: A very good question. If a Swiss chocolate bar costs a franc to manufacture and a franc is equal to X amount of gold, it must compete against a German chocolate bar that costs a DM to make, also equal to X amount of gold. If the DM is suddenly devalued to X-Y and the Swiss franc remains at X, then the same chocolate bar sells for less in DM than in francs. Even if only the Swiss make cuckoo clocks, they compete against other clocks and knick-knacks, which become “cheaper” in other currencies when only the Swiss maintain the franc rate of gold.
Of course, the Swiss chocolate maker could reduce the price of chocolate to compete, but then its shares are not valued as much on the stock market and will attract less capital for future growth. Meanwhile, as Mundell points out, the Swiss banking system is producing the best “accounting unit” in the world, the only one that is still as good as “X.” Everyone who trades goods across time will want Swiss francs and the Swiss banks will be able to increase the price they charge for them. The value of their shares will rise and capital will be attracted to them. So will labor. At the margin, people who make chocolate bars and cuckoo clocks will take courses in banking. This is what led Mundell to say that if “the Swiss could have held out, everyone in the country would be working for a bank and nobody would be making cuckoo clocks.” They did not “hold out” as that transition would have been too painful for an entire country. The answer to this question should help explain why only a very large country, such as the United States, could lead the world to a system as good as “X.” Other countries would find it easier to join the system than to remain outside it.
Q: About the 1970s... Would Nixon have been right to devalue the dollar against gold? That is, I don't think any dollar-denominated market for gold existed at the time. If one did, I would be interested to know if the prices on it were above $35/oz.? It seems logical that they may have been….Perhaps the only way to stick to a $35/oz. gold standard would have been to accept a Paul Volcker-like recession, because the optimal price of gold had moved, but since no dollar/gold markets existed, we did not know that it had moved. Had there been a free market in gold in 1970, maybe the dollar price would have been $50/oz. Maintaining the $35/oz. standard, therefore, may have been like fixing to gold at $200/oz. would be today, deflationary.
JW: After President Lyndon Johnson closed the London gold pool in late 1967, there was no longer any place where private citizens could exchange dollars for gold at $35. LBJ closed the pool because private citizens were draining out the gold with the dollars they were showing up with. Almost certainly, the dollars were in surplus because LBJ in 1967 was agreeing to a Vietnam “war tax,” which decreased the market demand for dollar liquidity. The Federal Reserve could have “mopped up” this liquidity by selling bonds from its portfolio, but the political consensus would not accept the idea of a monetary “tightening” of this sort. It was in this period that Mundell made his forecast that “the world was moving toward a floating regime, and the experience would be so painful that by 1980 it would be moving back toward fixity.” By 1971, the official gold price was $35, but because no government was making it available at that price, it had begun to sell on the private market for about 10% more, as the market increased its bet on a devaluation sometime in the future. The future came on August 15, 1971, when Nixon formally closed the “gold window” to foreign central banks -- although it had been for the most part informally closed since the Johnson administration.
Theoretically, Nixon did not have to do any of this. His desire was to expand the U.S. economy in order to get re-elected in 1972. His administration’s policy toward that end, designed by conservative Keynesians, was to increase the money supply while maintaining high tax rates to discourage inflation. If he knew of Mundell, then an obscure Canadian economist, he could have been told that he was aiming his two instruments at the wrong targets. Mundell would have told him to cut tax rates to expand the economy and to mop up whatever surplus liquidity there was by having the Fed sell bonds from its portfolio. Of course, if the tax rates were cut in the right manner, the market would have demanded the extra liquidity and the gold price would have lost its 10% premium.
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These were very good questions, class. Some were drawn from TalkShop, by the way. This lesson also marks the very first time I have ever written about the connection between the Vietnam war tax and the closing of the London gold pool. I don’t think Mundell ever made that connection himself. I will pass it on to him next week in Toronto, where he is being feted by the Canadian Club for his Nobel Prize in economics. The officials of the club invited me to sit at the head table! How about that?