For a Monetary Anchor Jude Wanniski May 27, 2000

We return here to a guest lecture by Reuven Brenner of McGill University in Montreal, delivered here at SSU in the fall semester of 1997, which also dealt with money and banking issues. It is most appropriate when we realize how much different the world would look today if the dollar had been anchored to gold at that time. The gold price would have been arrested well before it fell below $300 and the monetary deflation that carried gold and commodity prices down to levels that savagely distorted the capital markets. Farmers, miners and oilmen throughout the world were forced into bankruptcy and when the world economy began to adjust in late 1998 and early 1999, demand for those commodities exceeded inventories and prices climbed. With a monetary anchor, there still would have been debates at the Federal Reserve on whether or not to raise interest rates to slow down the expanding economy, but they would have been offset by the central bank’s obligation to supply or withdraw liquidity in order to keep the gold price from rising or falling. That is the nature of the anchor. Take note of Professor Brenner’s comments about Fed Chairman Alan Greenspan. Also note the importance I placed on Brenner’s attempt to bridge the monetarist and supply-side models in that November 7, 1997 introduction to his lecture. By the way, largely because of his lectures here, he is now a regular contributor to one of the most interesting of websites devoted to economics and finance, www.metamarket.com. His work during the years in developing the role of risk-taking will, I think, put him in line for a Nobel Prize in economics.

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Introduction, by Jude Wanniski, 11/7/97

Following is a guest lecture by Prof. Reuven Brenner of McGill University in Montreal, who I regard as one of the best economists in the world. He is the best by far in understanding the role of risk-taking in economic development, teaching me about this realm over the last decade since we first met. We were introduced by Bob Mundell, who considered him the finest economist in Canada and recommended him for the Repap Chair of Management at McGill. A graduate of the University of Chicago, Reuven carries on the tradition of the late Frank Knight, whose 1921 book, Risk, Uncertainty and Profit, demolished the old iron laws of wages and profits that were previously at the heart of classical economics. He was among the many economists who worked almost exclusively in the fiscal and regulatory side of financial mechanisms, while conceding the monetary frontier to Milton Friedman. While still considering Friedman among the best economists in the world, Reuven has rethought monetary policy in the supply-side framework during our decade of friendship. His guest lecture is extremely important in that it bridges the two theoretical schools in a way I’ve not seen done before. Those of you who have been wary of our gold arguments will appreciate the fresh thinking you will find here.


For a Monetary Anchor

In a recent speech at Stanford University, Alan Greenspan said "Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions."

Not a moment too late, as the events of last and this week have demonstrated. Indeed, it is a puzzle, why, with all the discussion that followed the fall of communism and the failure of fixing prices from a center, central banks, who see their roles as being able to play with interest rates and exchange rates -- two quite important prices -- have been immune to the criticism that Greenspan raises here voluntarily.

Current events in Asia serve as the perfect background to make a significant change in the world's monetary system and anchor it in a dollar formally linked to a commodity price rule. Countries which will link their currencies to the dollar will then see capital moving to their shores based entirely on the relative attractiveness of their fiscal policies and ability to attract and retain critical masses of skilled people.

Monetary Options

Greenspan lists in his speech the various rules-based monetary policy options, rather than event-adjusted ones, depending on the character and ideas of the central banker at a point in time. What are these options?

Greenspan mentions and then dismisses a number of them. One is Milton Friedman's well known advocacy of a fixed rule of expansion of monetary base. Greenspan dismisses this rule because its success depends on the velocity of some definition of money being stable. But Greenspan did not find either velocities to be stable, or good definitions for money today. Although, Greenspan did not exclude the possibility that there are times that this can happen, in which case a monetary rule could work.

Greenspan then mentions some currently popular academic theories, which suggest that looking at output and prices can guide monetary policy. He dismisses these recommendations too, on the grounds that the guidance these theories propose depend on knowing some key features of the economy. But the features are not known.

So what is one left with? The knowledge and opinion of a central banker or gold.

Gold?! But for Robert Mundell's writings, Jude Wanniski's, the pages of The Wall Street Journal, and occasionally Mr. Greenspan in his speeches and televised testimonies, gold has been out of sight and mind in public discussions as an option to anchor monetary policy. As a result, it is today probably the most misunderstood. Here is what Mr. Greenspan says about gold in the aforementioned September 5 speech: "Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value."

The rest of the speech suggests that Mr. Greenspan would much prefer to go back officially to the gold anchor, something he has been signaling for a while. In fact, one can say, that, de facto, Greenspan did establish an approximation of the gold standard rule for the dollar. But he understands that to do it formally, and bring the rest of the world on board, one must first re-educate the public to understand that those "discretionary fiscal and monetary policies that democracies now appear to value," and which are harmful to prosperity. These week's events may have just provided the necessary education -- by painful experience.

The rest of this piece explains how this anchor works, and how the stock market turbulence of the last week can be linked with gold and commodity prices.

Anchoring Prices

Changes in relative prices give consumers, producers, investors signals how to reallocate their resources, be it time, income or any form of capital. But prices "relative" to what? If there are N commodities, and in the absence of a fixed anchor, a common yardstick, there would be N(N-1)/2 prices, as each commodity would be priced in terms of every other. With a common yardstick, there would be N-1 prices and that's it.

To save on the extremely cumbersome pricing system in the absence of an anchor, since time immemorial every society, large and small, agreed very quickly on a common yardstick, some more successful than others: salt (that's where the word "salary" comes from), pepper, rocks, silver, gold, and in prisons, cigarettes. People also found that two anchors, whose values change one relative to another, cause many difficulties too. Relative to which one should people then price, especially if they want to enter into long-term contracts? Through a long process of trial and error, people around the world found that gold could serve best as the anchor relative to which everything was priced.

What happens when paper moneys come into existence? As long as a paper money, be it issued by private banks or central banks, is firmly linked to gold, and people believe that the anchor will not be lifted -- as it happened to the English pound for two centuries- - it really does not matter whether people price relative to gold or relative to the English pound. However, once the two values fluctuate one relative to another, problems start since we are back to the far more complex decisions of relative to which numeraire should one price? Mark Twain once wrote: "Custom is rock, laws are sand." Gold became such a rock, serving the custom of anchoring the price system. In contrast, "laws" concerning monetary policy, and political promises to maintain the value of currencies turned out to be nothing but blinding sand. And when the sand blew and blinded, that confusion between "nominal" and "real" prices, that some academic theories considered important happens (though, strangely enough in models where there was paper money only).

How does the monetary system work when the currency is linked to the gold standard? Bankers, central or private, do not have to guess growth, do not have to know what is velocity, and do not have to forecast what will happen to millions of variables in the domestic or international economy when shaping monetary policy. They have an automatic stabilizer providing a clear signal what is happening to liquidity in the economy. When people show up at the bank and want to exchange currency for gold, it's done, diminishing liquidity.

How can gold reserves, be it of private and central banks be defended in case too many people show up for gold or U.S. dollars? By issuing bonds in local currency and draining the surplus liquidity from the banking system -- an option many countries have had, though unfortunately they have not always exercised it. For example, Mexico in 1994, after inundating, for political reasons, their economies with unwanted pesos (secretly), opted for disastrous inflation and devaluation. Now, three years later, the Mexican stock market -- the best indicator of wealth creation -- is at less than 60% of its pre-1994 value, in dollar terms. Nobody is interested in pricing and valuating in unreliable peso terms. In contrast, Brazil is doing now the opposite, giving a clear signal to investors that it intends to maintain the link between the real and the dollar.

Robert Mundell predicted in 1969 that "the forces of history were determined to engage in one of their periodic experiments with a managed currency." He made this statement following comments by Robert Roosa, once the Treasury Undersecretary for Monetary Affairs in the Kennedy administration. The latter argued that the U.S. gold stocks may not be sufficient to maintain the dollar's value. Mundell's reaction was that if people in the administration do not understand that gold reserves could be defended by draining surplus liquidity in local currency by issuing bonds, then that's the dawn of the (mis)managed currency age.

Briefly: gold served as an anchor for all pricing, and through his actions, Mr. Greenspan has been signaling that he tried to restore the anchor. With an anchor in place, it does not matter if there are 1000 commodities in the economy or 1 million. Everything is priced relative to gold. That is why no matter how many innovations happened, and how complex products became during the time the gold standard was in effect, people could enter into long-term contractual agreements (even until infinity with England's consol, their everlasting bond). They knew that the purchasing power of their money will be stable -- and nobody needed economists and statisticians to calculate price indices. The fact that everything, new and old, was priced relative to the stable anchor provided by the link to gold insured that. By definition -- and custom.

Indeed, Greenspan emphasizes this crucial role of a numeraire in the aforementioned speech: "As long as individuals make contractual arrangements for future payments valued in dollars and other currencies, there must be a presumption on the part of those involved in the transaction about the future purchasing power of money...There will always be some general sense of purchasing power of money both across time and across goods and services. Hence we must assume that embodied in all products is some unit of output, and hence of price, that is recognizable to producers and consumers and upon which they will base their decision." He dismisses the ability of price indices and inflation-indexed bonds to provide the proper substitute, though he does not mention what the standard may then be.

As Chairman of the Fed, this silence is to be expected. Why? Because, as mentioned earlier, the advocacy of having gold a formally recognized anchor changes the rules of the political game. In a lecture titled "An Economic Interpretation of Our Time," at the Lowell Institute in Boston back in 1941, Joseph Schumpeter explained most clearly why: "gold is not popular because it ruthlessly and tactlessly always tells the truth." Indeed, once currencies stay stable, the flows of capital depend entirely on relative fiscal policies, and relative ability to attract and retain skilled people.

Recent events show how changes in gold prices, and flows of currencies do that.

In The Absence of the Gold Anchor

If the dollar is no longer anchored in gold, yet people nevertheless continue to look for an anchor to price and to enter into long-term contracts, two things can happen. As long as the federal reserve targets a gold price -- as Mr. Greenspan seemed to have been doing during much of his tenure -- everything works as if the economy had officially the standard. However, once monetary policy has no anchor, and does not respond to signals provided by gold, or other commodity prices -- as is now the case -- the deflationary troubles, reflected in bankruptcies around the world start.

Yes, troubles start, in spite of some much quoted superficial evidence to the contrary. Financial history books note that when Nixon closed the gold window in 1971, the stock market rallied, jumping 4% on record volume. What most books do not mention is that this misstep was part of a basket of policies including a 10 percent investment tax credit, a repeal of the 7 percent auto excise tax, proposed speed-up in personal income-tax exemption, a 5 percent cut in government personnel and many others. To say that one can identify the "gold effect" when responding to this mishmash, makes little sense.

Relative to what can people calculate prices and enter into long term contracts once the currency is not anchored? Some will price relative to the dollar, others relative to gold, still others relative to the DM or the Swiss frank. But as Charles Kindleberger, the financial historian, once pointed out: "The function of money becomes especially difficult when the relative values of two or more monies alter. How should distance be measured if the yard and the meter keep altering in relation to each other?" And this is the world we are dealing with now.

Under an official gold anchor a drop in liquidity would be automatically remedied by selling gold to the central bank. When there is no such anchor, the gold price -- and the prices of other metals and commodity prices -- drop, signaling unsatisfied demand for liquidity. Now whether central banks respond to this signal or not, that is the question. If central bankers, the IMF and members of others institutions are trained on the economic textbooks of the last decades, they probably will not, and we can see events such as this week's happening. Countries committing these mistakes will pay a price.

It is said that people learn best by experience. The U.S. needed the disastrous combination of the Smooth-Hawley protectionist act, followed by a sequence of monetary blunders, to learn how dangerous high taxes (in the form of high tariffs) can be, what sequence of events they may start. The Germans needed hyperinflation to put severe constraints on their central bank, and every obstacle in their politicians' ways to impose their inflationary spending wills on the bank. Maybe the experience of the last week and the 1992 events in Europe's financial markets, which have led to abandoning the European "snake," will bring about an official change in monetary policies around the world.

It will not be easy because by now there are many groups benefiting from the non-anchored system: politicians, financial markets, economists, statisticians. Looked upon from the angle presented in this piece, George Soros's much criticized comment, referring to "speculators" such as himself as "necessary evil," was accurate.

But it is true that if governments anchored their currency credibly, currency "speculators," who signal in which currency people should not anchor their long-term contracts, would indeed disappear, and, of course, much trading and Wall Street profits with them (and Travelers overpay for Salomon, whose profits draw so much on bond-trading). Maybe Soros would have been more accurate in saying that currency "speculators" respond to the necessary of evil of governments and central banks mismanaging their currencies.

But speculators and financial markets should not be too anxious fearing loss of their incomes. For better and for worse, customs are rock, and laws are sand. And, at times, orthodoxies, economic ones in particular, rather than blowing sand do the blinding. So for the time being, currency traders will continue to be well rewarded.