Monetary Q&A Jude Wanniski December 21, 2001

To: SSU Students
From: Jude Wanniski
Re: Q&A

Before we break for the holidays, I thought it would be useful to do a Q&A session that would not only fill in some holes in the lessons to date, but also provide a review of the semester’s basic aim to outline supply-side monetary policy. The first question is one that came in from a student who was embarrassed to ask the simple question that nagged at him, but it turns out to be one that is so fundamental that I must blame myself for not dealing with it early on. He said he had been reading about “the floating dollar” in my lectures and could not grasp the concept, try as he might. What the heck is a floating dollar?

A. I’ll try to answer this in several ways, so you can turn it around in your mind and grasp the concept completely. First, consider that a fixed dollar is one that has a definition and a floating dollar is one without a definition. Prior to 1971, when President Richard Nixon decided to end the fixed monetary regime by floating the dollar, the U.S. dollar was officially defined as one-thirty-fifth of an ounce of gold, of a specific purity. That is, 35 dollars would exchange for one ounce. It had been fixed at that definition since 1934 when President Franklin Roosevelt changed the definition from \$20.67 per ounce to \$35. The dollar had been defined at \$20.67 since 1879, when the government ended the dollar’s status as a floating currency, which you will remember from your history lessons as the “greenback” period of the Civil War. President Abraham Lincoln, as did Nixon later, had floated the dollar in 1863, ending its definition of \$20.67 per gold ounce. Lincoln did so thinking it would be easier to finance the war with paper money that the government did not have to guarantee in terms of gold. Some economic historians believe it might have been cheaper in the long run to simply issue bonds paying higher interest rates to finance the war. In any case, if we go back to the founding of the Republic, we find the dollar being defined at \$19 and change.

An official, legal definition of the dollar does not have to be in terms of gold to be fixed. It could be defined in terms of another commodity or index of commodities or of another currency. Most countries of the world that have fixed currencies define them in terms of another currency. China, for example, unofficially defines the yuan in terms of the U.S. dollar, even though the U.S. dollar has no definition at all, official or unofficial. The floating dollar means its value in terms of real things can and almost always does change from minute to minute. The vice chairman of our central bank, Lawrence Meyer, recently gave a speech saying how lucky we are to have a floating dollar, because it can ride the waves of an increasingly turbulent monetary ocean. Those of us who think a floating dollar is really a silly idea believe we have a turbulent monetary ocean at home and around the world because the American dollar is floating, with no specific definition. The world would be a much happier place, we think, if the 6 billion people had a fixed, standard unit of measure. A yardstick is a fixed unit of measure and so is a meter stick. So is a gallon and so is the slightly larger imperial gallon. It is much easier for people to do business across time and space when they can agree on the definition of their units of measure. Imagine how difficult it would be if the definition of the yardstick floated, sometimes 35 inches, sometimes 45 inches, occasionally by chance . There would be severe turbulence in the construction industry. If the dollar were to be once again fixed, we have been suggesting a definition of one-three-hundred-and-a-twenty-fifth of an ounce of gold, or \$325 per ounce. Once fixed, Fed Chairman Alan Greenspan and Vice Chairman Meyer would no longer be asked to manage the value of the dollar on a day to day basis, by raising or lowering interest rates. They would simply be required to take dollars out of the economy when the market price of gold tried to rise above \$325 and add dollars to the economy when the market price tried to fall below \$325. The reason we would not choose \$275 per ounce as our definition is because we believe that in the last five years the Fed has made a long series of errors in managing the floating dollar, essentially making it more and more valuable by making it scarce. It has deflated the dollar and is thereby punishing people who borrowed dollars when they were less valuable. When these people cannot pay their creditors, they go bankrupt and so do their creditors. It is the kind of mess we would expect in the construction industry if the yardstick floated.

Once we again had the dollar – the most important world currency -- fixed to a standard, the other currencies of the world would be able to fix to the dollar, as China does now. They would define their currencies in terms of the dollar, or they could then define their currencies in terms of gold, which is the equivalent of fixing to a gold/dollar rate. There are reasons, though, why it is the responsibility of the biggest economy, the world leader, to maintain the standard. If we maintain a yardstick at 36 inches, other countries could adopt our standard, as most of them do when building golf courses. Or they could use other measures that are fixed but easily equated with the yardstick. If you wish to get deeper into this topic, please read the “Gold Polaris” that is in the SSU library.

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Q. R. HALEY: I'm confused. In your lesson # 11 for the fall semester 2001, you state that the monetarists can create all the M's they want, and it won't solve the problem because the price of gold needs to rise. My question is, won't all these M's cause the price of gold to go up? (I assume by "M's" you mean the money supply). And if creating more dollars won't cause the price of gold to rise, what will? I might add that I've been following the gold price, and it sure does seem to be pretty stable around the \$270 range. Yet I've heard that the Fed is expanding the money supply pretty rapidly. Why doesn't the gold price respond. Are you saying that only a legislated gold price can solve the problem? Previously I thought you were saying that it would be sufficient if the Fed targeted a gold price and adjusted monetary policy to meet that price. But what policy would that be in the current climate except to create more M's?

A. When the Fed "monetizes debt," it replaces interest-bearing bonds or notes with non-interest-bearing dollar reserves. The "monetary base" is said to have expanded. It can also be said the Fed's "balance sheet expanded," as it holds more assets and has more liabilities, in exactly the same amounts. The "money supply" does not increase until those reserves held by the banks are loaned out to customers. The reserves can divide in two ways, either to cash or to deposits. The Fed has no control over the amount that goes to cash. It goes out the bank's cash window if someone is willing to give the bank an asset the bank will accept for cash. The cash then circulates, doing its job as a circulating medium. When you hear about the monetary base expanding, it could be that only the cash part increases and the reserve part that remains is stagnant or even declines. If the cash part increases, it could be because the market is willing to hold more because it is gaining in purchasing power even while sitting idle. If the demand for liquidity is greater than the supply, dollar liquidity becomes scarce, and we note that scarcity by observing a decline in the dollar/gold price.

Here stop for a minute and think about what you have read. You can see that it is possible for M's to increase at the same time the dollar/gold price goes down. Currency in the economy may be greater, but if it is not being used to buy goods or financial assets, it is not causing economic activity that leads to a demand for reserves. The banks look around and find no credible borrowers, only people who have exhausted their credit, or people with appetites for credit and no collateral. Since we began noticing the dollar/gold price begin its decline in November 1996, we observe that the M's have increased dramatically, but bank reserves have fallen from \$80 billion to \$70 billion. This is the nature of a deflation.

If the Fed wanted to end the deflation it would not really have to increase the amount of liquidity in the economy. It need only advise the market that it will no longer be a good deal to hold dollars, as it will no longer add liquidity just to meet the demand for overnight reserves at a specified "fed funds rate," but would put that target aside and choose a dollar/gold target perhaps \$50 higher than where it is now. Those in the market holding dollars in cash or reserves would become excited into spending them or offering assets as collateral to borrow them in order to spend, knowing the dollar will be losing purchasing power given this change in bank policy. With this dynamic underway, the amount of M in the economy held as cash could be expected to contract, as people will not wish to hold as much paper that is losing its value. At the same time, the part of the monetary base that is designated as reserves should increase, as the burden of deflation is lifted from the system and debtors are suddenly able to pay their creditors. We should expect bank reserves now at \$70 billion to rise to \$80 billion or more, but the monetary base itself might shrink as cash under mattresses comes out to buy back assets before they increase in nominal terms.

This is hard stuff, I'll agree, especially to those of you trying to understand money for the first time, but if you read this over a few times and follow the mechanics, it may end your confusion.

Q. MICHAEL DILLON: I can no longer resist the need to ask the simplest of questions: Why? Why support a system that is inherently unstable fluctuating mediums of exchange)? Does this create a class of EXPERTS who have a purpose? Is it a method of control? What were Johnson's and Nixon's motivations? What can I do?

A. Remember the classical supply model was discredited when its professional adherents could not explain the Crash of 1929 and the Great Depression. Demand-side economists – Keynesians focused on fiscal policy and Monetarists on monetary aggregates – filled the vacuum. Lyndon Johnson and Richard Nixon lived in a world totally dominated by these ideas and were at their mercy. It was in the interests of the monetarists to blame1929 and the Depression on the gold standard. For different reasons, the Keynesians of the 1960s took up the argument after the death of John Kennedy – a supporter of the gold/dollar – that the dollar was overvalued relative to gold and foreign currencies. They did not talk LBJ into abandoning gold, but persuaded him to alter the monetary system by giving foreign central banks interest-bearing U.S. bonds when they came to the Treasury with dollars asking for gold at \$35 per ounce, under the terms of the 1944 Bretton Woods system. The system was unstable because the Employment Act of 1949 required the Fed to use its powers to lower the unemployment rate, if necessary with “easy money,” which would cause an outflow of gold.

The Kennedy tax cuts solved the problem temporarily by increasing the demand for dollar liquidity, but when Great Society spending and the Vietnam War put demands on the budget, the Republicans insisted on raising taxes. Barry Goldwater, by the way, vehemently opposed the JFK tax cuts, so the LBJ landslide that crushed the GOP in 1964 was a big win for the electorate! Reagan, a one-time Democrat, rescued the country and the world by embracing supply-side economics. Alas, his advocacy of a return to a gold standard was undermined by Milton Friedman, with passive help from the Neo- Keynesians who now prefer a monetary system that enables them to “manage” the U.S. dollar. There was collusion between Milton Friedman and James Tobin of Yale.

I do appreciate your plaintive appeal, Michael. The fact is, though, that there are great big Intellectual Pyramids that stand in the way of the peace and prosperity of all mankind. In the early part of the 20th century, the great physicist Max Planck threw out the idea that progress can only be made when great men die. I thought of this the other day when the New Yorker ran a cartoon depicting a man in a doctor’s office, looking forlorn. The doctor tells him, “I’m afraid you have had a paradigm shift.” This is what the world is going through now. The demand-siders served their purpose when the classical economists screwed up, for reasons good and bad. But we’re now back to the classics. What can you do? Michael, you have done plenty by asking me this question, which I would not have addressed if it had not been posed. Otherwise, tell your friends about my website.

Q. BRET SWANSON: Jude, your von Mises speech reads just as well today as it must have twenty years ago. You forecast exactly today’s situation when you said that (nominal) interest rates would rise in either an inflation or deflation, as Mises had also predicted. Real interest rates, of course, have skyrocketed. Your focus on the plight of debtors rather than on some official measure of falling prices (although more and more we see that, too) was quite predictive as well. In your recent re-visitation of the return to gold after the Civil War did you find that the Greenback deflation was a cause of the great railroad bankruptcies? The longstanding consensus view is that a capacity glut brought down the transportation tycoons, just as most reporters and Wall Street analysts today believe a glut of bandwidth has destroyed the fiber barons. I suspect the "overcapitalization" of the railroads matches today's myth in communications.

A. Absolutely.... When an industry gears up for an expansion of the economic pie, monetary deflation is not taken into account. The size of the pie got smaller in the 1870's, both in real terms, and in nominal terms. There was the additional problem of over-expansion, as commercial interests supported competitive rail lines to prevent monopoly rents. JP Morgan spent a lot of his energies resolving those kinds of problems with mergers, but as I recall he had better luck in the '80s and '90s, when the real expansion took off and an adjustment to \$20 gold had been largely completed. My readings of modern history tell me there has been practically a conspiracy to ignore the monetary deflation of the 1870s and how it could have been avoided by returning to gold at \$40. It was the bankers who held U.S. bonds purchased before the Civil War who insisted on a return at the \$20 rate. Friedman's monetary history is especially disingenuous, as it never comments on the fact that in 1879, when convertibility resumed at \$20, the monetary aggregates exploded, but there was no increase in prices. If Friedman had treated the actual experience honestly, he would not have been so aggressive in pushing for his version of "monetarism," which was a curse for which he was awarded a Nobel Prize. Demand-siders stick together in Stockholm.

By the way, when the dot-coms were going through the roof, with totally unreasonable capitalizations, I talked to an analyst who said his firm had no choice but to get into the IPO's, because of what he called an "analytical" gap. He said if he took the time to study a company before investing in it, it would have already skyrocketed beyond his reach. A century ago capital flowed to hundreds of new auto companies, most of which went bankrupt. But nobody knew in advance which would succeed, which fail. They did not have a problem with monetary deflation, though. A shakeout of the dot.coms was inevitable, but the deflation caused two problems. First the New Economy had an early benefit of the commodity deflation. Intellectual goods became dramatically more attractive than labor goods. Then it got whacked as other intellectual goods and their prices began the catch-up to commodities.

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Merry Christmas, students, and a Happy, Peaceful and Prosperous New Year!