Final Q&A Jude Wanniski January 25, 2002

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

This Q&A session completes the Fall semester on Money. Some of the questions that came in were very long, so I have taken the liberty of paraphrasing them. The Spring semester which begins next week will concentrate on fiscal policy.

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Q. David Wood: Gary North's three-part exposition of "Von Mises & Money" appears to be taking a swipe at you when he asserts the invalidity of the following quote [from you]: "There is nothing more important that the government can provide individual producers than a reliable standard of value, a unit of account that retains its constancy as a measuring device." He is implying that this quote advocates a stable aggregate price level as a target. When I read the quote, though, it means to me just keeping one price stable, that of gold, and letting that be the "standard of value." These are very different meanings. I was wondering which, if either, is your view on this?

A: The noted Austrian economist Gary North has offered to engage us in a public debate about monetary theory. His three recent essays on Lew Rockwell's website are filled with misconceptions of the kind you have pointed out. North seems to think I disagree with Ludwig von Mises, but I think North disagrees with von Mises in a fundamental way, and von Mises would agree with the quote. I've never suggested that monetary policy be used to raise or lower the general price level, only to maintain the optimum price of gold. North seems to be lumping me in with someone like the early monetarist Irving Fischer, who argued in the 1920s that the dollar's gold parity should be adjusted in response to some commodity basket target, an idea that eventually led to the U.S. dollar devaluation of 1933-1934. Von Mises was appalled by the idea, and argued that prices should be allowed to go up or down as long as they are denominated in a stable (i.e., gold-linked) currency. I share the same sentiment, as I can find no evidence of a major monetary disruption in 1928-1930. The fall in general prices was due to a worldwide fiscal policy disruption triggered by the Smoot-Hawley Tariff of 1930.

Q. Jule Herbert: [John Maynard] Keynes and Irving Fischer believed gold to have a deflationary bias. The argument went: Suppose France deliberately undervalued the franc to attract gold, and gold flowed out of the U.S. to France in 1930 and 1931. The Fed then had to raise the discount rate to protect its gold stocks at the fixed gold/dollar rate, thus intensifying the U.S. deflation and contraction. The conclusion was you could not have an independent monetary policy with a fixed gold price.

A: Keynes and Fischer did not understand that the Hoover tariff and tax increases had caused the contraction, which brought a decline in prices. They reckoned prices could have been raised if the Fed were free of the "deflation bias" in the gold peg. Again, if they connected the tariff to the Crash, and the Hoover tax increases to the deepening recession, they would have absolved gold from any blame, as von Mises did. The example itself makes no sense. Why would a "strong franc" attract gold from the United States? If it did, why didn't it first attract gold from its neighbors? And if it did, why didn't the "strong" pound sterling attract gold from the United States? These were all senseless theories kicked around by economists who didn't understand the Crash of 1929. France did buy some gold in 1928 from the U.S. Treasury's surplus gold reserves, but that had zero monetary consequences. When gold did leave the U.S. Treasury in 1931, it was because the Fed was trying to boost the economy by "printing money" the banks did not want. When the Fed saw it was getting the dollars back as people turned it in for gold, they stopped doing it.

Q. Jule Herbert: Another question. Why would speculators participate in a rigged market, where it was announced in advance that their trades in gold higher or lower than the peg would be made unprofitable by the action of the Fed? If they didn't speculate, wouldn't the Fed be able to pursue expansionary monetary policies, just as they did under Bretton Woods?

A: The dollar does not pay interest and gold does not pay interest. If the Fed produces one dollar more than the market desires of a piece of paper that does not pay interest, it will make gold scarce relative to the paper and someone will come and ask for gold, at the pledged price of the U.S. Treasury. The system is "rigged" to prevent the Fed from issuing one dollar too many or one dollar too few, unless it is prepared to have gold reserves rise or fall. Meanwhile, the exchange economy gets the benefit of a unit of account that is as good as gold, eliminating all the problems of debtor/creditor relations that might arise out of monetary errors.

Q. Ed Rombach: Can the Fed add or subtract liquidity, and target interest rates at the same time?

A: When you target interest rates, Ed, you add liquidity to push the interest rate down to where you want it, or subtract liquidity to push the interest rate up to where you want it. It is the same process used to target the gold price, but with gold you subtract liquidity to get the dollar/gold price down and add liquidity to get the dollar/gold price up to the target price (dollar/gold exchange rate).

Q. Mike Kendall: Paul O’Neill “respects” the markets decision on foreign exchange and believes currency rates should be left up to the “markets.” Does this thought process fall under the idea that there is no difference between the supply and demand of currency vs the supply and demand of, say, wheat? How does the supply and demand of currency differ from the supply and demand of wheat?

A: I also respect the market’s decision on setting, say, the dollar/yen rate in a “non-system” of floating currencies. But O’Neill does not understand that a foreign-exchange rate is the intersection of the policies of the two central banks, the Fed and the Bank of Japan. If the Fed makes a mistake and does not supply the correct amount of dollar liquidity and the BoJ independently makes a mistake in not supplying the correct amount of yen liquidity, the dollar/yen rate is the intersection of the erroneous policies of the two central banks. Treasury Secretary Alexander Hamilton understood this 200 years ago, but in recent years, none of our Treasury Secretaries have. The difference between a dollar and wheat is that wheat has a precise definition that never changes and a dollar is a debt instrument issued by the government, a government non-interest-bearing debt that changes in value constantly, making economic life complicated for people who must use it in the exchange economy and put up with its fluctuations.

Q. Subbudh Parekh: Keynesians argue that having flexibility in monetary policy allows governments the opportunity to smooth over local bumps where under the gold standard it would take too long to reach. What is wrong with this argument? And when do you think we would return to a gold standard?

A: Keynesians, Monetarists and some Austrians believe what you say, that a fixed dollar/gold price prevents the government from suppressing unhealthy “booms,” caused, say, by “irrational exuberance,” or from pumping up recessions or depressions with more liquidity than a gold system would permit. Classical “supply-side” economists argue that any departure from a fixed commodity money, gold, will worsen economic conditions caused by problems having nothing to do with the money. Gold allows the markets for money to instruct the central bank when it has issued more money than needed and when it has not issued enough. As smart as he is, Alan Greenspan is not smarter than the market, although he thinks he is.

Q. Noah Ravitz: Will a large U.S. bailout of Argentina or Turkey provide the needed liquidity to reflate the dollar as you call for? What is your stance on aid for these countries?

A: Not unless the Federal Reserve monetized the debts of Argentina or Turkey, giving them brand new dollars that are liabilities of the Fed in exchange for their interest-bearing bonds. This would increase the amount of dollar liquidity in the system in excess of the market demand for it. But for it to cause a rise in the gold price and thus signal relief from the deflation, the Fed would have to refrain from issuing new bonds in exchange for the surplus dollars – the device known as “sterilization” of the liquidity addition. I would aid foreign countries by replacing economic bureaucrats at Treasury, the IMF and the World bank with graduates of Supply-Side University.

Q. Dick Fox: Would you explain the relationship between the value of the money supply, gold, and labor?

A: An economy needs something of fixed value as its “money.” Gold is the best “money” because the world has come to regard it over the centuries as the commodity best able to hold its value over long periods of time in relation to the labor required to extract it from the earth. Notice I said “labor,” and not “labor + capital.” It took a man with the simplest tools (capital) a certain amount of time to extract an ounce of gold from the earth a thousand years ago. It takes the same amount of time for a man with the same simple tools to extract an ounce of gold today. Once you add higher levels of capital, modern machinery and refining processes, it takes much less time to extract the ounce of gold, but its price at the margin is determined by the man at the margin willing to work with simple tools. The modern gold miner with modern tools will have to pay the same amount of gold for its equivalence in bread or wine, but instead of working a week for an ounce, he may only have to work an hour. No other commodity has performed with this constancy over the centuries, which is why it makes no sense to choose another or a basket of commodities that do not have the monetary properties of gold. Many economists make the mistake of thinking that capital determines the marginal supply of gold, but it is labor. When a man can earn more making bread with simple tools than mining gold with simple tools, there will be less gold supplied. I tend to be a Marxist on this issue, as Marx saw gold being “the commodity money par excellence.”

Q. Steven Piraino: Keynes argues that labor cannot protect itself against deflation. In other words, for one reason or another, laborers cannot or will not renegotiate their wage contracts to account for an unanticipated fall in prices. Doesn't this argument hold regardless of whether the fall in prices under consideration is a fall in "real" prices (however you define them) or nominal prices (see *Example below)? Given your answer to this question, do you rule out the possibility that the gold peg forced America to endure higher unemployment from 1929-32? *Example: Say a tariff is enacted that reduces the demand for goods. The resulting fall in (pre-tax) prices means that nominal wages become "too high" for employers, leading to unemployment that could be avoided by adding liquidity and raising prices.

A: Keynes made no distinction between a deflation and a contraction, the former caused by a scarcity of money the latter caused by a barrier to the exchange of goods and services. In a contraction, which was what the Great Depression was all about, workers resisted cuts in wages across the board, which would have meant everyone works for, perhaps, 20% fewer dollars. The only way to return to equilibrium is for 20% of businesses to fail and unemployment go to 20%, with workers receiving no wages at all. Because the money remained on a gold standard, workers were being asked to accept 20% less gold for their work and they would not. When the argument you make was tried in 1933-34, reducing the gold content of the dollar, the unemployment rate went higher, not lower, as the economy was hit with inflation on top of contraction.

In a deflation, the dollar increases in value because it is become scarce relative to gold, which means there is less resistance to lower wages by workers. The resistance comes from debtors who contracted to pay debts in cheaper dollars but now have to pay them in scarcer dollars. A deflation is not as painful as a contraction because the economy can adjust to it as debts are discharged. It still has the costs of adjustment, as we have been finding out as we proceed through the monetary deflation that began five years ago.

Q. Russ Wood: I understand from your lessons that banks (as creditors) get hurt right along with their consumers (as debtors) during a monetary deflation. When consumers are forced to repay their debt with more valuable dollars, they tend to default more often. We are currently seeing such a rise in defaults and bankruptcies. This obviously is not good for the banking industry. So why isn't the banking lobby screaming for a return to a gold standard? Are banks so good at hedging that they remain profitable during all monetary conditions? If a bank can successfully forecast monetary conditions, and take profitable actions, then why can't other businesses and even consumers do the same?

A: Modern bankers have the technical skills and the technology to learn how to live with inflations and deflations. They hedge their bets and still make enough money to prosper with a floating unit of account. As long as they have influence with the government and control foreign lending through the International Monetary Fund and World Bank, they can insure against collapse, except under extreme circumstances. The current deflation is making the banks sweat, but only when they face mountains of non-performing loans will they consider reforms. Japan’s banks have been ready to topple for years, but get infusions from the government. Ordinary people are those hurt the worst by a floating unit of account and are always the people ready to support a gold money. If President Bush supported a gold standard he would win re-election in a landslide. If he permits the deflation to continue, he might well lose in 2004, especially if a Democratic supply-sider shows up.

Q. Thomas Schmidt: How do we keep a government that adopts a gold Polaris from dropping it?

A: Once politicians discover that things get worse when you leave gold, they will not want to leave it. It will help if economists learned that too, and taught it to their students. Only very large economies can handle gold, but it only takes one so all the smaller economies can join it. The U.S. should take the lead, but if it does not, Euroland would be a candidate, so would China/Japan in a joint move, so would Russia/Ukraine/Eastern Europe. It really is the Superpower's responsibility.