Questions on Money Jude Wanniski April 25, 2003

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

This Q&A originally ran in this space on Oct 19 2001. Remember it was a time of budget surplus and there were giddy thoughts then of paying off the national debt. By now it is clear there will be no opportunity to pay down the national debt anytime in the near future, but the monetary principles remain the same.

Q. Some have proposed that the U.S. should pay off its national debt. I presume that this means all Treasury-issued instruments should be redeemed. If the situation were to come to pass that there are no outstanding treasury notes, how can the Treasury or any other entity increase liquidity? In other words, is there another mechanism for creating money other than the purchase by the Treasury of treasury instruments? (A.P. Paulikas)

A. The Fed was originally intended to provide loans to corporations through the discount window, which creates "liquidity." It developed open-market operations only later. Actually the Fed can buy or sell anything at all, and if it uses the "magic checkbook" it will create and destroy liquidity. If there are no more Treasury bonds and bills, the obvious choices are corporate debt, sovereign debt of foreign governments, or foreign exchange. I believe Singapore's central bank conducts open market operations primarily with foreign currencies and securities. But theoretically anything would work. You could even buy and sell antique cars. You could even "create" liquidity by throwing it out of helicopters, and "destroy" it during the payment of taxes. Not a very effective system, but nevertheless a possibility. The notes still would be "non-interest bearing debt of the government," in the sense that by issuing "liquidity" the Fed is in a sense issuing government bonds to purchase assets. (Jude Wanniski)

Q. Suppose an apple producer doubles his apple production in 5 years. Given that the supply of gold is relatively small, his gold comes at someone else's expense: His productivity increase has made someone else poorer in gold! This makes no sense. So what does gold measure? It's not apples, or suits; is it the amount of effort applied to get those items? (Thomas Schmidt)

A. If an apple producer wants to exchange apples for gold, he can only do so if someone with gold is willing to surrender gold for apples (or dollars). The transaction itself does not imply a change in value. Gold is a unit of account, which at its core represents a unit of labor, not capital. Gold is a "numeraire" because, over long stretches of time, its value in terms of other goods is constant. We know this because over thousands of years, the marketplace has decided on gold as a common yardstick against which other things can be valued. This is why we observe other commodity prices returning repeatedly to equilibrium with gold, not the other way around. (Michael Darda)

Q. Assuming gold remains in the $270-$290 range, as certainly seems likely, how long should it now take for deflation to work its way through the system and some level of equilibrium to set in, which I assume would set the stage for economic growth? (Dan Wolf)

A. It may take another two years for prices and wages to equilibrate with gold at $280, where it is today. The economy can grow in real terms even during the deflation process if other policies are optimal, but we still may see nominal measurements of the economy going down. Argentina is deflating with the United States because it has locked its currency to the dollar, but with higher tax rates, which means it is contracting and deflating simultaneously. China's largely commodity economy is also locked to the deflating dollar, but has been keeping tax rates down and reforming its new market economy in other positive ways. The real expansion has kept ahead of the nominal deflation. The question is a good one, but the answer can't be much more than directional, given the number of variables involved. (JW)

Q. If the Gold Standard were in place as the target for determining money supply and its price had been reached and stayed at the target price (showing stability), what would we use as a measurement to determine if the target should be moved? Business Starts? Employment Numbers? Tax Receipts? Growth inducing "regional" economic policies? (Mike Geer)

A. The gold target would not have to be moved as long as it remained the best proxy for the general price level, the best monetary unit of account. The value of gold as the proxy is that its properties make it the least "elastic" of all commodities. Its supply relative to demand is more constant than all the other possibilities in the commodity universe. A well-known economist recently agreed with me that the dollar should be stabilized, but that gold was "too inelastic" to accommodate the constant shifting of the modern economy. I pointed out that we want the unit of measure itself to be inelastic, with the banking system providing the elasticity to meet the shifting demands of the exchange economy. New forms of "money" are being created or extinguished all the time in the electronic/digital world, and interest rates move up and down to help direct capital flows. These elements are best able to operate with minimum transaction costs when the unit of account is not itself "elastic." If a yardstick were elastic as a unit of measure, constantly changing in length, the markets would search out and adopt a more reliable standard. Maintaining a standard of value is a trickier problem, and if it could be done without reference to anything palpable, the market would accept it. But over the last 30 years of trial and error, the burden of a floating unit of account on world commerce has become progressively greater. (JW)

Q. If you wanted to get the price of gold up to $325 from $280, how would you do it? How much liquidity would you have to add to get it up by that amount? (Talk Shop Question)

A. The government controls the value of the dollar, its non-interest-bearing debt. It can simply tell its creditors that from now on, it will devalue the market's price of that debt and make each dollar worth less in terms of gold. When the dollar is fixed relative to gold, a devaluation constitutes a repudiation of sovereign debt and almost always decreases the efficiency of the economy. In a floating world, when the dollar/gold price is higher than it had been, a devaluation will compound the problems of inflation. But when the dollar/gold price has fallen from earlier levels, the problem is deflation, which burdens debtors. In that case, the proper economic medicine is devaluation to cover that part of the deflation process yet to unfold. It dissolves deflation without causing new inflation.

The amount of new liquidity that has to be added to be banking system depends on how the government announces its decision to the credit markets. If there is a sudden, formal declaration of intent to stabilize at $325, there is sufficient "elasticity" in the system so the dollar/gold price would immediately go to that level. Nobody would be foolish enough to bet against the government, which has a monopoly power over the value of its debt. If, once the dollar/gold price got to $325, the government were to fall back to targeting the overnight federal funds rate, we would expect mass confusion. There cannot be two targets when the central bank only has one instrument at his disposal -- adding or subtracting liquidity. Once it announces a gold target, it is bound to add or subtract liquidity as demand for the dollar rises or falls, no matter what happens to the interest-rate schedule. The government announcement of a rise in the gold price it is willing to pay on its debt in and of itself has no macro-economic effect. The markets know immediately, though, that the dynamics of existing liquidity will push up all commodity prices. Liquidity that is now being held simply to gain in purchasing power as the deflation unfolds, instead of being put at risk, will scramble to get to the front of the line to replace inventories before prices rise. (JW)