More on Money and Gold Jude Wanniski January 31, 1997

Supply-Side Economics Lesson No. 9

Memo To: Website supply-side students
From: Jude Wanniski
Re: More on money and gold

Another question from Kevin Isbister for this week's lesson:

Q: From my basic understanding so far of the relationship between managing the economy and a fixed gold standard, it would seem that all hell has broken loose since the dollar started to float. This is because the value of things keeps changing relative to the old gold standard. If we had stayed at a fixed exchange rate, investments would increase because the investors would know that the value wouldn't suddenly change (they'd know exactly what they were getting into).

My question, then, is how has the dollar price of gold fluctuated over the past 25 years? Did it soar erratically for several years before more or less leveling off, or has it fluctuated up and back down, even as low as it was in the 1960s? If it's the former, then does a more-or-less-level gold price now operate in a manner similar to the fixed rate it was at a lower level 25 years ago? Bottom line: is ANY fluctuation in the value, no matter how small, the cause of economic consternation, or could we theoretically reach a point in the future when the floating dollar simulates a fixed rate simply by ceasing to fluctuate?

A: Your basic understanding is roughly correct. When the markets saw it could no longer rely upon a paper dollar as a unit of account, in order to correctly reckon the inherent risks in all contracts, all hell did break loose. As long as the paper dollar was defined as a fixed weight of gold ($35 per ounce from 1934; $20.67 per ounce all the way back to Alexander Hamilton), the broad marketplace of buyers and sellers and financial intermediaries (bankers) could be sure their deals were without monetary risk. Yes, there were plenty of other risks involving government — including the level of taxation, tariffs, regulation, etc., but the primary risk was taken care of by the gold guarantee. Throughout the history of the world, there have always been instances where one country or another floated its currency — the U.S. in the Civil War, for example — but there never before was a time when every country in the world had a floating currency. Somewhere or other, there were always countries or blocs whose countries were defined in terms of gold or silver.

In the last 30 years, the dollar/gold link first weakened in the late 1960s when the Federal Reserve began drifting away from its mission  of keeping the gold price at $35. Instead, it began "printing more money" than the market was asking for, on the idea that more money in the system would cause the economy to expand faster, with more jobs being created. That is, it was now trying to do two things at once, and that is not possible when you only have one lever. President Johnson had increased taxes in 1967 to pay for The Vietnam War, and the form of the tax was so destructive — an income tax on top of the income tax — that the market's demand for money began falling. Things were getting worse for the Fed, which continued printing dollars faster than they were being demanded, and they were being sent to Europe to buy up real estate and other assets. This is because it was illegal for Americans to own monetary gold at the time — only jewelry and collector coins. The demand for dollars weakened further in the Nixon years when Nixon increased the capital gains tax, on the advice of his economists and some big companies. In 1971, the flight of dollars to Europe was escalating, coming back to the U.S. to buy Treasury bonds. Nixon's economists told him he could get the economy rolling if only the Fed increased the money supply, which they tried to do in the face of a fall in the demand for money. The circular flow of dollars between the U.S. and Europe formally ended on August 15, 1971, when Nixon broke the US promise made at Bretton Woods in 1944, to keep the dollar at $35 per ounce. Because the rest of the world was tied to the dollar, when we broke the link, that linkage was severed for all currencies. The dollar gold price quickly advanced, first to about $70 at the end of 1971, then up to $200 at the end of 1972, then drifting back to $140 for the first part of '73. The Arab oil companies had been selling us oil at $2 a barrel, and in 1973 they realized they were being cheated at that price, which would mean it would take four times as much oil to buy an ounce of gold with the dollars they were receiving. So they announced they would quadruple the oil price. When the Federal Reserve kept pumping dollars into the banking system to accommodate the rise in the oil price, gold went from $140 to $280, and the Arabs doubled the price again. Gold came down a bit in 1975-76 when President Ford stopped asking for new tax increases and began talking about tax cuts. In 1977, when Jimmy Carter was President, he brought with him economists who believed the economy could only grow with a weaker dollar — to make our exports more competitive. The dollar went back up to $280 gold, and in the summer of 1979 President Carter brought Paul Volcker in as Fed chairman. In the fall, Volcker changed the Fed's method of managing money, to suit the arguments of the followers of Milton Friedman (the "monetarists"). At the same time, he announced that 1980 would see a faster growing economy, which will need more money. He would supply it in advance. As he shoveled unwanted dollar reserves into the banking system, the price of gold shot up, from about $300 in August 1979 to as high as $850 in early February 1980. The bond market collapsed, interest rates screamed upward, with the prime rate pushing over 20%. Reagan won the election by promising a  30% tax cut. At the time he won, the Fed had gotten itself under a bit more control, and gold came down to $625.

In the year that followed, Reagan's first, Congress passed the Reagan tax cuts, but instead of making them effective all at once, pushed the effective dates into 1982 and 1983. Still, the demand for money picked up in anticipation of the growth seen coming, and the Fed was now not supplying it. Gold began falling from its $600 heights and by September was at $400 and by the next February was at $300. Deflation! The recession was as bad as any since the 1930s, with unemployment running to 13%. I personally began pleading with Volcker to end the deflation by adding money to the banking system. He resisted, as Milton Friedman's monetarists followers predicted that if he began printing more money, the bond market would collapse again. In the summer of 1983, he had no choice, as Mexico said it could not pay its dollar debts, and if they could not, several major U.S. banks would collapse — including the Bank of America. Volcker was forced to add $3 billion in reserves to the banking system, in exchange for peso bonds, and the price of gold shot up above $400. Instead of causing a collapse in the bond market, it caused a boom, as I had predicted. (See William Greider's Secrets of the Temple for the story.) At last, the Reagan tax cuts and a reasonable monetary policy were working in tandem, which set off the Reagan boom years. Alas, Volcker came under increasing pressure from business interests to slow the economy down, and in 1984 and early 1985 allowed the demands for dollars not to be met, and gold fell again to $300. The price came up from that point when Treasury Secretary Jim Baker announced an end to Treasury's policy of not worrying about the dollar's exchange rate with foreign currencies. Gold crept back up and by February 1986 it arrived at $350. It has been more or less at that level ever since, with sharp upward swings and downward dips, but always coming back to $350 — exactly 10 times the old Bretton Woods price of 1944.

Greenspan is very happy with gold at $350, and if we knew he would be chairman for the next 30 years, the bond market might even reward us with a long bond closer to 5% than to 6.8%. Too bad he is 71 years old and may not be with us that long. A de facto Greenspan standard is now in place, which permits narrow swings in gold. It has come back to $350 because everyone is talking about lowering the capital gains tax this year. If that blows up, there will not be an increase in the demand for liquidity, and gold will drift back up. In other words, the market cannot give much credence to a de facto Greenspan gold standard. It needs the entire population of the United States, acting through its elected representatives in the White House and Congress, to formally make the dollar as good as gold, de jure. There are a lot of people who don't want this to happen, because they make their living off the volatility of the gold price. If it suddenly were rock solid,  interest rates would decline to 3%, and all those who think they benefit from knowing which way the dollar will go will have to find other employment. It is also to our advantage to keep dollar/gold volatile if we are ugly, greedy Americans, who wish to control the rest of the world. This is because the dollar is the key currency, to which all others are linked. When we jiggle the dollar, the rest of the world jiggles too, with even more volatility. If we stop jiggling the dollar, interest rates would fall all over the world, and the status quo would change dramatically. The people who benefit most are the people at the bottom of the pile, who would once again be able to accumulate a bit of savings without it being stolen by currency devaluation or inflation.

Those powerful American bigwigs and bankers who don't want things to change, because they enjoy being where they are, would have to scramble to stay on top if we fixed the dollar again to gold. They would no longer be able to use their current advantage of keeping other countries in line, doing what we want them to do, and not interfering in our lovely position at the top of the world. The people who work for the status quo are readily identifiable as the people who make fun of "returning to a gold standard." There are plenty around. Most Ph.D. economists, for example, who hate supply-siders for always being right. Also, those who work in the interests of the big guys, who try to buy the status quo by buying both political parties. These are the people who prefer The Beltway Standard to The Gold Standard.