CPI & Gold Jude Wanniski March 7, 1997

Supply-Side Economics Lesson No. 14

Memo To: Web site students
From: Jude Wanniski
Re: CPI & Gold

I thought the big dose of gold I gave you last weekend with my Golden Polaris would hold you for awhile, but right back I'm getting more questions in the monetary realm — because of all the discussions of public policy relating to price levels. Here is the question I picked for this week, from Andy Feltus:

Q: To me, the spot price of gold not only reflects the current price level, BUT also the future price level discounted back (at gold interest rates, not dollar rates). Thus, if the Fed embraced a gold standard, the spot and future price of gold would fall, as there would no longer be any inflation risk built into the price. Thus, gold is a good indicator of market expectations of prices, but not necessarily current price level. A gold fix at $350/oz. would probably be too high. Secondly, since gold was a regulated price for many years, it couldn't be considered a reliable price level since it did not reflect a real market. To compare CPI/gold moves from 1971 to present would not make sense; you would have to start in say 1950 or so to find a base year (when we were on a gold standard closer to the real thing). Thus, the inflation of the 1950's and more importantly the 1960's would also have to be included.

A: The price of gold is a ratio of two ratios. In the numerator we have the ratio of the supply of dollars relative to the demand for dollars. In the denominator we have the ratio of the supply of gold relative to the demand for gold. There are then four variables in the dollar price of gold. As you say, the spot price of gold reflects the future price level discounted back, but you are wrong when you say these are gold interest rates. In the spot price, all the action is in the numerator. The ratio of the gold supply and demand is a spot rate in the spot price. Gold is the only commodity that pays no interest, because it is the Polaris. The future price of gold is the current spot price plus the interest rate on the Treasury bill or bond rate along the yield curve.

There is no inflation risk in gold. It is a constant. The inflation risk is in the paper dollar, which is the numerator in our ratio of ratios. If there are too many dollars in supply relative to the demand for dollars, the dollar price of gold will rise. And vice versa. If the Fed embraced a gold standard, it would assume a constant denominator and focus entirely on keeping the numerator constant. There would be no fall in the spot and future price, nor could there be with a constant ratio of ratios. We would have our fixed unit, our Golden Polaris. The $350 gold price is the best ratio to fix because it has the most recent history at that level — dating back 11 years now. Most contracts that are now in existence have been made in the last 11 years in the U.S., which means if we try to fix the price at a level lower than $350, we will be benefiting creditors at the expense of debtors. The net result is not a happy one for the whole economy, because those debtors who cannot pay cause their creditors grief. Creditors who must write off bad loans may bankrupt themselves. The whole system suffers great trauma when gold moves in either direction.

You are technically right in saying that if we take in the 1950s and the 1960s we would more likely squeeze more CPI inflation out of the system. Some supply-siders like Art Laffer and Wayne Angell would prefer that we would do that. My resistance is more political, in that the cost of making that kind of harsh adjustment would ruin so many debtors that the gains Laffer and Angell see would not be realized anyway, as debtors would be able to mass sufficiently to push the Fed in the other direction, and the commitment to a gold standard, at $300 or less, would blow apart.

Most of the gains to be had in the world would come from fixing the price at a level that brings into balance the biggest dollar volume of contracts made over the most recent period. This must be done as far back as you can without putting the price variation ahead of the volume. Prior to 1967, with gold at $35 or one-tenth the current level, there were so few contracts made of greater than 30 years duration that they should be forgotten. If we were to fix at $350, all the countries of the world would be able to fix most easily at that price, because they have been keying off the dollar for the last 11 years too.

If you wish to read more about deflation, the best source I know of is Ludwig Von Mises, the great Austrian economist, a supply-side hero. His 1946 book, Human Action, is the first place I read about monetary deflation in a meaningful way.