Monetary Q&A Jude Wanniski October 16, 1998

Supply-Side University Lesson #6

Memo To: SSU students
From: Jude Wanniski
Re: Monetary Q&A

These are questions I've been collecting for the past several sessions relating to money and monetary policy, inflation and deflation. I've already answered the questions individually, choosing those I think will help the class the most. A great many very elementary questions came in, which I answer if I think the student has made a serious attempt to read the lesson or my book. Otherwise, I refer them to the TalkShop, where students who have been at SSU for several semesters should be able to help. As the number of students in the class approaches a thousand, it gets more difficult for me to find time to handle it all myself. I do try to read through all the TalkShop discussions and when I find confusion I step in for a clarifying comment. Mostly, I'm astonished at the scholarship of the older students, how much it has been possible for them to learn through this long-distance, electronic process.

Q: Could you explain to SSU students just how monetary deflation impacts production, and hence the demand for goods and services (output) resulting in falling prices, wages, salaries, incomes, and depreciates the standard of living. There seems to be a lot of confusion (people believing the costs of capital are actually low by looking at nominal rates).

A: First remember the cost of capital should not be too low or those with capital will not offer it on the market, either in the form of equity or of debt. Those who have capital may offer more of it even though ~the nominal cost appears to be the same, as long as the risks to the "  returns on the invested capital are reduced. Because of the monetary deflation, the cost of capital is falling here, but the people who are paying for that falling cost of capital are those who previously acquired capital and those who provided it. Their loss is our gain, to put it crudely.

When the money deflates, debtors have to pay back more valuable dollars and when they can't make the payments, the creditors must swallow bad debt. Those in distress have to unload their inventories at distress prices, which means those not in distress can't sell their competing goods and must lower prices and profits. Production must slow across the board until the surpluses are liquidated, at which time it can resume, but all prices, including the price of labor, must adjust down to the new general price plateau. Unemployment may rise in parts of the economy but fall in others during the correction process.

If the deflation occurs in a progressive tax system, real tax rates will automatically decline at the lower price plateau. In other words, if gold drops from $350 to $35 and the marginal income tax rate is 30% on $350 and 10% on $35, the monetary deflation will result in a tax cut. The system may be more efficient after a deflation, which is good, although the adjustment process does force unequal burdens on the population, which is bad for those bearing the greatest burden.

In a contraction, there is a difference. The unit of account remains constant, but a barrier rises between producers and consumers that discourages trade at existing prices on either side of the barrier. Those producers who have to sell at distress prices are not necessarily doing so because they have to pay creditors. It could be they are the least efficient producer. When their stocks are liquidated and they are out of business, the survivors continue to sell at the pre-recession prices. Labor does not have to adjust downward to meet a new, lower general price level. Unemployment simply rises during the period of adjustment and then subsides at a lower standard of living for the economy as a whole.

Q: Returning SSU students have heard a lot about deflation, and how it is separate from contraction (particularly in the example of the 1930s). I'd like to hear more about contraction. Big policy mistakes (and floating currencies) set up situations where the usual capitalist solution of letting the losers fail carries the risk of bringing the whole economic structure crashing down. LTCB was one example; the banks in Japan are another. Everyone in Japan is scared to death of a contractionary spiral (they call it a "deflationary spiral") that could ensue if, say, banks were all marked to market and loan books opened tomorrow. Yet, on another level, supporting "zombie" failed enterprises just wastes capital and destroys wealth. Can we have some observations on the process of contraction, and what a government like Korea or Indonesia can do to pull itself out of a contractionary situation once the damage is done?

A: Japan has been in a contraction and deflation simultaneously for the past decade. The yen has appreciated during the period, causing an adjustment process to a constantly lowering general price level, with pain felt by both debtors and creditors. It also has erred by raising tax rates on capital gains on real property. The society chooses to support "zombie" enterprises on the assumption that the economic AND social costs of allowing them to fail are too high, and that perhaps other solutions can be discovered to bring the zombies back to life. A few small changes in monetary and tax policy would do exactly that, but nobody in the government has yet made that discovery.

In countries like Korea and Indonesia, which get blindsided by major errors in the major countries they look up to — the twin deflations in the U.S. and Japan — the best defense is to shift as much of the burden of adjustment from the present to the future. Instead of raising tax rates on capital and labor, the government should try harder to lower those tax rates that are unnecessarily high to begin with. It also must avoid the temptation to devalue its currency against gold, although accepting a devaluation against the deflating dollar and yen. Devaluation of the local currency causes the burden of adjustment to shift from the state to the people, which really means pulling future burdens into the present. This is because the state is the biggest debtor and its people the biggest creditor. In any time of distress, it is best to shift the burden to the state as much as possible. This is especially true in a war.

Q: I wonder if we could have a more detailed explanation of the relationship between the central bank, which creates base money, and the banking/finance system, which multiplies that base money into liquidity for the economy (transaction money?). Jude has cautioned on a number of occasions not to confuse the two, and not to assume that the central bank's actions have an automatic effect on the liquidity situation. Could this be elaborated?

A: Liquidity is base money, by which we mean the fraction of the national debt that has been turned into currency and bank reserves, neither of which the government pays interest on. In a perfectly functioning monetary system, the central bank supplies only the amount of liquidity being demanded at the official gold price — the price the government guarantees its creditors. The private banks that use the dollar as the unit of account can then be at their most efficient in bringing transactors together. The Fed cannot create credit nor can it create currency. The private banks cannot "create" credit or money either, in any real sense. It is the potential producer of goods and service who creates the credit by offering more of his goods and services in the market place in exchange for equity or debt — pieces of paper denominated in dollars that hold claim to some variable or fixed amount of future goods and services.

The financial intermediary — the bank or the stock market or credit union — simply matches up such creditors with debtors who are willing to commit their future production of goods in exchange for the present production of goods. If the central bank does not maintain the fixed price of gold, or at least keep its floating price close to an optimum level, the risks to producers of current goods and promisers of future goods increase — a fact noted by the bank doing the intermediation. The inefficiency of the unit of account reduces the willingness of producers to produce and promisers to promise, and the economy loses some of its ability to satisfy its wants and needs. Its standard of living declines.

When the system is experiencing a contraction caused by a tariff or tax barrier rising between producers and consumers, a devaluation of the unit of account against gold does nothing to lower the risks to economic transactors. If a tariff barrier rises between Smith the American producer of bread and Schmidt the German producer of wine, the transaction might become uneconomic and not take place. The transaction will not take place if the U.S. government devalues the dollar or Germany the D-mark. A fiscal contraction cannot be rectified by a monetary error. And the terms of trade cannot be changed by a change in the unit of account. The monetary error in and of itself will cause higher risks to future transactions between Smith and Schmidt.

The same is true when Smith in New York trades bread for Jones' wine in California. If the income-tax rate rises at the federal level, it might well cause the trade of bread for wine to abort, being uneconomic. The Federal Reserve cannot revive that trade by devaluing the dollar against gold. The error increases the risks to all transactions, because the system loses confidence in the reliability of the unit of account. When the dollar is not fixed to gold, the central bank can only make errors, on one side of the accounting unit or the other. Alan Greenspan has been chairman of the Fed for more than 11 years, and it he did his job perfectly on even one day, it would be a miracle. Every day he goes to work he does a worse job than if he allowed gold to do his work for him.

Q: I'm trying to make the connection between a lower interest rate and the demand for liquidity.

A: Interest rates and the volume of liquidity in the system are two different things. "Liquidity" is the amount of debt that has been monetized, either government debt, or private assets that have been purchased by the Fed with "new money." In other words, liquidity is equal to the monetary base, the total outstanding amount of non-interest-bearing debt — currency and bank reserves. If the Fed were targeting the gold price, it would simply add or subtract from the monetary base to keep dollar/gold constant. In the current system, in which gold plays no role, the Fed ponders the correct amount of liquidity it thinks the system SHOULD HAVE, based on the individual theories of the dozen voting members. If it thinks it should have more liquidity, it announces a lower overnight rate (fed funds), on the presumption that the technicians will discover that in order to hit that lower rate, they will have to buy bonds from the banks with new money. That may not be the case. Aiming at one target to hit another target (like in playing billiards) is not always easy to do.

Q: Why is the price of gold the first to rise in an inflation and fall in a deflation? If I expect an inflation, why will that impel me to buy gold? If I expect a deflation, why will that impel me to sell gold? I have had a miserable time trying to understand the pro gold rationale the past couple of years, even though I am impressed by gold's empirical record as a monetary indicator.

A: The reason gold is the first commodity to respond is simply that it has more monetary properties than any others. So "the market" first switches from "paper money" to "commodity money" in an inflation and vice versa in a deflation. Think of it in another realm. If you ask for a ham sandwich and are told they are out of ham, do you ask instead for a bicycle wheel or a can of shaving cream or a baloney sandwich? You ask for the one closest to what you want. The market acts the same way when there are too many dollars or not enough. It asks for gold or gives up gold, not bicycle wheels, shaving cream, or ham sandwiches. Of these three, by the way, shaving cream has more monetary properties that bicycle wheels or ham sandwiches. You should be able to guess why.* The clearest example I can recall of the "market" deciding gold was overpriced relative to the dollar was in February 1980, when the gold price hit $850 on interday trading, the papers carried pictures of ordinary citizens lined up at pawn shops that offered cash for gold. When the price fell, the lines disappeared.

Q: Your essay on understanding money was excellent. I think it really behooved our student body when you explained why, in many cases, it takes years, or decades, for the price level to adjust to a new gold price. The analogies about how "contracts" unwind is most useful in conceptualizing this fact, as the front of the monetary train (gold) can zig and zag, while to caboose (the price level, always further away in a mature economy) isn't yanked in either direction for some time. Maybe you could explain why money wages are still rising, or at least why some of the statistics say they are. This is the main argument of those in the Keynesian and Monetarist schools who want to continue "tight" money policies. In my estimation, wages are the "stickiest" price. Neo-Keynesians attribute the sticky price, sticky wage model to market imperfections, but any mature economy, wherein capital and labor negotiate or contract to protect mutual interest in the act of production, will, at the margin, have a more prolonged price adjustment period. Do you agree with the "sticky wage, sticky price" theory of the Neo-keynesians????

A: Labor unions first took hold here in the monetary deflation of the 1870s, when employers were cutting wages of workers because of the deflation. The workers resisted because they had incurred debts at the higher gold price. Nominal wages would eventually fall in the current deflation, but what happens first is that some workers get laid off and get nothing, while others cling to higher wages. Wages are sticky going down for this reason. We have yet to go through this part of the process. Imagine if gold went down to $35 again. Carpenters were being paid $4 an hour TOPS back in 1967, the last time gold was really convertible at Treasury at that price. They would have to go down from $40 an hour, including benefits that are much higher now because of tax avoidance. Now that's not going to happen, but to get from the $385 plateau to the $285 or $300 plateau is a big drop. Cutting interest rates by little bitty quarter points won't do a thing. There must be a public commitment to get to $325 at least, with liquidity added until the market is sure that's where it will go.

*The answer to the question, which has more monetary properties — a bicycle wheel, shaving cream, or a ham sandwich -- is shaving cream. The sandwich will quickly rot, having no utility as a store of value. The bicycle wheel is not fungible — it is only good for the frame that goes with it. Shaving cream can be used all over the world by people who shave. It lasts a long time. Its value can be related in the spot and fixture market to other goods and services — so it has more utility as an accounting unit than a sandwich or a bike wheel. Over thousands of years, the people of the earth did these exercises with every conceivable commodity and decided upon gold as the best of the best, the "commodity money par excellence ," as Karl Marx put it.