Executive Summary: Since Labor Day 1981, the Stockman effort to recoup some of the tax-cut revenues with a new increase has chewed up 12 months on the calendar. But monetary policy, credited with inspiring the August bull market, is now center stage. Even Business Week relates Fed policy to the price of gold. In watching the movement of gold, stocks and bonds, it helps to think in three dimensions about the movement of prices. At $400 gold, statistical inflation will continue for many years. But with the burden of the tax bill on the economy, it would be too painful to move back to $350 or less. In 30 years, the most monetary of commodities, gold, has risen by more than 10 times, but basic prices, sans technology gains, are up that much too. Keep an eye on the IMF meeting in Toronto. Something might jell.
Exactly a year ago, just as President Reagan signed his three-year tax cut into law, I wrote my September letter for Polyconomics entitled "Now, Money." The central theme was that fiscal policy had dominated Washington in the opening months of the Reagan Administration and that the political class would now shift its focus to monetary policy. The supply-side aim would be to reform the monetary institutions so that policy would be compatible with the fiscal approach. A supply-side monetary policy puts the needs of producers and transactors — a stable value of money — ahead of those who argue the importance of managing the quantity of money. Without such monetary/fiscal compatibility, policies would continue to pull the economy in different directions, the "Monetary-Fiscal Stalemate" I described in my early February letter.
Instead of shifting to monetary policy, though, President Reagan was soon talked into the idea that he had gone too far with his tax cut and should get some of it back through reforms that would help balance the budget. The entire 12-month period was lost in this hedging operation, courtesy of David Stockman and James Baker III. The only news coming to the financial markets in that year involved the fiscal uncertainties of what would be in the tax bill and its size and the continuing monetary deflation with its global squeeze on dollar debtors.
What now? There are again mumblings from Business Week, Senator Dole, Murray Weidenbaum and others about the need for more "revenue enhancements" down the line. But for the moment at least it looks as if we are going to focus on monetary policy. Even Dole says it looks as if the third-year of the tax cut seems safe. Reagan will no doubt wish to avoid crawling back into bed with Tip O'Neill and Teddy Kennedy so soon. The congressional Democrats are attacking monetarism and stirring up discussion about interest-rate targets at the Federal Reserve. And more than anything, the August bull market demonstrated the power of the Fed to lower interest rates in the face of mounting deficit projections. A serious focus on monetary policy seems inevitable, with the monetarists in a much weaker position than they were a year ago. The financial press, which has been conditioned for years to focus on the monetary aggregates as a guide to Fed policy, is finally making a turn toward gold. As Business Week put it in its September 6 issue:
With the economy operating far below capacity, the Fed's governors undoubtedly welcome the sharp decline in interest rates and the runups in the stock and bond markets. But there are some reasons to believe that they are worried about the rapid rise in the precious-metals markets, where gold moved up by about $48 per oz. this week. To the Federal Reserve, the price of gold remains a fever chart of inflationary expectations particularly when the Europeans are arguing, as they are right now, that the U.S. has abandoned the fight against inflation.
In coming weeks, then, the price of gold may be as good an indicator as any of what the Fed will do next.
The price to key on now is $400 gold, which we suspect is about the upper limit before it begins to signal a rise in interest rates due to expected inflation. This isn't to say that interest rates couldn't be much lower at a much higher gold price. I have little doubt, for example, that interest rates would plummet if the President and Volcker announced that the Treasury and Fed would cooperate in fixing the price of gold at $450 or even $500 an ounce. Such a move would be followed by a comparable rise in the general price level over time, but interest rates would still fall, shedding inflation and deflation premiums. But in the absence of an institutionalized system, all the markets have to go on are the Fed's tendencies toward or away from correct policies. In this environment, a rising gold price would probably be taken as foreshadowing a rise in the price level without any guarantees of future stability. At $400 gold, there would still be a rise in the general price level over many years until the system was back in equilibrium.
Several weeks ago, a college student asked me how I could be talking about deflation when prices were still rising, how I could be worried about falling prices when wage contracts and the prices of consumer goods were still climbing. The question was a good one, the answer to which is worth reviewing as we get into the monetary debate and as we grope toward an understanding of why the financial markets are behaving as they are.
Prices cannot rise and fall simultaneously in two dimensions, but they can in three dimensions. Nor can prices rise and fall in a world without "money." After all, prices are merely ratios of one good to other goods. The price of an apple is an orange. The price of an automobile is 40,000 apples. In a world without money, the general price level can not rise or fall, although specific prices can change constantly.
It's a world with money that we are concerned about, money being a unit of account that enables us to simplify the pricing system. An apple is a quarter of a unit, an automobile 10,000 units.
The monetary authority, in this case the Fed, maintains the standard, the unit, and when it errs in one direction or the other, the error is felt instantly in the pricing system (although it takes many years for the error to be fully absorbed in all prices). The Fed makes an error in the direction of inflation when it produces an excess supply of dollars — non-interest bearing government debt — relative to the demand. Because gold is the most monetary of all commodities (the real good that has more "money" properties than any other), the dollar/gold ratio will be the first "price" affected by the Fed's error. It will now require more dollars to buy gold. The next ratio to change, perhaps, will be the dollar/oil ratio. When sellers of oil find their dollars now buying less gold, they will try to restore the gold/oil ratio by raising the dollar price of oil. In the dollar constellation, containing many millions of prices, it takes time for all prices to fully adjust to the Fed's mistake. A ballpark guess might be 30 years, that being the length of the longest contracts. That is, after the 30-year unwinding of contracts, all the original ratios will tend to be in place again. But of course relative price changes, especially those reflecting technological advances, will cause the price constellation to have a different look. An apple will still swap for an orange, but it might take only 30,000 apples to buy the equivalent automobile.
Now imagine that the Fed makes an error that causes the price of gold to go from $350 an ounce to $700 an ounce, a large error to be sure, but one the Fed actually made in 1979-80. If an ounce of gold were equal to 12 barrels of oil, at $35 an ounce a barrel would sell for $2.90, at $350 for $29.00 and at $700 for $58.00.
The price of oil never did get to $58 in 1980, but it would have if the Fed had maintained the dollar/gold ratio at $700 instead of coming back down. The price of oil was moving in that direction in the summer of 1980, when gold plateaued at about $625. The Klondike atmosphere in the domestic oil industry and the high-rolling at Penn Square reflected the implicit assumption that the Fed would keep gold pumped up to at least $625.
Other prices moved in the direction of $625 gold during the 1979-80 binge. Precious metals and commodity prices move fastest, with the price of labor appearing the slowest to move. This is why it could seem, as the Fed deflated back to $300 gold this year, that prices could be rising and falling at the same time. Those prices that had the least amount of elasticity in following gold up, those that followed closest on its heels, also followed it down the fastest. Those prices, including labor and finished goods, which have just been catching up to $200, $250 or $300 gold, the most elastic in their response, are observed still moving up while the other prices are tumbling. To the casual observer or the financial/political press, "inflation" is said to have been beaten when the index of prices stays constant or goes down a bit for a few months. But at a $350 gold equilibrium level, the government statisticians are simply adding together prices falling from $700 gold and those still rising from $35 gold decades ago (mortgages, bonds, natural-gas contracts, etc.) plus labor prices and finished goods and then dividing by two.
This is important to understand because it suggests that what the politicians are determined to have when they say they want to "end inflation" is not possible at $400 gold. If the Fed fixed at $400 gold, the price of oil would stabilize at $33 or thereabouts, by our rule of thumb, and there would be a rise in the general price level for many years — a "statistical inflation," if you will. Most of the rise, i.e., most of the adjustment would come in the first three years as labor contracts unwound. But the adjustment would be much gentler than any we've experienced in the last several years. The point to be emphasized is that we will certainly experience rising prices for the rest of the century at $400 gold. To eliminate a general price rise quickly would require gold stabilization at about $200, but it hardly seems worth the effort. So many prices would have to fall that the economy would have to pass through a major restructuring, a painful period of bankruptcies and unemployment that we got a good taste of as gold approached $300.
I had hoped that the Fed could hold to $350 gold, which would have been a reasonable point at which to fix the system given the varied interests of debtors and creditors. But passage of the tax bill, which adds a significant tax wedge burden to the economy, suggests that the system could only get back to $350 gold with great difficulty, and I'd expect to see the stock market give up its recent gains in the process.
The figure $350 seemed reasonable because it is exactly ten times the price of gold set by Roosevelt in 1934 and reaffirmed at Bretton Woods in 1944. If we figure the system was almost back in price equilibrium in 1955, with the indices barely moving, we'd find that the relevant prices are about ten times higher now. The cost of a skilled craftsman to a New York building contractor in 1955 was about $3.50 per hour, wages and fringes; the cost now is about $32 per hour. The basic Levittown tract home was $10,000 then and is about $100,000 now. A Yankee Stadium hotdog was 20 cents then and is $1.50 now, but in 1955 a vendor brought it to your seat and now you have to stand in line. The most basic consumer good, the loaf of bread, is up by a factor of five. But that's only the assembly-line produced sliced white bread. The bakery-produced oven-baked breads, which have not gained via technological advance, sell for about $1.50 a pound, almost ten times the price three decades ago.
Another question is asked: Who gains and who loses if you fix the price of gold at $400? In a static sense, everyone who borrowed when gold was below $400 wins, everyone who borrowed when gold was above $400 loses, everyone who lent when gold was below $400 loses, everyone who lent when gold was above $400 wins. In a dynamic sense, though, just about everyone wins, because the economic system gains enormous efficiency and productivity with a unit of account that holds its value. The winners and losers have already discounted the gains and losses in their portfolios. The level of perceived wealth would continue to soar with the decline in interest rates, as it did in two-week bull market of August, when more than $150 billion was added to the value of capital stock represented by the Wilshire 5000 index. After the dollar price of gold is fixed there are no longer winners or losers in the sense there are around a shifting paper numeraire. Only a historic change in the supply or demand for gold would alter the real values in dollar contracts.
The likelihood that this would happen in the next, say, 50 years is so remote that this factor would not even show up in interest rates. The chance that a major supply of gold would come to the market's present 80,000 tons is as great as the chance that the demand for gold would show a dramatic, relative surge (if gold were found to cure cancer, for example).
Certainly the risks to the productive economy would be trivial compared to the risks we face with a monetary authority trying to manage the paper numeraire. In his three years as chairman of the Fed, Paul Volcker has done his job hewing to the quantity of money, letting the economy adjust price. Gold has gone from $350 to $850 to $500 to $675 to $312 to $370 to $298 to $425 and now $410. While we have good reason to suspect, as does Business Week, that the Fed is now keeping its eye on the price of gold, we can't be sure it won't let it continue swinging as it pursues other targets.
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The International Monetary Fund has its annual meeting in Toronto, September 6-9, and we'll be there to keep an eye on the international bankers. A year ago, remember, the IMF met in Washington and the keynote speech, by Jelle Zijlstra, chairman of the Bank for International Settlements, urged central bank stabilization of the price of gold, when it was $425. The other finance ministers and monetary authorities of Europe have since been urging stabilization of currency exchange rates on Washington, always meeting resistance from the monetarists in the Reagan Administration. Maybe something will jell in Toronto.