Jude Wanniski
September 26, 2003


Memo: To SSU Students
From Jude Wanniski
Re: Q&A on Exchange Economy

The two lessons on the exchange economy prompted a series of questions from a new SSU student, a PhD economist who has a relatively influential post on Capitol Hill. As you will see, the economist is mostly curious about the points I'd made about the problems the dollar causes as it fluctuates in its price (exchange rate) with gold. The issues are directly relevant to the current debate in Washington over the dollar's exchange rate with the Chinese yuan, with U.S. manufacturers claiming the yuan is undervalued relative to the dollar. We also discuss the Democratic presidential candidates who believe the jobless recovery can be cured by tax increases. Here is the Q&A, which certainly does not exhaust this topic, but further discussion will have to wait for some future lesson. Next week we will return to this semester's primary topic of taxation and public finance.

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Q. Don't non-monetary fundamentals (new gold discoveries, changes in mining costs, changes in consumer demand for gold, changes in the desired portfolios of central banks....) add significant noise to the monetary signal you hope to extract from the price of gold? Given such noise, isn't the best approach to view gold prices as informative, but not a firm target of policy?

A. Fed Chairman Alan Greenspan used to make the best arguments for gold, especially on the "noise" issue. He told the House Banking Committee several years ago that gold is the best monetary commodity because its "stock" is the highest relative to its "flow." There are 130,000 metric tons of gold in the world and the annual additions (or "flow") to that "stock" are only about 2,500 metric tons. It really does not make any difference who legally possesses the gold with these tiny amounts shifting around. The Netherlands central bank was selling gold before anyone else when gold was $385 in late 1996 and the Bank of England was selling gold in 2001 when it was $250 an ounce.

Consumer demand for gold is almost totally determined by the price in the local currency. Gold's only function outside monetary policy is as jewelry, which in itself is a form of "money." At the margin, people buy more gold when there is more unwanted liquidity in the economy and buy less gold when there is more liquidity desired than is being supplied. I say "almost totally determined" because in the absence of a gold standard -- which assures the market the price variations will be held down to nickels and dimes -- the market will make temporary errors in guessing which way it will go. By temporary, I mean only by the time it takes for information to get around, not more than a business day.

Q. What, by the way, do you think gold is telling us now? How high does it have to go before it's time to load up on inflation-indexed bonds?

A. The gold price has come up from its low because of geopolitical risks, with 9-11 being the first launch pad. When businessmen pull in their horns, less liquidity is needed, and if there is no mechanism to mop it up, the gold price goes up. In other words, bad things caused the gold price to go up, and the volatility of gold today is the result of the supply-side tax cuts on capital enacted in late spring. The tax cuts increase the demand for liquidity while the financial costs associated with the distress in the Middle East reduces the demand for liquidity. Because we, at Polyconomics, believe the optimum dollar/gold price is about $350 per ounce, and it is now trading at $380 or so, the bias is toward inflation, not deflation, but it is so far slight, which means small positive changes in the demand for liquidity could send the dollar/gold price back down. Inflation-indexed bonds are not very attractive given these considerations.

Q. In the mid to late 1990s, the price of gold fell dramatically, even as US inflation, by conventional metrics, continued at moderate rates. This seems to reverse the example you presented, in which fiat money is more volatile than gold. Why doesn't this experience mean that gold could be disruptively volatile too?

A. It is gold that is constant and the dollar that fluctuates. You have been used to thinking of the dollar being constant and watching gold run up and down. The confusion arises from the fact that commodities that trade on the international spot market react first to a change in the dollar/gold price and that prices of goods that are not determined in the spot market change only as rapidly as contracts for those goods unwind. In an inflation, gold first moves up and other commodities soon follow, but all other prices catch up slowly, depending on the debt structure of the economy in question. In an economy where the average maturity of debt is several years, it will take even longer than that for all prices to re-equilibrate with gold. In an economy where inflation has become embedded in expectations because of perpetual inflation, people will not lend money to each other beyond a day or two. In these "hyper-inflations," when the price of gold doubles, all other prices double in a day or two. In a gold-standard economy, workers in labor unions will readily agree to contracts covering as many as three years. In a hyperinflation, they demand daily indexation. In between, depending on the recent experience of inflation or deflation, workers will either insist on frequent upward adjustments or agree to "give back" wage increases in order to preserve their jobs.

In the 1990s, gold drifted up to $385 from its optimum price of $350 -- determined by its average price over the previous dozen years when contracts were being drawn up in the exchange economy. This upward drift was caused by the 1993 Clinton tax increase, which reduced the demand for liquidity. Prices of commodities drifted up, including oil. The Fed tried to hold back these inflationary impulses by raising interest rates, either thinking this would increase the reward for holding dollars instead of spending them and driving up prices, or discourage economic activity in order to reduce the demand for goods. These actions dictated by demand-side economic theories will not work to prevent a monetary inflation and are actually perverse. The Fed raised interest rates several times and the gold price did not budge from $385.

In late 1996, as the market began to gear up for the bigger economy it knew would accompany the 1997 tax cuts, the demand for liquidity increased and the price of gold began its long decline. The Fed could not arrest the decline by lowering interest rates. It needed a mechanism that would have directly increased the gold price, which is what a gold-standard mechanism provides. If the dollar/gold price goes up by a nickel, to $350.05, the Fed withdraws liquidity. When it goes down by a nickel, to $349.95, the Fed adds liquidity. That nips inflations and deflations in the bud. The mechanism it now employs, adding or subtracting liquidity to hit a certain interest rate, can accommodate wide swings in the gold price, with all the inflationary and deflationary problems that are introduced to the exchange economy.

When you say inflation continued at moderate rates in the mid- to late 90s, you note "conventional metrics," i.e., the consumer price index or the producer price index, that are derived by averaging spot prices and contract prices. I'd warned government officials in April 1997 that the decline in the gold price would be followed by a decline in the oil price. These declines made the inflation "metrics" looking good and Greenspan was hailed as a "maestro." The unintended side effect was to shut down investment in the world's energy or BTU industry.

This is because the costs of building facilities to convert oil and gas reserves in the ground into product that could be sold to consumers had outstripped the prices being paid for product. When oil hit $10 a barrel in 1998, investment in oil and gas production around the world went to zero. Remember that commodity prices move first and it takes some time before wages and other costs of production catch up. This is why it is so costly to the world economy to operate with a floating unit of account, a U.S. dollar that cannot direct capital to where it is most needed. The industry could not justify spending on capital goods to move oil and gas to market when the price received at market produced a negative return.

When the world economy began its recovery from the dollar deflation, demand for British Thermal Units (BTUs) increased, but absent requisite infrastructure, production could not meet demand. The price of oil climbed back up over $20 and then $30 bbl., even with gold below $300. Other commodity prices remained low as prices of finished goods continued to fall. But because higher oil was averaged into the conventional metrics, they did not go negative. Greenspan still looked like a hero, but business and industry was being squeezed as the cost of production now had added energy costs on top of wages, pensions and health care costs that continued to rise because they had been contracted before the deflation. The only way to survive was to downsize, laying off workers.

We are of course still feeling the aftershocks of the monetary deflation, now into a "jobless recovery." Note the Democratic presidential candidates all blaming the Bush tax cuts for the economic weakness and loss of jobs since 2001. They simply do not understand how it was errant monetary policy that caused the distress and are now promising to raise taxes, as if that will cure the "jobless recovery." With gold now back up where it should be, there is no longer a need for downward price adjustments -- of commodity prices or of contract prices. Liberated from this drag and encouraged by the lower marginal cost of capital (by cutting the capgains and dividend tax to 15% from higher levels), the stock market can move up in anticipation of higher returns to capital. The recovery will eventually restore the demand for labor and jobs will appear, with higher wages made possible by the higher components of capital. Of course, if the repair process is interrupted by a reversal of the tax cuts as the Democrats demand, all bets are off.

Q. Why do conventional inflation measures differ so much from gold?

The numbers we get from the Bureau of Labor Statistics were designed for a gold standard world. As noted above, there are now enormous distortions that occur in the allocation of capital, when transactors must try to figure out costs and returns in the exchange economy. Years ago, Bob Mundell explained how the accounting rules were changed in the early part of the 20th century to reflect the previous era of deflation -- when the gold prices fell back to where it was before the Civil War, prior to the floating dollar of the Greenback era. You may remember the LIFO-FIFO debate in the 1970s on whether you should account for inventories on a last-in, first-out basis, or a first-in, first-out basis. The accounting rules written for deflation suddenly had to be applied in an inflationary era -- and businesses were being wrecked in the process. The only reason I pay any attention to conventional measures is that I know policymakers take them seriously as a way of determining what the Fed may or may not do.

Q. It sounds as though you do not attribute the gold increase to Fed actions. Why not?

The Fed has practically no influence on the price of gold because it can only raise or lower the fed funds rate, which has no NET effect on the gold price. It is the tax or regulatory policies of the government that cause gold to rise or fall -- or the risks to commerce that arise from errant national security policies, such as an unnecessary war in Iraq. The Fed can control ONE THING, but only one thing, because it only has one policy lever. It can increase the supply of liquidity or decrease the supply of liquidity. That's it. If it uses as its standard the fed funds rate... the market rate at which banks lend to each other overnight to meet their reserve requirements... the Fed can do that with a fair amount of precision. And that's what they choose to do now, in hopes of being able to influence the unemployment rate or GDP. If they want to fix the price of bananas, they can do that too, but that's all they could do. We would be on a banana standard and that would be a very volatile system, as the stock of bananas is extremely small relative to its flow. That's because bananas have a short shelf life.

If the Fed chose to fix the dollar price of gold, it would be easy and it would be most beneficial to the whole world economy. But it could only do that one thing with that one up/down lever on liquidity. The system broke down in 1971 because his economists advised President Nixon that the Fed could do two things with that one lever, keep inflation under control and also lower the unemployment rate. It was Robert Mundell who said at the time that for each target you need a separate arrow. If you want to lower the unemployment rate, you lower tax rates. But keep the monetary arrow aimed at the gold target, to keep inflation under control.

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