Several Questions on Gold
Jude Wanniski
May 23, 1997


Supply-Side Economics Lesson No. 24

Memo To: Website Students
From: Jude Wanniski
Re: Several questions on gold

Four questions from Jon Price:

I read with interest your essay, "The Gold Polaris" and do not dispute its logic, nor for that matter any of the logic behind classical economics. One point confuses me however. If Greenspan's Fed Policy has in fact pegged the dollar at $350/ounce for ten years, why has there been any inflation during the period? Shouldn't the inflation rate have fluctuated around a zero mean under the circumstances; i.e., shouldn't deflationary periods have approximately offset inflationary periods through the last decade? I know some claim that the CPI overstates inflation. Is it your claim that there is no inflation at all? Please advise.


1. Greenspan has not been "pegging" gold at $350.1 never said that. "Pegging" means nailing it to the spot at $350, which can only be done by keeping the supply of dollars equal to the demand for dollars at that rate. Greenspan has been keeping gold at $350 in mind, as he makes policy with the other governors. As long as the chairman wants to lean in that direction, he can help keep it there, but only as long as the market agrees with him.

2. The "inflation" of the past ten years reflected the gold price rising to $350 from $35 in the years 1967 to 1986. It takes a long time for all other prices to adjust to the price of gold in a country where there has been price stability for a long time. Gold had been at $35 since 1934. Contracts, bonds, mortgages, etc., all had to unwind a little at a time, so the statistical inflation was pushed into the future. Once we have passed the 30-year mark, there is much less of this kind of "leftover" price changing that needs to be absorbed.

3. Indeed, there have been fluctuations around $350 during this period, with gold rising as high as $850 in early 1980 and then deflating to below $300 at a few points in the 1980s. Debtors and creditors have been settling around the equilibrium of $350, where there is an equilibrium of interests.

4. Greenspan says the CPI overstates inflation. He is right in that it overstates the inflation that has occurred on his watch. He's wrong in that prices are still inching up due to the gold price increase that took place before he arrived. We really don't have to do anything about the CPI if we were to fix to gold from now on, because it would soon show nothing but zeroes. If anything, it may show minus numbers, as the CPI has been politically massaged a number of times to understate inflation.

Four questions from Winslow Burhoe:

1. What is behind the recent reduction in the price of gold? I assume that the rate of money creation relative to demand has not slackened and guessed that there has been an increase of supply caused by the sale of gold, perhaps from the Russian stockpile. More recently I have read that there has been a breakthrough in reducing the cost of gold production.

2. If the U.S. were to adopt the gold standard is there a large enough supply of gold to anchor the value of money? The size of the world economy is growing much faster than the increase of the store of gold, so that other wealth greatly overshadows that of gold.

3. Agents who have purchasing power in the hundreds of billions, can they purchase or sell enough gold to affect its demand?

4. Can the price of gold be set differently from its cost of production?


1. If the rate of money creation relative to demand had not slackened, as you assume, there is no way for the price of gold to have fallen. Sales of gold by the Russians, if they had any gold left in their stockpile, would not have any effect on the dollar gold price, even if they sold gold for dollars. Once they have the dollars, they have to buy something with the dollars. Either goods sold in dollars or paper assets sold in dollars. In either case, the goods or paper absorb the dollars they acquire in the gold sale. All that changes is that someone other than Russians holds the gold. The Russians hold what the gold was exchanged for. Imagine the Russians sold the gold for Deutschemarks and you will see the transaction could not have an effect on the dollar supply/demand. In the same way, any "breakthrough" in reducing the cost of gold production assumes a permanent increase in the flow of gold into the world, when in fact all that happens when there is a technological advance is that more people will be able to buy things made out of gold at $350 per ounce. In the transition, companies that have the new technology will be able to produce it at higher profit margins than companies stuck with picks and shovels. Prospectors will still be out there with their picks and shovels, though, as long as they might hit a bonanza. If there were suddenly a method to turn base metals into gold, we would have a problem. But there is no problem as  long as gold is gold. As a unit of account, it reflects the labor required to find and produce it, not the capital.

2. This question is the opposite of your first. Remember, your first question worried that too much gold would be produced in the world relative to everything else that is produced in the world, driving down its value. Now, you worry that not enough gold will be produced to satisfy the demands of those who produce other things and want gold in exchange, thus driving up gold's value. If we were to fix the dollar to gold, the dollar would inherit gold's central value as a monetary unit of account. The world doesn't need more units of account or less units of account. It only needs one that is as good as gold has been as a unit of account for several millennia.

3. If some maniac agent who had assembled $100 billion in cash and wanted to disrupt the dollar/gold unit of account, you say he could do so by buying gold in the market at $350 per ounce. Actually, the government would offer to buy gold at $345 and sell at $355, or even buy at $349 and sell at $351. The maniac agent would not be able to get the government gold at $351 because private sellers of gold would sell it to him at $350.99. That is, the private market would supply the gold at that amount until the maniac agent had gold instead of dollars. The price would not rise, because the Federal Reserve would be required to meet any incipient increase in the price of gold with a withdrawal of dollar liquidity. It does so by taking dollars out of the banking system and replacing them with bonds. The maniac agent now has $100 billion in gold, and the $100 billion in cash he had hanging over the markets, threatening inflation, is in the hands of people who no longer own gold. What do they do with their $100 billion in cash? They buy $100 billion in government bonds, to replace the gold they had been holding. Where do the bonds come from? The Fed, remember, has drained liquidity from the banks, replacing it with bonds. Now the maniac agent has $100 billion in gold that is worth no more than he paid for it, and realizes it does not earn interest. He has gone through the trouble of assembling the cash hoard only to disrupt the gold unit of account adhered to by the U.S. government. He had assembled the cash by selling other assets into the market, assets that earn interest. All he can do is sit on his gold hoard until he realizes his objective could not be realized as long as the Fed has unlimited freedom to buy bonds or sell them. Realizing his blunder, he will now sell the gold hoard back to the general population, but instead of selling at $351, he will get only $349. On the other hand, if he is not a maniac, but thinks through the scenario in advance, he will decide it is not worth it.

4. Can the price of gold be set differently than its cost of production? It can be set anywhere the government wishes to establish its currency as a unit of account. If our government suddenly decided to peg the gold price at $1000 per ounce, the only reason it would not is that it would cause a serious inflation, as all other goods and services, including the price of labor, would readjust to the new gold price. Or, it could set the price at $200 an ounce, and the ensuing deflation would bankrupt debtors, who would be unable to pay their creditors, who would thus be forced into bankruptcy as well. A wise government would set the dollar/gold price somewhere very near a point where the interests of creditors and debtors are in equilibrium. This suggests $350, around which the dollar/gold rate of exchange has fluctuated for the past dozen years. The producers of gold would be able to easily adjust to this rate, with a minimum of either inflationary or deflationary pressures.