Final Q&A Period Jude Wanniski January 29, 1999

Supply Side University Economics Lesson #18

Memo To: Website Students
From: Jude Wanniski
Re: Final Q&A period

This is the final lesson of the semester, one devoted almost entirely to money and monetary policy. Next week we begin the spring semester on tax and budget policy. How fun! Make sure you are registered and tell your friends to jump in too. Here are the best questions that came in on the last few lessons:

Q: (Barry Schneiderwind) I have noted a distinction when some people discuss gold between a currency pegged to gold and one based on gold actually held by the issuer of the money. Do you see them as different and do you see a pegged system avoiding the deflation problem that affected the U.S. during the 1870s to 1900? This has often been ascribed to the limited supply of gold and expanding production of other goods. Historians also ascribe the end of the deflation to the Klondike gold strikes and the arsenic refining technique for gold. Do you agree with this analysis? You have written about reinstating the prewar gold price as the cause of some of these problems, so do you see history taught this way as wrong?

A: The deflation problem could not be avoided when the U.S. government decided to fix gold at the pre-Civil War price of $20.67/oz. It didn't matter whether we had gold stocks or simply pegged paper to gold. Most of the debate in the last half century about what constitutes a gold standard and what doesn't is a confusion that arose out of the Crash of 1929. Because NOBODY at the time attributed the crash to the tariff act, all attention shifted to the Federal Reserve as somehow being the culprit. More to the point was the Fed's handcuff to gold. "If only it were not tied to gold, it could have been free to save us from the Great Depression!" This is all wrong, totally wrong. There was nothing the Fed could do to offset the damage of the tariff act. Is this clear?

Q: (Follow-up) Isn't it interesting the extent to which ideological battles are fought using different versions of history and how we are trapped by the version we were taught? I would bet that if I gave your answer when we studied the 1800s it would have been counted as wrong. A Supply-side analysis requires rewriting the history I was taught of not only the Depression but the 19th Century. Is it your view Bryan and the Free Silver crowd were wrong and that the deflation caused by the $20.67 gold price had run its course by 1896 or did the gold strikes and new process solve the problem?

A: You are quite right. The economic history of the late 19th century has been written by modern economic historians to comport with the Keynesian model. The greatest part of the monetary deflation that occurred in that period was in the years 1873 to 1880, as a result of the 1872-73 decision to make gold convertible at $20.67 on 1/1/1879. There was no monetary inflation in the 1880-1900 period, which was characterized by spectacular industrialization that kept productivity increases high, real wages rising, and farm prices low. The free-silver movement was supported by those populists who thought they should be able to discharge their dollar obligations with demonetized silver, which fell in price when it was demonetized in favor of the mono-metallic gold standard. The non-economic historians simply accept the stuff handed them by the Keynesians and monetarists, who look to gold as a burden to their theoretical models.

Q: (Revi N. Nair) What do Herbert Stein, Milton Friedman, George Schultz, et al, say today about the failed policies of the 1970s? Are they supply-siders now? If not, how do they rationalize their mistakes?

A: Friedman insists monetarism was never really tried, because the Fed never hit his M targets, which of course it is impossible to do. He may have been something of a supply-sider in his early years, as some of it peeps through now and then. But he has lived most of his adult life in a demand-side universe, dominated by Keynesians, and the result now is that all of his ideas come through that screen. Stein never paid much attention to monetary policy, deferring to Friedman and the monetarists when such questions arose. He is a dyed-in-the-wool conservative Keynesian, an ardent foe of economic growth through risk-taking and an advocate of a high capital-gains tax. He will argue now that the Reagan tax cuts caused the deficits and that the economy is better now because of the Bush/Clinton tax increases. Schultz is not a serious economist in this realm. I've spoken to him several times in recent years and he allows as how maybe going off gold wasn't good, but he really can't explain why. His training was as a labor economist, not a macro theoretician. Remember that when we left the gold standard in 1971, Arthur Laffer was his chief economist at the Office of Management and Budget. He didn't support Laffer's views because he did not understand them and the Gray Beards, as we referred to Friedman and Stein, were in the opposite camp.

Q: (Ron Sinclair) Can one small country, say a Thailand or Brazil or Malaysia adopt the gold standard and benefit or must it be first adopted by the U.S. as leader of world Monetary Policy? How about Japan adopting a Gold standard?

A: A small economy cannot set the gold price. It has to be the biggest economy, or a massive collection of economies within a trading regime. The unified Europe could do it by linking the Euro to gold. Or all of Asia could link to Japan if Japan were linked to gold, but Japan by itself could not, at least not without great stress to its export industries. A fixed yen/gold rate would give Japan a great comparative advantage in global finance, but at the expense of its industrial sector. The painful deflation it is experiencing now is the result of a failure of its central bank to observe the decline in the yen/gold price, which is causing distress to BOTH its financial and industrial sector. Switzerland in 1973-74 tried to stay on a gold standard but had to float the franc when its non-financial sector was being wrecked by a too-strong franc relative to the rest of the world. Even now, almost all Swiss watches are made in Asia, with the final assembly in Switzerland so they can be stamped: "Made in Switzerland.11 In 1974, when it was still keeping the franc as good as gold, Swiss watches, pharmaceuticals, chocolates, etc., were being priced out of the world market by economies made poor by too much labor and not enough capital.

Q: (David Gitlitz of Polyconomics) Here's the problem I have with your argument that the depression could have had no monetary antecedents because the price of gold remained stable. The thing is, under a gold standard, you can still have shifts in demand for the currency vs. gold, depending on general economic conditions and the actions of the central bank. The fact that gold stocks were rising sharply in the U.S. indicates that demand for dollars relative to gold also was rising. In other words, at the set price of $20.67 per ounce, dollars were becoming cheap in terms of gold. Since the nominal price of gold was fixed, the shift in real values could only be reflected through the net exchange of gold for dollars. This should have been a signal to the Fed that money was excessively scarce and compelled it to inject new supplies of liquidity. Instead, between 1928 and 1930, net monetary liabilities of the system shrank by more than 20%. From my perspective, the possibility that monetary error contributed to the crash/depression doesn't diminish the contribution of your insight about Smoot-Hawley in the least. It's quite possible the protectionist sentiments in Congress were aroused by the price weakness caused by the monetary deflation. According to the Roy Jastram (author of The Golden Constant) tables, wholesale commodity prices fell by 8% between 1925 and 1929, and this price decline more than doubled to 17% by 1930.

A: This is one of the biggest misunderstandings in the economic literature, one that always led monetarists astray. When gold stocks rise, it simply means the Treasury is buying gold with dollars from its bank account. The Fed does not buy or sell gold. The movement of gold stocks are fiscal events that do not affect the unit of account. When gold stocks decline, it means the Treasury is selling gold for dollars which it uses either to buy goods or reduce bonded indebtedness. The Fed still has to add or subtract reserves to maintain the dollar/gold price. You cannot say the Fed is too tight or too loose if  it is maintaining the official price of gold, the unit of account. The gold outflow simply signals the Fed may soon get in the position where it might devalue. A gold inflow may indicate the opposite, that the government is using scarce tax resources to acquire gold it doesn't need.

Q: I think I'm trying to get at the idea that a flow of goods and capital (being roughly the same) from one country to another can be motivated both by the desirability of the products and services, and the desirability of holding foreign securities. For example, in 1995, a rising yen vs. dollar would, in common analysis, tend to depress imports of Japanese goods and services due to their rising cost in dollars. However, a high yen and falling Japanese stock market might lead investors to move funds to the U.S., expecting to gain both from a rising stock market and perhaps from a fall of the yen vs. dollar. If they move funds to the U.S., a rising Japan trade and services surplus is inevitable, given that the U.S. is not inclined to give away valuable securities for free.

A: Work this out with two people in order to understand it. One makes wine and one bakes bread. Their trading relationship is in goods. If one makes wine in the spring and the other bakes bread all year round, there has to be a relationship in bonds — what you call "valuable securities." The vintner gets bread every day and gives the baker bonds most of the year, cashing them in with wine in the spring. One bottle for five loaves, let us say. If they agree to make the bonds out in dollars, with one loaf equaling one dollar, then the baker expects to cash in his 350 dollars for 70 bottles of wine, when the bottles are ready. Suppose the government devalues the dollar so it is legally worth half as much. When the baker present his $350, he gets only 35 bottles. He has been cheated by the government devaluation of its accounting unit, but there is nothing he can do about it. Legal tender is legal tender. If we examine the year, we find that in three quarters out of four, the baker is running a balance of trade surplus and a capital inflow, with a trade deficit iit the spring quarter and a capital outflow. The goods have already changed hands. That is all that's left as the valuable securities have been expunged. This is what goes on in the workaday world, except there are so many transactions that we do not realize new securities are constantly being issued or rolled over as old ones are being liquidated. When the baker and vintner strike a deal for the second year, they both agree that five loaves still exchange for one bottle, and that they must do the deal in dollars, but there is now a risk to the holder of the valuable security, the baker, and he must take out insurance in order to protect himself against "inflation."

In the second year, the government appreciates the dollar back to its original value, which equates to one loaf instead of a half. This time the vintner must cough up 140 bottles instead of the 70 he thought he agreed to. Now in the third year, he takes out insurance too. A currency market springs up to sell insurance to both, with a 5% cut of all bread and all bottles. Hmmm. Maybe if we were back on a gold standard, the government could not inflate the dollar or deflate the dollar. All those people employed in the hedging industry would be liberated from processing the paper and would be able to make bread, or wine, or cheese. The national standard of living would rise. Notice when you break all this down into simple terms, you cannot allow Ph.D. economists to fool you with their calculations and equations about how many jobs will be created by devaluing the currency. The only jobs created are those required to process the hedges. The chaos industry.

Japan has been running a trade surplus with the United States for many years, but the valuable securities are always liquidated within a specific time cycle. Because much of the paper they cash in for goods occurs here in the United States, when Toyota uses dollars it accumulated in Tokyo to build an auto plant in Oklahoma, we never really understand why the economists are complaining. In the simple example, real people are hurt when they are not hedged against currency swings that turn against them. The baker who got 35 bottles instead of 70 probably promised half of his wine to a cheesemaker. Now he can't pay and must declare bankruptcy, throwing himself on the mercy of the community and the public dole.

Q: (Scott Robinson) Lesson #17 on money is almost as tight as the House Managers'case against Clinton. Still, some questions remain. Is there something about the way the Fed operates (interest rate manipulation as its only mode of operation) that prevents it from acting as if there were a de facto gold standard? Couldn't the Fed buy bonds slowly and relentlessly until gold started to rise? Interest rates would be bid up by this I think. Would it be easier if the President just announced a gold standard?

A: The Fed is now officially operating on an interest-rate targeting mechanism. It can't also be on a gold-targeting mechanism. It is one or the other. Or an "M" target or a foreign-exchange target or a GNP target. It can't hit more than one target with only one arrow. If Greenspan wished to raise the gold price, .he would have to persuade his colleagues and the government that it would be a good thing to do. As soon as he indicated he wishes gold to be at $350, it would skip right up there. The market would accept it as the new mechanism. Interest rates would still be higher than they would if the government passed a law requiring the Fed to use its one arrow to hit only the gold target. Without such a law, bakers and vintners would not be able to trust the government, and would have to do a certain amount of hedging.

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Hope you enjoyed the semester. I did. You folks are getting smarter all the time. I'm having to go back to the books myself to stay a step ahead.