A Supply-Side Gold Standard
Twenty years ago this month I traveled through the snows to Hillsdale College in Michigan to give a talk in the Ludwig von Mises Lecture Series, my topic being "A Supply-Side Gold Standard." A few months earlier, I had only a vague idea who von Mises was and no idea when he had lived (1881-1973). Having accepted the invitation, I decided I did have to find out about the fellow and wound up taking Human Action, his magnum opus, out of the Morristown library. It was fortuitous, to say the least, that this happened just as we were in the midst of the 1981-82 monetary deflation. Von Mises turns out to be one of the rare economists who really understood the phenomenon and I became his eager student, eight years after his death. If I hadn't learned from him, I would not have understood the deflation we were in and certainly could not have spotted the one with which we are now wrestling. I'd forgotten all about my lecture, but a few months ago a fellow sent me an e-mail telling me how much he liked this website and the SSU lessons. He said when he was in high school, a buddy dragged him through the snows to hear my lecture, and he liked it so much he decided to go to Hillsdale College, expecting all the lectures to be like it. He said they were not, but he did not regret the Hillsdale experience. Here is the text, which I got by calling Hillsdale's bookshop and finding they had one copy of the 1981 lecture series left on their shelf.
A Supply-Side Gold Standard
When the United States formally ended the last link between the dollar and gold in 1971, the British economist Sir Roy Harrod wrote that it was perhaps the most important event in monetary history. "The British suspension of 1931," he wrote, "was followed by a decade of great disorder in the international monetary system. Will the world do better this time?"
Well, here we are. And Sir Roy, who is no longer with us, would surely observe that we have experienced another decade of great disorder in the international monetary system and that the disorder is with us yet. The convulsions of the 1930s – the great, global Depression – led the way to World War. As it happens, Sir Roy's mentor, John Maynard Keynes, helped rebuild the international monetary system at Bretton Woods in 1944, and it was that system President Richard Nixon abandoned a decade ago. Once again the word "Depression" begins to circulate among us as domestic and international unemployment lines lengthen, as farm and commercial bankruptcies mount to levels not seen since the 1930s. The distant drums of war come closer with each day's news from the Middle East and Poland, Central America and the Southern Cone of South America. Is prosperity just around the corner? Or a fallout shelter? Is it boom or is it doom?
I am an optimist, which means that in this context I think we will not wait this time around to have a world war before we reconstruct the international monetary system. This time, having learned a thing or two from history, we will head off Depression before it comes to pass and as a result many of the signs of tension and conflict that usually signal a general upheaval will recede and there will be peace, relatively speaking of course.
What I am saying, to be sure, is that I see a direct connection among the events of 1971, the current global economic contraction, and the strains between East and West that we all worry could lead to doomsday. Not many people make this connection and of course most of those people involved in the events of 1971 would and do passionately disagree. But I take the liberty of suggesting that if Ludwig von Mises were here today, he would see it clearly and stand with the "supply-siders" in urging President Reagan to call for a new Bretton Woods system. Many of Mises' students and associates would take exception to my suggestion, but then many of them – such as Fritz Machlup and Gottfried Haberler – long ago drifted away from his views and joined in the majority of economists who thought the Nixon break from gold was all to the good.
These were America's most influential and prominent economists, scores of them in New York and Washington, at the University of Chicago and along the Charles River in Massachusetts, distinguished economists, liberal and conservative, applauding President Nixon's closing of the gold window.
Economics, after all, is a science, and gold is "unscientific." At least this was, and still is, the conventional view. At the time, President Nixon was urged to close the gold window temporarily, so as to permit a scientific rearrangement of currency exchange rates. Once the new rates took hold, around a devalued dollar (which is to say when the promised benefits were in hand), the gold window could be reopened. In the spring of 1973, we recall, the promised benefits were still not in hand, the new dollar exchange rate was again being threatened by the "speculators," and so – egged on by Milton Friedman and other "monetarists" – the United States announced a permanent floating of the dollar. The applause from the economics profession was even more resounding, now stretching from Cambridge, Massachusetts, to Cambridge, England.
I'm not aware that Ludwig von Mises had anything to say publicly about these momentous happenings. He was then only months away from his death at the age of 92. But Mises had seen it all in those 92 years and I assume he would have had little to add to his observation in 1949, when he was merely 68, that "It is impossible to take seriously the arguments in favor of devaluation." Throughout his distinguished career, he had declaimed against all forms of credit and currency manipulation by government on the grounds that the general welfare could not be improved by changing the value of money. Debtors could benefit at the expense of creditors or creditors could benefit at the expense of debtors. These government-induced windfall gains or windfall losses could only subtract from the general welfare by subtracting from the public's confidence in the money.
President Nixon, after all, did not close the gold window and suspend the dollar's legal definition because he had to. He did so because the Keynesian and monetarist economists who advised him agreed that gold was holding us back in the United States. If we could only cheapen the dollar, said the Keynesians, or manage it scientifically, said the monetarists, we could combat the then-unacceptable 6 percent level of unemployment.
Yes, in the spring and summer of 1971 our nervous trading partners were asking for our gold with the dollars with which we had flooded the world, in a vain attempt to spark economic growth. But they did so only because they saw these economic theories pushing our policymakers toward devaluation or inconvertibility. Indeed, on the weekend prior to Nixon's suspension of convertibility, the joint Economic Committee of Congress – goaded by its chairman, Rep. Henry Reuss of Wisconsin – urged a devaluation of the dollar. The world financial markets were in frenzy the rest of the week as "speculators" dumped dollars. Representative Reuss, who helped trigger the worst inflation in our history, remains the most determined foe of a dollar/gold link in the Congress.
You might ask why there was inflation before we suspended convertibility – de facto – in 1968 (when President Johnson took the United States out of the London gold pool). I suggest that it could easily be observed in the market place from the mid-1950s that the United States was toying with manipulation of the monetary standard in one way or another. In my experience and in my reading of history, it is not apparent that the United States in the last thirty years has ever looked upon monetary policy as an instrument that should be devoted solely to maintaining the monetary standard. Inflation – the deterioration of the monetary standard characterized by rising prices – occurs as the market observes an intellectual erosion of the standard, an erosion that must precede the actual devaluation which produces the capital loss to holders of the currency.
When I speak of intellectual erosion, I speak of professional economists, who simply had no idea of what they were doing in counseling successive American presidents on monetary policy. These were the demand-siders, Keynesian and Friedmanite, who actually believed that the problem worldwide was a shortage of "money," and that the adherence to gold was preventing the central banks from providing that money for use in world commerce. Through the 1950s and 1960s, the Federal Reserve seemed to think it was managing the money supply – as if it were a commodity instead of a standard of value. For years, the Fed seriously pondered whether to increase or decrease the money supply, "easing" or "tightening," when all that was happening in reality was the disintegration of the system.
The flaw in Bretton Woods was in the inability of the American citizen to convert dollars into gold, President Roosevelt having made it illegal for Americans to own gold coin or bullion. The Fed would thus slice a surplus dollar into the economy, as if money were so much salami, and the American recipient would be unable to convert it directly at the Treasury into gold. The Fed would "slice this salami" by buying a government security from the banking system, "monetizing debt," as some call it, or "printing money" as others call it. It simply means the government substitutes non-interest-bearing debt for interest-bearing debt. The American recipient of this non-interest-bearing dollar would still be able to convert it into gold, but the process would be elaborate.
Say the Fed produces $100,000 by buying that amount of bonds and it winds up in the hands of citizens who, unable to convert it into gold, transfer it through the banking system to Germany. The $100,000 is exchanged for 250,000 Deutsche marks and the Americans use the 250,000 DM to buy German financial assets that pay interest or dividends. The German takes the $100,000 to the Bundesbank and converts it into 250,000 DM and the Bundesbank calls the U.S. Treasury and asks for gold. All that has happened, you see, is a Federal Reserve purchase of a reserve asset – a Government bond – and a Treasury sale of an equivalent reserve asset-gold. When, under President Johnson, the United States decided it did not want to give up any more of its gold stock, the Treasury began offering more and more Government bonds to the Bundesbank at higher interest rates, to satisfy them in lieu of their getting gold. Thus, a U.S. Government purchase of a $100,000 bond at 10 am. might exactly be offset by a $100,000 sale of a bond fifteen minutes later, a not unlikely lag given the speed of electronic banking.
All through the 1950s and 1960s and 1970s the Federal Reserve actually believed it was "managing the money supply" and all it was doing was spinning its wheels. Financial assets were being shuffled around internationally, but the entire net effect was close to zero. Americans owned more European debt and Europeans owned more American debt, and the illusion caused Europeans to think we were buying them up with our balance of payments deficit. At the same time, we became horrified at the enormous dollar assets that began piling up in foreign central banks-the "overhang," as it was called, if it cracked off, would take all our gold and buy up a big chunk of the United States. But of course there was and is no "overhang."
These confusions, which played into the hands of demand-side economists and led to the suspension of convertibility altogether, would have been avoided if Americans could have converted dollars into gold all along. Instead of having to transfer surplus currency abroad to have it offset by a foreign central bank, Americans would have gone directly to the gold window and turned the unwanted $100,000 into gold-and if the Treasury did not wish to give up gold from its stocks, it would have to persuade the Fed to sell a $100,000 bond on the open market-to soak up the non-interest-bearing cash and its claim on gold.
On March 2, 1973, 1 wrote a lead editorial for The Wall Street Journal describing the so-called "financial crisis" then besetting the Western world in general and the United States in particular. The editorial, titled "Rethinking the Dollar Problem," said in part:
In the current turbulence, we observe the curious phenomenon of yields dropping on short-term U.S. federal securities. Lenders here are well aware that the West German central bank will be rechanneling the dollars it is mopping up into short-term U.S. federal securities. At the same time, we suspect speculators are dipping into the money supply here, borrowing to finance their speculations abroad.
The capital flow is circular, with the direction determined by the speculators. The Fed, though, might be able to reverse the direction of the flow. A sharp tightening of the money supply, along with an announcement that it is intended as a temporary blow against the speculators, would do more than give the speculators pause. Dollars would still be needed for any number of projects, and fewer of them would be available domestically. American banks and multinational corporations would have to borrow marks, yen, etc., and cash them in for dollars to put to work in tasks where dollars are needed.
I quote this at some length to suggest to you that it is not by benefit of hindsight that supply-side analysis proceeds today. My editorial was a mere whisper into a wind of gale force and of course it did nothing to stop the official floating of the dollar a few weeks later. The forces of history were simply determined to try one of their periodic experiments with a paper standard. Robert Mundell of Columbia University had seen these irresistible forces gathering four years earlier, in 1969, and had forecast the floating of our currency and the anguish it would cause.
To the supply-side economist, who views the individual as producer rather than the individual as consumer for policy-making purposes, the monetary instrument is deployed with the maintenance of the dollar as a unit of account as the sole policy objective. The supply-sider begins with the assumption that there is nothing more important that the government can provide individual producers than a reliable standard of value, a unit of account that retains its constancy as a measuring device. The individual producer is never directly interested in the quantity of money in the system; he is always concerned with its prices, its value. The supply-siders observe, as Mundell did a decade ago, that the quantity of money is nevertheless determined in the private marketplace and there is nothing the monetary authorities can do about it. Money is a promise to pay, an IOU, and it is incredible that so many economists have been able to sell the idea that the government can increase or decrease the number of such promises as a way of managing the economy.
In the classical view, the government cannot increase or decrease the quantity of "money" in any real sense. All it can do through monetary policy is change the value of money and in so doing change the relationship between creditors and debtors. When the government devalues the money, it rewards debtors at the expense of creditors, be cause now debtors are relieved of paying to their creditors as much in the way of real resources. But creditors hence forth demand higher interest rates, on the expectation that the government will again devalue.
If the government changes the value of money in the other direction, causing it to appreciate, creditors benefit at the expense of debtors for the opposite reason, but now debtors can't pay, and creditors don't get what they had been pledged. Interest rates rise to offset the increased risk of deflation. Thus, the government causes interest rates to rise whether monetary policy is directed at either inflation or deflation, whether the price of gold in dollars is rising or is falling-gold being the proxy for all real goods.
In 1949, Ludwig von Mises described the process precisely, and he described the deflation that followed Britain's return to the gold standard after both the Napoleonic wars and World War I at prewar parities. The description, in his magnum opus, Human Action, fits the United States and the dollar area today. We are experiencing a classic deflation:
People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation. Yet the return to the prewar parity could not indemnify the creditors for the damage they had suffered as far as the debtors had repaid their old debts during the period of money depreciation. Moreover, it was a boon to all those who had lent during this period and a blow to all those who had borrowed. But the statesmen who were responsible for the deflationary policy were not aware of the import of their action. They failed to see the consequences which were, even in their eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them. Their conduct of affairs really favored the creditors at the expense of the debtors, especially the holders of the government bonds at the expense of the taxpayers. In the twenties of the nineteenth century it aggravated seriously the distress of British agriculture and a hundred years later the plight of British export trade. Nonetheless, it would be a mistake to call these two British monetary reforms the consummation of an interventionism intentionally aiming at debt aggravation. Debt aggravation was merely the unintentional outcome of a policy aiming at other ends.
(p. 784, 1966 Regnery edition)
In other words, since the election of President Reagan, the price of gold has plummeted by about $300. It went from the $625 range down to $312 and is now at about $350. All those contracted dollar debts in the past three years have been caught in this dreadfully swift monetary deflation. This includes families, businesses and governments around the world. And yet the bankruptcies and record unemployment rates somehow get blamed on President Reagan's "supply-side" tax cut-which amounted to a 11/2 percent across-the-board reduction last year in the face of a stupefying monetary deflation. Only had the tax cut been deeper, and earlier, as originally promised by the President, would it have offset some of the pressures on debtors and thus kept the economy from reeling.
As it is, we have been lucky so far that the President has been able to resist the pressures from his own staff and Cabinet and many Republicans in Congress to junk that part of his program entirely. In recent weeks, we have witnessed the spectacle of Republican leaders confronting this problem of a deepening recession by proposing a solution that involves an income-tax surcharge, a new tax on energy, and reductions in Social Security benefits. It is not enough that we have been going through one of the worst monetary deflations in our history, with families and businesses across the country pressed to the wall because of this debt aggravation. On top of it, the President's chief of staff, his budget director, and his Treasury secretary would have him levy new taxes on the middle class and "solve" the interest-rate problem by reducing the retirement benefits of the nation's elderly. The chairman of the Senate Finance Committee, Bob Dole, and the chairman of the Senate Budget Committee, Pete Domenici, have also been goading the President in this direction, and they in turn are being egged on by Congressional Democrats who are furious that Ronald Reagan has taken the tax-cut issue away from them. Of course, the President would destroy the economy and any chance of his administration's success if he followed their advice, which is to say if he walked into their trap. I don't think he will. But at some point, I don't see how he can expect to get the economy going with this cast of advisers, who seem absolutely determined to undermine the program he was elected to carry out.
It is no secret that I believe the monetarists have been the greatest burden the President has had to bear. Professor Friedman managed to get key jobs for some of his most devoted followers-at the Treasury Department, at the budget bureau, in the Council of Economic Advisers, and in the White House. President Reagan himself favors a return to a gold standard, but he gets no support from his economic team because they are absolutely dominated by the Friedmanites. At the outset of the administration, no prospective member of the economic team who favored gold could get through the barrier erected through the influence of the monetarists.
We have recently had the report of the United States Gold Commission flatly opposing a monetary reform, a gold convertible currency. But of course the 17-member Commission was handpicked by Treasury Undersecretary Beryl Sprinkel, Milton Friedman's most devoted disciple, and Anna Schwartz, whom I have described as the high priestess of monetarism, and who was named executive director of the Commission. There was certainly no way the Commission would have reported differently. These are people who are trapped in their own view of the world. They are sincere in their beliefs. But they cannot see why it is their experiment that has caused so much economic turbulence everywhere it is practiced. Always they find excuses to blame others for their own failures, however, and I believe the Reagan administration will be characterized by their failures as long as they are in positions that dominate policy. I remarked last year, facetiously, that Beryl Sprinkel should be publicly flogged. Now I say with absolute seriousness that he and the other monetarists in the administration must be removed for the sake of the economy, indeed the future of the world economy. The process of rebuilding the international credit system around a standard of gold can no longer wait through another round of monetarist failures.
There are many kinds of gold standards that have appeared over the centuries and are discussed today. The "supply-side” advocates reject most varieties as obsolete. We discard the various gold "cover" standards that rely on quantities of gold as a way of forcing discipline on the monetary authorities, and in this sense we would disagree with Ludwig von Mises and those of his followers who suspect any system that is not built entirely around the objective of discipline. The policy idea of holding so many tons of gold in storage for so many units of paper in circulation is one that flows from the demand model and its concern with the quantity of money. The concern of the supply-side model is with the quality of money, and to this end gold is viewed as a communications instrument. Indeed, von Mises understood this aspect of convertibility.
And he agreed with Adam Smith and David Ricardo that in an ideal world it permitted the economy to economize on gold. But he came to believe that politicians could not be trusted to observe the principles of a Ricardian gold standard and would have to be bound to gold in a way that would probably cause, at the outset, a credit collapse. But my reading of history and theory tells me that von Mises was fooled by the same illusion that destroyed the Bretton Woods system, and that universal convertibility would have taken care of much of the problem he chalked up to political weakness.
Those economists who view gold as being unworthy because it is unscientific fail to appreciate this aspect of convertibility-its utility as a communication device, an error signal. It is the convertibility school that attracts the supply-siders, convertibility that enables the marketplace to signal its needs to the central bank. It is not discipline we need, but a guide to the central bank as it ponders the public's marginal changes in the demand for currency as observed at the gold window. Monetarism fails because it provides no such guide. There is nothing in Milton Friedman's system that draws on the wisdom of the marketplace nor does that seem to concern him and his students. They know what's best for the market without any regard for the shifting demands for currency.
In the system envisioned, with the United States taking the lead in rebuilding an international monetary structure that all nations, large and small, can find shelter in, it isn't necessary for governments to hold gold at all, or at least much of it. As Robert Hall of the National Bureau of Economic Research explains, the substantive effect of the classical gold standard came from the legal definition of the dollar, not the government's control of the money stock. Essentially the same control of prices could have been achieved just from the definition of legal tender, without any control of the private creation of money. In any case, there was no serious attempt to control the deposits of banks, which were a growing fraction of the money supply.
The argument, then, that there is "too little gold," or that the Soviet Union or South Africa "controls the gold supply and thus our monetary system," is irrelevant. Because the system aims solely at maintaining the value of one dollar to thereby maintain the quality of all dollars-it does not need Russian or South African gold. If the Russians bring great amounts of gold-asking dollars, we would gladly comply by issuing them greenbacks, fully expecting the greenbacks would come back from the private market to our gold window. And if no Russian gold came into the system, if no gold were henceforth discovered, the unit of account would be maintained in a mildly deflationary world that transactors, creditors and debtors could easily adjust to without distress.
The key thing to realize is that if it chooses to do so, the United States can absolutely control the dollar price of gold, and in this manner stabilize the general price level and the value of all dollar contracts. The Russians can only control the ruble price of gold, South Africans, the rand price. Relative prices can change around the gold value, as the earth yields more or less gold or as the weather or personal tastes alter relative values. But the one constant unit of account eliminates entirely windfall losses and windfall gains among debtors and creditors. Debtors pay what was promised; creditors receive what was pledged. Once again, people will lend long at low interest rates.
The alternative is simply more of the same of what we have had for the past decade. There is, after all, no sign that the monetarists are any closer to discovering the secret of currency management than they were when the experiment began. Alan Reynolds, Robert Barro, and the younger monetarists now realize that even if the technical difficulties are overcome-if the money supply could be defined, tracked, and controlled-there would still be problems. As they now explain, a slowdown of money growth would be far more painful than any conceivable difficulties associated with gold convertibility.
If money growth is brought down gradually, as Herbert Stein proposes, it would take a decade or more to eliminate inflation. People would surely not believe that such a policy will persist through several changes of administration. Therefore, wage contracts and bond yields will continue to incorporate the assumption of eventual "reflation," so that rising costs pinch against any temporary squeeze on prices. Velocity may well increase more rapidly than the growth of money declines.
If money were instead brought down to, say 2 percent a year and held there, people might eventually believe it and therefore interest rates would plummet. With low interest rates, the demand for money would soar, velocity would fall. Any rigid quantity target (including a gold "cover") cannot cope with this rational adjustment to disinflation. With falling velocity, any rigid limit on money growth could produce an abrupt deflation, with widespread bankruptcies as prices fell faster than contracted costs. If money growth is then increased, that violation of the quantity rule undermines its credibility and revives all the symptoms of expected inflation. Neither a gradual nor sudden reduction in money growth can succeed.
To get to gold, where do we start? What steps do we take? There may be a thousand steps to get us to a gold-based fixed-rate system, but the first step would get us halfway there. Any positive step by the President in that direction would represent such a move. Mundell last September proposed that the Treasury stabilize the price of gold within a broad band, perhaps $400 to $450. Had we done so, the painful deflation and recession that followed would have been avoided or largely ameliorated. At about the same time, a similar proposal was put forward at the International Monetary Fund meeting in Washington. "Gold," said Jelle Zijlstra, who was then chairman of the Bank of International Settlements, "is no longer a dirty word." He was speaking to the year's most distinguished gathering of international bankers in the Western world at the annual IMF meeting. He observed that:
the present system cannot be termed satisfactory. . . . I feel that it is necessary for us, within the Group of Ten and Switzerland, to consider ways to regulate the price of gold, admittedly within fairly broad limits, so as to create conditions permitting gold sales and purchases between central banks as an instrument for a more rational management and deployment of their reserves.
So the initial steps are not only clear and simple, they also have the support of those, such as Mr. Zijlstra, who cannot be considered cranks or gold bugs or radicals. In conclusion, I say all that remains is for the President to decide-as he has on taxes-that with or without support from his monetarist advisers he wants to take that step. I for one believe that it will happen, and happen sooner rather than later. This hope and belief is the foundation for my optimism, for my expectation that it will be boom, not doom. When it happens, I could say with confidence that prosperity, to coin a phrase, is just around the corner.