Collision Course: Gold and Greenspan

Alan Greenspan has not always had as much difficulty defining money and differentiating it from credit as he did in his Humphrey-Hawkins testimony quoted in the prior commentary. In his 1966 essay "Gold and Economic Freedom" (reprinted in A. Rand, Capitalism: The Unknown Ideal), the future Fed chairman discussed the consequences of the Federal Reserve's decision in 1927 to reduce interest rates in response to a mild U.S. contraction and continuing losses of British gold due to its politically inspired lower rates:

The "Fed" succeeded: it stopped the gold loss, but it nearly destroyed the economies of the world in the process. The excess credit which the Fed pumped into the economy spilled over into the stock market -- triggering a fantastic speculative boom. Belatedly, Federal Reserve officials attempted to sop up the excess reserves and finally succeeded in braking the boom. But it was too late: by 1929 the speculative imbalances had become so overwhelming that the attempt precipitated a sharp retrenching and a consequent demoralizing of business confidence. As a result, the American economy collapsed. Great Britain fared even worse, and rather than absorb the consequences of her previous folly, she abandoned the gold standard completely in 1931, tearing asunder what remained of the fabric of confidence and inducing a world-wide series of bank failures. The world economies plunged into the Great Depression of the 1930's.

Today the Fed's critics see wild speculation, particularly in the technology sector where stock market valuations exceed all historic norms of rationality. However, the Fed chairman is among the most influential propagandists for the so-called "new" economy. Cogent commentaries on the new economy by Veneroso Associates (www.venerosoassociates.com) suggest not only that the new economy's claimed productivity increases are greatly exaggerated, but also that no one should be more aware of the shaky statistical foundations that underlie them than Alan Greenspan. See "The Myth of the Productivity Miracle: Part III," Sept. 20, 1999, pp. 2-3. Indeed, as he must know, the U.S. is the only major country in the world that uses the hedonic price deflator to adjust its GDP statistics for the increased power of computers. See "The Myth of the Productivity Miracle: Part II," Sept. 20, 1999, p. 7. While the distortions of GDP resulting from this practice are difficult to quantify precisely, there can be no question but that the result is a significant overstatement of GDP relative to both historic experience and other nations.

Wide availability of high speed computer power has given birth to a huge business in financial derivatives. Indeed, the Black-Scholes option pricing formula in combination with dynamic or so-called "delta" hedging has revolutionized financial markets. Highly complex trading strategies based on these concepts produced the 1998 LTCM debacle (www.pbs.org/wgbh/nova/stockmarket), which sufficiently threatened the world payments system to scare the Fed into three interest rate reductions when it should have been moving in the other direction. Nevertheless, both Mr. Greenspan and the Secretary of the Treasury have portrayed financial derivatives as useful financial stabilizers not requiring further regulation by Congress. See, e.g., Statement of Board of Governors of the Federal Reserve System, House Banking Committee, March 25, 1999, www.house.gov/banking/32599fed.htm.

Black-Scholes and delta hedging require estimates of volatility based on historic experience and operate properly only in fully liquid markets. Whatever the benefits of financial derivatives in normal markets, unexpected volatility or loss of market liquidity can raise havoc with them, leading not just to large losses but to market destabilizing events. Like LTCM, the problems of Ashanti, Cambior and certain gold banks brought on by the Washington Agreement illustrate what can happen when financial derivatives crash on wrong assumptions or abnormal conditions. John Hathaway with his usual insight gives an update on the gold banking situation in his most recent article, Apocalypse No (Feb. 2000, www.tocqueville.com/brainstorms/brainstorm0057.shthm).

Similar incidents are possible in interest rate or stock market derivatives, particularly under the unusual conditions that could follow from the Treasury's bond repurchases or an unwinding of current egregious overvaluations in leading NASDAQ tech and net stocks. Far more frightening, however, would be the consequences of a panic flight from the dollar on almost all financial derivatives.

A statistical analysis of recent gold price movements provides further evidence of Anglo-American manipulation of the gold market. See H. Clawar, A New Gold War? (March 13, 2000, www.gold-eagle.com/editorials_00/clawar031300.html). While Mr. Greenspan denies that the Fed is trying to control gold, he must know whether the U.S. and British treasury departments are actively involved in a coordinated scheme to cap the gold price. Indeed, the vehemence of the denial that he made to Senator Lieberman regarding possible Fed interference in the gold market suggests an effort to distance both the Fed and its chairman from an expected future scandal over manipulation of the gold price. Yet as long as this manipulation takes place sub rosa, gold's usefulness as a monetary indicator is compromised. One result is unwarranted criticism of the Fed's efforts to restrain credit growth. See, e.g., J. Wanniski, "The Numeraire" - Supply-Side University: Spring Semester, Lesson #6, March 10, 2000 (www.polyconomics.com/searchbase/03-10-00.html) ("There can be no 'inflation' or 'deflation' with gold constant," and only a "noodlehead" would think otherwise.)

The Fed chairman acts as if the new economy is the productive miracle that its fans assert, financial derivatives are the generally benign stabilizers that their promoters claim, and the gold price is as sensitive as ever to monetary debasement. In the process he has put himself in the same position as his predecessors in 1927-29. Speculative imbalances, fed by grossly excessive credit creation and abetted by dubious financial hedging strategies, are allowed to grow. At the same time, the gold market -- with British connivance -- is rigged. But what is different this time is that the gold standard cannot be made the scapegoat for the Fed's errors.

Domestically, of course, the currency is no longer tied to gold. Going off gold was supposed to give the central bank greater flexibility in managing the nation's money supply. Instead, the end result has been to undercut not just its ability to regulate money and credit but also the very foundation of the banking system itself. Banking depends on a workable distinction between money and credit. Without it, the Fed cannot control the growth of the broad monetary and credit aggregates, and banks no longer possess a unique franchise separate and distinct from other financial intermediaries.

Money market funds buying commercial paper, government agencies like Fannie Mae and Freddie Mac securitizing loans, and brokerage firms making margin loans all act effectively to expand credit, but they do so outside the constraints of bank reserve and capital requirements. For an interesting discussion of this process and its effects on the monetary aggregates, see D. Noland, "The Credit Bubble Bulletin - Commercial Paper," March 10, 2000 (www.prudentbear.com/markcomm/markcomm.htm). Banking based on gold is a demanding business that done properly is a public good; banking without gold is a crippled business that, however done, has heretofore always ended in an orgy of paper and national ruin.

Internationally, the euro is poised to assume many if not all of the settlement functions that since 1971 could only be performed by the dollar notwithstanding the breakdown of the Bretton Woods system. What is more, unless the ECB and EU nations lose their nerve, the days of the U.S. and Britain dictating international monetary arrangements are over. There is no practical bar today to the euro bloc declaring full independence from the dollar by linking the euro to gold in some meaningful fashion. Indeed, a simple declaration that henceforth most of the EU's international monetary reserves will be held in gold rather than foreign currencies would likely have major adverse consequences for the dollar and the pound.

Nor is monetary confrontation with the euro the only possible nightmare scenario for the dollar. A problem for any world reserve currency is that major external holders of the currency have a potential weapon they can use against the reserve currency country. The importance of this weapon is magnified when the domestic financial structure of the reserve currency country is overextended or its external accounts are out of balance. Thus today, for example, any major confrontation between the U.S. and China over Taiwan would inevitably be complicated not only by questions about what China might do with its very substantial dollar reserves, but also by what other large holders of dollar reserves might do to counter any perceived threat to the value of their holdings.

What was once known as the Great War became the First World War largely due to the unwillingness of western democracies to face hard facts at domestic political cost. What Mr. Greenspan was able to call the Great Depression could well become the First World Depression for fundamentally similar reasons. Although another global depression would almost certainly knock the dollar from its reserve currency perch, it would mark not so much the end of a dollar-based financial world as the end of an illusion: that paper can replace gold as permanent, international money.

Just as the Second World War forced a return to greater realism in the conduct of international relations, a Second World Depression should bring about restoration of a more normal gold-based international monetary system. But in this event, Mr. Greenspan, having set out to play Mr. Churchill, is likely to end in the role of Mr. Chamberlain -- the man run over by realities that he could not see or would not admit.