Memo on the Margin

May 12, 2000

Supply Side University: Spring Semester, Lesson #13

To: SSU Students
From: Jude Wanniski
Re: Q&A on a return to a gold standard

For this lesson, I asked David Gitlitz of the Polyconomics staff to pose for me the ten questions he most encounters when he lets it be known that he favors a return to a "gold standard." It is a useful exercise, I think, and I will take a run at answering them as crisply as I can.

1. The U.S. was on a gold standard of one form or another for almost all of its history until 1971. We went off gold at that time because it was not working, and the U.S. was in danger of losing its entire gold stock. Why would it be any different if we went back on gold now?

Answer: The system broke down in 1971 because the Nixon administration was trying to hit two targets with one arrow. It tried to increase the money supply faster than the market was demanding it in hopes this would fuel economic growth while also maintaining the dollar price of gold at $35 per ounce. Nixon abandoned the gold target on August 15, 1971, in favor of the unemployment target. The experiment was a failure. The gold price went up and so did the unemployment rate. In fixing the dollar to gold now, we would have to do so with legislation that makes it clear the Fed only has responsibility to maintain the gold price, by adding or subtracting liquidity -- buying bonds from the banks when the price of gold tends to go down and selling bonds when the price tends to go up. This keeps the dollar as good as gold and prevents gold inflows or outflows.

2. Gold has been called a "barbarous relic," and seems like part of an 18th or 19th century conception of economic organization ill_suited to a supercharged 21st century economy. Isn't the idea of restoring gold to the center of the monetary system an anachronism in this New Era economy?

Answer: Gold would not be central to a modern system of central banking. We no longer need gold as a medium of exchange or a store of value -- as long as we keep the dollar as good as gold. We should use gold for the function it serves as a signal -- of central-bank error on the inflation or deflation side. As Robert Mundell, the great Canadian Nobel Laureate put it in a recent Wall Street Journal essay, a floating system is not a "system."Paper currency has to have a definition in something real, something that comes out of the earth. It does not have to be gold, except that compared to all other possibilities, gold is the one that has the best history of serving that role... and it is the only commodity held as a monetary reserve by the world’s central banks.

3. Wouldn't a gold standard leave the U.S. economy susceptible to swings in private gold production, creating inflation when large new gold supplies hit the market and deflation during periods when fresh supplies are scarce?

Answer: Good question. If you are going to fix the paper dollar to one real commodity, gold is the one least susceptible to swings in private production of commodities. As Fed Chairman Alan Greenspan has advised congressional committees several times, the stock of gold is the greatest of all commodities relative to its "flow," i.e., its annual rate of new production and demand in the marketplace. If we are going to fix to any "thing," gold is the most stable. Fixing to wheat or coffee, where the inventories are low relative to their annual consumption, would cause great volatility in the dollar and defeat the purpose of fixing in the first place.

4. In the past four years, the price of gold has ranged from a high of $400 per ounce to a low of $250. What price would be set under a new gold standard? How would you know it would be the right price?

Answer: The "exchange rate" between the dollar and gold, i.e., the "price" of gold in dollars, could be set at $400, at $250, or anywhere in between. A study of those cases where nations left gold and came back to it -- usually during wartime -- suggests a price that is somewhere between the extremes will be most likely accepted by the general population of debtors and creditors. If it is too high (inflationary), it favors debtors, too low (deflationary) it favors creditors. A golden mean today would put the price somewhere near the mean of the last dozen years, about $325 perhaps. When you get close to the mean, an error in one direction or another would not be of any significance as the benefits to the general population of having a stable unit of account would overwhelm any minor mistakes in price setting.

5. Why do we need gold? If the objective is to ensure a stable price level, why not simply directly target consumer prices or some other broad inflation index?

Answer: If you could choose such an index and target it correctly, adding or subtracting liquidity when it goes down or up, it would at least be a "system" and thus superior to the present non-system. The standard of measure would necessarily be rubbery, depending on what goods and services and commodities comprised the index chosen. If gold is the best monetary commodity, though, averaging it in with another commodity or commodities would not improve the standard, but only add imperfections.

6. If the Federal Reserve's only task is to target the price of gold, how could it continue to manage the entire economy? How, for example, would the Fed maintain control over short_term interest rates, its primary tool of monetary policy, under a gold_targeting system?

Answer: The Federal Reserve was created in 1913 to manage the gold standard of that time, by permitting a small amount of "rubberiness" to enter the banking system. It was never designed to "manage the economy" as it is attempting to do today. If the dollar is kept as good as gold by the central bank, the Fed’s role would return to the minor one of cushioning the economy when there is an unexpected disturbance requiring a lender of last resort.

7. The Fed's performance under the chairmanship of Alan Greenspan has been nearly universally praised for keeping inflation low and maintaining strong rates of economic growth. How would the U.S. or global economy have been better off during these years if instead we had been operating under a gold standard?

Answer: From 1987, when Greenspan was appointed by Reagan, until 1994, the price of gold wobbled around, but stayed close to $350. The other nations of the world could use it as a guide to their own monetary policies and there was growing peace and prosperity. The swings in the gold price first up to $380 in 1994-96, then down as low as $250 in 1998, crated monetary and financial disturbances around the world. The Asian crisis would not have occurred if the Fed had subtracted liquidity when the dollar/gold price was rising or adding liquidity when it was falling. The price of oil and farm commodities would not have crashed and gasoline prices now would not be so high.

8. In this age of highly efficient and powerful global markets, isn't it unrealistic to think the Fed could single_handedly dictate the price of an internationally traded commodity such as gold? Governments have been unable to maintain the value of their currencies against sustained speculative attack. How could the Fed maintain the price of gold under such an assault?

Answer: The U.S. Treasury and the Federal Reserve have total and absolute control over the dollar price of any one commodity, by managing the supply of dollars in the monetary base. If one dollar in the smallish base of dollars is kept as good as gold, all the dollars in the world will be just as good. In the same way, every other central bank could also fix the price of its currency to gold, but only a very big and diverse economy like the United States could withstand, cushion, unanticipated shocks to its financial system from outside forces. It has always been the responsibility of the most important political economy to assume this responsibility.

9. What would happen to the foreign-exchange value of the dollar with a gold standard?

Answer: It would depend on the monetary policies of each individual country. If Japan fixed the yen to gold too, the dollar and the yen would be fixed as well. If the European Central Bank refused to fix to gold or the dollar, the euro’s value either would rise against the gold/dollar if the ECB erred on the side of deflation, or it would fall against the gold/dollar if it erred on the side of inflation. The commercial interests of Japan and the EC would soon insist in keeping their currencies as good as the gold/dollar rather than be whipsawed by inflations and deflations.

10. If restoring the gold standard is such a good idea, why do so many economists oppose it?

Answer: Economists trained in the classical tradition favor a gold/dollar exchange rate -- those in the "Austrian school" of Ludwig von Mises and Friedrich von Hayek are universal in their support of a gold-based monetary system, although they may disagree on the actual mechanisms to maintain it. The so-called neo-classical or "demand-side" schools which have dominated academic economics since WWII are those who urged a flexible currency on the theory that easy money could bring prosperity without inflation... or with only a small amount of inflation. It is time for them to acknowledge their experiments have been failures.

11. If we fixed to gold now, at an appropriate price near the golden mean, what would happen to the U.S. and the world economy?

Answer: There is no single thing the United States government could do more to invite peace and prosperity around the world than to fix the dollar to gold, which would provide a constant guide to the monetary policies of all the countries of the world. The risks of inflation and deflation would be removed for all individual workers and producers and for all traders of goods and services. This would mean the world as a whole could accept more risk in the production and exchange of goods. The poorest people in the world and the poorest countries of the world would benefit most, but the only losers would be those who now exist in the service of managing the chaos in the financial world.

12. Could the world continue as it has in its current floating non-system?

Answer: As long as the Federal Reserve can find a way to minimize the errors it makes by trying to manage the currency without regard to gold’s signals. Even as adroit a central banker as Alan Greenspan, though, has had great difficulty in this regard, which suggests that under a lesser man there would be even more financial turmoil in the future.