Business Week and the Gold Standard Jude Wanniski September 23, 1981

Executive Summary: The Business Week cover article of September 21, "A Return to the Gold Standard is now the journalistic standard, the pacesetter for the rest of the financial press and, in turn, the political press. The article is good because the BW editors avoided adversary journalism and did a straight reporting job. But because the team that worked on this story was trained in the various "demand models" and because BW does not have a supply-sider on its staff, there are many imperfections in the piece. There is probably no quicker way to improve on the journalistic standard set by BW than to point out these imperfections. As the great gold debate begins, the gold advocates are confident of winning precisely because their opponents have many misunderstandings of what a gold standard is and what it would do. As these misunderstandings are cleared up, seriatim, a point will be reached that will make it obvious to the skeptics that gold is indeed the solution.

Business Week and the Gold Standard

1. BW says "The gold advocates argue that the very fact of the dollar being backed by gold on demand will have two effects that will make the Reagan revolution in supply-side economics work. First, it will remove from the Federal Reserve the ability to create money at will, and, second, it will instill in the public a new confidence in the future of the dollar."

This is almost, but not quite, right. It is not that convertibility removes the Fed's ability to "create money'* that is important. It is gold's ability to guide the Fed in matching the economy's demand for money and credit with a supply of it. Gold serves as a source of information. The Fed can do this with precision at the end of every business day by accommodating all buyers or sellers of gold, letting private transactors create and extinguish money in the process of exchanging real goods and services. Supply-siders do not care about the quantity of money in use, only its value as a unit of account. The second point, thus, is also not clear enough. The public needs confidence in the future value of the dollar in order to set the terms of trade in the exchange of goods and dollar-denominated financial assets. There is nothing more valuable to the real economy than a reliable unit of account that does not result in one trader enjoying a windfall gain while his opposite suffers a windfall loss. BW misses this point throughout, but it comes close to seeing it; it's difficult to see in a demand model.

2. BW says: "With the exception of some supply-side economists such as Wanniski, no economists regard returning to a gold standard as a painless way of controlling inflation and getting interest rates down." This is correct, except that it gives the impression only a fringe of supply-side economists believe a shift from paper to gold as the "numeraire" will bring instant relief. The global monetarists, Laffer, Mundell, Lehrman, etc. all believe that we are now suffering "pain" and a turn to convertibility will bring instant relief. No one believes that a gold standard in and of itself will guarantee economic growth. Gold only guarantees the unit of account. Taxes and spending — fiscal policy — can destroy the economy or advance it, with or without a fixed numeraire. Thus Laffer "admits" that under a pure gold standard there were "a lot of economic crises and bank collapses." He doesn't "admit" anything, but rather acknowledges that gold's role is only one of several tools available to policymakers.

3. BW says the U.S. would not adopt a pure gold standard. "No one is suggesting that the U.S. return to a monetary system in which every dollar was backed by and convertible into gold." BW doesn't understand that in a gold standard, gold is defined as money, the dollar is merely a promissory note that the U.S. guarantees can be exchanged for a specified weight of gold. BW says "The total worldwide stocks of dollars and dollar obligations are estimated at about $1 trillion and U.S. gold holdings are 264 million oz." But almost all of that $1 trillion simply represents contracts in "ink" dollars between domestic and international transactors. Thus Jones, the baker, and Smith, the butcher, can agree to swap bread for beef, and draw up the contract in dollar units. Even if a bank does it for them, the dollars do not represent claims against the Fed. BW correctly observes that the actual liabilities of the Federal Reserve system amount to $163 billion. At $600 per oz., almost this entire liability would be backed by Fort Knox gold. A 40 percent reserve, though, would be more than enough, which suggests that we could sell off a bunch at the outset.

4. BW says that U.S. interest rates "would probably decline initially.' Yes, interest rates would decline, but not because of the demand-side reasoning BW presents, i.e.: "interest rates are high now because there is widespread skepticism that the U.S. can and will control the growth of the money supply when faced with the need to finance burgeoning budget deficits. By linking the growth of the money supply to a commodity such as gold, which is in limited supply, the U.S. will eliminate such expectations in the short-run."

First, interest rates are not high because of BW's hypothesis about "widespread skepticism." Transactors are never concerned about the "supply of money." They are always concerned about its price, i.e., its purchasing power in real goods. On the supply side, the producer says "What do I have to give up to receive a dollar in exchange?" To the producer who wishes to save his production, the question relates to the price of credit — the interest rate: "I wish to save 10,000 loaves of bread for five years. What price should I ask of the borrower to guarantee I get back the 10,000 loaves?" The producer qua saver asks a higher price the more skeptical he is that the borrower will only be required legally to pay back less, because the government can not maintain the unit of account. On the supply-side, money "supply" growth is not "linked" to gold. Only the price of money is linked to gold — by defining money as gold.

Gary M. Wenglowski of Goldman Sachs & Co. is quoted as saying gold monetization would boost stock and bond prices because inflation expectations would be curbed, but that if the government bends the standard by "cheating and compromising," inflationary expectations would zoom. Of course. The task for the supply-sider is to design a system that is as foolproof as possible. With no monetary standard at all, cheating and compromising are now the rule rather than the exception.

5. BW says Robert Weintraub's attempt to compromise with the supply-siders — maintaining gold backing of the Fed's liabilities but without gold convertibility — is "unlikely to satisfy the supply-siders or bring interest rates down because it would not constrain the Fed." Again, supply-siders are not worried about constraining the Fed, but of guiding the Fed. Weintraub wants to control "quantity" and supply-siders do not. They want to match supply and demand for money and credit. Without convertibility the Fed can not be guided by the marketplace and its constantly shifting demand for money.

6. BW says "the purpose of a gold standard is to make control of the money supply, and therefore inflation, automatic. Any country on a gold standard would lose or gain gold depending on whether it was inflating relatively faster or slower than competing countries."

This is a demand-side view. On the supply side, the purpose of a gold standard is to provide a reliable "numeraire," or benchmark — a unit of account — that enables transactors to set the terms of trade, both in real goods and in the exchange of financial assets for real goods. A supply-sider does not believe the "supply" of "money" can be discovered, any more than the "demand" for "money" can be measured. Only the intersection of the two — the price ratio — can be known. Only the price, then, can be fixed.

A country on a gold standard would not lose or gain gold depending on relative inflation rates, as BW asserts. Inflation is a decline in the monetary standard. If gold is money and paper dollars are promissory notes guaranteed at the Treasury in a specified weight of gold, there can be no "inflation" as long as such guarantees are faithfully met. The U.S. would lose or gain gold only if it chose to do so, if it decided it wanted a greater or lesser stock of gold, and this decision would not constitute inflation or deflation.

BW says of an inflating U.S. under gold: "As the gold stock diminished, the money supply would shrink, economic activity would slow, and eventually inflation would abate. As inflation slowed relative to other countries, gold would flow back in, and the process would reverse itself."

This is a common academic concept of the gold-standard mechanism with no basis in fact, a monetarist view that elevates "money supply." In the supply-side model, there are no gold outflows or inflows at the Treasury except when Treasury officials choose to increase or decrease gold stocks. All adjustments are effected through the transfer of debt, i.e., promises to pay a specified weight of gold in the future, with interest, if an individual demands gold with his promissory note. (The government exchanges interest-bearing debt for non-interest bearing debt.) In the reverse, if an individual asks for a promissory note in exchange for gold, the government buys back debt (exchanging non-interest bearing debt for interest-bearing debt). In a smoothly running system, the government need not have any gold at all in its inventory. The private market would hold all stocks of gold, enabling citizens to enjoy as much gold as possible as a commodity. If the government needed gold to exchange for dollars, it would issue bonds in exchange for cash and buy the gold. It can't print money as long as people are lined up at the gold window.

7. BW asserts that "The inflationary or deflationary impact of any sharp expansion or contraction of the gold stock was too harsh for governments to accept fully, even during the halcyon days of the gold standard and laissez-faire economics of the 19th and 20th centuries."

This is not true. There was no sharp expansion or contraction of gold stock in this period. The British maintenance of the gold standard kept long-term interest rates low for centuries. Financial panics and skyrocketing short rates occurred from time to time, reflecting fiscal shocks to global commerce — usually trade wars. The gold standard can not prevent economic contractions due to fiscal mismanagement.

8. BW describes the Laffer plan, which provides for "judicious discipline," a provision for currency inconvertibility to avoid "the crisis and bank collapses that emanated from extreme movements of gold," as Laffer puts it. BW reviews Laffer's plan, which provides for "several stages of tightening" as the U.S. is losing gold, and a three-month suspension of convertibility if the Fed must reset the dollar/gold ratio. "In practice, Laffer's plan is little different from what already exists," says Yale's Richard Cooper.

Superficially Cooper is right. But then, the Laffer Plan is of political design, of little interest to other supply-siders because they know it emanated from Laffer's desire to accommodate his critics — which the BW article indicates he has failed to do.

In Laffer's original plan of 1975, the U.S. would first auction off all but 1,000 tons of its gold hoard. This accords with the classical concept that only a small inventory is needed and there need be no movements of gold — or elaborate "stages" of "tightening." Laffer added complexity to the second plan in the belief that it would add credibility and make gold seem less threatening. The gold standard, though, will be embodied in a plan that eliminates rather than accommodates the bogeyman.

9. BW reports the charge of anti-gold critics that speculators have the ability to manipulate the gold stock and with it monetary policy — "including those overseas with access to the $800 billion Eurodollar market."

If in theory you do not need a gold inventory to run a gold standard, as supply-siders believe, it does not matter if there are $1 trillion of dollar "obligations" in the world or $10 trillion. If the U.S. maintains the value of one dollar, it maintains the value of all dollars. Speculators can not manipulate the gold stock under any circumstances because the U.S. government has a monopoly over the issuance of debt instruments. It thus has unlimited power to exchange interest-bearing debt for non-interest bearing debt, thus maintaining its gold stock within a milligram, no matter what "speculators" choose to do.

10. BW quotes Prof. William Fellner of the American Enterprise Institute, who argues that "world production of gold is inadequate to sustain strong rates of economic growth."

Fellner is in the demand model, incorrectly believing that quantity is important, not price. In the supply model, it is not especially important that any gold be discovered in the future. In the limiting case, with no new supplies added henceforth, all that would occur is a gradual change in relative prices. If the dollar/gold rates were fixed at $500 and no more gold discovered for 1,000 years, at the end of that period the dollar/gold ratio would still be $500, and a Rolls-Royce would sell for 15 cents. That is, the world would accommodate itself to a 2% annual deflation by drawing wage and price contracts along a gently sloping deflationary path.

Fellner says: "For a gold standard to work well, gold must be a good proxy for goods in general. This condition is not met if, when the real price of gold is rising, output is falling." Fellner's logic is impenetrable. Gold is the best proxy for goods in general. It is acceptable anywhere on earth in exchange for real goods and also financial assets of any national denomination. If gold were suddenly scarcer, why is Fellner's condition not met? We could more easily conceive of a problem if, suddenly, someone discovered a solid mountain of gold in the Amazon. In that unlikely case, the government would of course suspend convertibility and refix after the market judged the new dollar/gold ratio against the supply and demand for all other goods.

11. BW says "the trickiest matter to be resolved is the price at which dollars could be exchanged for gold." BW says Laffer and Lehrman predict the price would fall if the market were left to determine the fixed price. But, says BW, speculators say Russia and South Africa would buy gold to drive the price higher, and "futures traders" would also "drive the price higher" because a gold standard would lower interest rates, lowering the financial costs of holding gold. "For this reason, many analysts predict that the price of gold during a price-market setting would rise to between $1,000 and $ 1,500 per oz."

BW must be excused for this dubious analysis, which relies on "speculators" and "traders" like Charles Stahl, who know much about gold but nothing about money and banking. If, for example, interest rates will fall, the price of bonds will rise. Individuals holding gold would have to bet that the price of gold would rise faster than the price of bonds in order for gold to be withheld from the market. That is, if the dollar (and doIlar-denominated assets) will be as good as gold, which is non-interest bearing, holders of gold will have to forego interest in the hopes that they can make a capital gain exceeding the capital gain enjoyed by the buyers of bonds. The Laffer-Lehrman forecast rests on a belief that a return to a gold standard will enhance the value of financial assets relative to physical assets. In any case, if Stahl's nonsensical scenario were possible, and the Soviets bought gold during the free-market period in order to drive the price to $1,500 per oz., the President need only announce that the free-market price-setting no longer applied and that he would set the price at $500. The Soviets would suffer a horrendous capital loss. There is no chance anyway that the price would be entirely set by "free-market" forces, given the fact that the system must be designed to last for at least 30 years. The spot-price at any moment is not necessarily the best price to hold for decades. A $ 1,500 price would bring such enormous inflation in its wake that the system would not be credible at the very beginning. The free-market would grope its way to a "ballpark price" during the Stabilization Period, but individuals would have to reserve their judgment before setting a final dollar/gold ratio. This knowledge itself would eliminate the temptation of "speculators" to commit monkeyshines.

12. BW says "in overseas markets" the "quick psychological boost for the dollar would be worth 20% to 30% in value against all European currencies and the yen." It is interesting that BW has U.S. interest rates falling and the dollar rapidly appreciating against western currencies. It begins to suspect the power of a gold standard. Still the scenario is most unlikely because it is so easily apparent. A U.S. convertible currency would be so attractive to international transactors that all the European nations and Japan would be forced to join in with fixed exchange rates or lose massive business to U.S. banks. No industrial nation could remain on a "paper standard" with a floating numeraire if the United States went to gold. A German banking professor is quoted as saying "Governments might criticize it — Europe would be very much against it— but it would greatly increase the reputation of the U.S." Indeed, Europe would not be against it at all. Europe was opposed to the closing of the gold window in 1971 and the floating of the dollar in 1973. The worldwide collapse of interest rates that would follow a return to gold would bring global rejoicing.

13. BW goes on to say that if Europe were now fighting inflation as the U.S. is, instead of fighting unemployment, the "strong underlying predisposition in Europe toward gold" might have seen it welcome a gold standard. But now, it would " bring deflation at a time of record unemployment," a "squeeze." Again, BW is back in the demand model and quantity theory. BW has U.S. interest rates falling with a dollar/gold link, but somehow a gold-link with European currencies brings "deflation" and "unemployment." In the supply model, interest rates fall in Europe too, with beneficial effects on employment.

14. BW says what Europeans fear most about gold is a massive wave of deflation. There is, of course, nothing to fear if the dollar-gold ratio is safely fixed high enough to avoid depressing the nominal wage rate. Including Europeans in the deliberations is all it would take to bring them aboard — all they want, really.

15. BW says a return to gold would mean "taking apart the massive state capitalist systems built up over the past 30 years." Gold somehow means Europe must "dismantle the welfare state."

There is absolutely no logic in these assertions. There is the implication that the welfare state can only exist in an inflationary environment. But supply-side classical economics is not inconsistent with individualist, socialist or communist political systems. Adam Smith and Karl Marx were both classical economists. Fiscal policies, though, must be consistent with the gold standard.

16. BW says "a U.S. return to gold would mean the dollar equivalent of yet another 'oil shock' because the dollar-denominated oil price would soar." Interest rates would rise and spending would have to be cut to "stamp out the price increases." BW goes on to quote a German economist who says gold "would be extremely deflationary and very dangerous for the world economy." Prices would go up and down at the same time.

The supply-side analysis sees no rising oil prices in Europe; BW's analysis is very weak. A decline in U.S. interest rates mirrors a rise in the price of financial assets. Oil producing nations will be encouraged to trade more oil in the ground for dollar-assets and the relative price of oil will decline. Of course if Europe links to the dollar/gold ratio, it is impossible for interest rates to fall in the U.S. and rise in Europe. Fixed rates means all trading partners agree on the same unit of account, the same numeraire (it simply has a different name in each country — dollar, D-mark, yen, etc.).

17. BW says the LDCs could be "devastated" by shrinking trade and higher oil bills. This is simply assertion. The BW analyst who has written this section of the article never tells us why oil prices go up or why trade shrinks. Indeed, the LDCs benefit most of all, proportionately, because they will be able to refinance their enormous debt at a fraction of the interest rates they now must pay in London and New York. And there is no reason why the LDCs should not join the system and adopt the common international unit of account. Many of them fixed to the dollar for decades, until the dollar ceased to serve as an anchor for world commerce.

18. Finally, says BW, there is great doubt in Europe that the U.S. has the power unilaterally to reimpose a gold standard on the rest of the world.

Apparently the same BW editor makes another assertion. If the U.S. went it alone, and the dollar became the only international currency as good as gold, all international banking would be done in dollars. Europe and Japan would have to follow and they would be happy to do so.

Business Week:  Investing Under the Gold Standard

BW has it correct that bonds would be the surest investment bet, at least during the period when the interest-rate schedules were producing capital gains. BW doesn't say so, but of course the best investments will be the Treasury long bonds, because they are uncallable, and thus will produce the biggest capital gains.

BW says inflation hedges such as real estate and collectibles will fail, and that the price of gold coins will depend on the official price of gold to determine winners or losers. Actually, coins, raw real estate and collectibles are all in this boat. All will tend to fall in price, or at least fail to appreciate relative to financial assets.

Stocks face an uncertain future, says BW, but only because BW hasn't thought about the implications of tumbling interest rates on the nation's capital stock. An interest rate is a cost of doing business. The first benefits will be to shares of industries that use lots of credit as raw material in their products: banks, insurance companies, utilities, oil and gas pipelines, autos, homebuilding and the industries that serve these. After these industries have adjusted to the gold standard with a one-time writeup of capital stock, they will be overtaken by the high-tech industries, which use less credit as raw material and more human capital, which can respond to the tax cuts. That is to say, you can only go on the gold standard once, but you can keep cutting tax rates a few more times.

BW worries that "an ever greater (bond) rally would catch fire — at a terrible price to the economy — if a gold-enforced cap on the money supply were strictly enforced." The reason no such thing would happen is that gold does not cap the "money supply" at all, and imposes no limit on sound credit. BW seems to have in mind the rock-bottom nominal interest rates of 1930 when, after Smoot-Hawley's fiscal shock to the world economy, gold flowed into the U.S. and the Fed did nothing to offset the inflow via open-market purchases of bonds, as it should have.

David Jones of Aubrey Langston & Co. is quoted by BW, describing a horror gold scenario in which gold puts a lock on the money supply, interest rates are driven to stratospheric levels, leading to "collapses, financial panic, and business failures." He says "The gold standard would lead us straight to a depression." Jones, a static analyst, derives this scenario by holding the supply of credit constant. But the aim of fixing a dollar/gold ratio is to restore credibility to the dollar and boom the credit supply, as well as the real value of the "money supply."

BW correctly says that tangible goods would be "losers" in a deflationary scenario, in that nominal prices would fall. But they are mistaken in suggesting that in a deflation (if that were the result of a much-too-low dollar/gold ratio) it would be a bad prospect for stocks (because corporate earnings would fall). Even in a mild deflation, under a gold standard the savings in financial costs alone would increase the profits over time and price-earnings ratios would expand. In the 1920s, a mildly deflationary period under a gold standard, with falling marginal tax rates, stocks did not do poorly, to say the least.

BW does go on to say that "deflation also means that money later is worth more than money now, a situation that could generate huge new stores of savings/* Yes, but this also is a static model. The reliable golden numeraire would stimulate production, stock prices would be boosted, as BW suggests in this scenario, not because people have more money to buy stocks with (they could as easily buy gold coins, collectibles, real estate), but because the future real income stream from the productive sector would be seen as expanding.

BW says Americans could also be counted on to sell at least a portion of their massive private hoard of gold to the government, generating even more investable funds. Again, static analysis. The government doesn't want to add gold and as it showed up at the window, the Fed would print money to keep it from coming in (that is, exchanging non-interest bearing debt for interest-bearing debt). This is not inflationary because supply is meeting the added demand at a fixed price. The interest rate, a cost of doing business, declines. Government debt service declines, of course, as the citizenry is willing to hold more non-interest bearing debt (cash).

Who will profit? BW says one heavy buyer of gold mining stock would sell all his gold and gold mining shares on the day of fixing, and so would everyone else. Of course, if everyone sells, who buys? The government? No, as above, it issues more cash and reels in bonds, and the public continues to hold gold, but now enjoying it more as a commodity than as a hedge. BW, in the very next paragraph, says users of gold would suffer because they would be restricted in buying gold (when everyone is selling?). "At best, they would be forced to buy at higher prices/' BW is wrong. In a gold standard, gold's is the only price that can not change.

BW is correct that when the government fixes the dollar/gold ratio the biggest "loser" would probably be the gold futures market. But this would only represent a fraction of the productivity gains to the U.S. economy, as the insurance costs of hedging against the floating numeraire are eliminated (the human resources become available as economic outputs instead of inputs).

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