A Gold Standard Q & A Jude Wanniski April 5, 1984

Executive Summary: A gold standard may not be just around the corner, but a renewed debate about the merits of a gold standard is upon us, spurred by the question: Is the economy overheating? Should the Federal Reserve cool things off by raising interest rates? What evidence is there of "overheating," a concept that implies economic growth is inflationary? Nominal GNP is up sharply. Real GNP is zipping along. Money supply is near the top of its "permissible range." Employment is climbing. Leading indicators are up. Commodity price indices are up. Textile prices are up. Scrap metal prices are up. Et cetera. If you are not among those who wish to shut off the expansion, about the only sign that the economy is not about to burst into inflationary flames is the price of gold. Growth supporters who have resisted gold's allure are finding themselves attracted. In an important editorial March 26, "Snatching the Punch Bowl," The Wall Street Journal urged the Fed not to be spooked by rapid growth or monetary aggregates into tightening, but to observe that prices of "precious metals" are stable or declining. The Journal also recommended an "institutionalizing" of monetary policy in this vein. It's a bit obscure, but make no mistake: The Journal is embracing a formal gold standard, a process that will enhance the idea's respectability among businessmen and politicians. Gold blocs are being formed on Capitol Hill. A gold plank will be offered at the COP convention in Dallas this August. Legislation is being drawn up. It seems a good time for a Q & A on gold.

A Gold Standard Q & A

Q.    What is a gold standard?

A. A gold standard is a monetary policy, one that defines the national unit of account (the dollar, the pound, the franc) as a specified weight of gold. To make this definition valid, the government must be willing to redeem its own dollar debt in gold of that specified weight if its creditors desire the metal instead of the paper. The government need possess no gold as long as it keeps its paper currency as desirable as gold.

Q.    Why is this monetary policy better than others?

A. Because the most important function monetary policy can serve is to provide a unit of account that is constant in terms of real goods, neither inflating nor deflating, and gold is the best proxy for the universe of goods.

Q. Why is a unit of account constant in terms of real goods the most important function of monetary policy? And why is gold the best proxy for all other goods?

A. Most important decisions in the every day life of a citizen are affected by the value of the monetary unit, the dollar. Production, consumption, lending and borrowing of goods is achieved in terms of the monetary unit. If the value of the unit changes, the plans and contracts of the citizenry are skewed: Unexpected inflation benefits management at the expense of labor, debtors at the expense of creditors, while deflation cuts the opposite way. Gold is the best proxy for real goods because it is the most monetary of all commodities, having the fewest non-monetary uses.

Q.    Why is this so important?

A. The monetary unit can't be a commodity whose value changes in terms of all other goods just because of the business cycle or the weather. On a soybean standard, a bumper crop would force everyone to inflate, blight would force general deflation. Almost all gold is held as an investment, half by central banks, half by individuals in the form of coins, jewelry, etc. As a result, its relative price isn't effected by business cycles or the weather.

Q.    What, if anything, does effect its relative price?

A. By far the greatest factor is the market's expectation of government monetary policy. The price of gold is the first to rise during an expected inflation and is the first to fall when there is an incipient deflation. All inflations and deflations have been preceded by a rise or fall in the price of gold. Between 1971 and 1973, for example, the price of gold quadrupled to $140 an ounce after the United States left the gold standard. This price change preceded OPEC's quadrupling of the world oil price. It was U.S. monetary policy, not the cartel, that drove up the nominal price of oil and all other commodities.

Q. Isn't there any other commodity that would serve just as well as a leading indicator of inflations and deflations? What about a group of commodities serving as an index?

A. No. Gold is ideal because it provides a monetary unit that embodies future prices as well as current prices. It's the only commodity whose spot price is the same as its future price. That is, the gold price in the futures market is the spot price plus the going interest rate over that time span. The spot and future prices of all other commodities diverge and converge because of the influence of business cycles and the environment. A basket of commodities would simply add together the cyclical errors of the group, sometimes pluses with minuses, but also pluses with pluses and minuses with minuses. Even silver and platinum have too many industrial uses to serve as components of a reliable monetary unit.

Q.    Would a group of metals work better than the existing monetary policy?

A. Yes, if only because the financial markets would be assured by the government that future inflations and deflations would be limited to the aggregate relative price changes in the basket. As it is, with the government permitting the Fed total discretion in monetary policy, the markets must discount the possibility of future inflations and deflations of much greater severity. This is the chief reason why interest rates are so high.

Q.    Why would a gold standard lower interest rates?

A. At present, the government asks its creditors to take all the monetary risks. Because the monetary unit is not defined in terms of anything real, gold or soybeans, the government can sell a 30-year bond without committing itself to redeem the bonds in 30 years with dollars that have any real value. By pledging to redeem all debt in dollars as good as gold, the government increases the value of its notes and bonds. If the commitment to a gold standard were credible, demand for long-term government and private debt would soar, sinking interest rates.

Q.    How low would interest rates go?

A. That depends on the credibility of the gold standard. If the government were to reopen the gold window that it closed on August 15, 1971 at a price too high or too low, the markets would sense that the policy might not be politically sustainable. At or near the optimum price, a resumption of gold convertibility would probably bring long-term rates to 7 percent, and as the markets had a chance to observe the monetary authorities manage the policy effectively, interest rates could fall within a short time, a few years, to 5 percent or less. It would take several years, perhaps decades, before the government could sell bonds at 3 percent. During World War II, the government financed an enormous amount of debt at 2 percent, but the credit markets had a century and a half experience with the U.S. government's monetary integrity, a standard interrupted only during the Civil War.

Q.    What is the "optimum" price of gold?

A. The optimum price is the price that exactly balances the interests of dollar debtors and dollar creditors. This makes the price politically optimal, the greatest good for the greatest number.

Q.    How do you determine such a price?

A. Conceptually, $35 an ounce is obviously too low. A small number of creditors would in theory benefit enormously at the expense of numerous debtors who would be destroyed, which means it's not even clear the creditors would beneift. A price of $850 is clearly too high. Only a handful of contracts were drawn at that price in February 1980, so only that handful of dollar debtors would benefit greatly at the expense of all dollar creditors. The optimum price is obviously somewhere in between.

Q.    In between would be $408? Is that optimum?

A. Perhaps, but there's no way of knowing exactly. If you think of the dollar volume of contracts made around the world in the last several years, it seems most were drawn when gold was over $400 and below $450. So $425 or thereabouts seems right.

Q.    What if you choose the wrong price?

A. It would have to be well off the mark, up or down, to offset the great gains the system as a whole would enjoy by having a reliable credit structure restored. The lower the price from the optimum, the more you are asking debtors to take portfolio losses so that creditors would lose less, and vice versa. At some point the specific losses would exceed the general gains to debtors or creditors and a gold standard at that point makes no economic or political sense. Anywhere between $350 and $500 looks safe. At the moment, $425 seems close to optimal.

Q.    Some supply-siders insist $250 gold is right, don't they?

A. Art Laffer has argued that if the government were to announce gold convertibility at some point in the future, six months or a year, the price of gold would fall to about $250 as demand for gold as a hedge asset would decline. Laffer believes that at $400 there would have to be considerable increases in the Consumer Price Index before equilibrium in the general price level were restored. He may be right; certainly the CPI wouldn't rise at all following a deflation to $250 gold (oil would fall to about $15 a barrel). But the debtor losses around the world, especially in the Third World, would be severe. The Laffer scenario seems highly unlikely.

Q.    Would the CPI continue to rise if gold were fixed at $425?

A. Almost certainly. Gold is the leading indicator of movements in the general price level. The CPI is the most lagging indicator. When gold doubled in price to $650 from 1979 to 1980 it pointed to the eventual doubling of most prices, on average. But it takes several years for most prices to double following gold's lead. Labor contracts have to wind down, for example. When monetary policy caused the price of gold to plunge from $650 to $425 in three years, other sensitive prices that had almost doubled with gold then had to fall, while lagging prices are still making the climb from the $325 level. At $425 gold, the CPI might have to climb for a few years at 3-to-6 percent annual rates before the general price level returns to equilibrium.

Q.    How do you fix gold at $425?

A. The Treasury Department announces that it will buy gold from anyone at, say, $420, and sell gold to anyone at, say, $430. The dollar is convertible at these "gold points." The Federal Reserve is obliged to observe these gold points as a guide to its conduct of monetary policy. Simply put: It would ease when the gold price in the private market fell close to $420 and it would tighten, selling bonds on the open market, when the price rose to near $430.

Q.    Do you need a lot of gold to operate the gold standard?

A. Not when it's managed as described above. The central bank is merely using the information the market embodies in the gold price as a guide to its behavior. The price of gold is actually made in the private market, between the points. As long as the Fed is doing its job, nobody ever comes to the Treasury to sell gold at $420 because the private market is offering at least $421. Nobody ever comes to the Treasury to buy gold at $430, because the private market will offer it at less than $430. This is the way Great Britain managed the gold standard for centuries, the Bank of England raising or lowering its "Bank Rate" to discourage gold inflows or outflows.

Q. Wouldn't the Soviet Union or South Africa be able to disrupt this by withholding gold or dumping gold on the markets?

A. No. There are about 85,000 metric tons of gold in public and private hands around the world. The Soviets have about 2,000 tons of gold bullion. If they suddenly "dumped" it, the dollar price might fall to near $420, or Treasury might decide to temporarily take in some of it at $420. But this is really a small number. It would riot take more than a few days before the 2,000 tons were redistributed around the world in public and private hands; there would still be only 85,000 tons in all, except the Soviets now would have no gold reserves.

Q. What if the Soviets and South Africans stopped selling gold? Wouldn't that damage the world economy under a gold standard?

A. It's hard to imagine why this "worst case scenario" would come about, but if it did, all that would happen is that world prices would temporarily deflate by a trivial amount. New gold from all sources adds less than 2 percent annually to total stocks. If the Soviets and South Africans continued mining gold, but adding to reserves instead of selling it, there would be almost no effect on prices.

Q.    Why do critics of a gold standard so often cite this as a major problem?

A. Some critics talk as if a gold standard would limit economic growth to the amount of new gold coming into the world economy each year. This is a basic misunderstanding by those economists who think the economy needs a certain quantity of money. The world needs only a reliable monetary unit. If no gold were discovered and mined henceforth, the financial and labor markets would have to adjust to a 2 percent annual deflation, that's all. Gold's value as a monetary unit is that the total stock of the commodity is known and stable, which means debtors and creditors know they can't be surprised by sudden additions or subtractions from that stock.

Q.    Why don't private transactors simply draw contracts in terms of gold?

A. Because in a world of floating currencies, the dollar value of gold is determined by the Fed and can swing wildly as a result. The dollar, not gold, is the monetary unit for most of world commerce. It does no good for a small number of transactors to draw contracts in gold when almost all goods and taxes are payable in dollars.

Q.    Doesn't the dollar price of gold swing because of war scares and such?

A. No. This is largely a myth fostered by the financial press. In a floating regime, the gold price is always either rising or falling. In a crisis environment, the press will either report "Gold Rises in Crisis" or "Dollar Strengthens in Crisis." But there is no correlation, unless the specific crisis suggests an inflationary policy. Under past gold standards, crisis would push up the gold price and bring a run on gold because markets would fear the central bank would suspend the gold standard and devalue the currency in order to finance an impending war with greenbacks. During World War II the United States demonstrated that it is more efficient to finance a war with gold dollars than with greenbacks; gold convertibility was maintained and the huge deficits financed at 2 percent.

Q.    Could the U.S. go on a gold standard by itself?

A. Yes, but it is the only country that could, because the dollar is the invoice currency for 70 percent of world commerce, and gold or dollars are by far the dominant world reserves. Switzerland tried to maintain the gold/franc ratio in 1977, but the world demand for Swiss francs was so great that the currency appreciated dramatically. Swiss banking boomed, but its industrial sector was pinched in world markets dominated by the dollar. The United States is the only nation that would not have this problem.

Q.    Would the rest of the world remain off the gold standard?

A. Most in the western world would quickly fix their exchange rates to the fixed dollar/gold ratio, to share in the advantages of lower interest rates and prevent a loss in banking business to the U.S. They would no longer have to fear fixing their currencies to the dollar, which without gold would subject their economies to the inflationary and deflationary policies of the Fed, induced by the vagaries of the U.S. domestic scene, economic and political.

Q. Why didn't the gold standard work when we were last on it? Why should it work any better now?

A. It broke down because the Federal Reserve gradually forgot that it was created to manage the gold standard. In the late 1960s and most emphatically in early 1971, the Fed directed monetary policy at the economy itself rather than at maintenance of the monetary unit. The demand-side economists sold the idea that some inflation would induce greater economic growth, that dollar devaluation would enhance U.S. competitiveness. Ending convertibility brought no such benefits, only worldwide monetary instability. A restored system would work because it would be understood in terms of the failed experiment with a managed, inconvertible currency.

Q.    Was the system we left in 1971 a gold standard? Wasn't it called a dollar-exchange standard?

A. Yes, it was a gold standard and it was called a dollar-exchange standard. Economists give different labels to gold standards in different periods of history. But as long as the monetary unit is defined as a weight of gold and the monetary authority will exchange one for the other at that ratio, it's a gold standard.

Q.    What will the emerging system be called?

A. Something other than a gold standard, something on the order of a "gold-based international monetary system" or a "gold-based SDR system," referring to the International Monetary Fund's unit of account, the Special Drawing Right.

Q.    Does it matter what it's called?

A. Only because the words "gold standard" are meant to suggest an erroneous idea that debts must be settled with gold bullion or coin — an "honest-to-God gold standard," according to Milton Friedman, who supports this vision of harsh discipline as a means of discouraging talk of any kind of gold convertibility. The system can not be viewed in this fashion or people will be led to believe Brazil, for example, would be required to pay its $80 billion debt with gold.

Q. Why are we any closer to this gold-based reform than we were a year or two ago? What's changed?

A. Paul Volcker and the Fed have run out of room and options. Debt service costs are exploding, for domestic debt and Third World debt, as maturities shorten at high interest rates. The Fed can not lower interest rates forcibly by "printing money." It can only invite lower interest rates by increasing demands for dollar assets, doing so by reducing the risks of dollar inflation or deflation. There's no place left for the Fed to turn except to give such assurances to the financial markets via a "precious metals" price rule that becomes "institutionalized," as The Wall Street Journal editorial put it.

Q.    Would it be difficult to get this done? Legislatively?

A. All it takes is a telephone call from the President to the Treasury Secretary asking him to stabilize the dollar value of international gold reserves. Secretary Regan would have to ask Chairman Volcker's cooperation in that endeavor, which means Fed policy would have to be guided by the established gold points. We'd be on a de facto gold standard. Institutionalizing policy would take longer, involving international discussions and a new Bretton Woods conference to get the details ironed out. But most of the work could be done with a few telephone calls.

Q.    What are chances this will happen soon?

A. Not good at all. As long as a monetarist, Beryl Sprinkel, remains Treasury Secretary for monetary affairs, there's little chance monetary reform would come this easily. But there is growing support for the idea at the White House and among congressional Republicans, because there are no other apparent options. If Rep. Jack Kemp and Lewis Lehrman can succeed in making monetary reform a Republican issue in the presidential campaign, it could come in a second Reagan Administration.

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