Supply-Side University-991210 A Private Lesson for Pat Buchanan

A Private Lesson for Pat Buchanan
Jude Wanniski
December 10, 1999

Memo To: SSU Students
From: Jude Wanniski
Re: A Private Lesson for Pat Buchanan

I've made it clear, I think, that I have been helping Pat Buchanan get together his campaign for the Reform Party presidential nomination. We don't see eye to eye on several important issues, but over time perhaps we will reconcile those differences. We've been friendly for 30 years, since we met in the early days of the Richard Nixon Administration, he as a speechwriter, I as a political columnist for the National Observer. My contacts with him back then involved issues of foreign policy and national security, as I did not get rolling on economics until I joined the WSJournal editorial page in 1972. As a result, we really never had serious discussions about the origins of the economic problems that contributed heavily to Nixon's failed presidency. Although he is attracted to the idea of a dollar fixed to gold, Buchanan recalls how Nixon was forced to suspend the linkage. He raised these questions with me in a series of e-mails recently, and I thought it would be useful to present the ground I covered as a lesson here at SSU. It is particularly appropriate today, Friday the 10th of December, the day the prime mover of supply-side economics, Robert Mundell, delivers his Nobel lecture in Stockholm. Buchanan did not have a Mundell to guide him, so I'm trying to fill the role.

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The exchange began with Pat remembering that on August 15, 1971, Nixon assembled his advisors at Camp David, knowing that in the preceding months, Great Britain had accumulated billions of dollars under the Bretton Woods monetary agreement and was asking our Treasury to either give them gold for the dollars, or give explicit assurance that the U.S. would not devalue the dollar against gold. Because Nixon did not want to deliver that much gold out of our dwindling hoard at Fort Knox, and because he could not give assurances we would not devalue, the decision was made that Sunday in August to close the gold window at Treasury and devalue the dollar. It has been Buchanan's thinking -- and almost everyone else's -- that Nixon had no choice.

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For you to see that Nixon did have a choice, I begin with a brief discussion of money as I learned it from Mundell. The first thing you must hard-wire into your analytical framework is that we use federal debt as our money. The debt is divided into that large portion which pays interest -- bills and bonds -- and that smaller portion which pays NO interest -- cash and bank reserves. It is the central function of the Federal Reserve to decide how much of the debt should pay interest and how much should be interest free. The term "tightening" is generally taken to mean raising the federal funds rate and "loosening" taken to mean lowering that rate. This is an error on the part of the Fed, as raising or lowering interest rates does not bear directly on the amount of liquidity in the system. Tightening really involves a reduction in the amount of non-interest-bearing debt in the bank system, which occurs when the Fed sells bonds in the open market in exchange for cash, which reduces the amount of debt that pays no interest. The term "loosening" means the Fed will add to the amount of "liquidity" (non-interest bearing debt) in the banking system. In a "gold standard," the government guarantees its creditors that a dollar will be worth some weight of gold. IN ORDER TO KEEP GOLD AND DOLLARS EQUAL -- A DOLLAR AS GOOD AS GOLD -- THE FED CANNOT PERMIT THE AMOUNT OF LIQUIDITY IN THE BANKING SYSTEM TO EXCEED THE AMOUNT BEING DEMANDED BY THE MARKETPLACE. That, is when the market does not need any more "money," (debt which pays no interest), it will reject attempts to force it into the market. The surplus goes out of PAPER into commodities, with gold being the first commodity to react, because it is the most monetary of all commodities. When the price of gold rises, it is a sign that the monetary authority has erred on the side of excess. When gold falls, it is a sign the monetary authority has erred by being too stingy in supplying "money."

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Buchanan had written in his Great Betrayal that the Europeans knew by then, as they piled up those little green pieces of paper, that there was no way the U.S. could back them all up with gold. He more or less believed we were running a scam, pumping out money we could not redeem. As he saw it, when the Brits chose to cash in $3 billion, we could have let them clean out Fort Knox, or cut the dollar loose and let it float to its "natural level."

As I explained: The Fed was trying to force more "money" into the banking system than was being demanded. It was doing this because Nixon's economic advisors believed "easier money" would be loaned out by the banks in order to compensate for the loss of interest on the bonds they were forced to sell to the Fed. Because Americans could not take surplus "money" and demand gold with it, but Europeans could acquire dollars and through their central banks demand gold from us, that is the route that was followed. Why were Nixon's advisors pushing him in that direction? Because the answer is key to Pat's understanding, I decided to take him back to the earliest days of the administration. Because he was at the center of things, he should be able to recall all the arguments, but I said I had to rearrange them before returning to the SOLUTION to the problem he asked about above. (I did hint that he should be able to see that the SOLUTION would involve the selling of bonds from the Fed's giant portfolio in order to drain excess little pieces of green paper out of the system.)

It was the prevailing conventional view at the time, accepted by all the major media and practically all economists, that "fiscal irresponsibility" was at the heart of the problem. It remains so, and it still remains Pat's view. This view held that America's (LBJ's and Nixon's) guns and butter programs for Vietnam and the Great Society -- yielding deficit after deficit, plus the pumping out of money by Fed Chairman Arthur Burns -- convinced the world our pledge to redeem dollars for gold could not be kept. When the Brits rushed to be first to get the far more valuable gold, Nixon slammed the window shut before they cleaned us out.

I thought so too, at the time, but later learned that "guns and butter" was not the problem. It was Mundell who pointed out that we financed WWII's staggering deficits at 2% interest rates by remaining on a gold standard. The U.S. economy began to sour in 1967 because of the LBJ war surtax, which was a progression on top of a progression. The Dow Jones hit 1000 in midday trading in January 1966 and then began its long decline in real terms -- taking the real wages of workers down with it as one error after another was made. Nixon campaigned on ending the war and the surtax. When elected, he was persuaded by Chairman Paul McCracken of his Council of Economic Advisors and Herb Stein, a member of the CEA, to defer elimination of the surtax in order to narrow the budget deficit. He was also encouraged to raise the capital gains tax, with Stein the culprit along with Peter Flanigan, who ran Nixon's council on international economic policy. The stock market fell and the economy followed. (I seem to recall the number of IPOs dropped from 300 in 1968 to one or two in 1969.)

When Nixon asked why the economy had headed south, Herb Stein and Treasury Secretary John Connally of course did not tell him that they had made a mistake when they urged that the surtax remain and the capgains tax doubled. They said the Fed was being too tight. It did seem that way, of course, as the Fed was having to sell bonds to drain surplus reserves, in accordance with the gold standard. Otherwise, foreign central banks would demand gold under the Bretton Woods terms.

By a bizarre twist of fate, it was Art Laffer who provided the rope with which Nixon hung himself. Laffer, chief economist at the Office of Management and Budget under George Shultz, had presented a paper showing that GNP was closely related to the money supply. Laffer always insisted, correctly, that his paper was misunderstood. He never meant it as anything more than a showing of the correlation between money and GNP. But Shultz pushed the idea of increasing the money supply to a level that would equate with $1.064 trillion. The banking system did not want money supply, though, because the higher Nixon tax rates had reduced the demand for liquidity. There were no eligible borrowers. No matter. The decision was made to whip Fed Chairman Arthur Burns into action. All through the spring of 1971, Burns ordered the open-market desk to buy bonds from the banks, injecting dollars into the banking system. The banks would supposedly lend out the dollars and the economy would expand. Instead, the process tore apart the international monetary system. It took me until 1974 to figure this out, with the help of Mundell and Laffer. Instead, here is what happened:

Burns would have the open-market desk in New York buy $100 million in bonds on a Tuesday morning. Our banks would then wire the $100 million in surplus reserves (non-interest bearing federal debt) to Europe, where it would be traded for Deutschemark or sterling of an equal amount. The holders of the DM and sterling would use it to buy European assets. The dollars would wind up at the Bundesbank and Bank of England and under the terms of Bretton Woods, they would call Treasury and announce a demand for gold. Treasury, though, had already talked our allies out of demanding gold when France's DeGaulle precipitated a crisis by insisting upon gold in 1967. Instead, we sold them SPECIAL BONDS paying interest. The process was made circular. On Tuesday morning we were buying bonds with green pieces of paper. On Tuesday afternoon we were buying back that green paper with a the same amount of bonds we had bought in the morning.

Why this screwy process? It was because of the 1934 act that prohibited Americans from owning gold bullion -- on the notion that the Depression was caused by the gold standard. It was not until 1977 that I discovered the Wall Street Crash was triggered by the Smoot Hawley tariffs, with the economic decline accelerated by the Hoover/FDR tax increases and foreign devaluations and tariffs. I emphasized with Buchanan that if Americans could own gold, Arthur Burns's attempts to force unwanted liquidity on the banks immediately would have resulted in their customers demanding Treasury gold. This is what Alexander Hamilton predicted would happen when he explained his plan for a gold standard to Congress in 1791.

The best line of August 1971 was from Herb Stein, who said "We created a boom and then exported it," by which he meant the increase in the money supply was causing assets to be purchased in Europe instead of the U.S. He didn't get it. The United States was buying an income stream from Europe with its surplus dollars and the Europeans were using those dollars to buy an income stream of the same amount from the U.S. The failure to understand this loop was at the center of the decision to close the gold window -- which would supposedly force the money-supply boom to remain at home. Surplus reserves would not be wired to Europe because the loop had been cut. As a result, the "Eurodollar" market evaporated.

The breaking of the dollar/gold link on August 15, 1971, was to have been "temporary." At first, there would be a 13% devaluation of the dollar relative to gold. The mercantilists led by C. Fred Bergsten, who had been Henry Kissinger's chief economist at the National Security Council and in my view a Democratic viper in the Nixon nest, fed the idea to organized labor and John Connally. Our goods would be 13% cheaper and Japan's goods would be 13% more expensive, so the trade deficit would decline and 500,000 jobs would be created. When this did not work, Bergsten and his mentor at Yale, James Tobin, came up with the "J Curve," which argued that yes, things would get worse before they got better. In 1977, Laffer did a study of 151 devaluations and found trade deficits getting worse 76 times and better 75 times. There was ZERO CORRELATION, in other words. This is what classical economics teaches, one of my first lessons from Laffer and Mundell: You cannot change the terms of trade by changing the value of the unit of account.

Meanwhile gold did not stay at $42, where is was supposed to stay, but continued to climb as the Fed bought bonds with dollars, "monetizing" or "liquefying" debt. (Actually the Fed cannot create "dollars," but can only create bank reserves, which become dollars when they are successfully collateralized, i.e., loaned.) Gold went to $70 by the end of 1971 and $140 by 1973 -- four times $35. It was Mundell in January 1971 who explained that "We would soon see a dramatic rise in the price of oil and thence all other commodities." (The only reason corn and wheat did not follow gold as fast as consumer goods was because of the hybrid seeds, which came upon the scene in 1966, doubling and tripling output per acre in the decade that followed.)

In early 1973, it was all too obvious that the gold window could not be opened at $42 an ounce, so with Shultz now at Treasury, guided by Milton Friedman and Citicorp's Walter Wriston, the decision was made to float the dollar. For the first time in the history of the world, Mundell noted, there was no money defined in terms of gold or silver. When Bretton Woods blew up, everything floated. All kinds of terrible things happened as a result; although you now can only imagine what would have happened if Reagan had not come along, cut income tax rates and indexed them, cut capital gains tax without indexing, and appointed Alan Greenspan, Wayne Angell and Manley Johnson to the Fed. (If you read William Greider's book, Secrets of the Temple, you will find that I was advising Paul Volcker in 1982 on how the world was being led to total bankruptcy by his deflation -- which ended when he was forced to monetize $3 billion in Mexico's peso bonds.)

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Now to Buchanan's original point, that the Nixon team had no choice. Pat of course believed that because every economist on the Nixon team told him so, as he was trying his best to explain all this. Of course, they were all demand-side economists who had no idea how their policies had torn apart the economy. Remember Nixon saying: "We are all Keynesians now." It was Mundell who in 1960 said monetary policy should totally be devoted to keeping inflation under control; which prohibits the Fed from pushing unwanted liquidity into the system. When the economy appears to be sluggish even though monetary policy is doing its job, we know that there is a blockage in the fiscal or regulatory plumbing. Either tax rates somewhere in the system are too high or bureaucratic regulations have clogged the economy or problems in the rest of the world are sapping our economic energies.

In 1971, this would have meant one of two policy solutions to prevent the Brits from demanding our gold (when we would not give them assurance we would not devalue). WE COULD HAVE SOLD BONDS TO MAKE DOLLARS SCARCE, which was counter to the policy of Stein and Burns which was the reason the Brits had all that green paper. OR WE COULD HAVE ELIMINATED THE CAPITAL GAINS TAX, thereby creating a huge demand for all that surplus liquidity, sending the stock market straight up, and guaranteeing Nixon's re-election. But of course, that was counter to the Stein/Flanigan/McCracken policy of 1969. When you are saddled with bad economists and bad Treasury secretaries, you will have a bad administration. Those were the policy fixes Reagan chose, over the objections of Shultz, Stein & Co., who made sure Reagan was talked out of gold again and again. Milton Friedman was powerful then and the influence of his monetarist ideas remain a source of trouble today, with his followers wanting to slow down our economy with higher interest rates.

In our e-mail discussions, Pat indicated his belief that a fixed exchange rate, dollars for gold, is the right way to go. He wondered that the same regime that fixes the price of gold can unfix it; the same Fed that says it will keep gold at so much an ounce can renege on any such pledge. This was an argument that made the rounds in the Reagan years, but I'd countered by saying: A President who is elected on a pledge to finish the job that Reagan started -- making the dollar as good as gold -- will persuade politicians for 50 years to avoid a floating dollar. His concern, though, was that while it would be easy enough to fix the dollar/gold price if he were President, how did he know he would not have to abandon the fix if that became necessary in the sort of crisis that Nixon confronted in 1971. The only answer I could give was that he would have learned from the mistakes of the Nixon team and from the lessons of the Reagan supply-siders. He would not try to use "easy money" to offset a problem created by his fiscal or regulatory policies. Nixon was a sucker for the idea because he had been led to believe John F. Kennedy nosed him out in the 1960 election because the Fed "tightened" in the months before the elections. "Tightening" was necessary all during the 1950s after Eisenhower reneged on his 1952 campaign pledge to cut tax rates. As the economy grew, the entire work force climbed into higher tax brackets, slowing the economy, decreasing the demand for liquidity, and causing a steady dribbling out of gold reserves.

The other question raised by Buchanan is the same one thrown at Reagan in 1980, at Jack Kemp in 1988, and at Steve Forbes today: You can talk about the idea of a fixed dollar/gold rate in small groups, but the issue is too complicated for most folks to grasp on national tv, in debates or through ads. This is a big barrier for a presidential candidate to overcome, because almost every political expert believes the gold idea sounds coo-coo. How can democracy work, though, if both major political parties stay away from an idea that sounds coo-coo, even though it is correct, and then the Reform Party candidate decides to avoid it even though he believes in it? My belief is that, to the contrary, the electorate understands economics at this level. Making the dollar as good as gold is fundamental to the future of the human race.

As long as the dollar floats, the rest of the world is forced to live with it, because we are the biggest market. This translates into constant problems of overproduction and underproduction resulting from perpetual exchange-rate changes. Country A is then forced to dump its goods into country B, then Country B dumps its goods into Country A, as the tide goes in and then goes out. In that kind of chaotic world, we must have a World Trade Organization with supranational juridical powers. Like King Canute, Buchanan will not be able to stop it. On the other hand, with an international gold standard, the global marketplace becomes sovereign. Yes, we lose our ability to manage trade by devaluing the dollar, as Nixon was counseled in 1971, but we don't need that kind of flexibility. The number of trade disputes between nations will once again drop back to a low level, manageable by a GATT, or a WTO that has no greater powers than GATT. In a world of predictable money, which the 21st century could be, the WTO bureaucracy might just sit there with nothing to do, like the repairman on call to fix Maytag products that almost never break down.

In one way or another, all the issues where Buchanan has his sharpest disagreement with George Bush and Al Gore -- MFN for China, foreign policy, immigration, big government, taxes, etc., -- have their partial solutions in a dollar that is kept as good as gold. In early 1995, Greenspan was asked at the Senate Banking Committee if there was anything that might have prevented the peso crisis in Mexico. I remember it well, because I was in the third row when he testified, sitting next to Ross Perot. Greenspan said: "It would not have happened if we were on a gold standard." If we were on a gold standard and Mexico's peso was tied to the dollar, it would have sold peso bonds to mop up the surplus peso liquidity that appeared when word spread through the elite circles that the IMF, the Clinton Treasury and the new Zedillo administration were planning a 10% devaluation. That's what Greenspan meant.... And if it had been in place, two million Mexicans would have stayed in Mexico to enjoy rising real wages. And would have continued to run a trade deficit with us as they imported investment capital from us.

I completely agree that Pat is concerned about the right things that affect ordinary people, who have been flim-flammed again and again by the people they elect. I've been trying to get him to understand the monetary issue, because once he sees it is at the heart of all the problems he feels strongly about, he can translate his solutions in a way that will seem less harsh. As it is, his arguments about trade, immigration, foreign policy, etc., force him to wear a protectionist turtle suit. Third parties never win the presidency because the issues they bring to a presidential contest are either too small to overwhelm the other parties, or too easily cribbed, as Perot's budget balancing act was overtaken by both establishment parties. The gold issue is one big enough to win it all and also not easily cribbed. Al Gore would call it a risky scheme and George Bush would call it voodoo. In representing the establishment instead of ordinary folks, the major parties prefer a floating currency, even though it is not in the interests of people at the bottom of the pyramid. Andrew Young, who was Jimmy Carter's U.N. Ambassador and is now chairman of the National Council of Churches, was still in Congress when Nixon took us off gold. He has been saying for the last several years that all the progress black Americans were making stopped and all the problems they encountered in the last 30 years seemed to begin with Nixon's action. He's right, and until we fix our money, with a major party candidate or the Reform candidate, those problems will persist.