The inflation the world has experienced in the past quarter century has been the most unusual of the last two thousand years. All other global inflations have been relatively gradual, as in the 200-year decline of the Roman Empire. Or they have been isolated to a part of the world, as in the European inflation that accompanied the Black Death of the 14th century, when half the population died while the hard money stock remained constant. The global inflation of our time has been intense and universal. The U.S. dollar, which lost none of its value between 1791 and 1934, by one measure lost 70% of its value in the next 34 years. From 1968, by the same measure, it has lost more than 90% of its remaining value. During this period no country in the world has escaped the general inflation. This paper will argue that we are getting very close to seeing an end to inflation, initially in the United States and soon thereafter elsewhere in the world. The central thesis is that with the end of the Cold War the political forces which benefited from this general inflation no longer require it and, in fact, are organizing for an environment of stability to suit global commercial interests.1
For inflation, I use Robert Mundell's definition, which is the most meaningful one: A decline in the monetary standard. International inflation, he wrote years ago, is a decline in the international monetary standard. By these definitions, inflation is not measured by rising price indices, nor is deflation measured by falling price indices. Deflation, too, is a decline in the monetary standard. Just what does Mundell mean by this formulation, one that was the essence of classical economics, from Adam Smith to Karl Marx, and also of classical finance, from Alexander Hamilton to Andrew Mellon? To these great men, the central function of money was as a standard of price. To all of them, that standard was golden, the "money, par excellence," as Marx wrote in his monumental Capital. Only when we fully grasp the importance of this definition of inflation or deflation will we be able to understand how to rid the world of the twin evils of inflation and deflation. There is nothing the United States could do at this moment that would have quicker, more beneficial effects on all of mankind than to re-establish the integrity of our national monetary standard, the dollar, which, because of our standing as the sole global superpower, is also the international monetary standard.
Monetary policy has always been most difficult for political leaders to understand, but never before has there been a greater need for it. "Economists can view inflation from several different time and space perspectives," Mundell wrote 20 years ago, when the world was just entering the monetary problems that have haunted it since. "It is seldom, however, that contemporary observers fully understand its causes, or know how to correct it, at least efficiently. Contemporary understanding of the inflation issue is hardly better than it was several centuries ago, despite the sophistication of very large economic models involving great mathematical and statistical sophistication but very primitive economic understanding."2
A standard is a concept of common agreement that enables people to communicate with each other in order to efficiently organize themselves for the business of living. Language itself is the most basic of standards. We all agree that the sound "dog" has the same meaning everywhere on the planet where English is spoken, while "hund" is the sound made when the concept of dog is expressed in German. Sign language also has its standards, with common signs undoubtedly dating back millions of years and still employed by animals as they organize for work and play in their families and communities. A little puppy who would like to play with her sister signals by raising a paw, a gesture of friendliness similar to a human extending a hand for a shake. Civilization brings with it more complexity and the need for more standards for efficient living. The colors of traffic lights are standard everywhere in the world, for example. We can't imagine how difficult modern living would be if every country chose different colors for stop and go, let alone regions within countries. Standards of weights and measures are so necessary for civilization that they have been around for millennia. It would not be possible to build any modern structure without a common understanding of an inch or a meter or a degree of angle. If the tolerances were greater than the tiniest, buildings and bridges would not stand. As with languages, different cultures prefer different units of measure, but over time the dominant power will have its preferences prevail.
The game of golf provides a good example of an international standard. The United States is the only major country in the world that still employs the English measurement standard to the almost complete exclusion of the metric standard. When it comes to golf, the international standard is the English measurement system. There is no course in the world I know of where the distances are calibrated in meters. Fairways are calibrated in yards, greens in feet and inches. As long as Americans dominate international golf, and long after they cease to dominate the game, this will remain true. The costs of having the golfing population shift to a metric system overwhelm any of the benefits of doing so. It may in fact be that in the centuries ahead, English measurement will overwhelm the metric system and the highways and skyscrapers of Europe will be measured in feet. One standard will eventually overtake the other as the benefits of a common standard are great. In the same way, because Brittania ruled the waves at the time international shipping matured in the 18th century, global navigation today is still ruled by the English system of measurement: Throughout the world, on the sea and now in the air, distances are measures in miles, not kilometers.
Language will persist in its differentials for all time, however, as the benefits of differentiation overwhelm the efficiencies of commonality. English is the common language of banking everywhere in the world, because of the global dominance of the Bank of England and the pound sterling for the two centuries, 1717-1917. The bankers of Japan and China and even Italy, where banking was born, can converse in English. One cannot imagine all opera being sung in English, however. Language is more like music, in which the more is the merrier. Latin, now a dead language, gave birth to several different basic variations, with each of these branching into hundreds of further variations of tonality and pronunciation. On the other hand, Roman numerals remain very much alive, finding a useful niche in literary annotation and in the enumeration of Olympic Games and Super Bowls.
One standard is so clearly superior to differentiation that it has survived untouched for many thousands of years and will survive to the end of time on Earth. These are the latitudes and longitudes that pinpoint place on the entire planet. In every language and in every culture, East, West, North and South are the standards of terrestrial direction. It happened that out of the billions of stars in the sky, the Creator provided us with one, the North Star, that remains fixed in position. Every day on the planet is different than the day before, but the one constant is Polaris. Thank goodness for one fixed reference point in the heavens, which enables us to make sense of all other units of measure. If there were no fixed reference point, there could be no North, South, East or West. The four billion people on earth would be in a constant state of confusion. The directions to grandmother's house would be as complicated as astrological charts. Only a few airplanes could venture into the sky at the same time or they would forever be bouncing off one another. On the oceans, it surely would have taken several thousand more years for Columbus to venture across the Atlantic. But because of the standard reference point provided by a single star, organization can be as efficient as it is. Note that people south of the equator never glimpse the North Star, but still enjoy its benefits as a reference point. Even under the oceans, we can observe thousands offish, swimming in schools in incredibly close formation, turning as a unit, with slow-motion film revealing that they defy all the laws of probability by not bumping into each other. They move according to their own fixed reference points built by biological imperatives.
A STANDARD FOR MONEY
This brings us at last to the monetary standard. For thousands of years, the reference point provided by gold has been the equivalent of Polaris in the world of everyday commerce. Think of each star in the sky as a different commodity or item to be "priced" in the market. This star over here is a loaf of bread of a certain weight and quality. This star is a quart of milk. This star is the dental work required to fill a tooth. Another is an hour of a carpenter's time. As is readily apparent, the number of goods and services to be priced in the world of commerce constitute a galaxy. Unless civilization can agree upon one star in that galaxy, against which all other stars can be referenced, civilization could not progress much beyond the bartering of a jungle or desert commune. Imagine having a stall of apples for sale in the market with a list of all the goods or services that the seller would accept in exchange: One orange, eight slices of bread, half a quart of milk, 1/100th of a tooth filling, etc. It would be difficult enough to barter goods in this fashion. Think of how difficult it would be to draft contracts for the exchange of future goods. Happily, many thousands of years ago, soon after the dawn of civilization, mankind fixed on precious metals as the standards for pricing. Thus, the merchant will sell one loaf of bread for 1/100th of an ounce of gold or 100 loaves for an ounce, or a Cadillac for 100 ounces. Gold money will change for smaller money in order to make smaller transactions, one ounce for twenty of silver, or 6000 of copper. But it all starts with Polaris. For all these thousands of years, almost all contracts have been made with gold as the reference point. "Dollars" or "yen" or "francs" or "marks" have served as "symbols" of gold. The term is that of Marx, who joined the other classical economists in asserting that the responsibility of government was to keep the paper symbols of gold in circulation exactly equal to the amount of gold for which they would substitute. As long as this one task was achieved by government, the monetary standard would remain constant. This would be the case no matter how many contracts were drawn by public or private transactors using gold as the unit of account.
Unlike Polaris, which seems fixed immutably in the heavens, gold does have a slight wobble to it that shows up over the millennia. That is, at times it is discovered in greater amounts than usual, as in the California gold rush, but the variation over centuries is much smaller than the next closest candidate for money, which has been silver. As in the comparison with golf, where yards have prevailed over meters, gold has competed against silver as the best Polaris and has won decisively. It has the smallest wobble, which has made it more valuable than all other commodities as a monetary vehicle. The advantages of a small wobble to merchants who must contract to exchange goods across time and space is self-evident. A national paper currency that has held its value against gold for a long period of time gives that country's merchants the greatest advantage, in that they do not have to spend resources insuring against the wobble. Against the galaxy of prices in a national market, to have one serve as the unvarying reference point for present and future trade is as important as the North Star is to transport. Each day in the world marketplace, hundreds of billions of decisions are made around the monetary unit of account. One shopper with a cart in a supermarket will make several dozen in an hour.
When President Nixon in August 1971 made the decision to devalue the dollar against gold, to $42 from $35 per ounce, he repudiated the national debt by 20% and made inevitable the general rise in prices that rippled through the galaxy of all prices. This was bad enough, but it still left an unreliable fixed point in the dollar realm. The nation still had a standard of measure, suspect though it was. In 1973, Nixon went the next step and - with gold now at $140 per ounce — "floated the dollar." This meant the nation's Polaris would now drift in the sky. All Americans would have to spend considerably more time and energy in calculating prices in relation to their wages, savings, and their present and future needs. And because the dollar had supplanted Britain's pound sterling as the Polaris of choice in the commercial firmament, when Nixon floated the dollar,3 all other currencies in the world set up larger or smaller orbits of change around it. The national monetary standard had declined, and so had the international monetary standard.
The floating of the dollar caused financial tremors throughout the world, but its one great contribution, made unwittingly, was the collapse of the communist experiments in the USSR and China. The communist experiments relied on the fixed reference point provided by the dollar. Which is to say the central planners needed a stable unit of account against which they could calculate wages, prices and capital allocation. As long as the dollar was tied to gold and the ruble defined in terms of the dollar, these calculations could be made. When the dollar floated, the markets of the West were capable of managing the chaos, but the central planners in Moscow and Beijing were lost. The price relationships that had originally been set in 1928 no longer were close to reality as domestic and international prices widely diverged.4 Had Marx been alive at the time, he would surely have advised the Kremlin to cut loose from the floating dollar and fix to gold, in which case the West well may have lost the Cold War. To put it another way, market capitalism without a Polaris is less efficient than a command economy with one.
MONEY AND MORALITY
The chaos produced by the floating dollar was and remains immense. Just as we would expect more airplane crashes if there were no North Star by which to pinpoint latitude and longitude, the absence of a U.S. fixed "symbol" of gold caused more financial crashes in the years since 1973 than the world has ever before experienced. We speak not only of the collapse of financial institutions and enterprises in the absence of a fixed monetary standard, but also of the collapse of households and families by the tens, perhaps hundreds of millions. In the absence of a monetary standard to fix the value of contracts between people, the linkages between debtors and creditors were loosened and so were the linkages between effort and reward. As the value of money would change, debtors would lose in a deflation, creditors would lose in an inflation. Ordinary citizens, without any way of knowing which way the value would turn, might adapt to an inflationary environment after suffering losses, only to then be hit with a deflation, suffering further losses. The most powerful and influential men of wealth could play the speculative swings and become wealthier in the process, at the expense of ordinary people. Worse, they might use their influence with government bureaucrats in the central bank to cause the inflation/ deflation swings according to schedule. The Mexican peso crisis that still engages our attention reveals for all to see the corruption of the international financial institutions -- the International Monetary Fund having evolved into the darkest of all. When the floating began, how easy it was for the currency traders at the giant money-center banks in New York and London to infiltrate the IMF, to profit at the expense of the poorest people on earth. For the past two decades, the IMF has roamed the earth like a black whale, feasting on the poor, developing nations, while the scavenger fish accompany it to feed themselves.
In this way, the bonds of trust are broken between a people and their government, and those at the bottom of the wealth ladder find the only way to get ahead is to cheat and steal from those who have cheated and stolen from them through their influence in the halls of political power. We are well aware of the disintegration of morality in the Germany of the 1920s, when the life savings of all ordinary citizens were wiped out in the hyperinflation caused by the Versailles Treaty — a treaty designed to crush the abilities of Germany to wage war again. Hitler's fascism emerged out of this poisoned well. At the other end of the political spectrum, Mao Tse-tung led the successful communist revolution of China in 1949 with his pledge to restore the integrity of the Chinese currency. It had completely collapsed in the post-war inflation under the mismanagement of the ruling establishment, which abandoned the mainland and settled in what is now Taiwan. So too, with the floating of the dollar since 1971, ordinary Americans found themselves increasingly alarmed at the general decline of traditional values in our society. This reflects the decline in value of all contracts between individuals -- the galaxy of contracts that comprise the bonds of civilization. If a government does not keep its vows to its people, the bonds that knit together families and communities inevitably loosen as well. The breakdown of morality that intensely occupies the attention of the Religious Right -- divorce, illegitimacy, abortion, crime — is the inevitable consequence of the devaluation of the international unit of account. If a man is as good as his word, what of a government's? Which is not to say that a monetary unit fixed to gold will drive out immorality. It will only remove those negative influences on society that flow from the injustice of broken monetary promises. A poor man who saves his money to educate his children, only to find his savings wiped out by a government that cheats its creditors, will more likely have outrage and revenge in his heart than the man whose savings is intact when his children's needs are to be met.
It was a deep insight that led Mundell in 1969 to predict: "The world is moving toward a floating regime. The experience will be so painful that by 1980 it will begin moving back to fixity." The election of Ronald Reagan in 1980 began that movement back toward fixity. The years since have covered most of the ground of that movement. There is still a short distance to cover, but the last steps are the most difficult. As we approach the Polaris that Mundell saw dimly, but alone, 25 years ago, the advocates of a gold Polaris have essentially won all the arguments against the floaters, but they disagree among themselves on what shape the golden Polaris should take. Allies of 25 years in this battle are now raging against each other, debating the final steps. It is going to be a system that will last a century, which means it has to be correct on the first try.
A GOLDEN RULE
To the '49ers who headed for California in the last century, the dream was not of precious metal, but of abundance and opportunity, fertility and freedom. In the same way, the pioneers who left the Old World for America a hundred years ago were told of "streets paved with gold," but the image was understood to mean freedom and opportunity. The Golden Calf, we have been taught, was a false god, a physical idol. It was rather the concept of the Golden Rule that infused the spirit of this New World. Do unto others as you would have them do unto you. It is this concept that has interested me in monetary issues this past quarter century — a Golden Rule in our everyday business of living. How can men and women possibly live together in peace and harmony over any extended period of time without this Golden Rule? This central idea is at the heart of human civilization, the very essence of almost all religious and civil codes. It is, of course, the meaning of the Gold Standard in the monetary realm. It relates not to golden specie in bulk, to bars of gold bullion piled high in the hoard of King Midas, but to the trust that connects strangers to each other in the marketplace. In God We Trust represents the single Polaris of our Creator. Not "In gods we trust," for there is no pantheon of gods that can unite the human species in peace and harmony. Men would kill each other to the last in defense of their particular god, but an agreement on one Creator under different names holds promise of an eternal peace. There are not two or three or a dozen "North Stars" in the sky to guide the navigators. And there is only one golden rule. Paper monies of each nation can have differing names and appearances, but if each is defined in terms of one central physical specie, to connect concept to reality, they will all be linked across time and space to the same guiding standard.
Karl Marx, who agreed with the classical economists of the 19th century on monetary theory, put it well in the following passage of his Capital: "The weight of gold represented in imagination by the prices or money-names of commodities, must confront those commodities, within the circulation, in the shape of coins or pieces of gold of a given denomination. Coining, like the establishment of a standard or prices, is the business of the State. The different national uniforms worn at home by gold and silver as coins, and doffed again in the market of the world, indicate the separation between the internal or national spheres of the circulation of commodities, and their universal sphere." Note the word imagination.
Every trader knows, that he is far from having turned his goods into money, when he has expressed their value in a price or in imaginary money, and that it does not require the least bit of real gold, to estimate in that metal millions of pounds' worth of goods. When, therefore, money serves as a measure of value, it is employed only as imaginary or ideal money.5 It is literally impossible to imagine a colored piece of paper having a fixed value in terms of something concrete to the senses without some person or some government promising to exchange that something for it. A slip of paper that promises a kiss on Valentine's Day has redemptive value, but only in the future. It is not money, but a bond. An I.O.U. signed by me and given to you, promising to push a peanut up Fifth Avenue with my nose if and when the Chicago Cubs win the World Series, is a bond without maturity. It is not money. It is money if it can be redeemed on the spot, and it is money of fixed value if it can be redeemed on the spot or on St. Valentine's Day for the same something. Neither Karl Marx nor Alexander Hamilton nor David Ricardo would recognize a colored piece of paper, issued by the government without any redemptive value at all, as having fixed value. "The commerce and industry of the country," wrote Adam Smith, "cannot be altogether so secure when they are thus, as it were, suspended on the Daedalian wings of paper money as when they travel upon the solid ground of gold." The fact that the world can survive at all without a fixed unit of monetary value is testimony to the confidence of the world in the dollar and the people who manage its "floating promise." It is in this sense that Federal Reserve Chairman Alan Greenspan is the most important man in the world, as the slightest errors he makes in the management of the dollar are transmitted around the planet with lightning speed. Greenspan gets this enormous power first by virtue of being a citizen of the nation with the most important currency, the one which in recent centuries has been the most reliable in keeping its money as good as gold. Without a Gold Polaris, the dollar is the best port in the storm.
How did Greenspan get the job of managing a floating promise of a dollar? It is because he understands the importance of gold as his own best reference point in managing the floating dollar. As a younger man, Greenspan also connected the idea of gold's contribution to moral values and society's integrity. Younger Americans who have no recollection of life in this kind of world should be aware that it was not so long ago and was not so unusual. Greenspan's predecessor, Paul Volcker, also understood the importance of gold. Although a gold advocate, he was Treasury Undersecretary for Monetary Affairs in the Nixon administration when the dollar/gold link was broken on August 15, 1971. He was the protege of Robert Roosa, who was Treasury Undersecretary for Monetary Affairs in the Kennedy Administration. Roosa in turn was a devoted advocate of the gold standard at the heart of the Bretton Woods system and the founder of the London gold pool. President John Kennedy was a gold advocate, as was his father Joseph Kennedy. It was in 1968 that President Johnson closed the London gold pool, which had been exchanging gold dollars for foreign exchange. And it was Roosa's statement in 1969 that U.S. gold stocks may not be sufficient to maintain the dollar's value that led Robert Mundell to make his prediction that the world would soon be in a floating regime. If Roosa, a friend, could not understand that the nation's gold reserves could easily be defended by draining surplus liquidity from the banking system, Mundell said it had to be clear that "the forces of history were determined to engage in one of their periodic experiments with a managed currency."
CONSEQUENCES OF CHAOS
On the trek back to gold that Mundell prognosticated in 1969, the costs to the U.S. and world economy have been painfully high indeed. His study of economic history told him that the gains to be had from a common currency are so great that the world will always find a way back to one. The most serious damage in the United States occurred as the unit of account marched up the progressive tax system. Originally designed during World War I, when the dollar was defined as a twentieth of a gold ounce, the income-tax progression then exempted all but the highest income Americans — essentially professionals and the business class. Even then, the steep progression so inhibited capital formation that in 1922 a capital-gains differential was enacted. This was to encourage the flow of surplus capital from the business and professional class to ordinary Americans who aspired to the American dream. For the remainder of the 1920s, the WWI marginal income tax rates were reduced in a series of steps during the Harding and Coolidge administrations. The progression steepened again in the Hoover years, contributing to the depression triggered by the 1930 Smoot-Hawley Tariff Act. The progression steepened even more sharply in the New Deal years of Franklin Roosevelt, not only because nominal income-tax rates were increased at the top to 94% from 63%, but also because the dollar was devalued 70% against gold in 1934 in a failed attempt to spur the economy.
The impact of the 70% devaluation was cushioned by the long history of the dollar's preceding integrity.6 The average maturity of contractual debts, public and private, easily exceeded 10 years, and there were a great many contracts fixed at more than 20 years. The devaluation would be spread over this period as the contracts unwound, with some of the observed inflation occurring after World War n. In other words, the monetary standard declined by 70% in 1934 as the gold Polaris shifted, but it would take another 20 years for its full effects to ripple through the dollar price structure. The population experienced a "price inflation" after the war that Keynesian economists incorrectly attributed to a release of "pent-up demand." Actually, wartime price controls had held back the ripple from the 1934 devaluation and when the controls were lifted, prices surged.
It should be noted that the dollar did not decline by 70% in 1934 because of "market forces." President Roosevelt personally decided to made the gold price $35 instead of $20.67. This was in response to the monetarists of the day, who argued that the lower gold price had caused the economic depression - when in fact it was the Hoover tax and tariff increases. When two ships collide in a storm, we would not blame the constancy of the North Star. There is no record that FDR's Treasury Secretary, Henry Morgenthau, advised him that his action constituted a repudiation of a large portion of the national debt. Nor was the President told that the devaluation would over time be followed by a 70% rise in the general price level. He was simply trying all variety of things, hoping one or another would work.
Roosevelt, at least, did not abandon the gold Polaris, only shifting it in the commercial firmament. There is also no record that President Nixon's economists advised him that by completely closing the gold window on August 15,1971, he would invite the worst global inflation in recorded history. Rep. Henry Reuss [D-WI], chairman of the Joint Economic Committee, helped force this decision by announcing ten days earlier that it had to be done, an action that set off a wild selloff of dollars and dollar bonds in Europe. Reuss predicted that when the dollar no longer propped up the price of gold, it would amount to no more than $7 an ounce. The dollar now "floated" in value relative to gold and in two years hovered around $140 an ounce. The economists who advised the President to do this preferred to think of the dollar as being fixed while gold floated. Gold, said Milton Friedman, was now a commodity to be traded no differently than pork bellies. The general inflation that ensued rippled though the price galaxy much more quickly than it had following the 1934 devaluation. In 1971, of course, the dollar did not have a century of historical integrity behind it. The world was now getting used to a declining monetary standard in the United States.
By the time the Roosevelt devaluation ran through the price galaxy, its impact on the progressivity of the income-tax caused Internal Revenue's net to cast beyond the professional and business class, catching craftsmen and factory journeymen. The devalued Nixon greenback cast much further, bringing shop girls and apprentices into the net. Worse, the conservative Keynesians who advised Nixon in 1969 had persuaded him to sharply increase the capital gains tax to 48%. As a result, when the price inflation rippled through the system following the 1971 devaluation, it caused the real rate of capital taxation to soar. The economy slowed further, its decline masked by nominal increases in wages, prices and Gross National Product. When President Jimmy Carter arrived in 1977, gold was still at roughly $140, four times its Bretton Woods price. As Robert Mundell had predicted, by now the world price of oil had quadrupled as well, "black gold" adjusting to the gold Polaris.
In the four Carter years, the gold price quadrupled again, spending much of 1980 above $600 as interest rates climbed to their highest levels in U.S. history. It made not the slightest difference that Carter presented a "balanced budget" in January 1980. By the time Paul Volcker had arrived as Chairman of the Federal Reserve Board in July 1979, the price of gold was being totally disregarded as a monetary signal and was already up to $237. Without the Polaris, Volcker and the Carter Treasury began pushing buttons and pulling levers, hoping something would work. They tried credit controls, a switch of monetary targets, "jawboning" or "moral suasion," and raising the federal funds rate which the Fed controls. It did everything but drain surplus liquidity from the market — the one thing that would have worked. Indeed, in the fall of 1979, Volcker advised Congress that because the economy would grow faster in 1980 than had earlier been anticipated, it would need more liquidity! The price of gold jumped to $850 at its peak on February 1, 1980.
The rampant inflation underway was blamed on everything else but the central bank's dismissal of gold as a signal of surplus liquidity. The Arab nations were blamed the most for raising the price of oil. The Organization of Petroleum Exporting Countries (OPEC), though, specifically blamed the quadrupling of the gold price as their reason for wanting four times as many paper dollars for a barrel of oil. American economists also blamed American companies for raising prices, blamed management of American companies for raising executive compensation, and blamed American workers for excessive rising expectations. In the absence of a federal budget deficit to blame in early 1980, they blamed the U.S. trade deficit with Japan. When soaring interest rates then drove up the cost of debt service, and with it the federal budget deficit, the economists who had pushed Nixon into the devaluation blamed the "twin deficits," budget and trade.
THE REAGAN CORRECTION
When Ronald Reagan arrived at the White House in January 1981, the level of interest rates were near their all-time highs, forecasting the rise in the general price level signaled by the doubling of the gold price to $580 in the previous 18 months. To put it another way, the only way Reagan could avoid a dramatic rise in the general price level on his watch would be to somehow persuade Volcker to cut the gold price in half, to where it had been 18 months earlier. Otherwise, as contracts unwound, wages and prices of goods and services eventually would have to double as well. In fact, the Fed did keep a tight grip on the supply of new liquidity to the banking system. As the Reagan tax cuts began to invite new economic activity, the demand for dollars increased. This, of course, meant the existing supply of dollar liquidity was insufficient. What would we expect to happen? The price of gold would decline, signaling incipient deflation. That is exactly what did happen. In the year following Reagan's inaugural, the gold price declined to $320 from $580, the sharpest one-year percentage decline in U.S. history. The price actually dipped below $300 in early 1982. The shortage of dollar liquidity that it signaled put excruciating pressure on dollar debtors all over the world.
The monetary deflation did not end until America's biggest single debtor, the Mexican government, advised Volcker that it could not meet its dollar obligations. Mexico had borrowed $30 billion in 1980 from U.S. banks to develop its oil fields, expecting to easily repay its borrowings when oil rose to $40 or $50 per barrel, as conventional wisdom predicted. When gold dropped below $400 and oil dropped below $20 in the Volcker Deflation, Mexico became illiquid. So did the U.S. banks that held oil, other commodities and the land that supported them as collateral against loans. Penn Square of Oklahoma and Continental Bank of Illinois were the two most prominent failures of the period. The Federal Reserve was forced to abandon the money-supply targets that were substituting for the gold Polaris and create $3 billion in new dollar liquidity in exchange for $3 billion in Mexico's peso obligations. The liquidity surged through the U.S. banking system as Mexico made good on its obligations to the banks and the price of gold shot up, signaling an end to the deflation. Stocks and bonds soared in value as the supply and demand for liquidity bounced back to equilibrium.
The positive reaction in the bond market to a surge in new printing-press money was totally unexpected by the Federal Reserve or the Reagan Treasury Department. How can it be possible that long-term interest rates would decline with such "easy money"? Treasury Undersecretary Beryl Sprinkel, an avowed monetarist, had warned that an easing of Fed policy would reignite inflationary expectations and cause a collapse of the bond market. From that point onward, as he was proven emphatically wrong, monetarism's influence in policy circles went into steep decline. The flaw in the monetarist approach is that it does not contain any fixed reference point at all in the tangible world. In the classical approach, which views gold as its reference point, there is a dollar/gold price that is optimum in balancing the interests of debtors and creditors. It is optimum in that it is a price that makes it most likely that debtors will be able to pay their creditors. There can be no other logical definition. Debtors who can pay are obviously in better condition than those who cannot. Creditors who can get paid are in better condition than those who cannot.
At the time Volcker pumped $3 billion of liquidity into the banking system, to enable Mexico to pay its debts, the optimum gold price seemed to be somewhere between $400 and $425 while the actual price had been wavering between $300 and $340. How could we say the optimum gold price was between $400 and $425 at that time? We need only observe that in the previous four years, mid-1978 to mid-1982, when most public and private contracts were made in dollars, there were more days when the gold price was concentrated in that range than in others. The optimum gold price could not be $300, because at that level most debtors would bankrupt and creditors would get nothing. It could not be $600, which would cause creditors to bankrupt.
Indeed, the savings and loan crisis, was the inevitable result of the monetary inflation that followed the breaking of the gold link in 1971 and the floating of the dollar. This is the only place in the world where this occurred, because nowhere else has there existed a thrift institution devoted solely to financing home mortgages. Why? Because the United States was the only country in the world with a unit of account of such integrity that such an institution would be viable. When the dollar is as good as gold, a thrift can borrow short and lend long. That is, it can borrow a house from the community of people who together can build a house for hourly wages and promise to pay them back the house in 20 or 30 years, with interest. A carpenter and a painter and a contractor can make good use of such an institution, because they wish to save part of thek hourly wages that comes from home construction. When the dollar price of gold floated from $35 to $350 between 1968 and 1989, the S&Ls were bound to contracts that required them to accept as full payment 10% of the houses they had lent out. Their balance sheets were demolished as a result. Banks had the same problem, but because their intermediation on behalf of homeowners and homebuilders was a small part of their portfolios, they could squeeze by. The S&Ls were caught in the chaos of the floating currency in the same manner that the planners were in the Soviet Union. Try as they might, they did not have the flexibility to adjust to the new equilibrium.
The enormous increase in the national debt of the United States, which now is at the $5 trillion threshold, is entirely due to President Nixon's severing of the dollar/gold link in 1971. The S&L bailout was a small, but significant cost. The assertions by President Clinton and the Democrats that the deficit is due to the supply-side tax cuts of "Reaganomics" is based on false assumptions. The conventional OOP defense against this argument - that the debt was ballooned by the extravagance of a Congress controlled by Democrats for 40 years -- is equally misguided. Indeed, the national debt is now a much smaller proportion of the nation's per capita output than it was in 1945, at the end of the war. In terms of ounces of gold, the U.S. national debt was 12.5 billion ounces in 1971 and is now 13 billion ounces. The per capita debt in gold has declined, from 62 ounces in 1971 to 52 ounces today. The two political parties should at some future point simply agree that they jointly supported Nixon's devaluation and currency float, which repudiated 90% of the $435 billion in debt held by the public at that time. The decline of the economy in the past quarter century of Cold War can be wholly attributed to the inflation that has warped production incentives through its impact on the federal tax codes. The decline forced the American people to elect Democrats to Congress, to construct social programs and income redistribution schemes to ease the pain in the lowest income classes. Republicans would have attempted to balance the budget during these years even as ordinary people were having the value of their savings and pensions diminished by the inflation.
In 1982, we published a report at Polyconomics on five episodes in history where a nation that had left a gold standard had returned to it. The report was actually the result of a question posed to me that year by Paul Volcker, who wondered how and why we got back on gold after the Civil War. The introduction to the report summarized the findings:
The monetary instability of the past 15 years was not unusual. Strikingly similar episodes have occurred several times in U.S. and European history. These previous experiments with regulating the quantity of money have lasted from 12 to 22 years. But high interest rates, falling commodity prices, and government budget strains have always forced a return to a commodity standard.7
Clearly, fiscal pressures upon a government in each instance forced it to return to the practice of guaranteeing its debt in gold, to economize on debt service costs. It is for this most practical reason that this option has become a point of discussion in the 104th Congress. Sen. Robert Bennett [R-UT] has been making the case for a return to gold in order to balance the budget. He equates each percentage point decline in bond prices as the equivalent of $46 billion in annual savings as the $5 trillion national debt is refinanced.8
AN OPTIMUM GOLD PRICE
The U.S. economy now at least has made most of the financial adjustments that were necessary to survive in a floating regime, as Mundell called it in 1969, but only if the dollar floats in the vicinity of $350 gold. Why $350? We earlier cited $400 to $450 as the optimum price, citing the clustering of dollar contracts in that range between 1978 and 1982. In the intervening years, though, the optimum gold price fell steadily as the Federal Reserve pulled it down by maintaining a tight rein on new liquidity. It was able to do this without causing excruciating pain to debtors because of the Reagan tax cuts of 1981-83 and the tax reform of 1986, which brought marginal income-tax rates down sharply and thereby increased the demand for dollar liquidity. The deflationary monetary pain was alleviated by the increase in the general level of wealth and prosperity that accompanied the supply-side policies. When we now look back upon the last decade, we find the volume of contracts clustered around $350. The price of gold is now $380, and the longer it remains at this level, the higher the optimum gold price will become.
Why did it climb to $380 from $350, the apparent optimum? Because the tax increases pushed through by President Clinton reduced the demand for dollars and the Federal Reserve did not offset this decline by draining liquidity from the banking system. Instead, Federal Reserve Chairman Alan Greenspan took the advice of those who argued that the gold price — which he knows is the primary signal of inflation expectations — could be brought down by raising the cost of credit. The most important advocate of this position was Greenspan's close friend, and mine, former Fed Governor Wayne Angell. An important advocate of gold money who in his eight years at the Fed helped stabilize gold around the $350 benchmark, Angell had agreed that it would be easier to bring the gold price down to $350 by draining liquidity. He argued, though, that there was no political consensus to use gold as a primary target or even that the target should be at $350. He also said the operating procedures of the Fed were not suitable for a commodity target. Instead, he believed the gold price could be hammered down de facto — by ratcheting up the federal funds rate which is at the heart of the Fed's operating procedures.
What Greenspan learned in this experiment is that the paper currency cannot be strengthened by raising the price of credit as Angell argued. Classical economists and financiers have for centuries observed that a currency suffering demand problems is in surplus supply, and the prescription is to reduce the supply by extinguishing currency. In his report on a National Bank to the House of Representatives, December 13, 1790, Alexander Hamilton spelled it out as follows:
Among other material differences between a paper currency, issued by the mere authority of Government, and one issued by a bank, payable in coin, is this: That, in the first case, there is no standard to which an appeal can be made, as to the quantity which will only satisfy, or which will surcharge the circulation: in the last, that standard results from the demand. If more should be issued than is necessary, it will return upon the bank.9
The demand for a dollar or a peso or a Deutschemark can be increased by increased economic activity, which might follow a tax or tariff cut or some other fiscal or regulatory efficiency. Demand for money cannot conceivably be increased by a higher credit cost, which per force reduces economic activity. For Angell's idea to work, higher short-term interest rates must somehow decrease the supply of liquidity in the banking system. There is no logical way this can be achieved, directly or indirectly. To reduce the supply of liquidity in the system, the central bank can only sell bonds, shrinking its balance sheet. So we have seen the experiment fail. The fed funds rate climbed from 3% to 6% in a series of steps and the price of gold, while wobbling up and down, resolutely remained at $380 or slightly above.
The experiment was not without costs, as the credit markets punished Greenspan by bidding bond yields up by two percentage points, to roughly 7.8% from 5.8% in October 1993, when the market's confidence in the Fed was at its peak. The bankruptcy of Orange County, California was, of course, a direct result of this climb in credit costs. The financial crisis in Mexico was an indirect result of Greenspan's interest-rate experiment. Mexico went through a difficult political year, which reduced the demand for the peso independently of the tax and monetary events in Washington. The peso peg to the dollar while the dollar was losing 10% of its value against gold was an enormous burden upon the Mexican economy, however. This is because the price effects of the dollar's devaluation against gold would take several years to ripple through the U.S. economy where the average maturity of contracts is much longer than in Mexico. Only recently had Mexican businesses and households experienced a peso unit of account that held its value in a way that encouraged longer maturities. The Greenspan experiment was a reminder of the saying that emerged from Canada in the 1950s, that living next to the United States was like a mouse sleeping next to an elephant. Whenever the beast shifted its weight, the ground would quake. Even then, the reason for the elephant quake was the attempt by the Federal Reserve in the Eisenhower administration to expand the U.S. economy by printing money faster than commerce was demanding it. The result in the United States was an outflow of gold. Without our massive gold stocks, Canada defended itself by floating its dollar, which quickly appreciated by 5%.
Mexico was caught in the same predicament in 1994, inheriting the inflationary error of the United States through the peso/dollar umbilical cord. Instead of floating the peso to permit it to appreciate against the dollar at the beginning of 1994 when the error was first transmitted, the Bank of Mexico allowed its considerable dollar reserves to be drawn down. Classical economics would have recommended the Bank of Mexico in any case sell peso assets from its portfolio to extinguish pesos and thus prevent a further loss of dollar reserves. When 1994 began, the Bank held $30 billion in dollar reserves and a peso monetary base worth only $14 billion. It could have bought every peso twice! Instead, as it lost dollar reserves, it continued to print pesos, in a cycle doomed to failure.10 On December 20, the government succumbed to the advice of international bureaucrats and announced a 15% devaluation of the peso. The devaluation soon widened to 40% as the Bank responded to the collapse of international credit by supplying more peso reserves to the banking system. It should instead have been reeling them in at whatever cost in higher short-term interest rates. The cost to Mexico's creditors of having the peso price of gold double in such a short period of time is staggering. In a survey of small and medium-sized businesses in Mexico reported February 24,56% reported they expect to be in bankruptcy within the calendar year. The only beneficiaries are peso debtors, especially the international banks that sold the peso short, with assurances from their many contacts at the International Monetary Fund and U.S. Treasury that a devaluation was in the works.
By debasing the currency, wrote Adam Smith, the princes and sovereign states that do so...were enabled, in appearance, to pay their debts and fulfill their engagements with a smaller quantity of silver than would otherwise have been requisite. It was indeed in appearance only; for their creditors were really defrauded of part of what was due to them. All other debtors in the state were allowed the same privilege, and might pay with the same nominal sum of the new and debased coin whatever they had borrowed in the old. Such operations have always proved favorable to the debtor, and ruinous to the creditor. And have sometimes produced a greater and more universal revolution in the fortunes of private persons, than could have been occasioned by a very great public calamity. 11
In the large scheme of things, the Greenspan experiment of 1994 will be worth the costs if it contributes toward the movement back to a gold Polaris. It can do this by firmly closing out any notion that a currency can be strengthened by higher credit costs. Interest rates should be allowed to rise because of a draining of liquidity, not increased by mere announcement. Almost as important is the lesson learned in Mexico, a palpable example of the horrific costs of mindless devaluation. In recent weeks, with bolstered confidence, Greenspan has been taking greater chances in advancing the idea of fixing the dollar to gold. He told the Senate Banking Committee on February 9 that Mexico's problem would probably not have occurred if we had been on a gold standard. In another appearance on domestic monetary policy February 22, Greenspan told this same committee that a gold standard has always been his preference for the conduct of monetary policy.
THE BARRIERS REMAINING
There are still barriers to overcome on the way to a gold Polaris. The monetarists continue to oppose a fixed gold system by advancing the concept of a currency board as a suitable replacement for a central bank that pegs to the dollar or to gold. If Mexico had a currency board at the opening of 1994, it would have been able to use its dollar reserves when presented with surplus pesos, but could not have reissued the pesos until presented with dollars or other "hard currencies." It could run its reserves down to the size of its monetary base, but then would have to live with whatever interest rates the market demanded to accommodate the risk of devaluation. Clearly, a currency board would have been superior to the Bank of Mexico's conduct of 1994, and it is clearly superior to all sorts of mindless monetary systems associated with the pure floating of a currency. Its deficiencies, though, point up the clear advantages of a gold-based unit of account properly managed by a central bank.
In testimony on the peso crisis before the House Banking Committee on February 10, I compared gold to the North Star and a currency board to "the Pleiades, a cluster of stars that tracks through the heavens." For navigational purposes, it is of course better to have the Pleiades as a reference point than none at all. In a word without a gold Polaris, it is not accurate to refer to floating dollars, DM and yen as the "hard currencies" that would "back" the soft peso. There are now no "hard currencies" in the world, which is why Domingo Cavallo, the finance minister of Argentina, is now having difficulties with his currency board. This, despite the fact that there is nobody who has a keener appreciation of the philosophy of social contracts embedded in a country' s currency. In 1991, he told David Asman of The Wall Street Journal that "each peso is a contract between the government and the peso holder. That contract guarantees that each peso, as a unit of value that the worker has worked hard to get, will be worth as much tomorrow as it is today. If the government breaks that contract, it is breaking the law. The only role of the government in the economy should be to guarantee the integrity of market transactions."12
With this kind of commitment, one would expect the Argentine peso to be as sound as a dollar, in that for three years it has been pegged one-to-one with the U.S. dollar. And Cavallo will issue no new pesos unless his currency board is asked for them with dollars or other "hard currencies." Inasmuch as the dollar is a currency with the mass and contract maturity of an elephant and the peso has the three-year stability of a mouse, we see the Argentines being steadily "dollarized." That is, despite the fervent commitment of dollar convertibility, the dollar is still superior to the peso for contract purposes because it can more easily absorb errors made by the Fed. Businesses and households are steadily converting to dollar contracts and Argentina's banks find it more profitable to hold pesos in reserve and lend in dollars. We now see how true this is since the Federal Reserve transmitted its error of late 1993 to the Argentina peso through that umbilical cord. If anything, the error was magnified in Buenos Aires as compared to Mexico City, which had a six-year history of peso stability against the dollar compared to only three in Argentina.
Not only is Argentina losing the considerable seignorage associated with management of sovereign coin, it is also hostage to any further flawed experiments at the Federal Reserve. Domingo Cavallo's sacred commitment to the citizens of Argentina is thus a sacred promise to convert the peso into the floating promise of a dollar, supported by a currency board that is backed with a bouquet of other floating promises. If we were transported back to August of 1971, when the dollar was about to quickly lose 75% of its value relative to gold and the other "hard currencies," clearly a currency board would do almost as poorly. This enables us to see the inherent implausibility of a currency board. Put another way, imagine designing a unit of measure for a country based on the average of several units of measures of other countries, when each of the several units are not fixed. Throw together a floating yardstick, a floating meterstick, a floating rod, etc., average them together at a moment in time, and define your non-interest-bearing national debt in this mish-mash. The only people who really benefit from this method are those who have designed and patented it. They get to travel from country to country setting up currency boards.
We run into the same problem with any monetary system built around a reference point composed of a mixture or "basket" of commodities. In September 1987, Treasury Secretary James Baker addressed the annual meeting of the IMF and recommended a reform of the international monetary system that would fix a "reference point" for central banks around a "basket of commodities, including gold." Once again, we get back to an imperfect, wobbly unit of account. When there are only two commodities in the basket, as we had in the United States during the bi-metalic era, Gresham's Law takes over and bad money drives out good. That is, one commodity will always be more plentiful than the other, and it will be the one chosen to pay debt and taxes. The scarce commodity will be held back. This was the basis of William Jennings Bryan's complaint about the "cross of gold," a reference to the Gold Standard Act of 1873 that restored the pre-Civil War gold parity at $20.67 per ounce, but which ignored the pre-war gold/silver ratio. The debtors who flocked to Bryan's cause in the monetary deflation that followed wished to pay their debts and taxes in cheap silver rather than dear gold. For this reason, it is not likely that we will see "baskets" of commodities or currencies again.
Another reform variation that complicates the gold discussion is that of the "global monetarists," followers of the late French economist Jacques Rueff. The Rueffians, led by Lewis Lehrman of New York, are gold money advocates, but insofar as they focus on the world money supply, they diminish the importance of money as a unit of account. They argue that no major country should hold in its central bank the reserve assets of another country. The idea follows from Rueff s belief that the 1944 Bretton Woods international monetary agreement became unstable because the United States could print surplus liquidity and force other nations who acquired it to accept U.S. dollar bonds in exchange. Rueff argued that this somehow increased the world dollar supply and potential dollar inflation. The Rueffians obviously oppose currency boards, which require a country to back its own currency with the reserve assets of the "hard currency" countries. At the point where the U.S. government is ready to fix the dollar to gold again, the Rueffians will attempt to have their formula at the center of the reform. The only real problem they would pose is that they insist the optimum gold price is somewhere above $500 an ounce, based on theorems that have always eluded me.
The greatest difficulty in returning to a gold Polaris is that those who benefit most, the mass of ordinary Americans, are not organized for that goal. And the elites who benefit from an unstable money still represent a powerful force for continuance of that instability. Just as there is an enormous industry in the United States devoted to grappling with the complexities of the federal and state tax codes, there is an industry devoted to the world of monetary instability. The entire financial services industry is geared in one way or another to earn its way by guiding the commercial world at home and abroad through the choppy waters of dollar fluctuations. With a gold dollar once again fixed in the galaxy, most of these costly functions would be unnecessary and would soon disappear. In his presidential farewell, President Dwight Eisenhower warned of the influence of a military-industrial complex. The combine would use its massive political weight to exaggerate or aggravate tensions abroad, in order to profit by supplying the offensive and defensive goods at taxpayer expense. It does not operate as a conspiracy, but naturally organizes along pessimistic principles and attitudes, preparing for worst-case scenarios. Unless there is a democratic check on the complex, it will drain all of a nation's resources to insure against defeat by an imagined foe. There is also an environmental/industrial complex, which will use its influence in government to an equal extreme. Unless checked, it will close down all enterprise to save spotted owls and such.
So, too, with the "misery industry," which profits by defending Americans against the complexities and excesses of government at all levels. It is in the interest of this industry to explore to the nth degree the possible profits to be had in litigating between adversaries in the law courts, for example. It also profits by guiding 90 million or so taxpayers through the myriad volumes of the tax code, and by serving domestic and international clients by providing novel instruments to protect against monetary instability. The International Monetary Fund, which has effectively distanced itself from democratic restraints, is the most dangerous of the forces of pessimism. The United Nations bureaucracy also represents a threat in that it can offer to lead peacekeeping efforts in the wake of IMF programs, which create conflict through its promotion of instability.
If it were not for our democratic institutions, these various industries that serve the dark side of society would engulf all the forces of optimism with their demands on resources. They are now in thek weakest condition in generations, because of the end of the Cold War between the nuclear superpowers. This has removed one of the greatest sources of pessimism the world has ever known. It has also opened wide the opportunity for our democratic institutions to seize the moment both to refix the gold Polaris and to streamline the tax codes. The efficiencies to capital that these reforms would bring would quickly occupy the energies of the military-industrial complex and the other segments of American society that are necessary to serve the downside of life. Swords into plowshares.
It is a tall order for our democratic forces, as there is no realistic possibility that any other nation or group of nations is positioned to lead the way. It would be at least another generation and likely two or three before the European bloc or the Asian bloc could reach a consensus on monetary reform. The dollar is thoroughly embedded in the international psyche and its commercial fabric as the global unit of account. The American democratic system is also the only one in the world strong enough to overcome the entrenched forces of pessimism that have grown like coral reefs during the 20th century wars against fascism and communism. There is a window of opportunity to get the job done before the 21st century begins. It is only a window, because the longer the forces of pessimism can remain entrenched during peacetime, the more likely they will be able again to generate war.
Realistically, restoration of the gold Polaris will not come unless the President takes the initiative. The Constitution gives the Congress authority over money, but the President is the only person who is elected by all the people. The diffusion of power in Congress makes it too easy for the special interests that gain from monetary instability to distract Congress from monetary reform. In an essay I wrote for National Review, February 8, "Gold Standard Coming," I suggested the likeliest scenario would be one in which an executive order began the process. Theoretically, President Clinton could issue the order, but practically, his administration is dominated by advocates of floating money. It would more likely be a Republican President, who would promise a dollar as good as gold in his campaign. In his 1980 campaign, Ronald Reagan wanted to seek a gold mandate, but was persuaded by his advisors to drop it from his platform. For that purpose, they brought in George Shultz, who as Treasury Secretary in 1973 had presided over the official floating of the dollar.
How difficult would it be? All it requires is that the new President instruct his Treasury Secretary to stabilize the dollar value of our international gold reserves. The Secretary would then have to ask the Federal Reserve to follow the Hamiltonian practice of adding or subtracting dollar liquidity to keep the value fixed. Having gotten this far, legislation to make the stabilization permanent would not be difficult to enact. The hardest part is finding a President who will seek the gold mandate and follow through on it.
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1 Robert A. Mundell, The International Monetary Reform and Development Finance, (Waterloo, Ontario: University of Waterloo Economic Series, no. 67, 1972), p. 5. Mundell, the Canadian godfather of modern supply-side economics, once observed that 'The gains from using a common international medium are so great that some means of creating one has always been found."
2 Robert A. Mundell, "Inflation from an International Viewpoint," in The Phenomenon of Worldwide Inflation eds. David Meiselman and Arthur B. Laffer (Washington, D.C.: American Enterprise Institute, 1975), p. 41.
3 For the uninitiated, a basic description of the central bank's monetary mechanism is included at the end of this paper.
4 In 1928, a small apartment in Moscow would rent for 10 rubles per month or the equivalent of half an ounce of gold. With nominal rents frozen, the same apartment in 1985 went for 10 rubles or l/100th an ounce of gold, the equivalent in the West of a loaf of bread.
5 Karl Marx. Capital, A Critique of Political Economy (New York: The Modern Library), p. 108. It was thus clear to Marx, as it was to David Ricardo, that a country did not need gold to run a gold standard, only a credible commitment to keep the money as good as gold.
6 In a country that has just experienced a hyperinflation, people will hesitate to make contracts in the national money for any but the briefest periods. If a 10% devaluation then occurs, the general price level will rise by 10% almost immediately. If a country has maintained its currency's value for many years, contract maturities will reflect confidence in the money. If a 10% devaluation occurs, the general price level will rise only gradually, as these long contracts unwind.
7 Alan Reynolds, "Monetary Reform and Economic Boom: Five Case Studies 1792-1926." Polyconomics, Inc., Morristown, N.J., Dec. 6,1982. The five cases included the United States 1792-1808 and 1879-1914, England 1821-25 and 1925-34, and France 1926-1936. The U.S. example of 1792-1808 showed: "An 'unexampled business expansion,' with exports quintupled and a nine-fold increase in new firms. Interest rates fall, prices stop falling, and a staggering budget deficit turns into a huge surplus despite the abolition of most taxes."
8 Jude Wanniski, "A Gold Standard Coming," The National Review, Feb. 6, 1995, p. 42. By cutting three percentage points off the cost of debt service, the savings to the taxpayers over a 7-year period would exceed $1 trillion. This does not include the immense increase in revenues that would flow to the Treasury as a result of the non-inflationary boom that would ensue.
9 Cited in The Government and the Economy: 1783-1861, ed. Carter Goodrich, (New York: American Heritage Series, Bobbs-Merrill Company, Inc., 1967), p. 287.
10 Mexico contributed to its own problems even in the Salinas years by maintaining a "crawling peg" relationship with the dollar that produced a glacial, daily devaluation of the peso as a sop to the export industries. The higher cost of capital this produces swamps any illusory gain.
11 Adam Smith, The Wealth of Nations (New York: Modern Library, 1937), pp. 27-28.
12 David Asman, "Argentina Tightens Its Anchor to Avoid Mexican Drift," The Wall Street Journal, January 13, 1995, p. A15.
APPENDIX: MONETARY MECHANISM
Currency is non-interest-bearing debt of the national government. In the United States, it comes into circulation through the operations of the Federal Reserve Bank, which has the power to "create money." It does so through the simple process of buying interest-bearing debt that had previously been issued by the Treasury Department. That is, Treasury issues a bond in the amount of $1000 in order to finance its budget deficit. (Note that "money" cannot exist if there is no national debt.) The $1000 bond pays an interest to its holder at maturity. The Fed can "buy" the $1000 bond with a check for $1000 written in a checkbook that has simply been given it by Congress. When the Fed creates this "ink money," it has "monetized the debt," i.e. converted interest-bearing-debt to cash. The process works because the citizenry needs cash as a medium of exchange, and is thus willing to hold government debt for this purpose without being compensated by the payment of interest.
At the conclusion of the purchase, the Federal Reserve has in its portfolio an asset of $1000 that is paying interest and a liability of $1000 that is not. The interest amount covers the expenses of managing the central bank, and funds in surplus are given to the Treasury as part of its general revenues. The Fed also has the authority, of course, to reverse this process. It can decide to withdraw cash from circulation, doing so by taking the $ 1000 bond from its portfolio of assets and selling it on "the open market." The decision on whether or not to buy bonds to create cash or sell bonds to extinguish cash is made by the Fed's Board of Governors and the presidents of the regional Federal Reserve banks. They come together every several weeks as "The Open Market Committee" to decide on whether to buy, sell or hold steady. Their decision is communicated to the "open market desk" in New York City, which implements the policy decision through its own operating procedures. Conceptually, the process of creating money adds reserves to the banking system. The banks are required by law to hold a percentage of their deposits in ready cash or the equivalent of cash — its own checking account at the Mint. These reserves are a cushion to meet potential demands of the depositors.
Thus, a Fed decision to "ease" may put more cas\ into the banking system than the banks are required to keep by law. This will push the banks into finding borrowers who will take the surplus cash in exchange for an asset that will earn a profit for the bank. A Fed decision to "tighten" may take out reserves that the banks are holding in accordance with legal requirements. This means the banks have to sell assets to private buyers in order to get their cash reserves up to par.
The most critical part of the process is at the periodic meetings of the Federal Open Market Committee (FOMC). How does it decide whether to buy bonds to create money or sell bonds to extinguish it? Either it has a fixed rule that determines when to buy and when to sell. (We then say the dollar is in a "fixed system.") Or, it has no specific rule to guide the committee, which is permitted to consider a variety of signals from the market. (We then say the dollar is "floating.") Its value is determined by the "free market," as that market tries to guess what is going on in the minds of the open-market committee, which meets in secret.
When the central bank is on a "fixed system," the FOMC's power is enormously reduced. That is, it must act when the fixed standard it has chosen is being violated and it must not act when the standard is in equilibrium. A gold standard is one type of fixed rule. It requires that if the Treasury issues debt guaranteed in gold at the price which obtained at the moment of issue, the FOMC will be required to buy bonds when the dollar price of gold is tending to fall and to sell bonds when the dollar price of gold is tending to rise. In other words, if the target price of gold is $350, the Fed will be forced to advise the desk in New York City to buy bonds when gold has drifted to $349 and to sell bonds when it has drifted to $351.
If the credit markets know that the Fed by law is forced into this rigid operating procedure, keeping the dollar at all times as good as gold, they do not have to guess at what is going on in the minds of the FOMC members in their secret meetings. If gold remains the most reliable proxy for the value of all other commodities, the creditors of the national government will be assured that the gold or gold equivalents they lend by buying government bonds will be returned to them with interest at maturity. The risk of a small number of men and women making incorrect decisions at the FOMC is replaced by the risk of the broad market for government credit making the wrong decisions. It is for this reason that gold standard interest rates are inevitably much lower than interest rates on floating debt. Inasmuch as private citizens who are drawing contracts in the government unit of account benefit from this reduction of risk, they are able to take greater risks in their investments in each other. The efficiency of capital is increased.
It is also possible to fix an automatic course on the central bank's deliberations without gold or with gold averaged in with several other commodities. The Fed's desk could be required to buy bonds when the sum of the dollar price of gold, silver, cocoa, wheat, platinum and copper — divided by six — is, say, $200. The markets would be informed of this certainty by an act of Congress or an executive order of the President or, at present, by a simple vote of the FOMC. It may be that such a system would be superior over time to a system without any rules to guide the market, but it seems obvious that as a unit of account, such an index would require so many calculations that contracts drawn against it would carry interest rates considerably higher than a gold contract.
Yet another rule, proposed by the monetarists and actually followed in the first years of the Reagan administration, was a quantity rule. The Fed was forced to sell bonds when the quantity of all money in circulation exceeded an amount scientifically determined by the monetarists and to buy bonds when the quantity was beneath that target. The theory took no account of day-to-day needs of the market for liquidity, on the grounds that over a long period of time the excesses and deficiencies would wash out. It was in this period that the price of gold underwent its most violent fluctuations on a day-to-day basis as the Federal Reserve was hitting the monetarist quantity targets with some precision.
At present, the dollar is technically floating on what might be called a "Greenspan Standard." The FOMC members each have their own preferences on how fast the economy is growing nationally, how fast in their region, what statistics constitute rapid growth, how commodity prices are acting, how the dollar is performing against other national currencies, what the White House wants done politically, and what their advisors are advising. Of all the members, Greenspan watches the gold price most attentively, and as chairman he gets to throw his weight in that direction. In addition, his attempt to get the gold price down by raising interest rates instead of draining liquidity has not worked. This hardly constitutes a Polaris, especially when the markets also have to reckon on the value of the dollar a year from now, if Greenspan is replaced by a Clinton appointee who will be driven purely by political goals.
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