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 their 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 GOP 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