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 or 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.