Supply-Side University Lesson #15
Memo To: SSU Students
From: Jude Wanniski
Re: Why Nixon Left Gold
One of our more skeptical students last week posed the question: "If a gold standard is so good, why did we leave it, and why are so few people now in favor of returning to it?" The history is worth reviewing in our supply-side paradigm, which you will not find anywhere else. Some of it comes through in my book, The Way the World Works, but it is worthwhile to go over it now, fresh.
1. The Bretton-Woods system of 1944 provided that the United States would maintain the dollar value of gold at $35 and the other national central banks would maintain the dollar value of their currencies. If all to countries were fixed to the dollar and the dollar was fixed to gold, the fixed exchange-rate system was anchored to gold money, a design that prevented monetary inflation.
2. After World War II, when the wage and price controls were lifted, the general price level began to rise. This was a continued adjustment to the 1934 devaluation of the dollar from $20.67 per oz. Remember, in a country with a mature debt structure, it takes several years for a devaluation to run its course as wages and prices rise in stages. Friedrich A. Hayek discussed this process in Lesson #9 in November. The inflation caused a weakening of the economy as it impacted the progressive tax structure. In 1949, the Democratic Congress passed the Employment Act, which required the Federal Reserve to join the effort to lower the jobless rate. The Fed now had two tasks to achieve with one instrument. Or as Prof. Robert Mundell put it, two targets to hit with one arrow. This was the wedge that in the end led to Nixon's decision.
3. Economic growth in the 1950s was slow but steady. Dwight Eisenhower campaigned for president in 1952 to lower the income-tax rate, which at the time stood at a marginal rate of 91% at $100,000. Nobody really paid that rate because the tax system by then was riddled with loopholes called "tax shelters." Capital formation came from these targeted loopholes. Income-tax rates in the middle class were still very low and investments in the stock market were encouraged with dividend exclusions. When Eisenhower was elected, he immediately reneged on his campaign promise to cut tax rates. There later were some discussions about cutting taxes, but Ike had lost credibility on that issue and the Democrats regained control of Congress in 1954. In an attempt to get the economy moving, the Eisenhower administration urged the Fed to ease, and when it did, gold flowed out of our monetary reserves to Europe. Because of the productivity growth in the decade that followed, the entire workforce steadily moved into higher tax brackets. This of course raised the barriers between producers and increased pressures for more loopholes and monetary ease.
4. John Kennedy was elected in 1960 on a platform to get the country moving again. [I cover this in The Way the World Works, pages 198-201.] He tried the Keynesian move of investment-tax credits, but the financial markets and the economy yawned. The Kennedy proposal for income-tax cuts came out of advice from the German finance minister. The tax cuts passed, lowering the top rate to 70% from 90% and cutting the capgains tax. This was enacted after his assassination, amidst a terrific bull market. Increased liquidity demands made it child's play for the Fed to keep the dollar/gold at $35 without any loss of gold reserves.
5. In 1966, the DJIA began to slide amidst bipartisan discussions to impose an income surtax of 10% atop tax liabilities, ostensibly to help pay for Vietnam. When the tax was passed, the economy weakened, and the gold outflow resumed. When President Lyndon Johnson in late 1967 closed the London gold pool, it seemed clear enough to Bob Mundell that he predicted the world soon would be moving to a floating regime, which would be so painful that by 1980 it would begin moving back toward fixity. It is critical to understand that this gold outflow was the result of the refusal of the Federal Reserve or the professional economists other than Mundell to see that the surplus liquidity had been the result of the tax increase. The only way to prevent the gold outflow was to mop up the surplus with the sale of government bonds. Because this was deemed a "tightening" that would slow the economy, it ran afoul of the 1949 Employment Act.
6. Richard Nixon was elected in 1968 saying he would end the Vietnam War and also pledging elimination of the 10% surtax. Upon his election, he took the advice of his conservative Keynesian advisors — Herbert Stein and Paul McCracken (Stein is the father of tv personality Ben Stein) — deciding to maintain the surtax in order to balance the budget, and also to increase the tax on capital gains. Stein has been a lifelong proponent of high capital gains tax rates. This combination caused a further decline in the stock market as it anticipated the weak economy of 1970. Because European central banks could still exchange surplus liquidity for dollars, American banks began transferring the surplus dollars to their European branches, which would exchange them for foreign currencies in Germany, France, etc. Because we were no longer exchanging gold for our surplus dollars, we would issue special Treasury bonds to mop up the surplus. The foreign central banks would hold these interest-bearing bonds as reserves, instead of gold, although France refused to participate — refusing to hold U.S. debt as monetary reserves. France was smart in doing so, for as 1971 opened, the monetary crisis was ripening.
7. At the center of the crisis was Mundell's protege, Arthur Laffer, who served as chief economist to the Office of Management and Budget in the Nixon administration. His boss was George Shultz, a labor economist from the U. of Chicago who was friendly with Milton Friedman and the man Nixon had appointed Fed Chairman, Arthur F. Burns. In estimating Gross National Product for 1972, at a time when Nixon wanted the economy to be expanding, Laffer produced a model that suggested nominal GNP would rise apace with the money-supply aggregates. The administration accepted the idea because it enabled it to choose a GNP target of $1.065 trillion, and to achieve that goal by having Fed Chairman Burns produce enough liquidity to get there. This is when, as a reporter/columnist for the Dow Jones National Observer, I met Laffer, asking him to explain all this to me in simple terms, as I knew nothing about economics. Laffer explained that his model was misunderstood by the press, in that the GNP target would be a nominal target, not necessarily a real one. He further explained that it was meant to look backwards, showing what the money supply would be if the economy hit certain GNP targets. It was never meant to produce a monetary fix to a weakening economy.
8. Immediately, though, the Fed began creating liquidity to try to hit the GNP target, with Milton Friedman happy as a clam seeing the monetarist idea unfolding. He had the support of his friend Schultz, and also the support of another close friend, Citicorp President Walter Wriston. The Fed dutifully began shoveling reserves into the banking system to get Nixon re-elected. But because we were still tied to Bretton Woods [See Chapter 10 of TWTWW, "The Breakdown of Bretton Woods."], as fast as the reserves were received by the New York banks in exchange for their government bonds, they were transmitting them to London and Frankfurt in order to have them converted into foreign exchange. Because the foreign banks immediately called the U.S. Treasury to BUY U.S. bonds with the dollars they took in, there was no surplus liquidity at the end of each day. The Fed would buy bonds and inject lidquidity in the morning and the Treasury would sell an equal amount of bonds in the afternoon.
9. Not having the slightest idea what was going on, the Nixon economists decided that the GNP target derived from the Laffer model could not be hit as long as the money was flowing in this circular fashion. Worse, Treasury was in a constant state of crisis in managing the circular flow, which only the 30-year-old Laffer understood, and he was too junior to matter. As the foreign central banks added to their stockpile of Treasury bonds, Americans used the equal amount of foreign currency they had acquired to begin buying foreign assets — stocks, bonds and real property. Foreign economists, not knowing what was going on, complained that the U.S. was using its power to create deficits purposely to buy up Europe! Books were written denouncing the United States, becoming best-sellers, especially in France.
10. The Nixon administration insisted it would not devalue the dollar in order to alter the equations, but as the circular dollar flow became chaotic in August 1971, a Democratic member of the House Ways&Means committee, Henry Reuss of Wisconsin, publicly proposed a devaluation. (His wife was a Ph.D. Keynesian economist.) He also recommended freeing the dollar from gold, predicting that if this happened, the price of gold would plummet to $7 an ounce. The most active Keynesian economist who promoted devaluation was Fred Bergsten, who argued that the dollar had to be cheapened against the yen in order to give us a trade advantage. A Democrat, Bergsten still is director of the Institute of International Economics in Washington and continues to argue the dollar is too weak against the yen. He remains a favorite of The New York Times Treasury reporters, although his model has produced more carnage around the world because of the support it gets from the big banks than all the misery of several wars. Bergsten had been Henry Kissinger's chief economist at the National Security Council, until quitting with great liberal fanfare as an opponent of Nixon's Vietnam tactics. Bergsten's influence lingered on at Treasury with his fellow Democrat, John Connally, the Treasury Secretary, who became the most ardent supporter of dollar devaluation.
11. With the Reuss statement hitting the papers, the crisis deepened, with private citizens hedging by selling dollars. On Sunday, August 15, Nixon and his advisors met at Camp David and agreed on a plan to "solve the crisis.11 It included a 13% devaluation against gold and a total closing of the gold window, which meant no central bank could get gold from the Treasury. As this was supposed to be temporary, until the crisis passed, the dollar was still as good as gold, but at $40 an ounce instead of $35. Germany was aghast, as it had trusted the United States when it bought the bonds the French would not trust. Now, instantly, they had a 13% capital loss on the bonds.
12. Another component of what Herbert Stein told me at the time was a "mosaic" that had to be understood as a whole, was the temporary institution of wage and price controls that had been promoted by Arthur Burns for almost a year ~ benignly known as an incomes policy. It also increased the tariff on imports by 10%, clearly aiming this at Japan, with whom we had a trade deficit (which we still have), plus a grab-bag of tax cuts. It was announced early Sunday evening (I remember hearing it on the radio at a picnic in Schuylkill Haven, Pa., knowing I would be called upon to write about this blockbuster for the next edition of the weekly National Observer) The stock market greeted the proposal favorably, adding up the pluses and minuses of the moment to a net plus. This left the Nixon team assured it had done the right thing.
13. The Nixon decision was wildly popular among almost all Ph.D. economists. Keynesians were happy because the government was willing to use currency policy to manage our trade advantage, at the same time liberating demand-side policy from the burdens imposed by gold in maintaining a unit of account. Milton Friedman and his monetarist followers were thrilled, because his theories of managing the money supply could be employed — as long as the closing of the gold window was permanent, not temporary. This led Friedman to use all his influence with conservative think tanks and bankers — again with Wriston at Citicorp — to persuade Nixon to name George Shultz the Treasury Secretary. It was Shultz, then, who did the formal execution of Bretton Woods in early 1973, announcing a permanent floating of the dollar. As the de facto price of gold had floated up to $140 from the official $40, the oil-producing countries immediately set to work to quadruple the oil price. The economists of course blamed the Arabs! And the nation's newspapers, including The Wall Street Journal and NYTimes went to work to demonize the Arabs for this despicable behavior. To this day, the official line in the Political Establishment is that the floating of the currency was a necessary action and that the bad Arabs caused the inflation.
14. The same model today is being used to blame the bad guys in Asia for creating the Asian Crisis, not the Fed that is the real culprit. The International Monetary Fund and the World Bank are spinning their friends in the newspapers with the argument that if they only had more power, they could prevent crises from occurring before they begin. Dr. Michel Camdessus (alias Kervorkian) would like to have more authority to go into countries before they become ill and show them how to prevent illness — through higher taxes and currency devaluations.
Any questions? Please submit them for a Q&A session next week.