The Deflation Monster

By Jude Wanniski

In 1995, I predicted that inflation’s days were numbered. A year later I warned of a new, more exotic enemy—deflation.

Throughout the boom and bust of the late 1990s and the new millennium, I detailed this foe’s attacks as it stomped its way through Asia, Russia, Brazil and the U.S. farm and energy economies, and later as it crashed into Wall Street and Silicon Valley. Now it ravages global telecommunications companies and capsizes every Third World economy that counts its debt in dollars, from Argentina to Zimbabwe.

People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation…But the statesmen who were responsible for the deflationary policy were not aware of the import of their action.

They failed to see the consequences which were, even in their own eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them.

—Ludwig von Mises

On January 7, I met with Dick Cheney in his transition office near the White House, to warn him that the Bush administration had inherited an economy with a rare disease curable neither by Federal Reserve interest rate cuts nor by the timorous and dilatory series of tax rate reductions then being proposed by his administration. Indeed, although cuts in tax rates are entirely positive for the economy, they contribute to deflation by spurring the demand for money.

The problem, I told him, was a pure monetary disorder that would cause serious damage unless corrected. There was nothing he could do until the political establishment realized that conventional medicine would not work. In April, I gave the same warning to Treasury Secretary Paul O’Neill, and to Senator Trent Lott, who was then majority leader.

In late February, I advised my Wall Street clients that, until the problem was corrected, there would be no reason to buy equities. The adjustment to a monetary deflation takes time, but it is inexorable, forcing all nominal prices to fall—including the price of wages, assets, and all goods and services, even the price of haircuts. One hundred percent wage reductions, also known as layoffs, are frequent.

Japan is in the twelfth year of a deflation, the yen having doubled in value over the last decade. Equities there hit a 17-year low in mid-August, and only now are its political and economic leaders beginning to understand why interest rates cut close to zero percent have had no effect.

Money, in its simplest form, is non-interest bearing debt of the government. To acquire more money, economic actors give up “goods” or “assets,” which is why gold and sensitive commodity prices react first to changes in the demand for dollar liquidity.

Deflation—a significant undersupply of money relative to demand—is first signaled by a fall in sensitive commodity prices, which can change rapidly in highly liquid “spot” markets. Like inflation, it occurs when a central bank—in our case, the Fed—fails to match the supply and demand of money in the marketplace. In the absence of a reference point by which to gauge an under- or over-supply of money, the Fed has to guess.

The current deflationary process in the U.S. began in late 1996 when the dollar price of gold and all other commodities began to fall. In 1997-98, the pivotal price of oil plummeted from $25 to $10 per barrel. Over the next two years, petroleum exploration and investment in production and infrastructure ground to a halt. In one of many misleading signals whereby monetary ease and monetary tightness mimic each other, the sudden deflation-induced scarcity pushed the price to $35 per barrel in 2000. This, after the global economy had emerged from the Asian crisis against a backdrop of diminished crude supplies.

Deflation is especially destructive to debtors, who are committed to paying down their debt with more valuable dollars out of incomes that shrink because of declines in the prices of things they produce.

Since 1997, there has been a steady advance in bankruptcy rates, with a record 1.6 million filings in 1998. In 2000, more than $40 billion in corporate debt went unpaid, a record until this year. Corporate defaults increased to $58 billion in the first half of 2001, with the important telecommunications sector accounting for $16 billion.

The car leasing business is in turmoil. Bank of America will take a $1.25 billion charge in the third quarter to exit this business because of rapidly falling prices for used cars. Losses for General Motors, Ford, DaimlerChrysler, and other auto finance companies could total $18 billion over the next few years.

Financed with high-yield bonds, telecom companies like low-earth orbit satellite operator Globalstar and networks Viatel, Winstar, Teligent, and 360networks are bankrupt, and many of their compatriots building the new Internet infrastructure are teetering on the edge with stocks trading for just a few dollars and bonds trading for pennies on the dollar. New backers are hard to find. Even old (and new) economy stalwart Lucent Technologies struggles with a junk debt rating, for a stretch even contemplating default.

The raw number of bankruptcies is on the way to surpass 1998 this year and next as the process grinds on until it completes its adjustment by putting debt-laden companies out of business. New businesses then form with workers agreeing to accept lower nominal wages that have higher purchasing power, and bankrupt firms cease operations or reorganize under new debt structures, in either case leaving most of the original investors with little to show for the risks taken.

Deflation is not a beneficent return to normalcy after a long inflation but a wrenching process just as destructive to peace and prosperity. Nobel Laureate Robert Mundell’s definition is the most meaningful: inflation is a decline in the monetary standard. By this definition, inflation is not measured by rising price indices, nor is deflation measured by falling price indices. Deflation is not a statistic but 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 unit of account. The decline in a standard reflects not its rise or fall in value but its deteriorating stability, credibility, and constancy. To all the titans of classical theory and practice, that standard was golden, the “commodity 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 these twin evils.

Monetary
Yardstick

The Bureau of Weights and Measures maintains the precise length of one yardstick at thirty-six inches and is unconcerned about the quantity in use in the world.

In the same way, if the monetary authority devoted itself to maintaining the value of one dollar as a standard of value, a unit of account—a numeraire—it could be just as unconcerned about the quantity of them in use. The problem is that it is easier to measure distance than to measure value.

Monetary policy has always been most difficult for political leaders to understand, but never before has there been a greater need for it. As Mundell wrote 25 years ago, when the world was just entering the monetary problems that have haunted it since, “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.” Because far more rare and insidious—often deceptively wrapped in the remnants of rising prices and money supplies—deflations are even more slippery to grasp or remedy.

People confuse deflations with contractions. In a supply-side model, it is not consumers but producers of goods—those who supply them to the marketplace—who are the primary actors. They produce in order to exchange their output with producers of other goods and services. As I explained to Treasury Secretary O’Neill: if he is a producer of bread and I am a producer of wine, and we are planning to exchange our output with each other over a period of time, in a modern economy, this is done through the intermediation of banks and financial markets, not barter. A higher tax on producers of wine and producers of bread, or a higher tariff between domestic producers of one and foreign producers of another, will make some exchanges of goods unprofitable. Instead of being exchanged, they will pile up in inventories. This is a contraction, not a deflation. Prices will fall as the producers discount them in order to get them off the shelves, but this is normally a temporary condition, “an inventory recession.” As soon as the surpluses are liquidated, the rest of the economy bounces back at the old price structure.

The Great Depression was chiefly a contraction, not a deflation. It was not caused by the Federal Reserve making dollars scarce relative to gold, the proxy for all commodities. It was caused by tariff and tax shocks that erected barriers between domestic producers and between exporters and importers.

The Fed now has caused both a contraction and a deflation. By raising interest rates unnecessarily when long-term interest rates were already lower than short-term interest rates (remember the “inverted yield curve”), the Fed slowed the real economy, bringing about the contraction from the higher growth rates the economy had been enjoying. At the same time, by not supplying sufficient monetary reserves to meet the legitimate demand for money by American enterprises and households, the Fed also caused the deflation we see evidenced by the declining gold price.

The contraction part can be overcome by lowering short-term interest rates and more important, by cutting marginal income-tax rates and capital-gains levies. Affecting every personal and corporate decision and valuation in the economy, tax rates are the single most critical policy lever directly governing economic inputs and outputs.

Lower tax rates enhance the demand for liquidity; higher rates stifle it. However, within any fiscal environment, a deflation can only be rectified by having the Fed add sufficient liquidity. Otherwise, there will be a slow, grinding, downward adjustment of all dollar prices—the murky mirror image of the lurching, upward adjustment of all dollar prices that we knew as the inflation of the 1970s.

Inflations and deflations only can be understood as process phenomena. When President Franklin Roosevelt raised the dollar/gold price to $35 per ounce from $20.67 by executive order in 1934, the general price level took two decades to catch up with gold. This is because contracts had to unwind in a gradual inflationary spiral between capital and labor. When the debt structure of an economy is mature, it takes a long time for the process to be completed. The same is true of deflation.

Our honest attempts to produce bread and wine and exchange output with each other via financial intermediation will be messed up by either a deflation or an inflation. If our contract is such that I deliver O’Neill a loaf of bread every day, with the contract requiring him to deliver the wine all at once at the end of a year, the government must keep the dollar constant against a standard in that period, for if it deflates, O’Neill, who is in my debt, will be required to give me much more wine than he anticipated at the outset. If the dollar inflates, as his creditor, I will be forced to steadily increase the amount of bread I give him, and at the end of the year will have to be satisfied with much less wine.

Think back to the Savings and Loan crisis in the 1980s. Even when prices had been stabilized after 15 years of inflation, debtors who borrowed a whole house were paying back just one-tenth of a house. Today the S&Ls are thriving because homebuyers who borrowed one house must now pay back a house and a half.

But the interests of creditors and debtors only diverge in the short term. Over time, they are perfectly aligned. And in a world where the unit of account is floating against the real world of commodities and gold, inflations and deflations will be the rule, not the exception.

As wise a man as he is, Fed Chairman Alan Greenspan has not been wise enough to realize the problems he caused by ending the dollar inflation, only to preside over the dollar deflation that is now forcing down the general price level. It is as if he threw a cigarette butt into the brush back in November 1996, when the process began, and it has been burning its way through commodity producers ever since, but is now reaching up the mountain toward our production of intellectual goods and services. It is nice to be a commodity producer at the beginning of an inflationary process, when the prices for your output surge before wages, taxes, and capital costs can catch up. But the flames finally reach you, too, when the dollars you get for your commodity will no longer pay for the rising costs of labor, taxes, and capital needed to sustain the business (or farm).

In a deflation, it is nice to be an intellectual producer—producing goods and services out of your head, not out of the earth—and buying real estate and commodities at ever lower prices. But eventually all economic activity suffers from doubt and disinformation, panic and overshoot, when the monetary standard declines.

This is the deflation monster now chewing away at the economy’s foundations. It is so rare that few economic theorists were prepared for it. We cannot undo the damage that has been done, but we can prevent further deterioration as the deflation unfolds.

Gold remains the best signal of destructive monetary errors. Critics of this “barbarous relic,” as Keynes called it, will always be able to point to incidental turbulence in gold markets—from new leasing practices by central banks to changing marital dowries in India to new connective tissue on microchips—that is alleged to cripple gold as a monetary tocsin. Yet no alternative has emerged. With by far the largest permanent stock relative to annual production, gold offers a market where more than 98 percent of the supply ever mined is still available to respond to monetary conditions, as opposed to the weather or the demand for tantalum or pork bellies. Thus among all commodities, gold is the most accurate sensor of monetary policy. When the Fed creates too little money, given the market demand, the dollar becomes scarce relative to gold and the price of gold declines, eventually rippling through the economy until there is a new, lower general price plateau.

Increased liquidity would act as a firebreak, devaluing the dollar against gold with a mini-inflation that takes the gold price to $325, the number suggested by Jack Kemp in late June when he wrote about deflation in The Wall Street Journal. But just how much liquidity do we need? Interest rate cuts don’t seem to have worked. So how do we know?

Whatever its successes, the current monetary policy regime is far from ideal. Each episode has had to be treated as unique or nearly so. It may have been the best we could do at the moment. But we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions.

—Alan Greenspan

When President Richard Nixon broke the dollar’s link to gold in 1971, a young Canadian economist, who 28 years later would be awarded the Nobel Prize in economics predicted a serious inflation soon would follow. Robert Mundell said at the time that “Mankind seemed determined to attempt one of its periodic experiments with a managed currency, but the experience would be so painful that by 1980 we will be returning to fixity.” The inflation of the 1970s certainly was painful, and a great burden to the Nixon presidency and the Ford and Carter presidencies that followed. In 1980, on Mundell’s schedule, Ronald Reagan, a lifelong advocate of a gold standard, was elected, publicly stating his belief that he knew of no nation that left gold and remained a great nation.

Based on mastery of classical economic theory that had long been discredited by the Great Depression, Mundell’s insight gave rise to “supply-side economics,” the term I coined in 1975 while a member of The Wall Street Journal’s editorial board.

Inflationary monetary policy caused the dollar to lose 75 percent of its purchasing power relative to gold by 1973, when its price climbed to $140 from $35 per ounce in 1971, and when OPEC quadrupled the oil price to $10 per barrel from $2.50. The commodity inflation followed, and then came the adjustment of the general price level, as nominal wages and profits eventually rose by a factor of 10 to match gold’s rise to $350 (after a peak of $850 in early 1980).

It would be 1999 before the Swedish Academy recognized Mundell’s contribution to monetary theory and awarded him the Nobel Prize in economic science.

What nobody understood at the time, including Nobel prizewinners past and present, was that the demand for dollar liquidity would change as the tax structure changed.

All economic activity can be affected by the tax wedge between producers. If the wedge is large, marginal economic transactions cease. Hours worked, investments made, and risks taken all decline. Higher tax rates cause liquidity demand to shrink, and lower tax rates cause liquidity demand to rise. If the tax wedge is reduced, people work harder for a greater after-tax return, new enterprises spring up, and investors envision greater profits flowing to the firms they support. Production increases. Businesses, investors, and entrepreneurs require more money to liquefy the economy, now poised to expand.

In 1979-80, the Fed was pouring liquidity into the banks just as the inflation-swollen tax brackets and Jimmy Carter’s credit controls were sinking the demand for money. The Ms (the monetary aggregates) looked as if they were behaving, but the velocity of money—the rate at which money changes hands—was going through the roof and so was the price of gold, hitting $850 in midday trading on February 1, 1980.

When it became clearer that Ronald Reagan would defeat Carter and then cut tax rates substantially, the demand for liquidity rose, dollars became scarce as velocity fell, and the price of gold began a precipitous 18-month decline to $300 from $850. Focused on the money supply rather than the demand for money, however, the Fed was still fighting a decade-long inflation when deflation had suddenly become the problem.

The 1981-82 Reagan recession was the worst since the 1930s and almost destroyed the economy and his presidency. I called Fed Chairman Paul Volcker, on St. Patrick’s Day 1982 as I recall, practically begging him to ease monetary policy by buying bonds with newly created dollar liquidity. Gold was at $310. “You want me to inflate?” he asked incredulously. “No, I just want you to stop the deflation, or all the dollar debtors in the world will go bankrupt.”

Isn’t

Technology
Deflationary?

Some believe that technological advance naturally results in a general price decline. But this is like saying that as modern golfers hit the ball farther and farther with better equipment, the yardstick should gradually lengthen. A constant unit of measure is important because we want to know if we are hitting the ball farther. Otherwise, we might be asking, Tiger who? Similarly, we want to know how much more processing power we get from a microchip per unit cost.

When the dollar’s value is kept constant, technological advances may be translated into shorter units of time needed to produce goods and services. Over long periods when the dollar remained sound, you will note that prices of primary goods (such as a loaf of bread which cost the same in 1930 as in 1790) were constant, but that all workers shared in technological advances by working fewer hours to maintain a fixed standard of living (or vastly enriching it by continuing to work the same hours).

To the extent that technology spurs productivity and investment and exerts deflationary pressures, it is simply calling for more liquidity to satisfy the demands of a growing economy. If the liquidity demands are met, the currency will remain stable. Prices of high-end technology products may fall rapidly, but the unit of account should not change.

What may change is the relative advantage of debt and equity. Rapid technological innovation may punish companies that rely heavily on debt—such as telecom carriers today—which must compete with rivals using far more cost-effective, new equipment. The result mimics deflation in some of its effects but is better defined as “creative destruction.”

The deflation ended by accident in the week of August 11, 1982, when Volcker was faced with a crisis in Mexico, which could not pay interest on its $80 billion in debt to U.S. banks. He had to tell the Reagan Treasury he could no longer worry about the money supply because he had to monetize $4 billion in Mexican peso bonds. The price of gold rose $56 that week and the financial markets skyrocketed—bonds, stocks, the S&P 500, with Nasdaq out front. Monetary policy had been twinned with tax policy, both going in the same direction. The Reagan boom had begun.

The experience should have persuaded policymakers even then that a floating unit of account could do deflationary as well as inflationary damage. Here we are again, though, puzzling at the odd behavior of the financial markets, debating whether the dollar is too strong or too weak, and not quite realizing how heavy a price is being paid by everyone on the planet for not having a fixed standard of value.

As economic expansion led to Reagan’s landslide re-election in 1984, James Baker III moved from the White House to the Treasury, swapping jobs with Donald Regan, the former chief of Merrill Lynch, who was less interested in financial reforms than in effective administration. The move was a good one, leading to the major Reagan tax reform of 1986 and a Baker initiative in early 1985 to inch toward a gold-linked standard. First there was the Plaza Accord, an agreement at the Plaza Hotel in New York City among the major finance ministers and central bankers that was intended to coordinate monetary policy in a way that would lead to a gold-linked system. It worked very well at the outset, with the dollar/gold price rising from $280 in early March to $330 three months later. Stocks and bonds reacted positively.

Plaza was followed by the Louvre Accord, which was intended to ease the world toward a formal system that would be automatic, in the sense that each bank would manage the supply and demand for its money without having to consult each other or the money markets. If a dollar or a Deutschmark or a yen had to abide by the reference point, their cross-exchange rates would not change, and there could be no argument about one or the other having a trade advantage. Nor could there be an inflation or a deflation of any currency linked to the basket. If A=Basket and B=Basket and C=Basket and D=Basket, then A=B=C=D.

I did not like the idea of a “basket” of commodities because the prices of the goods in the basket would change from one minute to the next, causing the unit to inflate or deflate. As the most monetary of all commodities, gold’s large stock relative to its flow protects it from such gyrations.

Still, I celebrated the Baker initiative because I knew it would have to lead eventually to a focus on gold as the key reference point for the world’s monetary authorities. Unfortunately, a month later, the initiative was completely washed away by the October stock-market Crash on Wall Street. Although the Crash of 1987 was due at least in part to the newly expressed view of Fed Chairman Greenspan that the dollar was overvalued, on the Wednesday before the Crash, I had spent an hour at Treasury with Secretary Baker, bringing the urgent message from Professor Mundell that the dollar must be protected at all costs, even by selling bullion from Fort Knox if that is what it took.

From the outset the monetary adjustments enshrined in the Plaza and Louvre Accords suffered from contrary tax and monetary signals from Washington. While lowering the top income tax rate from 44 percent to 28 percent, the Reagan Tax Reform Act of 1986 had included an increase in the capital-gains tax to 28 percent from 20 percent without protection against inflation. Inflation can push real capital-gains tax rates above 100 percent on long-held assets, as the tax shifts from real gains to spurious inflationary increases in valuation.

Affecting the value of every asset in the economy, the higher capital-gains rate was having a day-by-day impact on all marginal business decisions. The net effect was a steady decline in the demand for dollar liquidity that portended a new siege of inflation and real capital-gains taxes at confiscatory levels.

With the subversion of the monetary valuationss of the Louvre Accord, the markets did not waste time seeing the odds of economic growth sharply diminished. On October 19, the day of the Crash, I was invited on a network television panel with several other economists to discuss the day’s events and made the argument that the Crash did not mean recession ahead, but was rather a buying opportunity, because the one-day adjustment had completed the downward valuation process. There would be slower economic growth, but as long as no other errors were made, the Reagan tax cuts would continue the expansion. The others on the panel—chief economists at the New York banks—practically laughed out loud. They were persuaded that the Reagan “bubble” had burst and that recession lay ahead.

In the days that followed, Greenspan flooded the banks with liquidity, as if insufficient liquidity were the problem. After the markets turned around, the idea of linking the dollar to gold disappeared from public discourse, as the opponents of gold asked the question: if Greenspan had been tied to gold, wouldn’t he have been prevented from flooding the system with liquidity when the Crash occurred? The underlying assumption is that there may be times when a gold standard prevents politicians from doing something desirable and if Greenspan did not have this freedom of action, the market Crash might have turned into a serious recession. This reasoning admits no possibility that the Crash occurred because the steps being taken to stabilize the value of the dollar in real, commodity terms went up in smoke.

There are of course myriad times in human history where the constancy of gold as a monetary unit did not prevent panics and crashes, recessions and depressions. It was Mundell in 1960 who first made the argument in this context, that if a government has two targets, it needs two “arrows” (policy instruments) to hit them. Monetary policy cannot hit both at once. If government wants stability of the general price level, with no inflation or deflation, it should use a monetary arrow to hit that target. If it wants economic expansion, it should use the fiscal arrow for that. The principle should boil down to “tight money and easy fiscal policy” in combination, to achieve non-inflationary growth. There was nothing necessarily “supply-side” about this formulation, and to be sure it was presented as an alternative to the policy mix proposed by James Tobin of Yale, who was a member of President John F. Kennedy’s Council of Economic Advisors when Mundell was at the International Monetary Fund in the early 1960s. Tobin recommended “easy money” to spur growth and “tight” fiscal policy, i.e., higher taxes, to contain inflation.

It was the Tobin policy mix that won, which inevitably led to the abrupt, formal break with gold in 1971 and a decade of stagflation. The slump was faintly disguised by rising prices in the U.S. But to the rest of the world, stuck with a catastrophically devalued hoard of dollar denominated bonds, the key event was the closing of the U.S. gold window and the rise of the price of gold from $35 to over $800.

As a result of this ferocious inflation, sweeping up oil, land, and other commodities, Germany and the rest of Europe would never again agree to an international monetary system designed like Bretton Woods. In 1944, when the U.S. owned two thirds of the monetary gold in the world, it seemed reasonable to Europeans to give the U.S. central control over the mechanism. The U.S. would keep the dollar/gold price constant and the Europeans would keep their currencies constant relative to the dollar. When Nixon suddenly devalued against gold, however, everyone else was left holding the bag, especially if they held special U.S. bonds in their monetary reserves instead of gold. In a new regime, we might expect the United States to get more say in its management than other member states, but not a monopoly power, which is what it had in the Bretton Woods system. I believe Mundell could design such a system between breakfast and lunch, as he has been thinking about it for decades.

An
Information
Standard?

Critics of gold often cite as an alternative the increasingly efficient global movement of prices across the photonic webs and electromagnetic links of world currency markets. They say a gold standard has been rendered obsolete by a more complex and sophisticated Internet information standard. But information systems are governed by information theory.

Conceived by Claude Shannon in 1948, the real “information standard” is called entropy. Shannon’s entropy measures the information content of a message by its “news,” expressed in digital form as unexpected bits. It takes a low entropy (no surprises) carrier to bear a high entropy (newsworthy) message. Thus the electromagnetic spectrum is a supreme vessel for information because its waves are perfectly regular and are governed by the speed of light, which is absolute in any medium. “Modulations” (messages) are easily added at one end and detected at the other.

Although gold is not as stable as light speed or electromagnetic sine waves, it plays an analogous role in economics as a relatively low entropy carrier for crucial high entropy data about monetary policy. In the information theory of money, the 130,000 metric tons of gold available from all time represent the predictable ballast for a low entropy vessel that can bear unexpected news about the supply and demand for liquidity.

By contrast, without guidance from gold, currency markets resemble a communications system without a predictable carrier. Such free floating markets lack any objective means to differentiate the “news” (a change in monetary conditions) from the “white noise” of a thousand clamorous markets.

—George Gilder

Most economists, though, are paralyzed by that belief that the gold standard contributed to the Wall Street Crash of 1929 and the Great Depression that followed. The only contrary theory was the simple “bubble” idea put forward by Harvard’s John Kenneth Galbraith. But it is simplistic to say the market crashed because silly people bid it up in an outburst of irrational enthusiasm. The big markets in particular tend to incorporate the best information available.

This recognition—learned at The Wall Street Journal at the same time I was learning about monetary policy from Mundell and fiscal policy from his protégé, Arthur Laffer—is what prompted my momentous discovery that the 1929 Crash was caused by the Smoot-Hawley Tariff Act of 1930. I made this discovery in March 1977 while researching my book, The Way the World Works. How could a 1930 piece of legislation cause a market crash in 1929? Easily, if in the last week of October 1929 the United States Senate is in the process of changing its mind on the tariff, from no to yes. While the issue would not be completely settled until June 1930 when President Herbert Hoover signed the act, the market had not waited around to sell. Granted, few people in the market knew why they were selling or why they were forced to sell. If they did, it would not have taken me 47 years to figure it out. It is like a tote board at a race track, where suddenly the odds change in favor or against a horse, and the players in the stands take all that into account without knowing on what information the bets had been placed.

To a Keynesian economist, the dire effects of a collapse in aggregate demand could have been offset by a cheaper dollar. This is exactly the argument made by the monetarists, Milton Friedman & Co., who note that one-third of the money supply vanished in the early years of the Depression as one-third of the banks went bankrupt. If Friedman et al have their causality right, the banks went belly up because the Federal Reserve did not print money fast enough.

However, when Roosevelt did try to get more money into the economy by devaluing the dollar in 1933-34 and making it illegal for Americans to own gold, the Great Depression only got worse. There was a bit of an inflation, as would have to happen when the dollar cheapens against gold. But all that did was cause nominal prices to rise and push workers and investors into the triply higher tax brackets that had been created by Hoover in 1930 and Roosevelt in 1933, long before the term “bracket creep” was coined.

Law,” says Professor Reuven Brenner, “is built on sand. Tradition is built on rock.” The McGill University economist in Montreal used the phrase to explain the endurance of gold as a standard of value. Even though governments decide they would rather manage without it, the ordinary people who make up the markets continue to use it as the best measure of the money their government provides for them. Where it may seem as if the price of gold swings up and down, what is actually swinging is the price of the dollar in terms of gold, first inflating, then deflating. Money, after all, is nothing more than a convenient IOU, a piece of paper or an electronic entry in a bank that can be passed around among workers, consumers, savers and investors as reminders of who owes how much in exchange for something else. When it changes in value as it passes from hand to hand, it causes confusion, which is why thousands of years ago people around the world began using gold—and here and there, silver—as the basic unit of account. Goods and services could be traded over long distances and long periods of time for delivery if the producers understood the values in terms of gold, or the currency chosen to represent gold as a circulating medium.

It was by trial and error that civilization wound up with gold, partly because it is rare, constituting only 5 parts per billion of the earth’s crust while silver is roughly 50 parts per billion. Better yet, it does not corrode or tarnish. It is also dense, so it does not take up much space, and it is soft, so it can be easily divided. We know pretty much where all the gold is and how much there is, about 130,000 metric tons, only enough to build one-third of the Washington Monument out of solid gold. It is the most monetary of all commodities, widely accepted in lieu of various paper currencies in exchange for local goods and services. It is hard to disrupt the world gold market by adding gold faster from gold mines, or withholding it, because its total stock is so enormous compared to annual production of less than 2,500 metric tons.

The most telling point is that the world market continues to price gold’s future value in terms of today’s value in the spot market, plus the interest rate on government bonds over the future period being examined. No other commodity on earth enjoys that respect for constancy and integrity over time. I learned all this from Fed Chairman Greenspan, who explained it to the House Banking Committee several years ago when asked why gold was more important than other commodities as a monetary commodity.

Unfortunately, when the price of gold began its decline from $385 per ounce in 1996 to about $275 today, Greenspan decided it was not a useful signal of monetary deflation. To do so, he would have had to acknowledge errors in his personal decision to manage the economy for purposes other than price stability. He saw the stock market as being inflationary. Then he saw the decline in unemployment as being inflationary. Lastly, he identified the rise in corporate bond yields as a harbinger of inflation. Now, with seven interest rate cuts and no positive reaction from the commodity or financial markets, Greenspan cites “fast” M2 growth as a sign that policy has become stimulative.

An obsession with inflation can be counted upon to bring delation. In its first phase, producers of things that come out of the ground are the first to see their products fall in price, following gold’s lead. This is because gold only measures a unit of labor, not a unit of capital. A unit of labor is the same everywhere, in the poorest and the richest countries, with wages differing according to the capital added. It was not entirely “inflationary,” after all, for the value of real estate in downtown Tokyo to rise sharply as it did in the 1980s. The rise in asset values was due to favorable capital-gains treatment for real property. When that tax treatment ended in 1990, the so-called real estate bubble burst.

In 1996, as Internet investment accelerated and the election results pointed to a tax cut in 1997, the price of gold began its decline. Mostly blind to these developments, even misreading them as inflationary and deploring them as “irrational exuberance,” the Fed failed to supply the liquidity the market needed. Greenspan was worried about the mini-inflation he allowed when the Clinton tax increase of 1993 reduced the demand for liquidity, and the Fed did not remove the surplus by selling bonds. Gold had averaged $350, more or less, since 1985. It rose to $385 in 1994 and stayed there, despite Greenspan’s efforts to squeeze out the inflation with higher interest rates. The classical economists could have told him, as did I, that he could only bring down the gold price by selling interest-bearing bonds from the Fed’s cache, withdrawing the liquidity. But gold had been so demonized by the demand-siders that Greenspan probably believed he would have been ridiculed for any gold-based move. So he hunkered down and hoped for the “best.”

The best, as I see it, is that the deflationary process has only been partially completed. It cannot be reversed unless someone the president respects picks up the phone and tells him there is no remedy except an inflation to readjust the gold price. With Greenspan now turning 75 and wishing to retire, the pieces may fall into place before year’s end. When it does, the gold price will either shoot up and stop at a point where the interests of debtors and creditors are in balance, or it may shoot up much higher, as it did when the deflations of 1982 and 1985 ended. Long-term interest rates are as high as they are, even in this deflation, because they have experienced this phenomenon before.

Inflation hawks, of course, will deny that deflation is possible while the CPI ekes up and various money supply indices bulge like mattresses in a banking crisis. The CPI was also registering “inflation” during the 1981-83 deflationary squeeze, as it is today. Then, the indices were still being driven up by the previous inflation and had not yet fully reacted to the dollar/gold price. Because contracts can take decades to unwind, this process is gradual. Only now are we beginning to see the “noise” created by the deflation-induced crude shortage removed from headline consumer and producer price indices.

Thirty years after going off gold, there is virtually no talk anywhere in the world of going back to it. We seem to have somehow gotten along without it after all. Or have we? Those who continue to believe a dollar/gold link is the only way the market can effectively tell the Federal Reserve how much money it needs are now prepared to argue that the world can no longer endure a floating standard of value. Jack Kemp, a leading Reaganaut of the 1980s and champion of gold and low tax rates, most recently reiterated that there really is no alternative to a gold anchor. He sees how gold would have prevented the accumulation of errors that now bedevil our economy—and that of the entire world, which looks to the United States dollar as the key currency. It is always the poorest people and the poorest countries that are most damaged by the absence of reliable standards of measure. The Third World would benefit most with a return to gold. But as the only superpower in a unipolar world, the United States is the only country in a realistic position to make the move.


*Jude Wanniski is president of Polyconomics, Inc. and author of The Way the World Works, one of National Review’s 100 best non-fiction books of the twentieth century.*