It used to be easy to sell 100-year bonds at 3 percent; now people are ecstatic to find a 20-year mortgage at 14 percent. That symptom infects many seemingly separate problems from the budget deficit to the instability of international commodity prices to the Polish and Mexican debt crises. The entire dollar economy, worldwide, is precariously dependent on short-term debt. There is an urgent need to lengthen debts, to restore the confidence in future dollars needed to entice savings out of the short-term money market into long-term investments in stocks, bonds, and mortgages.
There are three hurdles that must be passed in moving from that problem to its solution:
• Is the problem fiscal or monetary?
• If the problem is even partly monetary, should the nation and the world move toward predictable rules governing monetary policy or continue to leave central banks with unlimited discretion?
• If long-term monetary rules are desirable, should they emphasize quantities of money (like M1) or prices—interest rates, exchange rates, or the price of gold?
Once the debate at last progresses to that final stage, there will then be broad agreement that economic progress requires a credible long-term monetary policy in at least one major nation. The world is starving for a monetary anchor, a stable unit of account for long-term contracts that eliminates windfall gains or losses to debtors or creditors.
The recent downturn in interest rates is of questionable duration. The devastating rise in long-term interest rates did not begin with Reaganomics but has instead continued in every single year since President Nixon severed the last connection between gold and the dollar in August 1971 and set the dollar afloat. Interest rates rose after the tax surcharge of mid-1968, kept rising as the federal budget deficit was slashed by 80 percent from 1972 to 1974, and rose again as the deficit was reduced by 58 percent from 1976 to 1979.
The supply-side fiscal reforms proposed by President Reagan were intended to reduce the average burden of government by reducing federal spending relative to private production and to reduce the marginal burden by retroactively indexing personal income tax rates. These policies can scarcely be the source of the recession—not only does the recession predate them, but nothing much in the way of supply-side fiscal reform has yet happened, despite heroic efforts.
Nondefense spending was a record 17.7 percent of the gross national product (GNP) in 1982, up from 15.9 percent in 1979. Although the July reduction in personal tax rates survived the disciples of President Hoover, a married couple, each earning the equivalent of $25,000 in 1979, will nonetheless face a tax bracket of 44 percent when they file their tax returns for 1982—up from 42 percent for 1981. Without the 1981 tax law, that marginal rate would have risen to 49 percent.
The government's financial problem cannot safely be shifted to households and firms—they already have the same problem themselves. After homeowners and corporations have made their interest payments, there is nothing left for the tax collector. Long-term interest rates, however, never exceeded 5 or 6 percent under any kind of gold standard, before or after the international monetary policy hammered out at Bretton Woods after World War II. If interest rates and unemployment were down to even the highest levels of the Bretton Woods era, the budget would soon be in surplus. The federal deficit is just one of many symptoms of a monetary crisis.
The United States has no predictable monetary policy at all. Nobody knows what the Federal Reserve is going to do in the years ahead, or how or why. Meanwhile, the Fed uses rusty tools to roughly massage a variety of shifting and irrelevant targets in order to meet unknown and probably unachievable objectives. Neither the Fed nor its critics can measure the quantity of money or predict its velocity, the rate at which it is moving through the economy.
It should be painfully clear that a decade of collapse in long-term financial markets requires a long-term monetary solution. In recent years the Federal Reserve has shifted from trying to control interest rates to trying to control the quantity of money. But how could any believable long-term rule of monetary policy be expressed as quantity of money when (1) the definition of money is rapidly changing, (2) connections with the monetary base are eroding, and (3) all models to predict velocity have broken down since August 1971, when President Nixon closed the gold window? The 1982 Economic Report of the President answers that "the rule could be revised from time to time" at the discretion of the Federal Reserve. That is not a meaningful rule. Inflation is indeed caused by too much money, but only the markets know how much of which kinds of money is consistent with a dollar of stable value.
Monetarists, who advocate a quantity rule, ordinarily posit a two- to five-year lag between changes in the money supply and changes in the price level. Now, they want credit for the apparently cyclical slowdown in inflation. But to do so, monetarists must drop the idea of a lag and ignore the acceleration of the monetary base (bank reserves and currency) and of the broader measures of money.
In the past year, real interest rates higher than at any time since 1932 have forced the liquidation of inventories, commodities, and houses at distress-sale prices. A global going-out-of-business sale can indeed depress price indexes that are dominated by liquidated goods. But there is a world of difference between selling what we have at lower prices and producing more at stable prices. In fact, the falling value of claims against future output (such as bonds and mortgages) has raised the expected cost of living in the future and reduced the incentives to expand future production.
To restore confidence in the future purchasing power of money, many supply-siders could easily endorse some variant of the Stein Plan. In Contemporary Economic Problems, 1980, Herbert Stein wrote that "one can hardly imagine a hyperinflation and all its attendant uncertainties going on while the government honored a commitment to sell gold at a fixed price. Some version of a gold standard may, therefore, be useful…to provide assurance that there is a limit beyond which inflation will not go." One of the standard objections to a gold standard is that the government cannot control the quantity of gold. But, Stein goes on, "This function does not…require a continuous tight link between the quantity of money and the quantity of gold. The purpose could be achieved by a commitment to sell gold at a fixed price, the government remaining free to manage monetary policy by whatever rules or lack of rules it chose, so long as it protected its ability to honor that commitment."
Such convertibility imposes no rigid link between the Treasury's gold inventory and any measure of money—only a behavioral link. Concerns about having enough gold or enough money are therefore irrelevant. The supply of money becomes a residual—whatever people are willing to hold without converting into gold. Thus, the annual growth of M2 was 19 percent from 1879 to 1882, but consumer prices were unchanged. People trusted the money and held more of it.
This flexibility of a gold standard minimizes any costs of adjusting to zero inflation. On the other hand, if a monetarist quantity rule were somehow believed, interest rates and velocity would fall, and that rising demand for real money balances could only be met by deflation or by abandoning the rule. People would want to hold more money if inflation were stopped but could not do so with an arbitrary limit on the money supply.
In the past year, of course, the Economic Report of the President has been widely quoted as destroying any case for a gold standard. What the report actually did was to perfect the technique of distorting history.
First, pretend that the Bretton Woods system was not based on pegging currencies to a dollar convertible into gold. This forces advocates of convertibility to instead defend the 1879–1914 period when there was no deposit insurance, no unemployment insurance, no central bank, and none of the stability that should flow from today's service economy with modern communications, transportation, and inventory control.
Second, pretend that ancient indexes of wholesale commodity prices are a reasonable measure of the purchasing power of money. That is, use an index of a few bulk commodities (mostly farm products), excluding consumer prices, services, and housing. This can indeed prove that wheat prices varied, but it cannot prove that the dollar did.
Third, start with a peak inflation year in which Britain or the United States was not on a gold standard, like 1814 or 1872, then compare commodity costs with the worst slump of the century, 1896. This method can fabricate a "deflation" of about 2 percent a year, which mostly occurred before gold was reinstated and was later largely due to productivity gains that lowered costs.
Fourth, insinuate that every failure of banks or crops was due to the gold standard. Actually, no serious research has blamed a single major recession on the gold standard per se, though government threats to the standard did cause trouble in 1884, 1890–96, 1929–34, and 1968 to date.
When all else fails, raise undefined fears about strange foreigners raiding "our" gold hoard or dumping gold on the US market or both. But suppose the Soviets did sell tons of gold to get dollars and used those dollars to buy grain or repay debts. Any inflationary pressure would make the fixed price of gold a relative bargain, encouraging those with extra dollars to exchange them for gold. The only net effect would be that Americans received Soviet gold—rather than IOUs—for their grain. Similarly, if Arabs unloaded T-bills to buy US gold, the interest rate would rise, inducing others to sell gold to acquire T-bills. Gold convertibility is a self-correcting mechanism.
Proponents of a modern gold system are not obliged to defend ancient history, except by comparison with the uniformly disastrous history of fiat money. Still, the return to gold in 1879 has some limited relevance. An 1874 bill initiated a return to convertibility at the start of 1879. Bond yields dropped by a third from 1873 to 1881, stock prices rose by 30 percent. A strong economic expansion took off immediately, with a 16 percent rise in real output in 1879.
Victor Zarnowitz recently updated the old business cycles for the National Bureau of Economic Research. Instead of 10 recessions from 1879 to 1914, he finds only 7 in 35 years. In the most recent 35 years, we had 9. The average expansion from 1879 to 1914 was not 22 months, as originally thought, but 39. Annual growth of real GNP exceeded 4 percent. Employment of manufacturing workers soared from 2.7 million to 6.6 million. Industrial production rose by 534 percent. Real wage rates in manufacturing rose by over 30 percent from 1890 to 1914; they did not rise at all in the past 10 years (even before taxes). The classical gold standard performed very well, considering the disadvantages a century ago, but it is certainly possible to do better.
There are, of course, a few standard objections to any meaningful change. Some argue that any monetary rule is likely to be bent during wars or crises, therefore we should skip the rules and go directly to the bending. Since the value of the dollar used to be changed every 36 years, we might as well let it change every 36 seconds. Another argument is that we have to end inflation first before we introduce any system to deal with it. In scientific language, "We can't put the toothpaste back in the tube."
It is easier to attack change per se than to defend the existing non-system. The unwillingness to commit savings to long-term uses is profoundly serious. People do not trust the money. Chasing the elusive Ms from week to week is not the solution but the problem. There is only one way that confidence in currency, once lost, has ever been restored, and that is by guaranteeing it in gold.
Alan Reynolds is an economist at Polyconomics. This article is adapted from a presentation at a conference, "Supply-side Economics in the 1980s," sponsored by the Federal Reserve Bank of Atlanta and Emory University.
This article originally appeared in print under the headline "Honest Money".