Viewpoint: A $600 Question


Illuminated by hindsight, historic changes and opportunities often have a conspicuousness that they did not possess at the time they occurred. A good example is the US government's decision, in August 1971, to demonetize gold. Until that time the Treasury had been selling gold to foreign governments for $35 an ounce. When this was stopped, many people assumed that gold, deprived of a monetary role, would decline in value. Few saw the historic opportunity.

The $35-an-ounce sale of the metal had been the functional equivalent of a worldwide price control. The Treasury's steady supply of gold, plus arbitrage, had ensured a market price never much above $35. When that supply ended, gold's price had nowhere to go but up. And if, as Rep. Henry Reuss suggested, gold's price would drop to $2.50, why hadn't foreign central banks been selling the metal to the Treasury at the premium price of $35 instead of buying it?

As I say, these things are obvious in retrospect. But not at the time they happened. I recently undertook a brief survey of press coverage after August 15, 1971, and there was no understanding of the foregoing facts. Even the markets were confused. In the week following the closing of the gold window, gold stocks dropped about 15 percent. The news media—then pretty much in the dark about all aspects of economics (there has been an improvement since)—were above all jubilant about President Nixon's decision, made on the same day, to impose wage and price controls. This, said Business Week, had sent "a wave of confidence rolling through the country."

So today I pose the question: Are there any developments right now, the implication of which will seem obvious to people in 1995, but today are still quite obscure to us? I do have a suggestion. I confess it could be utterly wrong. But first a little more history.

Following gold demonetization in 1971, inflation predictably occurred. The egregious Arthur Burns, then chairman of the Federal Reserve Board, and his equally bad successor, G. William Miller, accommodated the various groups with a vested interest in inflation (notably government). Of course, their excuse was that they thought they were helping the economy by driving down interest rates. The dollar plunged. Gold soared.

By 1980, with the prime rate at 20 percent, there was a feeling that things were out of hand and that inflation was here to stay. But at the same time there was an important change: lenders, who for years had been fooled by inflation, began to demand and receive a positive rate of return. That is why interest rates were so high instead of so low. (Arthur Burns was rewarded with an ambassadorship.)

The conventional wisdom today still is that inflation may come roaring back at any time. Note that on February 11, 1983, the gold price was $503 an ounce—the same day it was announced that producer prices fell 1 percent in January, the Consumer Price Index having risen by only 3.9 percent in 1982. These figures indicate that a lot of people think inflation will resume.

My suggestion, nervously proposed, is that a new sophistication in the financial markets makes this unlikely. Gold advocates, noting gold's current sideline role, think that this cannot be. But I believe we have something new today, something absent in the gold-standard years: immensely sophisticated, highly elaborate, worldwide markets that respond swiftly and efficiently to new information. In particular, they respond to news of US debt monetization by the Federal Reserve. It is now understood (and a market reality) that monetizing debt is inflationary, and lenders will eventually demand higher nominal rates of interest. These higher rates then inhibit the creation of credit. This cycle of events, I submit, is stable—comparable to a "negative feedback" loop in engineering (a machine action provokes a response, which then damps down the original action).

Normally, when the government buys some commodity, thus increasing its demand, the price goes up. But when it buys bonds—that is, buys its own debt—bond prices, will decline after a while. In this instance the act of purchase not only disorients the yardstick of economic measure—the dollar—but also devalues the units (of debt) being traded. This is because the purchase is made with money created ex nihilo.

The upshot, I suggest, is that the Fed's hands are now tied. If it tries to drive interest rates down to spur economic recovery, interest rates will soon go up instead. Once this is understood—and I believe it is understood already—then passivity is the Fed's only rational policy. Since the Fed's board is composed of rational individuals, it is reasonable to suppose that they will not undertake to dilute the dollar when that only leads to higher interest rates and aborted economic recovery. Thus, no matter how much the inflationists in Congress will disapprove, inflation may be a thing of the past. If this turns out to be true, it will be a remarkable illustration of the limits that free markets place on political power.

If I am right, why are inflationary expectations, as expressed by the gold price, so high? Well, sometimes it does take time for economic wisdom to find its way to prices. Think, for example, of the immediate market (and pundit) belief that the gold price would drop after August 1971. On the other hand, if gold is $600 an ounce by the time you read this, I will be wondering what is wrong with the above analysis.

Tom Bethell is a free-lance writer, a contributing editor of the Washington Monthly, and a columnist for National Review.