“Alan Goldspan”
By Reuven Brenner*
Seemingly out of the blue, the U.S. Federal Reserve chairman is hinting at a return to the gold standard. If so, currency markets are in for a shock.
Last month in a speech before the Economic Club of New York, Alan Greenspan praised the gold standard, the first time he has unambiguously done so since joining the U.S. Federal Reserve. “Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800,” he stated. “But in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent over-issuance of money.”
Is Greenspan returning implicitly to his long-held strong beliefs, which he voiced explicitly before he became Fed chairman, of having the gold price guide U.S. monetary policy? If so, that would mean keeping the gold price (in terms of the dollar) stable. Under this standard, as Greenspan accurately points out, the price level in the United States stayed stable through wars and much technological and political upheaval. The implication is clear: There is no problem achieving such stability in future, even if the United States goes to war, and even if much technological and political upheavals continue. During the six decades since the Americans left the gold standard, prices rose tenfold. This happened not because these decades were more turbulent than the preceding 13, but because of the faddish belief, rationalized by much of the economic profession, that central bankers could do a better job managing monetary policy by setting interest rates and exchange rates than by market-guided, gold-price-anchored discipline.
The fad’s long life is not surprising. Central planing, based on the belief that bureaucrats know how to price wheat, physicians, nurses and teachers better than people involved in the respective businesses, has been enduring for centuries, in spite of evidence to the contrary. The view that central banks could best manage monetary affairs by pricing interest rates and exchange rates thus fit perfectly into this bureaucratic frame of mind. Though, as Greenspan points out, the evidence contradicts this viewpoint.
Before 1996, Greenspan often indicated that gold prices were guiding his monetary policy. Then he abandoned all reference to them — until last month’s speech. His strong statement comes like lightening out of the blue sky. With another Federal Reserve governor, Ben Bernanke, repeating part of Greenspan’s comments, we get a strong signal of where the U.S. dollar is heading — if Greenspan goes from words to actions. Before we get to the numbers, here is what Greenspan said concerning monetary policy and deflationary pressures:
“But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in over-issuance of money, even at the cost of considerable economic disruption. By 1979, the need for drastic measures had become painfully evident in the United States. The Federal Reserve under the leadership of Paul Volcker, with the support of both the Carter and Reagan administrations, dramatically slowed the growth of money. Initially, the economy fell into recession and inflation receded. However, most important, when activity staged a vigorous recovery, the progress made in reducing inflation was largely preserved. By the end of the 1980s, the inflation climate was being altered dramatically.”
Greenspan also said that, in the short and medium run, the link between money and prices is unclear, which means that targeting “inflation” rates cannot have the desired effects. If Greenspan will act upon all these views — and that’s yet to be seen — U.S. monetary policy will be radically transformed.
What can we expect, then, to happen to the U.S. dollar? To gold prices? To the euro? To the Canadian dollar?
First, let’s understand that using gold prices for monetary guidance means, as Greenspan emphasizes, that companies and governments can safely get into U.S. dollar contractual agreements without worrying about its value, be it over short, medium or very long hauls. The difference between a gold-guided policy and one guided by inflationary targets is important. Price levels are backward looking and mismeasured. It’s not surprising, then, that although central bankers have targeted low inflation in the United States, Europe, Canada and elsewhere, the policy did not have the desired results that most economists expected. Exchange rates have fluctuated up and down in 50% ranges, violating the value of contractual agreements and making capital more expensive. While one could mitigate the consequences by hedging with complex and expensive derivatives, derivatives do not come cheap.
What happened to lead Greenspan to abandon his opaqueness of the last few years and clearly tout the benefits of the gold standard? Here I enter the realm of speculation.
In the last decade, the world lost two of its three reserve currencies — the yen and the DM — leaving only the U.S. dollar. The Japanese have been mismanaging their economy and monetary policy for a dozen years and, contrary to expectations, the euro has not been anchored in the DM, but in a vague, unreliable “inflationary” target that Greenspan dismisses with good reason: As noted above, such targets did not prevent exchange rates from sharply fluctuating. Something was obviously not working. The euro’s recent rise is no indication that it is about to become a reserve currency. The dollar continues to stand alone, its mismanagement over the last five years notwithstanding .
Between late 1993 and mid 1996, gold was roughly at US$400, give or take US$10. At the end of 1996, the severe decline in gold prices and the rise in the U.S. dollar starts, with gold hitting its lowest level on July 20, 1999 at $252.80. Why did the U.S. dollar go up relative to almost every currency and commodity prices? The increased demand for the dollar had a number of causes, only one of which was its expanding status as reserve currency. Another cause was the growing demand for the U.S. dollar around the world with the faster growing economies of the 1990s. Greenspan did not respond to the increased global demand; instead he brought about the disastrous currency fluctuations of the last six years.
Based on Greenspan’s earlier speeches, we may then speculate on what might have caused him to pursue the erroneous policy, and what may have led to his drastic change of mind. It was in 1996 that Greenspan made his famous speech on “irrational exuberance” at a time the Dow was in the 6,000 range. Since now, six years later, the Dow is hovering between 8,000 and 9,000 even after expectations of lowered growth rates, terror, war and Latin American upheavals, Greenspan may have realized his mistake, thinking that the 6,000 level was too high, and that he must apply restrictive monetary policy to lower it. Also, last year, finally, Greenspan started to talk about deflation. Since Greenspan had been an ardent believer in the gold standard before becoming chairman of the Fed, he may have put together the sequence of events and recognized the errors of his ways. After all, if one looked at all these facts and sequence of events over the last six years through a “gold price” perspective, they should not have been a surprise. They were predictable.
This realization does not imply that the Fed will now buy either treasury or other government bonds (the two options that he and Bernanke raised in their speeches) with newly minted dollars until gold goes back to the US$400 level. With war and diminished growth rates on the horizon (even with the fiscal stimulus), the global demand for the dollar is not what it was in the late 1990s. Choosing a rough, rounded average of US$350 as a target may be a reasonable guess for a Greenspan “target” point. He might have chosen it already: He knows that the global demand for the dollar has been declining since 2001, yet the monetary base is up by roughly 8% over the last year. Unsurprisingly, the dollar has been in decline relative to most major currencies, sliding to a level where it should have been.
If my analysis is in the right ballpark and Greenspan from now on uses the gold price to guide his monetary policy, no further significant increase in the price of gold should be expected. If demand for the U.S. dollar continues to drop, the Fed will issue treasury bonds, and if it rises, it would buy them or other government bonds. Once the U.S. dollar becomes “as good as gold,” even if informally, and with the present fiscal stimulus, capital will flow to the U.S., the euro will weaken, and so will the Canadian dollar.
*Reuven Brenner, a professor at McGill University’s Faculty of Management, is the author of Force of Finance (2002) and coauthor of A World of Chance: Betting on Religion, Games, Wall Street (2008). Special thanks to Dr. Brenner for providing this article.
This article was originally printed in the Financial Post, January 21, 2003, and reprinted as part of the White Paper before the Australian Senate from the Committee on How to Re-Plan Australia, p. 16, Spring 2004.
Image by graur razvan ionut / FreeDigitalPhoto.net.
