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[golden-bear]

Greenspan or Gold?

by Lawrence W. Reed

[Posted May 16, 2001]

Alan Greenspan has again lowered the price of short-term credit (the interest rate that he controls) in an effort to keep the economy from falling into recession. Rather than speculate on whether this will work, I’d like to raise a different set of questions.

What is it about our monetary system that permits Greenspan and a handful of others to make such momentous decisions? In a free market, prices are determined by the voluntary actions of individuals who buy and sell. Errors in such a system tend to be self-correcting.

Why is money treated differently? And how can we know whether Greenspan is doing the right thing? How can he know?

Under a free-market system of money management, such decisions are left to the market, not to monetary central planners. We once had such a system, and it was called the gold standard. But in a step-by-step process over the course of the twentieth century, the U.S. government gradually departed from any direct link between its paper dollars and gold.

Some economists regret this and believe that the United States may someday feel the same way. While there is no remaining formal link between gold and the dollar, many economists (even some who are not advocates of a gold standard) do believe that there is still a residual and necessary link—even if it is only psychological—between paper money and the value the paper is supposed to represent.

For example, many people would take a mass sale by the U.S. government of its gold as a reason for having less confidence in the dollar and the government`s ability to maintain its value. This sentiment is not unjustified.

Gold, in my view, still retains a certain mystique, and a government that strips its shelves of gold, so to speak, runs the risk of a loss of confidence. This is because, at least instinctively, many market participants believe that maintaining a gold supply is a sign of discipline and responsibility, and they would see the sale of that gold as a sign that government wants more room to inflate or otherwise mismanage the money supply. That would likely mean a resumption of dangerously high rates of paper-money creation, which would send prices higher and imperil the stability of both the currency and the economy.

The idea behind a gold standard is to remove from the hands of politicians or their political appointees the discretion of determining a nation`s supply of money. The opposite of a gold standard would be a fiat paper standard, whereby the monetary authorities of government have complete discretion: They can inflate or contract the money supply at will.

Historically, because such situations grant enormous power to government without restricting the potential for abuse, vastly destructive abuses have, in fact, occurred. History is littered with many examples of governments printing their paper money—to pay for everything from elections to foreign military adventures to welfare programs—until it becomes utterly worthless, destroying people`s savings and confidence in the economy.

Hence, the reasonable yearning throughout history for some sort of "sound money" that will retain its value and allow an economy to function without monetary upheavals.

Gold emerged as the marketplace`s preferred medium of exchange because it tends to retain its value over long periods of time. That’s the real advantage to a gold standard. The gold supply tends to grow at a rate of about 2 percent per year, which some economists believe to be "about right" when it comes to the growth rate of the money supply (though this point is open to debate).

When paper money emerged, it first appeared as simply a "receipt" for the real thing, gold. It was later that governments discovered that if they took it over, they could gradually or swiftly sever the connection between the paper and the gold, and then print lots of paper money to pay their bills. Of course, that destructive policy may serve the short-term needs of a spendthrift government, but it ultimately destroys the money, the economy, and sometimes the government, in a blizzard of inflation.

There`s a lot of wisdom to the saying "Governments don`t like gold because they can`t print it." Even when governments adopt a formal link between their paper money and gold, they come under great pressure to erode it, so that they eventually can be free to print more paper. Think of a gold standard as a kind of discipline on the monetary authorities.

From 1900 until the 1930s, the standard rate was that one dollar equaled 1/20th of an ounce of gold. That limited how many paper dollars either the government or the nation`s banks could print, since their quantity had a legal connection to the amount of gold on deposit. That sounds like a pretty strict gold standard, except that, at the same time, the government took progressive steps to gradually weaken the gold-to-paper link, such as the establishment of the Federal Reserve System in 1913.

President Franklin Roosevelt changed the ratio from 1/20th of an ounce to 1/35th of an ounce (to the dollar) early in his first term. This gave government more room to inflate the paper money supply. Roosevelt also took the dramatic step of making gold ownership by private individuals illegal, which was a huge step away from the gold standard. What little was left of an American gold standard was eliminated by Richard Nixon in 1971, when he announced the United States would no longer redeem dollars in gold for foreigners.

Today, we don’t have a gold standard in any form. We have paper money issued by government fiat and managed by the Federal Reserve. Although it would appear that the monetary authorities have exercised proper restraint in recent years to prevent inflation, there is no law on the books to prevent them from printing as much paper money as they wish. Moreover, the damage caused by an inflated currency can take place long before it becomes visible in the form of higher prices.

No formal connection with gold exists, leaving open a door through which less scrupulous leaders than our current batch might someday walk with impunity.

By lowering rates yet again, Greenspan may or may not be on the right track. As the designated monetary central planner, he has an impossible job—one that the gold standard accomplished without the intervention of central bankers or the influence of politics.

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Lawrence W. Reed, an adjunct scholar of the Mises Institute, is president of the Mackinac Center for Public Policy in Midland, Michigan. See his Daily Article Archive and send him mail. This is adapted from a Q&A on the Mackinac site.

[golden-bear]

Fed`s rate slashing spurs inflation worries
Long-term Treasury bond yields already show the effects

Kathleen Pender Wednesday, May 16, 2001

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There`s an old saying that the bond market rarely makes mistakes, and for the past few months the bond market has been saying that Alan Greenspan`s aggressive interest rate cuts could stimulate inflation.

Should investors take heed, and consider adding some inflation-busters to their portfolios?

If you asked Greenspan, he would probably say no.

In its interest rate pronouncement yesterday, the Federal Reserve said, "With pressures on labor and product markets easing, inflation is expected to remain contained."

But the bond market begged to differ.

The price of long-term bonds declined yesterday, and their yields rose, reflecting fears of higher inflation.

Interest rates and inflation usually go in the same direction, so when investors see inflation coming, they sell existing bonds because they think they can get a higher interest rate on new bonds issued in the future. When this happens en masse, the price of existing bonds falls and their yield -- which moves in the opposite direction -- rises.

Since January, the Federal Reserve has cut the target federal funds rate five times in an attempt to stimulate the economy. The Fed hopes that lower interest rates will encourage consumers and businesses to borrow money and buy stuff and get the great American dream machine cranking again.

The Fed`s cuts had the intended effect on short-term interest rates. The yield on 3-month Treasury bills has fallen dramatically, to 3.7 percent from 6. 4 percent in November. That has cut the interest rate investors earn on short- term investments such as money market funds and certificates of deposit.

But yields on long-term bonds have gone in the opposite direction because investors fear the Fed`s dramatic rate cuts -- the steepest ever -- could overstimulate the economy and spark inflation.

Since late March, the yield on the 10-year Treasury bond has risen to 5.51 percent from 4.76 percent and the 30-year Treasury bond yield has risen to 5. 91 percent from 5.26 percent.

Investors will get a better read on inflation today when the Labor Department releases the Consumer Price Index for April.

In the first three months of this year, the CPI advanced at an annual rate, seasonally adjusted, of 4.0 percent, up from 3.4 percent last year and 2.7 percent in 1999.

When the economy was booming, inflation was almost nonexistent. So why are people worried about inflation now, when the economy is in slump?

Because three things have changed: productivity growth is slowing, energy prices are soaring and the money supply is exploding.


PRODUCTIVITY
During the boom years, productivity -- or output per hour worked -- grew faster than normal, which allowed robust economic growth with little inflation.

But during the first quarter of this year, productivity actually fell by 0. 1 percent, the first decline in six years.

Sung Won Sohn, chief economist at Wells Fargo & Co., explains that about two-thirds of the Consumer Price Index comes from labor costs -- compensation (wages and benefits) minus gains in worker productivity.

In the fourth quarter of last year, compensation grew 5.7 percent and productivity grew 3.4 percent. The difference -- 2.3 percent -- contributed to inflation.

In the fourth quarter of this year, Sohn predicts that compensation will grow 5 percent and productivity will grow only 1.5 percent, which means labor costs would add 3.5 percent to inflation.

According to Sohn, productivity is the sum of two parts: long-term growth, largely from investment in information technology; and short-term, cyclical changes.

Cyclical changes occur because output changes faster than employment. When the economy booms, companies can`t hire workers fast enough to keep up with demand, so output per hour improves. When the economy slows, employers are slow to lay off workers, so output per hour falls.

Some economists say that the productivity gains of the past few years came largely from technology investments, and will keep inflation in check.

The Fed is apparently in that camp. Its statement yesterday said, "Although measured productivity growth stalled in the first quarter, the impressive underlying rate of increase that developed in recent years appears to be largely intact, supporting longer-term prospects."

Other economists say that the gains from technology are overblown, and that productivity is dominated by cyclical factors. Sohn sides with this group, and doesn`t expect to see any genuine improvement in productivity until the economy comes roaring back. In the meantime, inflation could be a problem.


ENERGY PRICES
Rising energy prices could also fuel inflation.

When the CPI for April comes out today, economists are expecting to see an increase of 0.4 percent in the overall rate, but only 0.2 percent if you exclude food and energy (electricity and gasoline).

Bill Quan, director of research with Aubrey Lanston, says the overall rate will be even higher -- 0.7 percent -- because of high energy costs.

"I`m forecasting a 4.5 percent increase in electricity and a 9 percent increase in consumer gasoline prices," he says.

Quan says high energy prices will cause the CPI to "creep up, but when you look at the impact to the overall economy, it almost has a depressive effect."

That`s because demand for electricity and gasoline doesn`t fall much when prices increase. "That takes money out of consumers` pockets, so they spend less on other goods. In that sense it`s not inflationary."

The net effect: Quan predicts that inflation will rise from 3.4 percent last year to 4 percent this year and 4.25 percent next year.

Sohn says that energy prices alone could add as much as half a percentage point to the CPI.

"You may buy fewer bubble gum and bicycles," he says. "On the other hand, everything we use consumes energy. As a result, the prices of all these things go up."


MONEY SUPPLY
Sohn`s final worry is the money supply, which has surged since the Fed began cutting rates.

When the Fed announces a rate cut, it buys Treasury securities on the open market, which pumps cash into the economy. Lower rates also encourage consumers and businesses to take out loans, which further feeds the money supply.

All that money floating around gets the economy humming again, but it can cause inflation if you get too many dollars chasing too few goods.

If inflation gets out of hand, the Fed can turn tail and increase interest rates, which shrinks the money supply and dampens inflation. But Sohn says that doesn`t happen immediately.


WHAT, ME WORRY?
David Bowers, chief global investment strategist at Merrill Lynch, dismisses these risks.

"Inflation is a dead issue," he says. "Inflation comes when you have a synchronized global pickup."

If the United States, Europe and Japan all rebounded at the same time, then he`d start looking for inflation hedges.

Nevertheless, Bowers admits that outside his shop, concern about inflation is growing.

In a survey published yesterday, 28 percent of 250 leading money managers polled said they thought global inflation would be higher in 12 months. A month ago, only 14 percent thought so.

The bottom line? Nobody really knows where inflation is headed, but if you think it could be an issue, you might want to consider adding some investments that do well in inflationary environments -- such as real estate, inflation- indexed Treasury bonds, natural resources or even gold -- to your portfolios.

Net Worth runs Tuesdays, Wednesdays and Fridays. E-mail Kathleen Pender at [e-mail].

©2001 San Francisco Chronicle