Golden Times: A Call for Better Monetary Policy

by Mike A. McGarr, CFA -- Portfolio Manager, Equity Research Analyst at Becker Capital Management

“There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency”

-Lord John Maynard Keynes (1883-1946)

“I am now a Keynesian in economics”

-President Richard M. Nixon as quoted in the New York Times, January 4, 1971

President Nixon’s newfound enthusiasm for the demand-based policies of Lord Keynes apparently did not include the great economist’s admonition to also protect the currency.  Seven months following the Times article, facing 6% unemployment, accelerating inflation, the costs of the Viet Nam War and his predecessor’s Great Society programs, Nixon believed bold policy action was required.  The fact that he was facing re-election the following year also undoubtedly played into his calculation.

On August 15^th, 1971 the Nixon Administration closed the “Gold Window” through which our trading partners could previously convert their holdings of dollars into gold bullion.  Simultaneously, the government imposed wage and price controls in an attempt to insulate consumers (and voters) from the inevitable spike in prices owing to the de facto devaluation of the dollar.  In so doing, the Nixon Administration effectively ended the post-World War II global monetary regime known as Bretton-Woods, under which the world’s major currencies were tied to the U.S. dollar, and the dollar was tied to gold.  For a time it even seemed to work.  Inflation subsided briefly in 1973, but then began to climb against the backdrop of the Middle East oil shocks, political turmoil, and importantly, an attempt to keep interest rates low and credit cheap by means of an expansion in the money supply.  Among policy-makers there was a belief that higher employment could be achieved with just a modest level of inflation.  It didn’t work out that way. 

By 1979, inflation was advancing at double-digit rates causing havoc among savers, bond-holders and all those for whom price stability was important.  Real economic growth was still slow and unemployment had failed to respond to the Fed’s policies.  Observers referred to it as “stagflation”.  With the situation deteriorating, President Carter appointed Paul Volcker to chairmanship of the Federal Reserve.  It fell to Volcker to propose tough policies aimed at slowing the growth of the money supply and bringing inflation under control.  Nor was it accomplished without considerable pain to the economy.  Volcker was eventually successful in slowing inflation, but not stopping it.  The value of the currency continued to decline.

Nixon’s decision to abandon a “hard money” standard was just the final step in a decades-long retreat from gold-based currency to “fiat money”, that is, money with no intrinsic value and no backing other than faith in the politicians and their central bankers.  Wracked by the costs of two world wars, war reparations, a global depression and the costs associated with more social programs, the fiscal discipline that a gold standard demanded had become impossible to maintain.  More and more countries were abandoning it.  Britain had suspended the gold standard during World War I to pay for the conflict and tried to re-introduce it in the interwar period.  An unrealistic exchange rate coupled with indebtedness and a war-damaged economy doomed that effort, and by 1931 Britain had again dropped the gold standard. 

Defeated in the First World War and their gold reserves taken by the allies as reparations, Germany never had a chance to resume a gold standard.  With few options, the Weimar government in the early 1920’s resorted to printing paper money in vast quantities.  According to Gwartney & Stroup, “the supply of German marks increased by 250% per month for a time” (Macroeconomics, Sixth Edition).  The resulting hyper-inflation from 1921 to 1924 ravaged savers and bond-holders while shredding the fabric of German middle class society.  Some believe this period may have helped set the stage for the rise of the Nazis to power in the 1930’s.  To this day, the legacy of that period influences German policy-makers as they confront the challenges of the massive sovereign debt and budget imbalances within the Eurozone. 

In the United States in the early 1930’s, high unemployment, farm and business failures, and declining confidence in the U.S. financial system caused many overseas trading partners to demand gold in exchange for their dollars.  Fearful, many U.S. citizens held onto their gold rather than trust the banking system.  Newly-elected President Franklin Roosevelt ordered citizens to surrender gold coins, bullion, and gold certificates to the Federal Reserve in exchange for other certificates at a rate of $20.67 per ounce.   In 1934 the government further increased the price of gold to $35 an ounce, depreciating the currency even further and giving the Federal Reserve room to inflate the currency as a means of stimulating the economy and making our exports less expensive to our trading partners.   Faced with the choice between a stable exchange mechanism and stable prices, or the independence to conduct its own monetary policy the United States eventually chose the latter, thus putting the final nail in the coffin of the gold-based system.  Global monetary policy has never been the same.

Now, with the economy still in the grips of a global financial crisis brought on by excessive issuance of debt, misallocation of capital, trade imbalances and spending deficits, governments everywhere using massively accommodative monetary policies to try and counteract the potentially deflationary effects of the debt crisis.  Recently, the Federal Reserve through its Federal Open Market Committee pledged to buy mortgage-back bonds in the open market and use other measures until such time as they see substantial improvement in the unemployment level.  This follows on two earlier programs by the Federal Reserve, so-called “Quantitative Easing”.  The result of all this monetary easing can be seen in the accompanying chart of the nation’s “monetary base”, highly liquid money that is available for payment or lending.  This massive increase in available money has not been accompanied without controversy.  While some view it as necessary to forestall a return to recession and price deflation, others view it with considerable alarm, noting that the Federal Reserve has forgotten the painful lessons of the 1970’s and early ‘80’s, and will be unable to respond effectively given the highly leveraged condition of the country’s balance sheet.  Writing in the Fall, 2011 issue of National Affairs economist John Cochrane noted that “The key reason serious inflation often accompanies serious economic difficulties is straightforward: Inflation is a form of sovereign default.  Paying off bonds with currency that is worth half as much as it used to be is like defaulting on half the debt.  And sovereign default happens not in boom times but when economies and governments are in trouble”. 

No matter how this episode resolves itself, there is growing agreement that a more transparent and consistent approach to conducting monetary policy is required.  Advocates of a return to a true gold standard argue that gold-backed money, while certainly not perfect, offers the “least bad” approach and the most stability, and the least potential for political interference, something sorely lacking in recent years.  They maintain that few of the imbalances afflicting the global economy would ever have taken hold under the discipline of a gold standard. Others, noting that while gold-based money has certain advantages, believe that a gold standard is too inflexible to work well in such a large and global economy.  Instead, they advocate for the institution of more rigorous and rules-based monetary policy.   All, however, agree that that the current precarious state of the nation’s, if not the world’s, finances only serves to complicate policy decisions.  Getting our fiscal house in order should be the first priority.