Published April 15, 2014
Association of Private Enterprise Economics (APEE) Annual Conference
The Three Major Problems Congress Created by Ending the Classical Gold Standard
John D. Mueller
APEE 2014 Conference Panel T1.11
“Is There a Case for a U.S. Return to the Gold Standard?”
Las Vegas, NV, 15 April 2014
I’m grateful for the invitation to take part at the 2014 annual Association for Private Enterprise Economics (APEE) conference in this panel asking “Is There a Case for a U.S. Return to the Gold Standard?”–especially in company with such distinguished fellow panelists as our chair John Tatom, Larry White, and Adrian Oswaldo Ravier.
Our panel’s question can be answered in a word: Yes. I’d like to draw on a chapter in my book, Redeeming Economics (Mueller 2010), to explain why only proper monetary reform—specifically, restoring the international gold standard without official-reserve currencies—will end three interconnected problems which have long undermined the United States: first, endlessly expanding federal deficit spending; second, chronic episodes of inflation (or deflation), typically ending in recession; and third, declining U.S. international competitiveness. I’ll close by explaining why the reform that eluded President Ronald Reagan is now finally doable.
The stability of the U.S. dollar has varied widely in history. Building on the insights of the French economist Jacques Rueff, Lewis E. Lehrman and I have shown that this variation is explained by two factors: first, how policymakers set the monetary standard for the dollar; and second, whether policymakers in other countries use securities payable in dollars as their own monetary standard—that is, use the dollar as their official “reserve currency.”
The United States has alternated between two kinds of standard money: inconvertible paper money, on the one hand, or a fixed weight of some precious metal, on the other. The dollar was an inconvertible paper money during and after the Revolutionary War (1776–92), the War of 1812 (1812–17), the Civil War (1862–79), and again from 1971 to the present. The dollar was effectively defined as a weight of silver in 1792–1812 and 1817–34, and as a weight of gold in 1834–61 and 1879–1971. The dollar was not used by foreign monetary authorities as a monetary reserve asset before 1914. But it has been an official “reserve currency” for many since 1914, and for most since 1944.
Applying both criteria divides the monetary history of the United States into ten distinct phases. We can compare the stability of these monetary regimes by examining the variation in the Consumer Price Index (as reconstructed back to 1774) and in real GDP (as reconstructed back to 1790). For each we use two simple measures: for the CPI, maximum long-term stability and minimum short-term volatility, and for real GDP, maximum long-term average real GDP growth and minimum short-run real GDP volatility.[i] Weighting these criteria equally, we find that the classical gold standard from 1879–1914 was unparalleled as the most stable of all U.S. monetary regimes, with not only the most stable price level—this despite the fact that the CPI was mostly food at the time—but also the highest real growth over time, with the lowest variability in both the price level and real output.
Let’s consider the three problems that followed the gold standard’s abandonment.
First, Loss of Federal Budget Discipline. The current monetary system, which is based on monetizing U.S. public debt, is the main cause of the loss of federal budget discipline.
By President Ronald Reagan’s self-assessment, the Reagan Revolution was incomplete when he left office. “With the tax cuts of 1981 and Tax Reform Act of 1986, I’d accomplished a lot of what I’d come to Washington to do. But on the other side of the ledger, cutting Federal spending and balancing the budget, I was less successful than I wanted to be,” Reagan wrote in his autobiography. “This was one of my biggest disappointments as president. I just didn’t deliver as much to the people as I’d promised” (Reagan 1990, 355).
President Reagan’s disappointment can be traced to the unintended consequences of applying Milton Friedman’s “allowance theory” of federal budgeting under the paper dollar standard. “I have long favored cutting taxes at any time, in any manner, by as much as possible as the only way of bringing effective pressure on Congress to cut spending,” Friedman explained. “Like every teenager, Congress will spend whatever revenue it receives plus as much more as it collectively believes it can get away with. Reducing spending requires cutting its allowance” (Friedman 1997). President Reagan often borrowed Friedman’s allowance analogy.[ii]
C. Northcote Parkinson famously theorized that “work expands so as to fill the time available for its completion” (Parkinson 1955). Rather than advice on time management, Parkinson’s Law was the history professor’s attempt to explain the inexorable growth of bureaucracy. Friedman’s allowance analogy amounts to Parkinson’s Fiscal Corollary: public spending expands to absorb all available tax revenues.
But the strategy failed in practice by overlooking Parkinson’s Debt Corollary: public borrowing expands to absorb all available means of finance. If tax revenues are Congress’ “allowance,” then purchases of U.S. public debt by government trust funds and the banking system are its “credit cards.” The congressional teenager’s spending won’t be fazed by a cut in allowance, unless the indulgent parents also cut up the credit cards. Those “credit cards” consist, first, of the government trust funds accumulated ostensibly as “reserves” for Social Security and other supposedly self-financing programs, and second, purchases of U.S. public debt by the banking system, especially central banks that use such debt as official monetary “reserves.” Thus, while U.S. public debt jumped about 40 percentage points of GDP between 2006 and 2013, from 60 to 100 percent of GDP, debt to the non-bank public rose from only 9 to 21 percent of GDP—because most of the increased debt was purchased by trust funds and especially central banks.
The Congressional Budget Office predicts that U.S. public debt will keep growing exponentially–though it arbitrarily ends its forecast when public debt hits 250% of GDP (CBO 2013). It’s worth recalling that the U.S. Constitution never contained a balanced-budget amendment. None was needed, because the federal budget was continuously balanced under the domestic and international gold standards. By requiring that debts be discharged with money of the same gold value as when they were contracted, the gold standard operated as a perfectly written balanced budget amendment. Without monetary reform, efforts to add a balanced-budget amendment to the Constitution are a fruitless distraction.
Given the monetary system, the loss of budget discipline causes price instability. Milton Friedman was correct to say that “money matters,” but mistaken in ignoring Jacques Rueff’s discovery that foreign official dollar reserves have the same ultimate impact on the price level as the high-powered dollars created by the Federal Reserve. Rueff pointed out that pointed out that when a monetary authority accepts dollar claims for its official reserves, instead of settling its balance of payments deficits in gold, purchasing power “has simply been duplicated, and thus the American market is in a position to buy in Europe, and in the United States, at the same time” (Rueff 1932, 52-53).
In this way, Rueff showed, “the gold-exchange standard was a formidable inflation factor. Funds that flowed back to Europe remained available in the United States. They were purely and simply increased twofold, enabling the American market to buy in Europe without ceasing to do so in the United States. As a result, the gold-exchange standard was one of the major causes of the wave of speculation that culminated in the September 1929 crisis.” Lehrman 2013 and Lehrman 2014 contain excellent and accessible summaries of Rueff’s monetary theory, distinguishing it from Keynesian theory and domestic monetarism. As the chart shows, the U.S. stock market’s 1920s boom and 1930s bust were coincident and commensurate with the rise and fall of dollar balances deposited in New York.
What I call the World Dollar Base is an effort to implement Rueff’s monetary insights that I have just described. The World Dollar Base is the sum of U.S. currency and commercial bank reserves plus foreign official dollar reserves. I’ve been able to reconstruct the World Dollar Base back to 1830, and its variation relative to the real growth of U.S. productive capacity has preceded each major episode of consumer price inflation or deflation.
Of course, the relation is a bit more complicated than that. As the next chart shows, the commodity-led inflations that triggered the recessions of 1974–75, 1979–80, 1990–91, and the Great Recession of 2007–09 were each proceeded by commensurate monetization (or less often, demonetization) of U.S. public debt.
This next version of the chart compares the annual rate of inflation of CPI nondurable goods—mostly food and energy prices—with a ratio of the main factors affecting demand for them: the lagged “World Dollar Base,” divided by a proxy for the current demand for high-powered dollars: U.S. currency and commercial-bank reserves times current world oil production). In each case, voters blamed the president: Richard Nixon, Gerald Ford, Jimmy Carter, George H. W. Bush, George W. Bush, or now Barack Obama.
The next chart depicts the third problem: The dollar’s official-reserve currency role has eroded U.S. international competitiveness. In 1980, U.S. residents owned net investments in the rest of the world equal to about 10 percent, but by the most recent figures (end of 2012) had become net debtors equal to more than 30 per cent, of U.S. GDP. Meanwhile U.S. net official monetary assets—official monetary assets minus foreign official liabilities—declined by almost exactly the same amount. Yet the books of the rest of American residents simultaneously remained in balance or even slight surplus. This comparison proves that the entire decline in the U.S. net investment position has been due to federal borrowing from foreign monetary authorities; and explains why ending the dollar’s role as chief official reserve currency is necessary to end chronic U.S. payments deficits and restore U.S. international competitiveness.
Reagan’s Unfinished Monetary Reform. As Congressman Jack Kemp’s staff economist just before and during both Reagan administrations, I can attest that in 1980, then-Governor Ronald Reagan’s advisers agreed that it was necessary to limit the power of the Federal Reserve governors who make monetary policy. But nothing was done because the advisers disagreed about the policy rule.
“Domestic monetarists,” following Milton Friedman, proposed that the Federal Reserve regulate the quantity of bank reserves and the money supply. Many “supply-siders” advising Jack Kemp proposed to make the value of a paper dollar equal by law and convertible into a weight of gold, as it was for most of the two-hundred-plus years of U.S. history. But among them, “global monetarists,” following Robert Mundell, advocated at least a temporary return to the 1944 Bretton Woods gold-exchange system. Others of us heeded Jacques Rueff’s warning that only restoring a multilateral gold standard without foreign-exchange reserves would be effective.[iii]
Futility of a “gold-price” target. In response to Jude Wanniski, I explained why “Targeting the price of gold under the current monetary system is not the same as a gold standard. This is because, under a gold standard, the creation of money is directly tied to the gold market. The monetary authority keeps its money at parity with gold, by purchasing all gold supplied but not demanded, or by selling all gold demanded but not supplied, in the private gold market.
“But under a ‘gold-price rule,’ the central bank does not buy and sell gold; it buys and sells financial assets like Treasury securities. The money created in this way is not issued in response to anyone’s demand for such money; it is issued on the initiative of the central bank. And this new money must make its circuit all the way through the rest of the economy – first bidding up the price of financial assets and then forcing all producers in the economy to adjust their plans – before the fact that the money is not demanded is reflected in the price of gold; a process that takes a good two years. Because the process takes time, the central bank is always responding to the balance of supply and demand for money two years earlier. Moreover, the central bank will be unable to remove all the money it created as long as the government budget is in operating deficit. So the inflation is, in practical terms, irreversible.” (Mueller 1991, 39).
Some like Nathan Lewis (Lewis 2013) still follow Wanniski in arguing that a commitment by the monetary authorities to target the price of gold is equivalent to a gold standard. But as Larry White has correctly observed, under a gold standard “gold is the medium of redemption,” not merely the unit of account, and what Lewis proposes is not a gold standard, but a “fiat standard with a gold price target” (Cato Institute 2014).
Moreover, ending the U.S. gold standard greatly lengthened the lag with which monetary policy affects U.S. consumer prices, to two years or more. This lag, which as I mentioned also affects the gold price under the current fiat standard, is far too long for any form of “price rule” or “price target” to be a feasible policy.
Why is it possible now to achieve what President Reagan could not? Though they often disagreed, Milton Friedman and Robert Mundell both exhibited colossal integrity in acknowledging that changing circumstances had made their earlier proposals infeasible. As Friedman summarized in a Financial Times interview, “The use of quantity of money as a target has not been a success. I’m not sure that I would as of today push it as hard as I once did” (London 2003). Similarly, according to a Wall Street Journal interview with Judy Shelton, Mundell believes that “it would not be possible today to forge a monetary system with the dollar as the key reserve currency, as President Franklin Roosevelt and Treasury Secretary Henry Morganthau did in the 1940s. ‘To be fair, America’s position is not nearly as strong now,’ he concedes.’” (Shelton 2010).
Thus, it is now finally possible to restore the first principle of successful presidential economic policy, which goes back to George Washington and his Treasury Secretary Alexander Hamilton. As Rueff showed, the essential requirement is that the major countries agree to replace all official foreign-exchange reserves with an independent monetary asset that is not ultimately some particular nation’s liability: gold.
There are two conditions for the success of such a reform.
First, the gold values of all national currencies must be properly chosen to preclude the deflation of wages and prices that occurred in the 1920s and 1930s in those countries (notably Britain and the United States) which tried by the expedient of substituting foreign exchange for gold reserves to keep parities that did not allow for past wage and price inflation. Other countries, notably France in 1926 and 1959, restored gold convertibility successfully with strong economic growth but without inflation, deflation, or unemployment. (Rueff chose the parities on both occasions.)
Second, existing official foreign exchange reserves must be removed from the balance sheets of monetary authorities by consolidating them into long-term government-to-government debts that would be repaid over several decades—much as the Washington-Hamilton administration funded the domestic and foreign Revolutionary War debt.
My final chart shows the reason why the next successful president will end the reserve currency curse and restore the gold standard: both inflation and deflation are deeply unpopular, and American voters hold the U.S. president directly responsible. Whenever the consumer price of gasoline rises, the sitting president’s popularity drops. This is why any presidential candidate who does not wish to become a byword will have to restore the gold dollar and end the dollar’s “reserve currency curse.”
Cato Institute (2014). Gold: The Monetary Polaris. Conference on Lewis (2013). (12 February). http://www.cato.org/multimedia/events/gold-monetary-polaris
Commission on Public Debates (1980) The Anderson-Reagan presidential debate (September 21). available at http://www.debates.org/indexphp?page-september-21-1980-debate-transcript, accessed 7 July 2010.
Congressional Budget Ofice (2013) The Long-Term Budget Outlook. Washington, DC. (17 September) available at http://www.cbo.gov/publication/44521
Friedman, M. (1960) A Program for Monetary Stability. New York: Fordham University Press.
_________ (1997). If only the United States were as free as Hong Kong. Wall Street Journal. (July 8) available at http://www.hoover.org/publications/digest/3522326.html
Keynes, J. M. (1913) Indian Currency and Finance. London: Macmillan.
Lehrman, L. E. (2014) The Federal Reserve and the Dollar. Cato Journal, Vol. 34, No. 2 (Spring/Summer). Washington, DC. Cato Institute.
_________ (2013) Money, Gold, and History. 2nd ed. Greenville, N.Y.: TLI Books.
_________ (2012) The True Gold Standard. Greenville, N.Y.: TLI Books.
_________ (2013) Money, Gold, and History. Greenville, N.Y.: TLI Books.
Lehrman, L. E., and Paul, R. (1982) The Case for Gold. Washington: Cato Institute.
Lewis, N. K. (2013) Gold: The Monetary Polaris. Canyon Maple Publishing. New Berlin, NY.
_________ (2007) Gold: The Once and Future Money. Hoboken, NJ. John Wiley & Sons.
London, S. (2003) “Lunch with the FT: Milton Friedman.” Financial Times (7 June).
Mueller, J. (1991) “The Rueffian Synthesis.” The LBMC Report (June/July). Arlington, Va. Serialized in 2013 at www.thegoldstandardnow.org/the-rueffian-synthesis.
_________ (2010) Redeeming Economics: Rediscovering the Missing Element. Wilmington, Del.: ISI Books.
Parkinson, C.N. (1955) “Parkinson’s Law,” The Economist. (November). London. available at http://www.economist.com/node/14116121, accessed 18 February 2014.
Reagan, R. (1982) Remarks at the Annual Policy Meeting of the National Association of Manufacturers, http://www.reagan.utexas.edu/archives/speeches/1982/31882c.htm, accessed 17 February 2008.
_________ (1990) Ronald Reagan: An American Life. New York. Pocket Books.
Rueff, J. ( 1979) Theorie des Phenomenes Monetaires. Paris: Payot. Republished for The Lehrman Institute. Paris: PLON.
_________(1932) “The Case for the Gold Standard.” Lecture delivered at L’Ecole des Sciences Politique, March 17. Translated into English and reprinted in Rueff (1964: 30–61).
__________( 1981) L’Ordre Social [Social Order]. Paris: PLON for The Lehrman Institute.
__________(1947) “The Fallacies of Lord Keynes’ General Theory.” Quarterly Journal of Economics 63 (5): 343–67.
__________(1949) “Sur la theorie quantitative et le phenomene de regulation monetaire” (“The Quantity Theory and the Regulation of Money”) Econometrica 17 (July): 295–306. Unpublished Lehrman Institute translation, III/1–4a.
__________( 1967) “Un instrument d’analyse economique: la theories des vraies et des faux droits.” In E. M. Claassen (ed.) les Fondements Philosophiques des Systemes Economiques. Paris: Payot.
__________ (1964) The Age of Inflation. Translated by A. H. Meeus and F. G. Clarke. Chicago: Gateway Editions, Henry Regnery Company.
Shelton, J. (2010). Currency Chaos: Where Do We Go From Here? Weekend Interview. Wall Street Journal. New York. (10 October).
White, L. H. (2013) The Merits and Feasibility of Returning to a Commodity Standard. Mercatus Center conference “Instead of the Fed: Past and Present Alternatives to the Federal Reserve System” (1st November). George Mason University. Arlington, VA.
__________ (1999) The Theory of Monetary Institutions. Malden, Mass.: Blackwell.
 John D. Mueller is the Lehrman Institute Fellow in Economics at the Ethics and Public Policy Center, and president of the forecasting firm LBMC LLC, both in Washington, DC.
[i] Long-term CPI stability is measured by the annual average change from beginning to end of each monetary standard. Short term volatility is measured by the standard deviation of annual CPI changes (up or down) during the period. Real GDP is measured by average annual real economic growth and its variability by the standard deviation of real GDP.
[ii] Notably in a 1980 presidential campaign debate, when Reagan said, “increasing taxes only encourages government to continue its irresponsible spending habits. We can lecture it about extravagance till we’re blue in the face, or we can discipline it by cutting its allowance” (Commission on Public Debates 1980); and a 1982 budget speech: “John [Anderson] tells us that first, we’ve got to reduce spending before we can reduce taxes. Well, if you’ve got a kid that’s extravagant, you can lecture him all you want to about his extravagance. Or you can cut his allowance and achieve the same end much quicker. …Increasing taxes only encourages government to continue its irresponsible spending habits. We can lecture it about extravagance till we’re blue in the face, or we can discipline it by cutting its allowance ” (Reagan 1982).
[iii] On June 29, 1984, Congressman Jack Kemp introduced the Gold Standard Act of 1984, which would have defined the dollar as a fixed weight of gold, restored gold convertibility of Federal Reserve notes and deposits, and provided for gold coinage. Both Kemp’s explanatory statement and Lewis E. Lehrman’s op-ed of that day, which Kemp inserted into the Congressional Record, remain valid.