Greenspan & Gold
Jude Wanniski
July 20, 1994


We have not yet seen a transcript of this morning's Senate Banking Committee hearings, with Fed Chairman Alan Greenspan delivering his mid-year Humphrey-Hawkins report. CNBC only carried snippets and C-SPAN's taped coverage won't be available until sometime tonight. Sen. Robert Bennett [R-Utah] did manage to squeeze in a few questions on gold that elicited some important answers. According to a skimpy report on the Dow Jones wire, he reaffirmed his view that gold is a useful indicator of inflation. "It really always has been in one way or another...My own impression is it's quite useful." He described gold as "a special monetary commodity" that distinguishes it from other commodities, in that it is a direct inflation measure. According to a staffer present, Bennett asked if Greenspan agreed that the country with the most stable currency would have the lowest interest rates, and Greenspan agreed. He then asked if a country tied its currency to gold, isn't it logical that it would have the lowest interest rates, and Greenspan agreed again. 

Bennett also asked Greenspan about the fact that the enormous debt raised during World War II was financed at 2% interest rates, while we were on a gold standard. This could have opened an interesting line of questioning, regarding the financing of the current $4.5 trillion debt, but Greenspan insisted the 2% interest rates of WWII had nothing to do with the gold standard. He said the Treasury and the Fed had simply made up its mind to keep interest rates at 2% during the war by selling as many bonds as necessary to finance the deficit. Here the Fed chairman is clearly wrong, reciting the Keynesian textbook answer, written by economists who hated gold and had done everything they could to disparage it. In fact, WWII was financed at 2% interest rates, because the decision was made in Washington at the outbreak of the war to preserve the legal definition of the dollar as one-thirty-fifth of an ounce of gold, and that foreign central banks could continue to acquire gold at that rate for dollars. And foreign governments did sell gold to the U.S. at that rate, acquiring dollars with which to buy war material. 

If the U.S. had announced it was suspending the legal definition of gold and financing the war debt with greenbacks, as it had during the Civil War, the market price of gold would have risen during WWII, as would the prices of everything else. While it was illegal for U.S. citizens to own bullion, gold was available for jewelry, dentistry and industrial uses, and the price for the raw metal was $35 per ounce. If the Fed could make up its mind to finance at 2% a war debt twice the size of our current debt, as measured in GNP, why don't Greenspan and his colleagues make up their minds to do so today? 

In response to another Bennett question, if my source is correct, Greenspan also erred in saying that in order to fix the price of gold at $350 per ounce, the U.S. Treasury would have to buy and sell gold to achieve that objective. He said the buying and selling of government bonds could not do the job. It's not possible to know from this response what is going on in Greenspan's mind, but he could not be more in error. If the dollar price of gold is rising, it is because the market values gold more than the dollar according to the usual law of supply and demand. The price of gold can be brought down by having the Treasury sell gold for dollars, as Greenspan says. This increases the supply of gold in the market and reduces the supply of dollars. The same objective could be achieved by exchanging government interest-bearing bonds in the Fed's portfolio for non-interest-bearing dollars held by the banks. The supply of gold in the market remains constant, but the supply of dollars is reduced. This is in fact exactly what happened during World War II. If the Fed at the time was trying to fix the amount of M1 or M2 or the fed funds rate or bank reserves, as it has since 1971, it could never have persuaded creditors to buy bonds at 2%. The idea that "patriotism" allowed this to happen is sociologically ridiculous. For every "war bond" that went unsold at a rally, the commercial banks were on hand to snap them up with surplus liquidity, believing they were as good as gold. 

We may make a little progress if Greenspan would think through these historical and economic errors, which he obviously has thus far accepted as textbook facts. They are less important than his public confidence in a dollar-gold link as a certain way of achieving the lowest interest rates in the world. Just as importantly, Senator Bennett is now hot on the trail of this issue, and finally understands its fiscal implications. If only the government would make the simple decision to restore the link, it could refinance the entire national debt at 3% instead of 8%, and save the taxpayers $200 billion per year.

We normally would wait to see a complete transcript before commenting on Greenspan's testimony, and we will have more to say after his testimony before House Banking on Friday. This was too interesting to pass up, though. The parts of his testimony that were reported in full were so dismal that all we could do was watch the markets sag during his presentation. He may do better Friday, if only to scotch the impression he left today that he will be jacking up fed funds again next month. Even from what I saw today, it isn't clear that this is so. Greenspan was much more elliptical.

Senator Connie Mack [R-Fla] on May 27 presented Greenspan with a written question at the Banking Committee hearings, which Greenspan answered on July 13. Mack asked if Greenspan considered gold a reliable indicator of inflationary expectations, and if his interest-rate increases were meant to reduce such expectations, why has the gold price not come down? Greenspan replied: "It is true that inflationary expectations as suggested by the price of gold, implicit inflation premiums on long bonds, and other variables have not significantly contracted since we initiated our monetary tightening February 4th. However, monetary policy has long lags before its impact is discernable. As a consequence, I suspect it is too soon to see the types of responses you imply in your question." That is, Greenspan still has his fingers crossed that the price of gold will decline and the bond rally will resume, and that he will not have to raise rates again. On the other hand, the implication of today's testimony that he may have to raise rates again will continue to keep the price of gold from falling and the price of bonds from rising, as the Fed's open-market desk continues to add liquidity to the banking system in order to keep interest rates from rising in anticipation of higher rates ahead.

The Fed's operating mechanisms should have been questioned today, but no Senator brought them up. It is difficult finding members of the House Banking Committee who understand the mechanisms sufficiently to even approach Greenspan with such questions. It is clear from his responses, though, that Greenspan continues to believe that by targeting the fed funds rate at a certain level, the level of bank reserves will respond in a certain way, and eventually it will produce the decline in the gold price that he desires. This is certainly the long way around, allowing him to cross his fingers and wait for the "long lags" he described to Senator Mack. The fact is, if Greenspan wished the price of gold to fall, or rise, he could do it with ease, with zero lag, by buying government bonds to make it rise, selling them to make it fall. Inch by inch, we are making progress, folks, but it is certainly a painful and frustrating path that we are on.