That Barbaric Metal
Jude Wanniski
September 30, 1999

Can you imagine how dumb the British government must feel, having decided to auction off 25 metric tons of its gold monetary reserves two weeks ago at $252 per ounce, at the very bottom of the market, then watching it soar as high as $329 in yesterday's trading and bouncing between $305 and $320 today? It was the exact reverse of how the Dutch government felt when it sold a chunk of its gold reserves in late 1996, at $385/oz., just as the Federal Reserve's long monetary deflation began. Did the central bank in Amsterdam know what it was doing in 96? In a way, it did. It guessed right on technical grounds, I think. At $385, gold was 10% higher than its average over the previous several years and seemed unlikely to go higher, given Chairman Alan Greenspan's determination to prevent inflation from creeping back into our money. At the time, it was our call that gold would go lower as chances improved of a supply-side tax cut in 1997, including a cut in the capital gains tax. We reasoned the anticipation of the tax cut would increase the demand for dollar liquidity as economic actors prepared for the economic expansion that a more favorable tax climate would bring. If we were on a gold standard, the Fed would be forced to supply the dollar liquidity at the fixed price. But Greenspan could ignore the market's call for more liquidity, which would make dollars scarce relative to gold, and therefore decrease the dollar price of gold -- with other commodity prices following in train.

In 1997, the market guessed right about a bipartisan deal on the budget and a tax cut. The stock market went up and the gold price steadily declined. Woe to those central banks in Asia that had pegged their currencies to the dollar, thereby importing the Greenspan deflation. By July 1997, with gold below $330, the Thai central bank in Bangkok had so starved its economy of liquidity in order to maintain the peg that it finally had to devalue the baht -- and with the IMF jumping in with more poisonous counsel, the errors metastasized into the Asian crisis. The dollar deflation spread into Latin America in 1998 and wrecked our own agricultural sector, as corn, wheat and soybeans followed gold. But gold did finally stabilize in the $285 range, a new equilibrium level in the need for dollar liquidity and the Fed's supply of it. Because there was no sign of further changes in our tax structure in 1998, an election year, there was no expanded need for liquidity, and thus no further pressure on gold.

This year, from the outset of the 106th Congress, there has been a replay of 1997, with economic actors anticipating a better tax environment coming out of the White House and Congress. Why not? Budget surpluses were now projected as far as the eye could see. The GOP leadership seemed determined to produce a serious tax cut and the President, weakened by impeachment, seemed ready for some sort of compromise. The stock market took off again, the demand for extra liquidity increased anew, and with an intellectually-confused Greenspan still seeing inflation where none exists, the gold price continued its decline. At the same time, the 30-year Treasury bond, which should have been falling in yield in the deflation, rose instead from the 5% level a year ago to 6+%. We reasoned the bond market had been educated to expect that sooner or later there would be a decline in the demand for liquidity, and the Fed would not mop up the surplus in the system. The likeliest time for that to occur would be around Y2K, when at the very least there would be an inventory sell-off. Or, the equity market would have to give up gains that were discounting the promised 1999 tax cut -- and as a result the real economy would experience a sudden decline in the demand for dollar liquidity.

It was not until two weeks ago, just as I was leaving for my vacation in Ireland, that the prospect of a 1999 tax cut this year began to dissolve completely. Everyone in the world had expected President Clinton to veto the Republican tax bill that had passed before the August recess, but the signals from Senate Majority Leader Trent Lott, the GOP House leaders, and the White House pointed to a second compromise bill that would take shape in the final months of the year. As recently as Sunday, September 12, Lott was still insisting on Meet the Press that he was not giving up on getting a tax cut this year, but in the next few days he threw in the towel. He had lost control of the Senate Republicans and the budget schedule had unraveled to the point where he now had to avoid a repeat of the Gingrich "train wreck" that shut down the government in 1995, which also saw a promised GOP tax cut go down the drain. In this brief period, the Dow Jones Industrial Average fell more than a thousand points, roughly 10% from its high, and the price of gold climbed 28% as the gold bears were swamped, overwhelmed by the decline in the demand for dollar liquidity.

Jonathan Fuerbringer, the gold man of The New York Times, stubbornly refuses to listen to any argument that Fed policy has anything to do with the gold price. He continues to write rubbish about the gold run-up being caused by the G-7 announcement that it would limit gold sales to 400 metric tons per year for the next five years and that it would limit private leasing of central bank gold stocks (which only will increase the volatility of the dollar/gold price, not its direction). This is the only fig leaf he and similar gold writers have, although Fuerbringer this morning at least notes in his final paragraph that the G-7 central banks had actually been expected to sell more than 400 tons a year! We have spent more than 20 years unsuccessfully trying to get the press corps to understand that the supply and demand for the metal itself has almost no effect on its price. This is because its stock -- 125,000 metric tons in circulation or bullion hoards -- is so enormous relative to its annual production of roughly 2,000 metric tons. The Brits sale of a measly 25 tons was insignificant, a drop in the bucket.

Where will gold go from here? There is still Y2K, folks, which will subtract from dollar liquidity demands. We have been reasoning for several months that the demand for dollars would fall and the demand for gold would rise as we approached the end of the year. And if Greenspan suddenly is spooked by the gold run-up, he may again be hot to get inflation under control by slowing the economy with a further hike in interest rates. Unless there is something done to shock the Fed into targeting gold instead of the Fed funds rate, the existing operating mechanism only allows him to wreck the economy without affecting the gold price or inflation rate. The only vehicle in sight is the Jack Kemp proposal to have the President sign an executive order that forces Greenspan to target gold -- a proposal that even Kemp's friends at The Wall Street Journal refused to report. What's happening now is exactly what he warned the President would happen, just a bit earlier than we expected because of Lott's leadership failure.

Of course, there are major beneficiaries in this mess, the biggest being dollar debtors at home and abroad and commodity producers at home and abroad. Unless gold goes berserk, the economies that had pegged to the dollar through thick and thin -- mainly China, Hong Kong, and Argentina -- now get relief. Nobody benefits if inflation comes back in spades, though, and it will be some fun at Y2K if the computers can't keep up with the churning of world currencies, commodities, and the barbaric metal.