Q&A Period
Jude Wanniski
January 15, 1999


Supply-Side University Lesson #16

Memo To: Website Students
From: Jude Wanniski
Re: Q&A period

Q: (Michael Gilliland) I am a supply-sider very much in favor of free trade, but struggle with a particular aspect of the issue. What do we do in cases such as the steel industry where foreign dumping causes our own industry to suffer? Do we just allow the industry to die and count it a necessary loss to the efficiency of the free market or do we take some action? And what actions can we take that will be based upon the finest principles of free enterprise instead of big-government regulation?

A: The steel industry has every right to seek political redress from the wave of steel washing up on our shores at fire-sale prices from abroad. Government exists to protect an individual or a corporation from injustices that befall them. Has the steel industry been harmed by an unjust action? If it is simply losing business because a competitor abroad has figured out a way to make cheaper steel, the answer is obvious. If the steel is coming in at firesale prices because the foreign competitor is located in a country that has suddenly taken actions injurious to its steel producers, the U.S. government must take that into account when assessing our steel industry's petition for relief. I would argue against relief, on the grounds that this is part and parcel of the risks our steel industry must take in the normal course of doing business. The market will not punish our industry, because it knows that as soon as the surplus inventory is unloaded, our industry will have one less competitor.

In the present case, we have a different problem. The dollar price of steel, indeed the dollar prices of all commodities, have been driven down by the policies followed by the U.S. Federal Reserve, an agent of the federal government. In other words, the people of the United States in this indirect fashion are responsible for the steel industry of the United States being damaged. The responsibility is lessened by the fact that foreign governments which relied upon the stability of the dollar damaged their own economies by doing so, causing their steel industries to be forced to sell inventories at distress prices.

What do we do to offset the damage to the steel industry? The losses it bears are not permanent because the adjustment is to a new equilibrium. Its stakeholders take a hit as a result of the deflation, but we probably can't arrange to do much to ease their pain. U.S. citizens and corporations are constantly affected in one way or another by unexpected consequences of federal policies. It would not be in the national interest, for example, to enact legislation of any permanent nature, i.e., a tax or regulatory barrier to future steel imports. Better to prevent future lurches of this kind by fixing the dollar/gold price.

Q: (Ben Sessions) I am trying to decipher how the agricultural and oil industries, for instance, are suffering so immensely from our currency crunch but most of the rest of us have remained virtually unharmed. Can you point me to some reading which would help me better understand the impacts of deflation and how it cycles through the economy, or, perhaps, you could talk about it?

A: When you change the value of the unit of account relative to gold, the first price changes that occur are in other commodities that are internationally traded in auction markets. When the price of gold falls, the price of a haircut stays the same until the prices of all other goods and services fall in domino-like fashion. If the price of gold falls in a country where the average maturity of debts is several years, it may take several years and several reductions before the barber changes the price of his haircuts enough to equilibrate with the lower gold price. The decline in the gold price does not hurt as much for those who do not produce internationally traded commodities, like the barber who can still get the same price for his haircuts while the goods he buys that involve oil and farm prices are falling. Our monetary deflation was caused by reductions in those tax rates that had been depressing economic growth. The resultant growth required more liquidity, which the Fed did not supply, which caused the dollar price of gold to fall. Thus, good things were happening to one part of our economy while bad things were happening to another. It is because our economy is the least reliant in the world on commodity production for its national income that our deflation can seem so painless.

Q: (Ron Hardin) How would you change the story if the supply-side paradigm included that after the mid '80s gold had lost its status as numeraire and was on its way to an industrial commodity? Whatever you think of it, it's the competing account, that gold has a history and can change depending on what it comes up against in history.

A: Gold would lose its status as numeraire if its "moneyness" would change. As Fed Chairman Alan Greenspan has pointed out before congressional committees, gold is more important as a monetary commodity because its stock is so large relative to its flow. There are 120,000 metric tons of gold in the world and only 2500 metric tons produced each year to meet new demand. If you tried to build the Empire State Building out of solid gold, 120,000 metric tons would only complete the first three feet. For gold to lose its status as numeraire, someone would have to suddenly discover a source of cheap gold that rapidly would increase the flow relative to the inventory. That would make gold too inflationary. Or, if someone found an industrial use for gold that meant we would have to cut into the inventory at a rapid rate, that would make gold too scarce to be used as numeraire. If this happened, the world would probably have to switch to another commodity, some other precious metal.

Q: (Anthony) How come, in spite of American savings depleting, the U.S. economy is still rolling along pretty well? I thought one of the rules was only real capital growth can occur if it comes from real capital (i.e., savings) and not through credit expansion (Federal Reserve rate cuts). Joblessness is at it lowest rate and U.S. consumers are buying a lot of goods and services. Is this truly a strong economy or is it a bubble economy?

A: In a sense, production equals consumption plus saving. But in reality all production is consumed, or it would not be produced. If a baker bakes a thousand loaves, they must all be consumed before they go stale. If General Motors produces four million autos, they must be bought before the new models come out. None are "saved." In the modern world, as opposed to the animal world where squirrels store away nuts for the winter, inventories are extremely small relative to consumption. It is pointless to discuss savings, because there really are no "savings" that can be measured with any accuracy. Even "production" cannot be measured with any meaningful accuracy, because so much production does not add meaningfully to the living standards of the population. When the only incremental "Gross National Product" added in a calendar year is the building of a prison to house the criminals in a society with an expanding crime rate, the "production" can't be viewed in positive terms. We know our "economy is still rolling along pretty well" because the value of financial assets have been rising in terms of the gold numeraire. The total value of our capital stock as determined in the auction markets is a relatively good measure of living standards, because they net out the costs of unproductive activity. Supply-side economics focuses on the production (supply) side of the economy, and assumes that if we can optimize government tax, monetary and regulatory policies, production will be more efficient and the population will be able to "buy" more useful things with their wages, which is how national living standards rise.

Q: (John Coolidge) In today's lesson (Jan. 8) you suggested that you would answer the question "why aren't others in agreement with your view favoring the gold standard." You did not. For this novice I am puzzled about the motives of those who disagree with your position. If they are repeatedly proved wrong, why do they maintain their position? What am I missing ?

A: If you spend your life learning the ins-and-outs of a specific paradigm, it is almost impossible to train your mind to work in another. A Ph.D. in the Keynesian paradigm or in the Monetarist paradigm are the equivalent of Ptolmaic astronomers in a Copernican world. If you have spent your life learning how to reckon in a model that assumes the sun revolves around the earth, it is almost impossible to unlearn that thinking and begin anew with the assumption that the earth revolves around the sun. Your brain is trained in the same way it is when it grows up in one culture or another. An American can never really fully learn how to think like a Japanese or a Libyan. The motives of those who disagree with the classical model are as simple as that. The only reason I think the way I do is that I grew up in a demand-side world, but was never trained in its intricacies. It was as if I grew up in a Ptolmaic world, trained as a philosopher, not an astronomer. When I became concerned that the Keynesian paradigm did not seem to work as a useful model, as a young man trained in political science I began the process of finding a model that would be useful in its predictive powers. The reason I decided to open this Supply Side University is because I could see it would be the only way interested young men and women could do what I did in learning the classical model through daily telephone discussions with Robert Mundell and Arthur Laffer, the two economists who were alone in the entire world in truly understanding the old model. In some ways, I understand it better than they do, because their first "language" was the Keynesian language, while my first training was in the supply model.

There was a time early in my education in economics that I believed Milton Friedman's monetarist model was superior to the Keynesian fiscal approach. In fact, I've retained a greater respect for the Keynesian approach than the strict monetarist model, which I think has no value. As Fve tried to demonstrate in this semester's lessons on money, I do not believe the government has any power to control "the money supply," as Friedman would have us believe. It can only increase or decrease the amount of the national debt that does not pay interest. Part of that amount of non-interest-bearing debt is commonly understood as "money;" part of it is understood as "bank reserves," which may become "money" if the reserves become loans.

My greatest advantage is in discovering the cause of the Wall Street Crash of 1929. It was because the supply-side classical economists could not explain the crash that a vacuum developed in the economics profession. The vacuum was filled by John Maynard Keynes, who argued that the supply model had become obsolete because of the inefficiency of the private marketplace, and it was the responsibility of government to manage the economy by managing the aggregate demand of the nation's total population through use of its tax and spending power. Monetarism emerged as a conservative contradiction to the idea of using fiscal powers to manage demand, arguing that managing the money supply would be sufficient to keep the economy growing productively. Neither the Keynesians nor the monetarists can  afford to accept my thesis of the Crash, as being caused by a supply shock to an efficient market, because the new assumption requires the construction of an entirely new paradigm. In the early days, Copernicans were burned at the stake.

Q: (Scott Robinson) In the WSJournal of Jan. 16, Milton Friedman has an op-ed about Japan: "The implications of this experience for policy in Japan and the U.S. are in some respects the same, in some different. For fiscal policy, both countries would benefit from cutting high marginal tax rates and government spending. For monetary policy, Japan needs to be decidedly more expansive; the U.S., decidedly less expansive." I think [you] would agree. Friedman's monetary aggregates are incapable of measuring liquidity as well as the price of gold. Since the latter is not rising, even though aggregates are rising, they are not rising at a rate which will satisfy yet ever increasing demands for liquidity.

A: Friedman's model requires him to argue that with rising monetary aggregates (the "M" money supply numbers), there has to be inflation on the way. The gold price now is irrelevant in the monetarist model because the paper money has been officially disconnected from it. At the time of the disconnect in 1973, Friedman said gold was now the "monetary equivalent of pork bellies (bacon)." In order to keep his followers from having to admit that what he has taught them is utterly useless, Friedman now has them saying the surplus money has been inflating stock prices on Wall Street. Asset inflation. The market now is a speculative bubble, he is saying, which puts him on the side of the Keynesians on the road to government intervention. In the classical model, the monetary aggregates are rising because non-interest bearing debt of the U.S. has been increasing in value. In other words, relative to gold as a proxy for purchasing power, the dollar has been appreciating. Holding a bag of dollars under your mattress gives you an untaxable capital gain, so you hold more of them.

In Japan, the yen has also been appreciating and causing Japanese people to hold more of them for capital gain, but the combination of monetary deflation and high taxation has reduced the demand for money for transaction purposes, and this shows up as a scarcity of monetary aggregates. If the Bank of Japan would abandon its interest-rate target and focus on raising the yen price of gold, to 40,000 or more per ounce from 32,000 per ounce, the demand for yen for transaction purposes would soar and the demand for yen because of its appreciation under the mattress would fall. The aggregates, though, would rise.

Q: (Judith Grady) On NEC news: the hog farmers are going bankrupt. Hog prices are 100% lower than they were in 1997 (and you all do know that hogs are a commodity, I am sure). It costs $45 to raise a hog which today will only bring the farmer $40, so the farmers are going bankrupt. Many are giving their stock away, rather than take the loss. The phrase "depression era prices" was used. However, it was noted that the meat packers and the retail grocers have not changed their prices at all. So, we the consumer are not seeing any savings. The packers and the grocers are just making a larger profit. Meanwhile, 4th generation farmers are losing their farms. America is not hurt by the current deflation? Such needless suffering. Is this an example of retail pricing lagging wholesale commodity pricing? Are hog prices more sensitive to Fed policy than, say, supermarket pork chop prices? Or is it just overproduction, with a weeding out of inefficient producers?

A: Another SSU student, Tom Horn, had the answer: "Advertised prices for pork products in the local newspaper from several different grocery stores Hormel sirloin chops 1.99/lb save 2.00/lb; Hormel picnic roast 79/lb save 200/lb; Hormel pork chops 1.49/lb save 1.50/lb; boneless sirloin chops 1.48/lb save 1.50/lb; boneless spareribs 1.58/lb save 1.00/lb." There are of course upscale markets where the customers pay little attention to prices when they want pork chops, but where people shop seriously, list prices of pork chops give way to discounts and half-off coupons. In the worst inflation period, when vendors of all kinds worried about a resumption of wage-and-price controls, they would hike list prices for the government's statistics and records, but sell at discount prices to customers who were scouring the market for bargains. In the case of pork, there is something else going on in addition to the monetary deflation. The American Farm Bureau Federation (a client of Polyconomics, by the way) informs me that federal meat inspection rules were changed early last year regarding hogs, but with an effective date of Jan. 1, 1999. As an unintended consequence of one provision, farmers had an incentive to raise more hogs in 1998 so they could to a degree get relief from the regulations by being grandfathered. They thus were hit from two sides, monetary and regulatory.

Q: (Dick Fox) In his memo to economist Paul Krugman, Jude wrote: "Smaller economies could not do it [gold standard], because of the political strains that it would impose on its people by forcing an internal shift in comparative advantage to the financial industry and away from nonfinancial industry." But Jude has also recommended Russia and China establish a gold standard. It seems to me that any monetary system would be better on a gold standard, and that any argument against it would apply to all economies not just small ones. Can you help me here?

A: If you are the only country in the world on a gold standard, you will have a comparative advantage in the financial services industry because people who trade in your currency will not have to take out insurance (hedge) against currency loss. This is exactly the reason why I recommended a gold standard to Russia and China, so that they could give birth to a financial service industry. Under communism, there was no such thing as private banking. When I first made the case in the U.S.S.R., in Moscow before the entire senior staff of the state Gosbank, I even argued that once they had established the ruble's value in terms of gold and the world came to appreciate the ruble's value as a trading vehicle, it would take so much banking business away from New York and London that it would force the U.S. and U.K. onto a gold standard.

Small countries that have mature economies that trade manufactured goods internationally cannot easily go on a gold standard because their work force will be drawn into the banking sector by the country's comparative advantage in banking. When Switzerland in 1973-74 tried to remain on gold all by itself, the world was clamoring for Swiss francs and the currency became the strongest in the world. Its pharmaceutical industry and chocolate business and tourist business was being destroyed by the process, and the Swiss chamber of commerce finally persuaded the government to float the franc in order to keep its other businesses competitive. For a time, interest rates in Swiss banks were negative. To deposit dollars, you had to pay the Swiss bank for the privilege. Robert Mundell, who explained this to me in 1974, recently reminded me that the biggest economy in the world always is the one responsible for setting the currency price of the gold numeraire. Other currencies can then come in under its umbrella without fear of having its internal economy disrupted.

Q: One of the participants raised an interesting question in the TalkShop not directly related to monetary policy, noting that Ludwig von Mises discussed the economics of environmentalism in his 1949 book, Human Action. "You wouldn't think that Von Mises would have anything to say about the environment in 1949, before the modern environmental movement began to appear." Here is Von Mises on p.639: "There are institutional conditions that cause the persons involved to prefer satisfaction in the nearer future and to disregard entirely or almost entirely satisfaction in the more distant future. . . . they do not concern themselves of the temporally more remote consequences of exploitation. Tomorrow does not count for them. The history of lumbering, hunting, and fishing provides plenty of illustrative experience; but many other examples can also be found in other branches of soil utilization."

A: My recollection is that modern environmentalism really began in England a hundred years ago, with the Fabian Society and the "Fabian socialists" Sidney and Beatrice Webb. The argument Von Mises made in 1949 was made by the Fabians as a rationale for government intervention. The ideas came to the United States in the 1890s and ripened when the Progressives and Theodore Roosevelt picked them up. It is of course true that men who financially are put under stress will do what they have to do to survive, even if it means stealing from the future. The Greenpeace environmentalists coincided with the inflation that began in the late 1960s when President Lyndon Johnson closed the London gold pool. As the economy declined under the hammer of inflation, industrialists were led to "economize" by polluting the environment with wastes that they would not have emitted if they were still enjoying economic expansion.

The most pollution the world experienced in this century was in the communist countries, when the population became so strapped for calories that they paid no attention at all to the environment. The water around Leningrad became undrinkable. The nuclear pollution at Chernobyl was the worst example of this inattentiveness to the environment. In China during the Cultural Revolution, forests were cleared for fuel. Oddly enough, American environmentalists tended to be in coalition with liberal Democrats who continued to marvel at the wonders of the Soviet economy right up to its collapse John Kenneth Galbraith and Lester Thurow being two of the most frequently quoted. One aspect of this coalition was that the liberal news media in the United States studiously avoided criticizing the despoliation of the Russian environment. The depth of its problems was not revealed until the Cold War was over.

When a nation is experiencing genuine economic growth, it becomes more and more conscious of tending to Mother Nature without prodding by organized environmentalists. Tokyo's air pollution was so bad in the 1960s that citizens wore masks to get around, but as the economy grew by leaps and bounds the industrialists cleaned things up with little pressure from the government. In my early lessons from Mundell, he pointed out that the price of gold is an environmental signal, in that its rise alerts us that mankind is exploiting natural resources at a more rapid pace than nature can stand. In this monetary deflation, the gold price is signaling that nature is ready to yield more of its resources to development without damage. I'm not entirely sure the metaphor is exact, but it is an interesting way to connect monetary policy and the environment.

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Any further questions?