A substandard golden rule

The gold “price rule” denotes the monetary reform proposal put forth in various forms by a number of supply-siders, including Arthur Laffer, Robert Mundell, and Jude Wanniski. Laffer’s detailed formulation of the proposal also served as the basis of the Gold Reserve bill, introduced in the Senate by Jesse Helms in January 1981.

The scheme has reared its head once again in H.R. 1576, the “Dollar Bill Act of 2013,” introduced by Congressman Ted Poe, and strongly supported by Steve Forbes.

According to Laffer’s blueprint from the 1980s, at the end of a previously announced transition period of three months, the Federal Reserve would establish an official dollar price of gold “at that day’s average transaction price in the London gold market”. From that date onward, the Fed would stand ready to freely convert dollars into gold and gold into dollars at the official price. In addition, “when valued at the official price, the Federal Reserve will attempt over time to establish an average dollar value of gold reserves equal to 40 percent of the dollar value of its liabilities”. This level of gold reserves Laffer designates the “Target Reserve Quantity”.

Once Laffer’s plan was fully operational, the Fed would have full discretion in conducting monetary policy through discounting, open market operations, etc., provided that: the dollar remains fully convertible into gold at the official price; and the quantity of actual gold reserves does not deviate from the Target Reserve Quantity by more than 25 percent in either direction, i.e., actual gold reserves do not fall below 30 percent or rise above 50 percent of the Fed’s liabilities, which are also known as the “monetary base.” However, should gold reserves decline to a level between 20 percent and 30 percent of its liabilities, the Fed would lose all discretion in determining the monetary base which, as a result, would be completely frozen at the existing level. If, in spite of this, gold reserves continued to decline to between 10 percent and 20 percent of the Fed’s liabilities, the Fed would be legally constrained to reduce the monetary base at the rate of one percent per month.

Should these measures prove incapable of arresting the decline in the dollar value of gold reserves before it reaches less than 10 percent of Fed liabilities, then:

The dollar’s convertibility will be temporarily suspended and the dollar price of gold will be set free for a three month adjustment period.

During this temporary period of inconvertibility, the monetary authorities will be required to suspend all actions that would affect the monetary base. Again, the price of gold would be reset as before and convertibility would be reinstated.

Laffer’s plan also includes “a symmetric set of policy dicta” which are to be implemented in the case in which actual gold reserves exceed the Target Reserve Quantity.

It must first be pointed out that Laffer’s monetary reform proposal, whatever its merits or drawbacks, is not a blueprint for the gold standard. Rather, it is an outline of an elaborate scheme for legally constraining the monetary authority to adhere to a “price rule” in determining the supply of fiat money in the economy. In fact, as Laffer himself has made clear recently, gold has no necessary role in the implementation of such a price rule. According to Laffer and Miles:

… the Fed would institute its dollar “price rule” by stabilizing the value of the dollar in terms of an external standard. This standard would be a single commodity or a basket of commodities (a price index).…

Regardless of precisely which external standard is chosen, there are two basic rules of Fed behavior under the price rule. First, if the dollar price of the standard starts to rise (the dollar starts to fall in value), the Fed must reduce the quantity of dollars through open market sales of bonds, foreign exchange, gold, or other commodities. Second, if the dollar price starts to fall (the dollar rises in value), the Fed must increase the quantity of dollars through open market purchases of bonds, foreign exchange, gold or other commodities. The Fed is charged with keeping the value or price of the dollar stable in terms of the external standard.

Compare this to Forbes’s explanation of Poe’s 2013 plan:

Unlike in days of old we don’t need piles of the yellow metal for a new standard to operate. Under Poe’s plan—an approach I have long favored—the dollar would be fixed to gold at a specific price. For argument’s sake let’s say the peg is $1,300. If the price of gold were to go above that, the Federal Reserve would sell bonds from its portfolio, thereby removing dollars from the economy to maintain the $1,300 level. Conversely, if the gold price were to drop below $1,300, the Fed would “print” new money by buying bonds, thereby injecting cash into the banking system.

Even if gold is chosen as the “external standard” in the price-rule regime, it is not itself money, as in the case of a genuine gold standard, but merely “the intervention asset” or “the item for which dollars are exchanged.”

When we strip away its gold plating, Laffer’s and Poe’s price rule appears as a technique designed to control inflation under the current fiat money standard. It is thus differs only in technical detail from the quantity rule advocated by the monetarists. Laffer and Miles admit as much when they state, “in an unchanging world where all information is freely available, there of course would be a ‘quantity rule’ which would correspond to a given ‘price rule”. In fact, Miles and Laffer prefer a price rule to a quantity rule because they believe that, under the current monetary system, the former is technically superior to the latter in “restraining the supply of dollars”.

Under close examination, the Laffer/Poe/Forbes approach thus turns out to be, in essence, a kind of “price-rule monetarism,” the references to gold notwithstanding. The most serious defect in both variants of monetarism is that they fail to address the underlying cause of inflation, namely, the government monopoly of the supply of money. This is true of Laffer’s plan despite the elaborate set of legal sanctions which would be invoked against the monetary authorities for their violations of the price rule. For, in the end, such sanctions, even if rigorously applied, do not prevent inflation but merely respond to a fait accompli. This point is implicitly recognized by Laffer, who includes in his plan a provision for “temporary periods” of dollar inconvertibility. These would readjust the official gold price following sustained bouts of monetary inflation which cause gold reserves to fall below the legally permissible lower limit.

Furthermore, as in the case of the gold certificate reserve, we may appeal to history for evidence regarding the success of the gold price rule in stanching the flow of government fiat currency. We need look no further than the late, unlamented Bretton Woods System (1946–1971). Under this “fixed-exchange-rate” system, the U.S. monetary authority followed a gold price rule, buying and selling gold at an officially fixed price of $35 per ounce. Foreign monetary authorities, on the other hand, pursued a dollar price rule, maintaining their respective national currencies convertible into dollars at a fixed price. According to Laffer and Miles, “as long as the rules of the system were being followed, the supplies of all currencies were constricted to a strict price relationship among one another and to gold”.

Unfortunately, “the rules of the system” were subjected to numerous and repeated government violations and evasions, including frequent outright “readjustment” of the price rules, i.e., exchangerate devaluations, when they became inconvenient restraints on the inflationary policies pursued by particular governments. Needless to say, the Bretton Woods System did not prevent the development of a worldwide inflation which brought the system to its knees in 1968 and led to its final collapse in 1971.

After duly noting the political manipulations involved in the destruction of the Bretton Woods System, Laffer and Miles clearly delineate the reasons why governments prefer and benefit from the removal of any and all checks on their power to inflate the money supply:

Why should governments be biased toward increasing the money supply at a faster rate? There are essentially two incentives—a political incentive and a financial one. The political incentive is political survival. Many politicians, especially those up for reelection, are familiar with the theory that increases in the money supply promote expenditure, increase GNP, and reduce unemployment. These changes in turn are assumed to make the citizens of the country look more kindly upon the incumbent government. While there may be some validity in this theory, unfortunately it is often implemented under the notion that if a little money creation is good, a lot must be even better.

The financial motive for printing money is the fact that while money is practically costless to produce, it can be used for purchasing goods and services. The resulting seignorage represents revenue to the government. Revenue gathered in this way means less revenue must be gathered in another way, say, through direct taxation.

Given these incentives to print money, it can be seen why removal of the monetary constraints on governments tends to create inflation rather than deflation.

Given his recognition of the powerful inflationary bias built into the political process and of the historical failure of monetary price rules to hold such a bias in check, Laffer’s advocacy of a renewed gold price rule was always something of a mystery.

In light of the inherent flaws of all varieties of the gold price rule, Forbes and Poe should seriously rethink their advocacy of its resurrection.

This article was adapted from an excerpt of ‘Money Sound and Unsound’ by Joseph T. Salerno. It was previously published at Mises.org.