Gold traded above $370 per ounce this week, for the first time in six years. Anxiety about war with Iraq has no doubt contributed to gold’s surge — but a look at history suggests that gold may be telling us as much about Alan Greenspan as it is about Saddam Hussein.
The last time that gold was above $370 was December 6, 1996. Students of military history won’t find that date significant, but Fed-watchers will. That was the day following Alan Greenspan’s speech in which he first warned of “irrational exuberance” in the stock market. And it was the day that Alan Greenspan took America off the gold standard.
What? Didn’t Franklin Roosevelt abrogate gold convertibility in 1933? And didn’t Richard Nixon close the Treasury’s gold window for good in 1971? All true — but nevertheless, from the time he took the chair of the Board of Governors of the Federal Reserve System in 1987 to that speech in 1996, Alan Greenspan had implicitly returned America to a gold standard.
The chart below proves it. From 1987 to 1996, the Fed funds rate very closely tracked the 2-year moving average of the gold price. We may never know the exact thought process, but this much is clear: For that decade, when the gold price was rising, Greenspan was raising the federal funds interest rate, just as though he regarded gold as a leading indicator of inflationary risk. Conversely, when the gold price was falling, Greenspan eased.
It should not be entirely surprising that Greenspan would use gold as his monetary compass. As a long-time libertarian, Greenspan has always been an admirer of gold as a regulator on the state’s ability to print fiat money. In 1967 he penned a passionate paean to gold — “Gold and Economic Freedom” — which was published as part of an anthology of Ayn Rand’s laissez-faire capitalist essays.
But in 1996 something new replaced Greenspan’s golden compass — the stock market. In his “irrational exuberance” speech, he wondered out loud,
. . . inflation can destabilize an economy even if faulty price indexes fail to reveal it. But where do we draw the line on what prices matter . . . equities, real estate, or other earning assets? Are stability of these prices essential to the stability of the economy? . . . we should not underestimate or become complacent about the complexity of the interactions of asset markets and the economy. . . . asset prices particularly, must be an integral part of the development of monetary policy.”
As early as February 1997 Greenspan was testifying before Congress about what would evolve into his famous “wealth effect” theory — the idea that unsustainable stock market gains would create an inflationary imbalance between supply and demand. A month later Greenspan raised the fed funds rate, even as gold began to fall.
And from that point on, monetary policy became entirely detached from gold. As gold continued to fall, Greenspan at first failed to cut rates, and eventually raised them sharply. With the benefit of hindsight, it is clear that the result was monetary deflation — an idea that was virtually heretical at the time.
The first consequences of deflation were the major recurring crises in currency and commodity markets in the late 1990s — which were relieved temporarily late in 1998 when Greenspan lowered interest rates. Ironically, shortly afterwards Time magazine featured Greenspan on its cover as the leader of “The Committee to Save the World.”
Thus emboldened, Greenspan continued to speak about the wealth effect, and the need for pre-emptive action against potential future inflationary pressures. He started raising interest rates again, even as gold continued to fall. He didn’t stop until it was painfully clear that the stock market was no longer posing any threat of creating too much wealth. The result was continued deflation — and today’s recession.
Today Alan Greenspan is huddling in a foxhole, and he’s almost out of ammunition. The man who had been lauded for slaying inflation is now under pressure to stave off continued deflation. And even after an historic fusillade of rate-cuts that have left the Fed’s gun nearly empty, unemployment is over 6% and still rising, investors are worrying about a double-dip recession, and asset markets are in shambles.
So what does a man do when he is running out of bullets? He picks his targets very carefully — and that means focusing on fighting deflation. And what does a man do when he’s huddling in a foxhole? He gets religion — and for Greenspan that means coming home to gold.
That was the message of a remarkable speech by Alan Greenspan last month, missing by only two weeks the sixth anniversary of his “irrational exuberance” speech. The press didn’t really pick up on the importance of this speech, because we’ve all become accustomed to thinking of gold as a “barbarous relic,” to use Keynes’ famous phrase. But the fact is that from the very first sentence of the speech, we can see that Greenspan has rediscovered his golden compass — a compass he admits pointed true even in the speculative “bubble” of 1929:
Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800.
Later in the same speech Greenspan acknowledged, for literally the first time, the urgent danger of deflation. That’s the very thing that the falling price of gold was warning Greenspan about in 1997 — now he knows he was wrong not to listen.
And in the same speech he once again renounced the idea that the Fed can or should try to prevent stock market “bubbles” — though that’s precisely what he had tried to do in the name of the “wealth effect.” But we can forgive him. It’s like the teenage boy who brings home a smashed car and denies that he was drag racing. Regardless of what he says, it’s unlikely he’ll drag race again.
A chastened Alan Greenspan, once again firmly grasping his golden compass, is a wonderful thing for the economy. A lot of damage has been done, but that compass will point the way to the long-term price stability that will provide the best kind of base for economic recovery.
No doubt that compass will suggest to Greenspan that he keep interest rates very low for quite a while yet. A glance back at the chart shows that gold has a long way to climb before it gets back in synch with the fed funds rate. That would be true even if the fed funds rate were cut all the way to zero. And that suggests that there’s still so much leftover deflationary pressure working its way through the economy that it will be a very long time before we have to seriously worry about inflation again.