Economics / History

The Turn to Disinflation Part 3—More Distorting Than Wartime Price Controls

The Korea Exception

My previous research identified the Korean War as the only major American conflict that did not produce significant postwar inflation during the first eight decades of the twentieth century.  One of the reasons for this occurring is that Eisenhower either bit the bullet or threw up his hands and allowed unemployment to rise as it was wont to do during the demobilization.  Another good reason to avoid going to war, I’d imagine.  But the more general reason was the gold market— the international gold market in London, having shut down more than a decade earlier during the Second World War, would not reopen until the year after the Korean armistice.  In a quirk of history, reasserting part of the gold standard through Bretton Woods put a brake on Korean War inflation before the huge distortions associated with that misguided policy could be fully felt.

I’ve managed to avoid in two posts the moment monetarists and gold-hardliners are quick to point out changed everything—the “Nixon Shock” of August 15, 1971.  I’ve steered clear of this for numerous reasons, but I am now compelled to address the closing of the gold window.

What’s Wrong With This Picture?

Below lays a table of gold prices over a 134 year period, the first the value per ounce in nominal terms and the second inflation-adjusted (both values are rounded to the nearest dollar):

1967 $35 $239
1966 $35 $249

 

1965 $35 $256

 

1964 $35 $260

 

1963 $35 $264

 

1962 $35 $267

 

1961 $35 $271

 

1960 $35 $273

 

1959 $35 $276

 

1958 $35 $279

 

1957 $35 $284

 

1956 $35 $294

 

1955 $35 $299

 

1954 $35 $299

 

1953 $35 $300

 

1952 $35 $298

 

1951 $35 $307

 

1950 $35 $331

 

1949 $32 $305

 

1948 $35 $331

 

1947 $35 $358

 

1946 $35 $408

 

1945 $35 $445

 

1944 $34 $440

 

1943 $34 $451

 

1942 $34 $477

 

1941 $34 $529

 

1940 $34 $555

 

1939 $34 $564

 

1938 $35 $571

 

1937 $35 $552

 

1936 $35 $572

 

1935 $35 $581

 

1934 $35 $598

 

1933 $26 $462

 

1932 $21 $345

 

1931 $17 $258

 

1930 $21 $283

 

1929 $21 $275

 

1928 $21 $275

 

1927 $21 $272

 

1926 $21 $268

 

1925 $21 $272

 

1924 $21 $276

 

1923 $21 $284

 

1922 $21 $283

 

1921 $21 $264

 

1920 $21 $238

 

1919 $21 $276

 

1918 $21 $314

 

1917 $21 $370

 

1916 $21 $432

 

1915 $21 $471

 

1914 $21 $471

 

1913 $21 $480

 

1912 $21 $492

 

1911 $21 $503

 

1910 $21 $503

 

1909 $21 $517

 

1908 $21 $517

 

1907 $21 $504

 

1906 $21 $529

 

1905 $21 $543

 

1904 $21 $530

 

1903 $21 $544

 

1902 $21 $544

 

1901 $21 $560

 

1900 $21 $559

 

1899 $21 $574

 

1898 $21 $575

 

1897 $21 $575

 

1896 $21 $560

 

1895 $21 $558

 

1894 $21 $544

 

1893 $21 $530

 

1892 $21 $517

 

1891 $21 $517

 

1890 $21 $517

 

1889 $21 $516

 

1888 $21 $504

 

1887 $21 $504

 

1886 $21 $504

 

1885 $21 $492

 

1884 $21 $480

 

1883 $21 $470

 

1882 $21 $470

 

1881 $21 $470

 

1880 $21 $470

 

1879 $21 $469

 

1878 $21 $470

 

1877 $21 $449

 

1876 $21 $440

 

1875 $21 $430

 

1874 $21 $413

 

1873 $21 $397

 

1872 $21 $390

 

1871 $21 $390

 

1870 $21 $362

 

1869 $21 $350

 

1868 $21 $333

 

1867 $21 $318

 

1866 $21 $299

 

1865 $21 $291

 

1864 $21 $304

 

1863 $21 $375

 

1862 $21 $469

 

1861 $21 $543

 

1860 $21 $574

 

1859 $21 $574

 

1858 $21 $574

 

1857 $21 $543

 

1856 $21 $558

 

1855 $21 $543

 

1854 $21 $558

 

1853 $21 $607

 

1852 $21 $607

 

1851 $21 $607

 

1850 $21 $607

 

1849 $21 $607

 

1848 $21 $607

 

1847 $21 $574

 

1846 $21 $607

 

1845 $21 $626

 

1844 $21 $626

 

1843 $21 $645

 

1842 $21 $574

 

1841 $21 $543

 

1840 $21 $543

 

1839 $21 $504

 

1838 $21 $504

 

1837 $21 $492

 

1836 $21 $504

 

1835 $21 $543

 

1834 $21 $543

 

1833 $21 $558

This is the gold standard, the pegging of the price of gold (a single ounce in this case) that supposedly is the Holy Grail to head off inflation.  Looking at the inflation-adjusted numbers, the effects clearly show inflation year-to-year can be kept quite low.  1848 to 1853, 1858 to 1860, 1878 to 1883, 1886 to 1888 and 1889 to 1892 were all time periods that saw little to no change in inflation rates.  Any time the inflation-adjusted value rose year-to-year indicates actual deflation.

Saltwater economists argue that deflation is extremely dangerous, having the potential and historically does inflict widespread misery while freshwater economists generally retort the deflationary bias of the gold standard was preferable to the threat of hyperinflation.  Neither set of professionals ask a basic question that puts these arguments in stark relief.

So, I ask this question: what’s wrong with this picture?  Are there any problems with pegging gold to a set dollar value?

Wait, isn’t it the other way around?  No—gold is a commodity, a single commodity, which was valued at the same price (except that one year where the price was adjusted down in the face of severe deflation) for 100 years.  How on Earth could that not be inflationary?

This data series begins in 1833, when gold was valued at $558 an ounce in 2012 USD.  By 1920, wartime inflation (explained in this post) had eroded that valuation to $238 an ounce in inflation-adjusted 2012 USD.  The inflation problems from the latter half of the 1910s were “solved” with rampant deflation

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1920 16.97 % 20.37 % 20.12 % 21.56 % 21.89 % 23.67 % 19.54 % 14.69 % 12.36 % 9.94 % 7.03 % 2.65 % 15.90 %
1921 -1.55 % -5.64 % -7.11 % -10.84 % -14.08 % -15.79 % -14.90 % -12.81 % -12.50 % -12.06 % -12.12 % -10.82 % -10.85 %
1922 -11.05 % -8.15 % -8.74 % -7.73 % -5.65 % -5.11 % -5.08 % -6.21 % -5.14 % -4.57 % -3.45 % -2.31 % -6.10 %
1923 -0.59 % -0.59 % 0.60 % 1.20 % 1.20 % 1.80 % 2.38 % 3.01 % 3.61 % 3.59 % 2.98 % 2.37 % 1.80 %
1924 2.98 % 2.38 % 1.79 % 0.59 % 0.59 % 0.00 % -0.58 % -0.58 % -0.58 % -0.58 % -0.58 % 0.00 % 0.45 %
1925 0.00 % 0.00 % 1.17 % 1.18 % 1.76 % 2.94 % 3.51 % 4.12 % 3.51 % 2.91 % 4.65 % 3.47 % 2.44 %
1926 3.47 % 4.07 % 2.89 % 4.07 % 2.89 % 1.14 % -1.13 % -1.69 % -1.13 % -0.56 % -1.67 % -1.12 % 0.94 %
1927 -2.23 % -2.79 % -2.81 % -3.35 % -2.25 % -0.56 % -1.14 % -1.15 % -1.14 % -1.14 % -2.26 % -2.26 % -1.92 %
1928 -1.14 % -1.72 % -1.16 % -1.16 % -1.15 % -2.84 % -1.16 % -0.58 % 0.00 % -1.15 % -0.58 % -1.16 % -1.15 %
1929 -1.16 % 0.00 % -0.58 % -1.17 % -1.16 % 0.00 % 1.17 % 1.17 % 0.00 % 0.58 % 0.58 % 0.58 % 0.00 %
1930 0.00 % -0.58 % -0.59 % 0.59 % -0.59 % -1.75 % -4.05 % -4.62 % -4.05 % -4.62 % -5.20 % -6.40 % -2.66 %
1931 -7.02 % -7.65 % -7.69 % -8.82 % -9.47 % -10.12 % -9.04 % -8.48 % -9.64 % -9.70 % -10.37 % -9.32 % -8.94 %
1932 -10.06 % -10.19 % -10.26 % -10.32 % -10.46 % -9.93 % -9.93 % -10.60 % -10.67 % -10.74 % -10.20 % -10.27 % -10.30 %
1933 -9.79 % -9.93 % -10.00 % -9.35 % -8.03 % -6.62 % -3.68 % -2.22 % -1.49 % -0.75 % 0.00 % 0.76 % -5.09 %

…bringing the inflation-adjusted price of gold back to $345 an ounce.  In 1932.  During the worst economic contraction in American history.

Neoclassical economics is fond of complaining how price stability suffered after 1933 when the onerous effects of the ancient $20.67 (rounded to $21 in the data set) gold peg forced nations all over the world to abandon the gold standard in the face of gigantic losses in economic output.  I don’t see at all what was stable about prices in the 1920s; the first few years after the U.S. dropped the gold standard inflation was pretty well controlled (maybe a little over-controlled) with Federal Reserve monetary policy…

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1933 -9.79 % -9.93 % -10.00 % -9.35 % -8.03 % -6.62 % -3.68 % -2.22 % -1.49 % -0.75 % 0.00 % 0.76 % -5.09 %
1934 2.33 % 4.72 % 5.56 % 5.56 % 5.56 % 5.51 % 2.29 % 1.52 % 3.03 % 2.27 % 2.27 % 1.52 % 3.51 %
1935 3.03 % 3.01 % 3.01 % 3.76 % 3.76 % 2.24 % 2.24 % 2.24 % 0.74 % 1.48 % 2.22 % 2.99 % 2.56 %
1936 1.47 % 0.73 % 0.00 % -0.72 % -0.72 % 0.73 % 1.46 % 2.19 % 2.19 % 2.19 % 1.45 % 1.45 % 1.04 %
1937 2.17 % 2.17 % 3.65 % 4.38 % 5.11 % 4.35 % 4.32 % 3.57 % 4.29 % 4.29 % 3.57 % 2.86 % 3.73 %
1938 0.71 % 0.00 % -0.70 % -0.70 % -2.08 % -2.08 % -2.76 % -2.76 % -3.42 % -4.11 % -3.45 % -2.78 % -2.01 %

…even though the price of gold had relented slightly.  Gold in 1933-34 was nominally revalued upwards almost 70% to $35 an ounce, bringing the inflation-adjusted value up to $598—7% higher than 101 years prior.  Let me ask this again—can anyone see an issue with valuing a highly-sought after commodity at exactly the same price (other than dropping the value briefly in 1931) for a century?

Gold Price Distortions Meet Wartime Distortions

The World Wars upended the gold dynamic.  The Great War represented humanity’s final transition to modern war—conflicts that demand and use far more resources than had previously been expended.  The First World War and especially its larger successor ushered in an age where entire nations had virtually no choice but to devote significant economic resources to military development and readiness in peacetime.  This necessitated vastly increasing in the size of standing militaries and supporting infrastructure compared to previous conflicts, as evidenced with the increasing number of support and logistics roles modern militaries have added to their permanent ranks since 1914 accompanied with the rising number of companies specializing in military products that eventually coalesced into the military-industrial complex.

With this transition the deflationary economic bias began to grind slowly, in constant conflict with the highly inflationary economic bias of wartime in the World Wars and immediate postwar eras.  Deflation was definitely the tonic of the day in 1921-22 and 1926-33, hitting immense proportions.  The rate of inflation averaged more than -10% in 1921 and 1932 at the troughs of the worst two economic contractions in American history (deflation hitting a staggering -15.79% inflation rate in June 1921).  Deflation was reasserted during the 1937-38 recession (only the third worst economic contraction)…

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1938 0.71 % 0.00 % -0.70 % -0.70 % -2.08 % -2.08 % -2.76 % -2.76 % -3.42 % -4.11 % -3.45 % -2.78 % -2.01 %
1939 -1.41 % -1.42 % -1.42 % -2.82 % -2.13 % -2.13 % -2.13 % -2.13 % 0.00 % 0.00 % 0.00 % 0.00 % -1.30 %

…to tame the post-World War II inflation…

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1949 1.27 % 1.28 % 1.71 % 0.42 % -0.42 % -0.83 % -2.87 % -2.86 % -2.45 % -2.87 % -1.65 % -2.07 % -0.95 %
1950 -2.08 % -1.26 % -0.84 % -1.26 % -0.42 % -0.42 % 1.69 % 2.10 % 2.09 % 3.80 % 3.78 % 5.93 % 1.09 %

…and to tame the possible emergence of post-Korean War inflation:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1954 1.13 % 1.51 % 1.13 % 0.75 % 0.75 % 0.37 % 0.37 % 0.00 % -0.37 % -0.74 % -0.37 % -0.74 % 0.32 %
1955 -0.74 % -0.74 % -0.74 % -0.37 % -0.74 % -0.74 % -0.37 % -0.37 % 0.37 % 0.37 % 0.37 % 0.37 % -0.28 %

I might even argue inflation was better controlled during peacetime in the period between 1934 and 1965 (the start of major American military involvement in Vietnam) than at any time prior in American history:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1965 0.97 % 0.97 % 1.29 % 1.62 % 1.62 % 1.94 % 1.61 % 1.94 % 1.61 % 1.93 % 1.60 % 1.92 % 1.59 %
1964 1.64 % 1.64 % 1.31 % 1.31 % 1.31 % 1.31 % 1.30 % 0.98 % 1.30 % 0.97 % 1.30 % 0.97 % 1.28 %
1963 1.33 % 1.00 % 1.33 % 0.99 % 0.99 % 1.32 % 1.32 % 1.32 % 0.99 % 1.32 % 1.32 % 1.64 % 1.24 %
1962 0.67 % 1.01 % 1.01 % 1.34 % 1.34 % 1.34 % 1.00 % 1.34 % 1.33 % 1.33 % 1.33 % 1.33 % 1.20 %
1961 1.71 % 1.36 % 1.36 % 1.02 % 1.02 % 0.68 % 1.35 % 1.01 % 1.35 % 0.67 % 0.67 % 0.67 % 1.07 %
1960 1.03 % 1.73 % 1.73 % 1.72 % 1.72 % 1.72 % 1.37 % 1.37 % 1.02 % 1.36 % 1.36 % 1.36 % 1.46 %
1959 1.40 % 1.05 % 0.35 % 0.35 % 0.35 % 0.69 % 0.69 % 1.04 % 1.38 % 1.73 % 1.38 % 1.73 % 1.01 %
1958 3.62 % 3.25 % 3.60 % 3.58 % 3.21 % 2.85 % 2.47 % 2.12 % 2.12 % 2.12 % 2.11 % 1.76 % 2.73 %
1957 2.99 % 3.36 % 3.73 % 3.72 % 3.70 % 3.31 % 3.28 % 3.66 % 3.28 % 2.91 % 3.27 % 2.90 % 3.34 %
1956 0.37 % 0.37 % 0.37 % 0.75 % 1.12 % 1.87 % 2.24 % 1.87 % 1.86 % 2.23 % 2.23 % 2.99 % 1.52 %
1955 -0.74 % -0.74 % -0.74 % -0.37 % -0.74 % -0.74 % -0.37 % -0.37 % 0.37 % 0.37 % 0.37 % 0.37 % -0.28 %
1954 1.13 % 1.51 % 1.13 % 0.75 % 0.75 % 0.37 % 0.37 % 0.00 % -0.37 % -0.74 % -0.37 % -0.74 % 0.32 %
1953 0.38 % 0.76 % 1.14 % 0.76 % 1.14 % 1.13 % 0.37 % 0.75 % 0.75 % 1.12 % 0.75 % 0.75 % 0.82 %
1952 4.33 % 2.33 % 1.94 % 2.33 % 1.93 % 2.32 % 3.09 % 3.09 % 2.30 % 1.91 % 1.14 % 0.75 % 2.29 %
1951 8.09 % 9.36 % 9.32 % 9.32 % 9.28 % 8.82 % 7.47 % 6.58 % 6.97 % 6.50 % 6.88 % 6.00 % 7.88 %
1950 -2.08 % -1.26 % -0.84 % -1.26 % -0.42 % -0.42 % 1.69 % 2.10 % 2.09 % 3.80 % 3.78 % 5.93 % 1.09 %
1949 1.27 % 1.28 % 1.71 % 0.42 % -0.42 % -0.83 % -2.87 % -2.86 % -2.45 % -2.87 % -1.65 % -2.07 % -0.95 %
1948 10.23 % 9.30 % 6.85 % 8.68 % 9.13 % 9.55 % 9.91 % 8.89 % 6.52 % 6.09 % 4.76 % 2.99 % 7.74 %
1947 18.13 % 18.78 % 19.67 % 19.02 % 18.38 % 17.65 % 12.12 % 11.39 % 12.75 % 10.58 % 8.45 % 8.84 % 14.65 %
1946 2.25 % 1.69 % 2.81 % 3.37 % 3.35 % 3.31 % 9.39 % 11.60 % 12.71 % 14.92 % 17.68 % 18.13 % 8.43 %
1945 2.30 % 2.30 % 2.30 % 1.71 % 2.29 % 2.84 % 2.26 % 2.26 % 2.26 % 2.26 % 2.26 % 2.25 % 2.27 %
1944 2.96 % 2.96 % 1.16 % 0.57 % 0.00 % 0.57 % 1.72 % 2.31 % 1.72 % 1.72 % 1.72 % 2.30 % 1.64 %
1943 7.64 % 6.96 % 7.50 % 8.07 % 7.36 % 7.36 % 6.10 % 4.85 % 5.45 % 4.19 % 3.57 % 2.96 % 6.00 %
1942 11.35 % 12.06 % 12.68 % 12.59 % 13.19 % 10.88 % 11.56 % 10.74 % 9.27 % 9.15 % 9.09 % 9.03 % 10.97 %
1941 1.44 % 0.71 % 1.43 % 2.14 % 2.86 % 4.26 % 5.00 % 6.43 % 7.86 % 9.29 % 10.00 % 9.93 % 5.11 %
1940 -0.71 % 0.72 % 0.72 % 1.45 % 1.45 % 2.17 % 1.45 % 1.45 % -0.71 % 0.00 % 0.00 % 0.71 % 0.73 %
1939 -1.41 % -1.42 % -1.42 % -2.82 % -2.13 % -2.13 % -2.13 % -2.13 % 0.00 % 0.00 % 0.00 % 0.00 % -1.30 %
1938 0.71 % 0.00 % -0.70 % -0.70 % -2.08 % -2.08 % -2.76 % -2.76 % -3.42 % -4.11 % -3.45 % -2.78 % -2.01 %
1937 2.17 % 2.17 % 3.65 % 4.38 % 5.11 % 4.35 % 4.32 % 3.57 % 4.29 % 4.29 % 3.57 % 2.86 % 3.73 %
1936 1.47 % 0.73 % 0.00 % -0.72 % -0.72 % 0.73 % 1.46 % 2.19 % 2.19 % 2.19 % 1.45 % 1.45 % 1.04 %
1935 3.03 % 3.01 % 3.01 % 3.76 % 3.76 % 2.24 % 2.24 % 2.24 % 0.74 % 1.48 % 2.22 % 2.99 % 2.56 %
1934 2.33 % 4.72 % 5.56 % 5.56 % 5.56 % 5.51 % 2.29 % 1.52 % 3.03 % 2.27 % 2.27 % 1.52 % 3.51 %

Oddly enough, this was most likely due to the reinstatement of the gold peg:

Thirty-five dollars was, after all, the official gold price as set by the United States Treasury from 1934 on. Prior to 1934, the gold price had been fixed at $20.67 for almost a century, before President Franklin Roosevelt confiscated Americans’ gold and revalued the price to $35 that year.

The $35 price was an integral part of the Bretton Woods Agreement negotiated after World War II. Bretton Woods specified a system of fixed parities between the US dollar and other industrialized currencies, and the convertibility by foreign central banks of US dollars into gold at $35 an ounce. In other words, each dollar paid out around .03 ounces of gold, or 0.888671 grams.

This was not like the classical gold standard of the 1800s but a pseudo gold standard foisted on the world by central planners. Convertibility could not be exercised by private individuals, only central bankers, and most currencies were not redeemable in gold; only the dollar was.

The 1944 Bretton Woods international financial agreements set the U.S. dollar as the world’s reserve currency, to the chagrin of neoclassical economists such as Friedrich Hayek, Jacques Rueff and, oddly enough, John Maynard Keynes (Keynes advocated creating bancor, an international reserve currency).  To try to alleviate the concerns of the neoclassical schools, American negotiators agreed to peg the dollar to $35-an-ounce gold.  As part of these accords, U.S. dollars were convertible to gold—an exchange process that was colloquially referred to as the gold window.

Hidden Gold Inflation

So, what was all the hubbub that led Nixon to close the gold window (thus ending dollar convertibility) on August 15, 1971?  This:

1968 $39 $255
1969 $41 $257
1970 $36 $213
1971 $41 $231
1972 $58 $320

Gold had become monstrously undervalued by 1970, having lost 65% of its inflation-adjusted value since 1934.  Considering gold was and remains viewed as a hedge against inflation, the situation was untenable.  Most histories of the gold peg ignore these powerful underlying forces, but John Paul Koning’s data-driven history is a welcome exception.  He begins with the stresses of controlling the price of gold increasing as market forces were permitted to resume in 1954:

Our chart begins in 1954 with the reopening of the London gold market, which, prior to being closed at the outbreak of World War II, had been the world’s largest venue for trading the metal. Through the 1950s the London price fluctuated between $34.85 and $35.17. These upper and lower limits were set by arbitrage and the threat thereof. Foreign central banks, as stipulated in Bretton Woods, could go to the Federal Reserve in New York and convert their dollars into gold or gold into dollars at $35 plus 8.75¢ commission. The cost of shipping and insuring gold from New York to London and vice versa was 8¢ to 10¢ per ounce.

Thus, when the London price traded down to $34.82 or so, it made sense for central banks to buy gold in London, ship it to New York for 8¢, then sell it to the US Treasury at the $35 official price less 8.75¢ commission, earning arbitrage profits of around 1¢ an ounce. Conversely when gold rose to $35.18 in London, it made sense to buy gold from the US Treasury at $35.0875, ship it to London for 8¢, sell it at $35.18, and earn arbitrage profits of 1¢.

Beginning in 1954, central bank demand increased for a commodity that, regardless of a $0.01-per ounce profit margin, was a guaranteed winner because the price of American gold was set permanently at $35-an-ounce.  Can anyone see what might be wrong with this picture?

Nineteen fifty-eight marked the first year in which foreign central banks exercised their convertibility rights in significant amounts and returned their dollars for gold. US gold reserves fell 10% from 20,312 metric tons to 18,290 that year, another 5% in 1959, and 9% in 1960. At the same time, the US Federal Reserve continued to increase notes in circulation, resulting in dollars being backed by ever smaller amounts of gold. Since this threatened future potential convertibility, rumors grew that the United States would be forced to devalue the dollar to staunch the outflow.

The US government tried to prevent gold from leaving by twisting the arms of foreign central banks to keep their dollars, and, later, setting travel limits on American tourists overseas and US private investment in Europe. By 1958, London gold was trading closer to its $35.18 upper limit rather than the bottom limit at $34.82, which it touched in 1957. Participants in the London market — increasingly dominated by throngs of private investors and speculators — were ever more certain that the United States’ plunging gold reserves would force it to dramatically devalue the dollar.

So, private demand for gold also shot up starting in 1958, ‘dominated by throngs of private investors and speculators.’  To this day, concerns about Federal Reserve dollar circulation and potential currency devaluations (or outright currency collapses) stem from a fundamental misunderstanding about the gold peg.  Setting gold at $20.67 or less for a century, following with a generation of $35 gold, and encouraging gold speculation under the cumbersome Bretton Woods system vastly increased the underlying inflationary forces from severely undervalued gold.  The instability of the gold peg price controls should have been evident from the start, but 1960 ended the charade:

In September 1960, the United States experienced its largest weekly decline in reserves since 1931 as foreign central banks went to New York for the metal. At the same time it was becoming evident that presidential challenger John F. Kennedy would win that fall’s election. Kennedy’s promises to lower interest rates and increase government spending convinced many that gold outflows would only increase. The Dow Jones Industrial Average plunged 12% from the end of August to October 25, hitting its lowest point since 1958.

Here I start to part with John Paul Koning.  I suppose he believes lower interest rates and increased government spending is always and everywhere a recipe for a spike in budget deficits and runaway inflation.  Maybe he can tell me when the deficit should explode:

1* – Presidential control
2* – Senate control
3* – House control

D = Democrat R = Republican

Year Nominal Dollars Inflation Adjusted 1* 2* 3*
1958 $2.8 Billion Deficit $22.22 Billion Deficit R D D
1959 $12.8 Billion Deficit $100.79 Billion Deficit R D D
1960 $0.3 Billion Surplus $2.33 Billion Surplus R D D
1961 $3.3 Billion Deficit $25.38 Billion Deficit D D D
1962 $7.1 Billion Deficit $53.79 Billion Deficit D D D
1963 $4.8 Billion Deficit $36.09 Billion Deficit D D D

As for inflation…umm…

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1959 1.40 % 1.05 % 0.35 % 0.35 % 0.35 % 0.69 % 0.69 % 1.04 % 1.38 % 1.73 % 1.38 % 1.73 % 1.01 %
1960 1.03 % 1.73 % 1.73 % 1.72 % 1.72 % 1.72 % 1.37 % 1.37 % 1.02 % 1.36 % 1.36 % 1.36 % 1.46 %
1961 1.71 % 1.36 % 1.36 % 1.02 % 1.02 % 0.68 % 1.35 % 1.01 % 1.35 % 0.67 % 0.67 % 0.67 % 1.07 %
1962 0.67 % 1.01 % 1.01 % 1.34 % 1.34 % 1.34 % 1.00 % 1.34 % 1.33 % 1.33 % 1.33 % 1.33 % 1.20 %
1963 1.33 % 1.00 % 1.33 % 0.99 % 0.99 % 1.32 % 1.32 % 1.32 % 0.99 % 1.32 % 1.32 % 1.64 % 1.24 %

Some context is probably also appropriate.  The U.S. was in an economic recession in 1960, unemployment having spiked, naturally:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1960 5.2 4.8 5.4 5.2 5.1 5.4 5.5 5.6 5.5 6.1 6.1 6.6
1961 6.6 6.9 6.9 7.0 7.1 6.9 7.0 6.6 6.7 6.5 6.1 6.0
1962 5.8 5.5 5.6 5.6 5.5 5.5 5.4 5.7 5.6 5.4 5.7 5.5

Under the circumstances, I would think lower interest rates at the very least would be called for.  At worst, Kennedy ran an annual deficit in 1962 of $54 billion in inflation-adjusted 2012 USD.  Call me crazy but that doesn’t seem too excessive.

But even though dire consequences did not materialize from JFK’s desired economic policies, Koning’s characterization of gold traders in 1960 having those fears seems historically accurate.  The demand for gold certainly spiked:

In this context, London gold prices rose above $35.20 for the first time in September 1960, and on October 20 hit $36, far above the ceiling implied by arbitrage. The next week, a speculative gold rush touched off and the price soared, briefly hitting $41 before closing at a high of $38. With London trading at an impressive 17% premium to the official price, the world’s monetary architects had lost control of the market price of gold.

You don’t say.  So, get rid of the peg and ride out the painful adjustment period that always accompanies the cessation of price controls?  Of course not:

At the eleventh hour, the New York Federal Reserve cut an informal deal with the Bank of England to resupply said bank with any gold it spent, at its own discretion, in suppressing the gold price. Prices soon began to fall as the Bank of England sold. As one of his last acts as president in 1960, Eisenhower tried to suppress gold demand further by making it illegal for Americans to buy the metal overseas — an extension of Roosevelt’s 1933 ban on American domestic holdings of gold. By March 1961, the gold price had been strong-armed back to $35.10.

But this in no way implies demand had abated:

Fearing another gold rush in October 1961, Western central banks formalized a plan by which they pooled together several hundred million dollars worth of gold, this stock to be mobilized to control the London gold price. Thus was born the famous London gold pool. The pool became an active buyer of gold when the London price fell below $35.08 an ounce and a seller at $35.20. In its first test — the week of the Cuban Missile Crisis in October 1962 — the pool effectively supplied the London market despite demand for the metal being greater than the 1960 gold rush. Prices could not penetrate $35.20. The pool’s reputation strengthened: gold would stay benign and near $35.08 for the next few years.

Koning even uses the term ‘gold rush,’ indicating demand has driven the market far out of balance.  The pressures inevitably will resume, which Koning attributes to American military expenditures and Great Society programs when U.S. inflation climbs after 1965:

But with the Gulf of Tonkin incident in late 1964 and the acceleration of the Vietnam war in 1965, US foreign military spending exploded. This was compounded by President Lyndon B. Johnson’s expensive Great Society project, paid for in part by the Federal Reserve issuing new money to buy government debt.

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1965 0.97 % 0.97 % 1.29 % 1.62 % 1.62 % 1.94 % 1.61 % 1.94 % 1.61 % 1.93 % 1.60 % 1.92 % 1.59 %
1966 1.92 % 2.56 % 2.56 % 2.87 % 2.87 % 2.53 % 2.85 % 3.48 % 3.48 % 3.79 % 3.79 % 3.46 % 3.01 %
1967 3.46 % 2.81 % 2.80 % 2.48 % 2.79 % 2.78 % 2.77 % 2.45 % 2.75 % 2.43 % 2.74 % 3.04 % 2.78 %
1968 3.65 % 3.95 % 3.94 % 3.93 % 3.92 % 4.20 % 4.49 % 4.48 % 4.46 % 4.75 % 4.73 % 4.72 % 4.27 %
1969 4.40 % 4.68 % 5.25 % 5.52 % 5.51 % 5.48 % 5.44 % 5.71 % 5.70 % 5.67 % 5.93 % 6.20 % 5.46 %
1970 6.18 % 6.15 % 5.82 % 6.06 % 6.04 % 6.01 % 5.98 % 5.41 % 5.66 % 5.63 % 5.60 % 5.57 % 5.84 %

I’m beating a dead horse, but I feel the need to reiterate—the gold peg itself was the problem.  Setting the price of a commodity like gold at the same nominal price for decades requires deflation to offset bouts of wartime (usually) inflation.  This system is completely unworkable as conflicts became more frequent and more inflationary, especially as deflation had already been demonstrated to be a national security threat during the Great Depression when the future Allied Powers suffered immense damage to national combat capability and the industrial base that supports those military forces.  The systemic lack of deflation kills off the London gold pool in March 1968:

The balance-of-payments deficit grew ever faster, and the United States lost more gold reserves to dollar-laden foreign central banks exercising convertibility and through gold-pool sales in London. US gold reserves resumed their downward trajectory, declining by 9% in 1965. At the same time, speculators were buying gold in record numbers in London, forcing price up to $35.20, the London pool’s line in the sand.

Things only got worse with the exit of the French from the gold pool in early 1967, tensions in the Middle East, and the collapse of the British pound in November 1967. The Tet offensive of early 1968 indicated the US commitment to Vietnam would only grow. Speculators bought en masse in London through the remainder of 1967 and into March 1968. By March 14, the members of the gold pool, having sold about $2.75 billion worth of gold to protect the $35.20 ceiling, or about 10% of the member’s total reserves since the pound’s devaluation, had had enough.  They asked the Queen of England to close the London market the next day and dissolved the once-feared gold pool. When London reopened two weeks later, without suppression, prices immediately vaulted up to $38 and would soon rise to $42.

The Ides of March

The gold pool ceased its actions on March 15, 1968.  Gold prices rocketed skyward…

…an untenable situation that threatened to derail Bretton Woods:

[The] gold price steadily rose from $38 to $42. The 20% price differential between the official price of $35 and the market price put a mockery to the whole managed Bretton Woods system. In essence, the market was saying it didn’t believe that the US dollar was worth the gold value that the authorities claimed. Rather than a dollar being convertible into 0.81 grams, the market was betting that, once the chips were down, the dollar was likely only convertible into just 0.67 grams.

At the same time, the price differential provided a tremendous arbitrage opportunity to central banks. To make an easy profit, all they had to do was bring their dollars to the Federal Reserve, convert them to gold at $35, ship their horde to London, and sell it for $42, further exacerbating the US’s already significant gold outflows.

Here again I have to disagree with John Paul Koning.  He is implying that the U.S. dollar, due to Vietnam War inflation, was overvalued compared to gold.  To my mind the problem is far more sinister—gold has been persistently undervalued to a massive extent for more than a century, and the underlying pressures and imbalances in the gold market came to a head on the Ides of March, 1968.  That may appear to be two sides of the same coin, but as this saga drags on the differences will become apparent.  Koning describes the conflicting interests of the United States and gold’s largest extractor, South Africa, in apocalyptic terms:

The US authority’s fight to keep gold pegged at $35 had by no means ended with the Pool’s demise. Instead it shifted to a new front. That same month a massive gold embargo against South Africa, the world’s largest gold producer, was initiated by the US, a battle that would last till early 1970.

The US led embargo against South Africa, backed implicitly by the largest military in the world, highlights the gradual but steady tendency for authorities to back the failing $35 peg by forceful means. This is the inevitable route taken by any state-run financial system experiencing difficulty. Whereas in a free banking system mistakes are fixed through market discipline, competition, and failures, the state’s mistakes in banking are maintained as long as its monopoly on force can keep these mistakes from destroying the system.

Huh?  The U.S. was ready to wage war against South Africa over gold margins?  Was the U.S. Navy imposing a “quarantine zone” like the blockade Kennedy ordered around Cuba in October 1962?

Without price suppression from pool sales, the market price of gold immediately vaulted to $39 upon the [London gold] market’s reopening. That same day, in what became to be called the Washington accord, western central banks led by US Treasury Secretary Robert Fowler announced that the world’s monetary reserves were “sufficient” and no subsequent purchases or sales by central banks in any market would be necessary.

This last seemingly innocuous statement had large repercussions. If central banks ceased buying gold, monetary demand for the metal would dry-up. South Africa, producer of some 75% of the world’s gold, would suddenly find no outlet for a bulk of its new gold. After all, the lion’s share of world gold demand was by central banks.

Fowler hoped that the boycott would force South Africa to funnel gold sales into the relatively small London market, dominated by jewellers, speculators, and other private parties, depressing the market price from $39 back to the official one at $35. This amounted to substituting the London gold pool, active from 1961-68, and its dampening influence on the gold price, with South African sales, the latter without South Africa’s permission. Letters were sent to 95 central banks asking them to desist from all gold purchases.  The boycott had started.

So, no incidents, skirmishes or small battles breaking out between American and South African military forces in close proximity during this so-called embargo?  There doesn’t seem to be any evidence of the respective nations’ military forces being in the same general vicinity of each other.  This seems less bellicose than Koning was stating, which I suppose shouldn’t surprise anyone as the U.S. was militarily preoccupied with a little Southeast Asian nation known as Vietnam throughout 1968.  I should think Koning is aware of this, as he mentioned the Tet Offensive previously.  What happened next, Mr. Koning?

Despite the pressure on South Africa to sell in London, the London gold price never caved. Rather than selling gold on the market, the Reserve Bank of South Africa skirted the boycott by purchasing the gold produced by mining firms and hoarding it. By the end of 1968, South African gold reserves at the central bank had doubled from an opening balance of about $600 million to $1.2 billion.

While this kept gold off the London market and prices high, it meant that the nation could no longer send its main export product overseas to pay for imports. Luckily, South Africa had been running a significant capital account surplus since early 1965. World equity markets had been rising since the last bear market bottomed in 1966. Foreign investors, bullish on South Africa, were flooding South Africa with foreign currency, and for the time being there was no need to sell gold.

Okay, so this was simply a case of South Africa and the United States having opposite economic interests.  The South Africans wished to maintain the higher gold price while the Americans desired the private gold market price to sink back to the $35 peg.  Sounds like a tense business negotiation; $42 versus $35 an ounce adds up rapidly when you represent 75% of the world’s gold extraction.

I have digressed to give a piece of advice I am quite aware no one will heed (or see or hear, given this blog’s traffic): please stop intimating that business and economic negotiations are akin to war unless they involve actual combat.  Robert Fowler is not General Curtis LeMay or General Thomas Power (but does anyone know how he became president in Tom Clancy’s universe)?  But back to Mr. Koning:

The boycott amounted to a game of chicken between the US and South Africa. At some point the flow of investment capital into South Africa could dry up and the nation’s gold reserves would have to be sold in the open market to fund imports. But before that, the differential between gold’s market price and the official price could stretch even wider, weakening the resolve of the participants in the American led boycott to the point where central banks, in particular those in Europe, might start buying gold again.

Many South Africans hoped to see an official devaluation of the dollar, i.e., a rise in the official price of gold, South Africa’s main source of income. With the market price of gold at $42, arbitrage profits might get so tempting that the world’s central banks would converge on the US en masse to convert dollars to gold. US reserves would plummet, and a devaluation would be forced. In this game of chicken, it was a question of what happened first: South Africa being forced to sell its gold or a run on the US forcing it to give up $35 gold.

Devaluation, that sounds bad, right?  The U.S. dollar loses purchasing power, weakens American prestige…wait, what was the inflation rate in 1968-69?

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1968 3.65 % 3.95 % 3.94 % 3.93 % 3.92 % 4.20 % 4.49 % 4.48 % 4.46 % 4.75 % 4.73 % 4.72 % 4.27 %
1969 4.40 % 4.68 % 5.25 % 5.52 % 5.51 % 5.48 % 5.44 % 5.71 % 5.70 % 5.67 % 5.93 % 6.20 % 5.46 %

The U.S. dollar was already losing purchasing power—the South Africans were right.  But far more importantly demand for gold was rising rapidly, indicating gold was severely undervalued (how many times will I have to make that point…).  So the South African position won out?

Around the world, the bull market in equities that had begun in 1966 was ending as markets began a downwards spiral into the 1969-70 bear market. South Africa, once attractive to investors, began to lose its shine. By the second quarter of 1969, South Africa’s capital account revealed a deficit, its first in three years. Net inflows of private capital amounted to a paltry £11.7 million for the first half of 1969, down from £218 million the year prior.

The pillar that had been allowing South Africa to avoid open market gold sales had cracked. To fund imports, South Africa began to sell its gold in earnest. Reserves, which had hit a peak of $1.4 billion at the end of May 1969, fell to $1.2 billion by July and $1.1 billion by August. The gold price in London fell from $43.50 to $41. According to estimates, all new South African gold production, about 20 tonnes a week, was now hitting the market.

The sell off turned into a bloodbath in late October. Prices broke below $40. Through November gold continued to plummet, falling into the $35 range at the end of the month. On January 16, 1970 prices touched $34.80, the lowest level since the London gold market had reopened in 1954.

Nope—South Africa was done it by the 1970 recession.  Coincidentally, stagflation was already apparent in the United States by this time.  Inflation rose from an annualized 5.46% in 1969 to 5.84% in 1970 even as the economy contracted and unemployment rose.  Nor had the underlying imbalances in the gold market been rectified:

With gold at $35, in December 1969 South Africa agreed to the US compromise offered more than a year before. Its freedom to sell monetary gold was still drastically limited — it could still only sell to the IMF, and at prices below $35 — but this was better than nothing, and at least a floor had been set below the gold price.

Even with South Africa selling most of its gold in London, the gold price steadily rose through 1970, ending the year at $37.50. By August 1971 it would be trading in the free market at $43.50, again 20% above the official price. In spring of 1971 a run on the US dollar began. Central banks lined up at the Fed’s doors in ever increasing numbers to demand their gold. On August 9, the British economic representative asked to convert an astonishing $3 billion into gold, or about 2,500 tons.  The South Africa gamble had been the last trick up the US’s sleeve, and on August 15, 1971 President Nixon officially abandoned the dollar’s $35 peg when he ended convertibility of dollars into gold.

Gold Fascism

Koning makes a cogent point about to the extremes the U.S. went to protect the $35 gold peg:

The monetary authority’s goal was to forcibly stem the flow of US dollars overseas, reduce the gold price, and plug the rising number of conversion claims for dollars to gold on the part of foreign governments.

For instance, in 1959 Eisenhower made it illegal for Americans to buy gold overseas — extending Roosevelt’s 1933 ban on American domestic holdings of gold. In 1964 a new tax was imposed by President Kennedy on foreign currency deposits to prevent Americans from investing overseas — the Interest Equalization Tax. In August 1970 President Nixon was given discretionary authority to impose wage and price controls on citizens.

Some of what Koning wrote needs to be explained.  August 1970 was when Democrats in Congress preemptively gave Nixon authorization for price control regime he enacted a year later; the legislators hoping to humiliate the president before the mid-term elections.  Oh, and the 1964 tax obviously wasn’t imposed by JFK the year after he had been murdered in Dallas.  Koning’s discomfort with more overt coercion is well-taken:

Soft nanny state campaigns by the state to discourage tourism and therefore dollar outflows, including Lyndon B Johnson’s comments that “We may have to forego the pleasures of Europe for a while,” and “I am asking the American people to defer for the next two years all non-essential travel outside the western hemisphere,” became common. In 1968 Johnson would also forbid all American investment in Europe and impose limits on investments elsewhere.

All this is terribly ironic as Kennedy, Johnson, and Nixon were clamping down on American economic freedoms at the same time that they were waging a war of aggression in Vietnam. By forcing the American public to spend less overseas, Kennedy and Johnson realized they would free up more room for their own overseas campaigns.

There are umpteen examples of forceful means being used to reduce the freedom of individuals in order to save the $35 peg from that era. One by one they failed, including the London Gold Pool, only to be replaced by even stronger forms of coercion.

This is all the more disheartening given that the Executive Branch through four presidential administrations was essentially defending and enabling European governments to rip off the U.S. Treasury.

Koning makes no mention of this in his article, but one of the images in his tome makes an important point:

At point 5, Koning points to a run on the dollar starting as the West Germans permit their currency to float (an event that occurred, along with the floating of the Dutch guilder, on May 9, 1971).  This marked (pardon the pun) the beginning of the end of the fixed-exchanged system.

The U.S. was running balance of payments deficits through the 1950s and 1960s, but was running persistent current account surpluses for the most part before 1971:

Historical Data ChartHistorical Data Chart

The U.S turn to current account deficits began during the second quarter of 1971:

Historical Data Chart

…and lasted through the end of 1972.  It might also be helpful to note May 9, 1971 wasn’t the first time Bonn had floated the Deutschmark.  Less than two years prior, the DM was floated from September 28 to October 24, 1969—the mark having revalued 9.3% during that month.   Was it a coincidence the floating the Deutschmark amidst a strong bull market for commodities turned a 17 year-long outward flow of gold from U.S. coffers into a full-blown current account and capital account crisis?

In this light, the “Nixon Shock” was less a signaling event than an almost obvious reaction to the slow-motion collapse of Bretton Woods that was already in progress.  The laments about Nixon ending sound money and Milton Friedman destroying the gold standard conveniently overlook that Bretton Woods was an unmitigated failure when it came to stable currency exchange rates.

Britain devalued the pound sterling by 30.5% on September 18, 1949 (starting a wave of other IMF-approved devaluations).   The French devalued the franc by 16.7% on August 10, 1957 and a further 14.8% on December 29, 1958.  Both the DM and the Dutch guilder were revalued by 5% on March 6 and 7, 1961.  Britain devalued the pound by 14.3% on November 18, 1967.  The franc was devalued 11.1% against the U.S. dollar on August 8, 1969.  The DM was floated in September 1969 and again in May 1971.  In the nearly 30 year system of fixed exchange rates, the only rate that stayed constant was the convertibility of 35 U.S. dollars into an ounce of gold and vice-versa.  When Britain came demanding 2,500 tons of gold (more than 10% of the initial American gold stock in the 1940s) in August 1971, what did PM Edward Heath expect Nixon to do?

Milton Friedman is Still Wrong

As John Paul Koning’s work has assisted me so, I will thank him by pointing out this part of his piece:

Bretton Woods vs. Free Banking

To understand this system, it helps to compare it to a hypothetical world of private banks issuing currency in a free market. In such a system, the option that currency holders have to exercise gold convertibility forces discipline on individual banks. A bank that issues more of its branded money than the market is willing to support, say by lowering its own interest rate on loans below the market’s rate, will soon face a wave of its own currency returning to it for conversion. The irresponsible bank’s gold reserves will decline and it will be forced to call in loans to rebuild reserves, or increase interest rates back to at least the market rate to attract gold deposits.

I find this “what-if” scenario is common in classical and neoclassical economics, this time a private bank issuing currency in a free market.  I can’t help but think that this logic is fatally flawed.  Currency by its very nature seems to be a creation of the state, administered by the state for use by the citizens, residents, and travelers to the state.  At the very least, the issue of counterfeit almost requires the involvement of a criminal justice system to interdict such scofflaws.  I have to ask: when, ever, has private enterprise issued currency?

In a free banking system, customers are free to choose the notes of whatever banks offer the most reserves to back up their issue, further disciplining banks that might wish to expand beyond a reserve ratio that customers prefer. At the extreme, transgressing banks are punished by run which may lead to bank failure. In that case, remaining assets are taken over by competitors, restoring balance to the system.

I think Koning has conflated debt with currency but I may be mistaken.

The US Federal Reserve operating under Bretton Woods was by no means exempt from the same pressures that individual banks in a free banking system would be subject to.

Wait, what?  He’s seriously arguing central banks are subject to the same forces put on private enterprise?  Maybe I should acknowledge Koning’s piece appeared on the website of the Ludwig von Mises Institute.  Needless to say, Koning and the Austrian institute expose some strange opinions:

As happens in a free banking system, once the mass of dollars created by the Fed exceeded demand they began to be returned to the US for conversion into gold by foreign central banks. This process began in earnest in 1958, when US reserves plummeted by 9%. A free bank would have been forced by competitive forces to reduce money creation, call in loans, increase interest rates, and rebuild reserves. Here is where the comparison between the Fed under Bretton Woods and free banks end, because the Fed and its partner the US government have one other policy option that the free banks don’t; they can resort to their monopoly on force.

Umm, Mr. Koning?  The Federal Reserve isn’t a private bank that partners with the U.S. government.  It is a federal institution, an institution of the state, with admittedly a high degree of outside influence from private enterprise.  The only evidence necessary to demonstrate this fact is the Fed refunds to the Treasury the interest it earns on its bond holdings.  I’m supposed to believe the Fed is a not-for-profit?

History oftentimes, I’m finding, isn’t well researched.  Simple patterns aren’t recognized.  Take 1958, for example.  Koning points out that the American gold stock (I refuse to call that commodity a reserve) dropped 9% that year and states this gold flow should have required the Fed to tighten monetarily.  I’ve got news for those who are so dense as to not know what the Fed was doing with monetary policy that year:

Unemployment-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1957 4.2 3.9 3.7 3.9 4.1 4.3 4.2 4.1 4.4 4.5 5.1 5.2
1958 5.8 6.4 6.7 7.4 7.4 7.3 7.5 7.4 7.1 6.7 6.2 6.2
1959 6.0 5.9 5.6 5.2 5.1 5.0 5.1 5.2 5.5 5.7 5.8 5.3

Plus:

Inflation-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1957 2.99 % 3.36 % 3.73 % 3.72 % 3.70 % 3.31 % 3.28 % 3.66 % 3.28 % 2.91 % 3.27 % 2.90 % 3.34 %
1958 3.62 % 3.25 % 3.60 % 3.58 % 3.21 % 2.85 % 2.47 % 2.12 % 2.12 % 2.12 % 2.11 % 1.76 % 2.73 %
1959 1.40 % 1.05 % 0.35 % 0.35 % 0.35 % 0.69 % 0.69 % 1.04 % 1.38 % 1.73 % 1.38 % 1.73 % 1.01 %

I could break out monetary base graphs and GDP data, but safe to say this is the 1957-58 recession—a proverbial “Fed-induced recession.”  This was the first recession the U.S. suffered through after the London gold market had reopened in 1954.  It coincided with high gold demand.  The next major gold spike was in 1960…and what do you know:

Unemployment-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1960 5.2 4.8 5.4 5.2 5.1 5.4 5.5 5.6 5.5 6.1 6.1 6.6
1961 6.6 6.9 6.9 7.0 7.1 6.9 7.0 6.6 6.7 6.5 6.1 6.0
1962 5.8 5.5 5.6 5.6 5.5 5.5 5.4 5.7 5.6 5.4 5.7 5.5

Inflation-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1959 1.40 % 1.05 % 0.35 % 0.35 % 0.35 % 0.69 % 0.69 % 1.04 % 1.38 % 1.73 % 1.38 % 1.73 % 1.01 %
1960 1.03 % 1.73 % 1.73 % 1.72 % 1.72 % 1.72 % 1.37 % 1.37 % 1.02 % 1.36 % 1.36 % 1.36 % 1.46 %
1961 1.71 % 1.36 % 1.36 % 1.02 % 1.02 % 0.68 % 1.35 % 1.01 % 1.35 % 0.67 % 0.67 % 0.67 % 1.07 %

It’s almost as if the Fed is tightening in response to gold demand spikes when it induced the 1960-61 recession.   All because gold traders believed runaway budget deficits and inflation was right around the corner; or my theory that the gold controls had thrown the market so far off kilter active intervention would be needed for now on to maintain the peg.  But remember, the 1960 gold demand spike was much stronger than in 1958, erroneously indicating to gold standard defenders that monetary policy caused the problem in the first place.  This is more evidence of what I keep referring to as deflationary bias; an unfortunate requirement with gold price controls that there can never be enough tightening.

This also shows a fallacy to Milton Friedman’s famous thoughts about monetary policy.  Inflation, which I have already demonstrated is also generated as a byproduct of waging war, likewise is a serious consequence of decades-long ill-advised price controls.  Without any doubt, I must state that inflation can be produced in the absence of a change in the monetary supply.

But notice that outright deflation was never triggered in either of these two recessions, and the Fed’s reaction to the 1968-69 gold “crisis” was far different:

Unemployment-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1967 3.9 3.8 3.8 3.8 3.8 3.9 3.8 3.8 3.8 4.0 3.9 3.8
1968 3.7 3.8 3.7 3.5 3.5 3.7 3.7 3.5 3.4 3.4 3.4 3.4
1969 3.4 3.4 3.4 3.4 3.4 3.5 3.5 3.5 3.7 3.7 3.5 3.5
1970 3.9 4.2 4.4 4.6 4.8 4.9 5.0 5.1 5.4 5.5 5.9 6.1

Inflation-

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1967 3.46 % 2.81 % 2.80 % 2.48 % 2.79 % 2.78 % 2.77 % 2.45 % 2.75 % 2.43 % 2.74 % 3.04 % 2.78 %
1968 3.65 % 3.95 % 3.94 % 3.93 % 3.92 % 4.20 % 4.49 % 4.48 % 4.46 % 4.75 % 4.73 % 4.72 % 4.27 %
1969 4.40 % 4.68 % 5.25 % 5.52 % 5.51 % 5.48 % 5.44 % 5.71 % 5.70 % 5.67 % 5.93 % 6.20 % 5.46 %
1970 6.18 % 6.15 % 5.82 % 6.06 % 6.04 % 6.01 % 5.98 % 5.41 % 5.66 % 5.63 % 5.60 % 5.57 % 5.84 %

In the late sixties, the wartime inflationary bias rules the day.  The Fed adopts an almost devil-may-care attitude, simply allowing inflation to rise steadily into 1970.  But that’s understandable—not triggering an economic contraction during wartime to me is good Fed policy (regardless whether the war itself is good policy).  The 1970 recession was purely from war-related stagflation.

This brings me to August 15, 1971—the day gold standard defenders still gnash their teeth over.  As I wrote previously, Nixon’s price controls/gold window closing actually worked—until the conclusion of Operation Linebacker II in December 1972.  Inflation slowed for more than a year:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec Annual
1971 5.29 % 5.00 % 4.71 % 4.16 % 4.40 % 4.64 % 4.36 % 4.62 % 4.08 % 3.81 % 3.28 % 3.27 % 4.30 %
1972 3.27 % 3.51 % 3.50 % 3.49 % 3.23 % 2.71 % 2.95 % 2.94 % 3.19 % 3.42 % 3.67 % 3.41 % 3.27 %
1973 3.65 % 3.87 % 4.59 % 5.06 % 5.53 % 6.00 % 5.73 % 7.38 % 7.36 % 7.80 % 8.25 % 8.71 % 6.16 %

…and unemployment slowly dropped:

Year Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec
1969 3.4 3.4 3.4 3.4 3.4 3.5 3.5 3.5 3.7 3.7 3.5 3.5
1970 3.9 4.2 4.4 4.6 4.8 4.9 5.0 5.1 5.4 5.5 5.9 6.1
1971 5.9 5.9 6.0 5.9 5.9 5.9 6.0 6.1 6.0 5.8 6.0 6.0
1972 5.8 5.7 5.8 5.7 5.7 5.7 5.6 5.6 5.5 5.6 5.3 5.2
1973 4.9 5.0 4.9 5.0 4.9 4.9 4.8 4.8 4.8 4.6 4.8 4.9

On that day in August forty one years ago, Nixon traded gold price controls for domestic price controls.  Again, like the American/South African gold faceoff, Nixon succeeded handsomely before everything crashed down onto his head.

The Sky is Falling—the Great Readjustment of 1973

Robert Fowler and the U.S. Treasury department were not the only agencies that launched ill-fated campaigns to save the gold peg.  The International Monetary Fund (IMF), itself a creation of Bretton Woods, began issuing Special Drawing Rights (SDR) in 1969:

A country participating in this system needed official reserves—government or central bank holdings of gold and widely accepted foreign currencies—that could be used to purchase the domestic currency in foreign exchange markets, as required to maintain its exchange rate. But the international supply of two key reserve assets—gold and the U.S. dollar—proved inadequate for supporting the expansion of world trade and financial development that was taking place. Therefore, the international community decided to create a new international reserve asset under the auspices of the IMF.

IMF hoped a more liquid instrument like SDR would bring an end to the outsized demand for American $35-an-ounce gold.  An idea that probably would have been far more effective before 1958 when the margin between the gold peg and the market price brought in a penny profit per ounce, in the face of $7.00 margins that resumed in 1971 the IMF effort was far too late to save Bretton Woods.

In some ways, the August 15, 1971 is the wrong date for gold defenders to obsess about.  While convertibility ended that day, the system of fixed exchange rates remained.  The U.S. dollar remained pegged to gold, first being devalued to $38 an ounce through the Smithsonian Agreement on December 18, 1971.  But devaluation and revaluation could not bring the gold market into equilibrium.

June 23, 1972 brought an end to the sterling area.  Britain, having lost massive amounts of its gold stocks defending the exchange rate, floated the pound.  The U.S. dollar, strengthening through the latter half of 1972, soldiered on until 1973, when a second devaluation to $42.22-an-ounce was forced on February 12.

Less than a month later, foreign exchange markets shut down all over the world on March 2, 1973.  The markets did not reopen until March 19, at which point the fixed exchange rate system had been discarded and all major currencies, including the U.S. dollar, began floating.  This naturally is regarded as the result of “speculative attack,” but in reality was far simpler:

1972 $58 $320
1973 $97 $502
1974 $159 $741
1975 $161 $685
1976 $125 $503
1977 $148 $560
1978 $193 $680
1979 $307 $967
1980 $613 $1,706

A highly sought-after commodity whose name in most of the world is synonymous with value did just that—increased rapidly to its free-market value and signaled traders to do the same for other commodities.  In other words, the massive distortions from controlling the price of gold for centuries set off a wave of inflation when the controls collapsed.  When combined with the stagflation already brewing from the end of a decade-long, extremely expensive war, the damage wrought inevitability by immense commodity revaluations triggered inflationary storms and ebb flows that buffeted the United States for almost ten years.

Still Not Done…

Next up, petroleum.

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3 thoughts on “The Turn to Disinflation Part 3—More Distorting Than Wartime Price Controls

  1. Pingback: The Failure To Understand History (Stagflation Edition) | In The Corner, Mumbling and Drooling

  2. Pingback: The Turn to Disinflation Part 1—Correcting the False History | In The Corner, Mumbling and Drooling

  3. Pingback: The Week of Reckoning | In The Corner, Mumbling and Drooling

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