Two months ago, Morgan le Fay and I confessed to meditating nostalgically about gold. 1 Not in a covetous way, I stress, but rather in the context of global monetary arrangements established after World War II at Bretton Woods, New Hampshire. Since then, both Fed Governor Bernanke and Fed Chairman Greenspan have thought out loud about gold, too. Morgan and I like the company! Very cool, she wiggles her ears; and I agree.

I'll come to what Ben and Alan had to say in a moment, but first, let me review why Morgan and I had wistful memories about gold, as part of the Bretton Woods arrangements. It was really a very simple deal: the dollar was pegged to gold at $35 an ounce, and everybody else was pegged to the dollar . Theoretically, the arrangements were a prophylactic against accelerating global inflation, in that the set-up putatively required America to embrace sustained monetary and fiscal discipline, so as to keep the dollar "as good as gold," limiting dollar creation via the fiat printing press. Such had been the foundation of gold-linked currency regimes for time immemorial: a check against the inflationist (immoral, many would say!) tendencies of governments, from kings to dictators to democracies.

Britain's John Maynard Keynes and America's Harry Dexter White were the architects of the Bretton Woods arrangements. And they were good. Indeed, it boggles the 2002 mind that the developed world could, at the end of World War II, actually have a "political elite" (thank you, my dear friend Mohamed, for that wonderful phrase!) get together and hammer out a set of rules for global financial arrangements. Now, it seems, the developed world couldn't arrange a keg party in a brewery (paraphrasing my British friends). Bretton Woods was founded on sound principles, with an aim to re-globalize the world financially, after it had damn near blown itself up militarily. Bretton Woods was policy art, not just craftsmanship; and it was very fine art.

 The figure is a line graph showing the JOC Index (the Journal of Commerce Industrial Commodity Index) superimposed with the gold price, from 1973 to 2003. The JOC Index trends upwards over the time period, finishing the chart at around 80 in 2003, up from about 34 in 1973. But the gold price trends downward from the late 1980s, to about $300 an ounce in 2003, versus its peak of almost $700 per ounce. Even though the JOC is much higher 30 years later, it trends downward from a peak of around 108 or so in the mid-1990s.

American Mojo
America has never really been enamored with sustained monetary and fiscal discipline. America likes prerogatives and power. And progress and wealth. America was founded on a risk-seeking ethos, a willingness to "bet on the come" and deal with whatever may come. Therefore, the Bretton Woods arrangements suited America's mojo very nicely: we could print as many dollars as we liked, forcing other countries to print in sympathy, so as to keep their currencies from rising against their pegs to the dollar.

Put differently, the Bretton Woods arrangements were tailor-made for America to engineer accelerating global inflation, if America deemed that to be in America's best interest. If other countries didn't like it, they could simply re-value their currencies up against the dollar: importing deflation, but also undermining their competitiveness versus American industry. Alternatively, they could try to convince America to slow down the printing press, by presenting their "surplus" reserve dollars to the Fed for exchange into gold at $35 an ounce.

And, indeed, that was the path that ended the Bretton Woods arrangements in 1971: France's President Charles De Gaulle indignantly requested that America prove the dollar was "as good as gold" by swapping some of America's gold for France's "surplus" dollars; at $35 per ounce, of course. America's President Dick Nixon told him to stuff it, "closing the gold window." Henceforth, the dollar would be worth precisely what America said it was, and not an ounce of gold more, Nixon declared (actually his Treasury Secretary John Connally, a Texan who lived his state's motto: don't mess with Texas!).

By "going off gold," America effectively admitted that (1) it had abused its prerogatives and powers under the Bretton Woods arrangements, while (2) declaring it had no intention of "taking the pain" of deflating to live up to its obligations. Deflation was simply not on America's menu of policy options: the future belonged to those willing to take risk, not to those torqued-off about wanting their debts paid in currency "as good as gold." Stuff happens, Connally said for America, and the rest of the world could stuff it if they didn't like it.

Grease Is The Word
America's ditching of the Bretton Woods arrangements was a regime shift , not just a cyclical wiggle in monetary affairs. And for investors, it was a profound moment: with America flipping the bird to Bretton Woods, inflation could only accelerate. Gold could only rise. And the dollar could only fall. Investment professionals live for such singular, transparent moments, when the authorities in charge of (1) "legal tender" laws, and (2) a printing press that makes legal tender tell the policy truth .

Which, of course, ushered in the miserable 1970s, if you were a creditor . Or an equity holder, beholden to the valuation anchor of default risk-free bonds. The 1970s were a time to be long stuff and short financial assets, a time to light your cigar with paper money, while making jokes about the naiveté of the French. Stuff, real things, like land, like commodities, like oil, like gold were the place to be. Dallas was the cat's meow, while Boston's mutual fund offerings were for the cat box.

Truth be told, America didn't do all that badly in the 1970s, regardless of how self-interested gray beards on Wall Street remember it. America embraced racial equality. America embraced gender equality. America got the hell out of Vietnam. America declared that capitalists must "internalize the externalities" of their polluting of the environment. America created jobs, lots and lots of them, making room for a dramatic rise in labor force participation rates, notably by women.

While those on Wall Street with too little fiber in their diets didn't do well, regular Americans - like my parents, indeed most Baby Boomers' parents, who were long an appreciating house on a low fixed rate mortgage! - did just fine. Bonds became known as "certificates of confiscation." But it was a great time for debtors , who got to service and repay their obligations with pieces of paper worth less, much less, in terms of goods and services they could buy.

Eventually, of course, America discovered that too much of a good thing is not a good thing after all. A little bit of inflation lifts capitalists' animal spirits, and makes life easier for debtors. But too much inflation (deflation), particularly when it is unanticipated, destroys the climate for capitalism, while arbitrarily and capriciously redistributing real income and wealth from creditors to debtors (and visa versa). Too much of a good thing is not, contrary to Mae West, always a good thing. Too much inflation, particularly uncertain inflation, leads capitalists to spend all their productive energy trying to anticipate and exploit accelerating inflation, rather than increasing the nation's productivity.

And so it came to pass in America as the 1970s unfolded. And finally, in 1979, America repented for torpedoing Bretton Woods, with the cardigan sweater-wearing President Jimmy Carter appointing Paul Volcker to downshift the Fed's printing press. Volcker's mission, as beautifully chronicled by the brilliant Bill Grieder in his classic Secrets of the Temple , was to break - as in, impoverish! - those that had bet on borrowed money that inflation could only accelerate.

Volcker did, commencing a secular war on inflation, fought with high real interest rates and a high real exchange rate for the dollar, and a secular bear market for gold. Current Fed Chairman Greenspan continued the war, pursuing "opportunistic disinflation": preemptively tightening on accelerating growth, but reactively easing on decelerating growth . 2

As the millennium turned, the war was won. Boston mutual fund operators were the cat's meow, and the American people believed that stocks could be as sure a thing as Grandma's silver back in the days of Billy (Carter) Beer. And the dollar was not just "as good as gold," but better than gold, with central banks everywhere puking the yellow metal out in disgust. America, the American dollar and American stocks had not only been redeemed of the sin of trashing Bretton Woods, but sainted! The God Almighty Dollar was indeed mighty again!

That was three years ago. And the truth of the matter is that America's redemption from inflationary sins had morphed into a bubble of irrational exuberance. What a long strange trip it had been from America's paroxysm of Jimmy Carter malaise. As the millennium turned, stocks crashed, just like gold and silver had crashed two decades earlier. And interest rates crashed with stocks, at the hands of aggressive Fed easing by Mr. Greenspan, the exact opposite of Mr. Volcker's frontal assault of soaring interest rates.

America's war against inflation was over and a new secular war against deflation risks was initiated. Mr. Greenspan never put it exactly that way two years ago, of course. But the proof of the pudding has been in the eating thereof, and short-term interest rates futures have been some mighty fine pudding over the last two years. The only question has been whether and when the aggressive reflationary easing would/will "get traction." 3

"What the Sam Hill do you guys want?" I'm sure that Mr. Greenspan has asked more than a few times over the last two years. Finally, as I wrote last month, 4 Greenspan found his answer: we, the risk takers of Wall Street, have wanted the Fed to quit pretending that it was not reflating . Reflationary tapioca wasn't enough.

We have wanted the Fed, in broad daylight, in front of the mother-in-law, and with no apology, to pour a reflationary fifth of the good stuff into the punchbowl: a put beneath private sector debtors' wings . Then, and only then, would private sector risk managers ask for a cup of the stuff with default risk. In November, the Fed finally poured, with Mr. Greenspan and Mr. Bernanke hailing the reflationary power of the printing press. Ever since, we in the private sector have been drinking up. It's good reflationary hooch: the Bernanke Put!

Particularly good stuff, say the gold bugs amongst us. I happen to agree with them, though I've never had a fondness for gold. If the war against inflation was started with the Fed flogging the gold speculators, then the war against deflation risk should logically commence with a Fed embrace of the gold speculators. The simple fact of the matter is that America, and the world, needs a devaluation of paper versus "stuff," the exact opposite of twenty-odd years ago . And gold is the global symbol for "stuff."

Over thirty years ago, America was forced to bust up the Bretton Woods arrangements, because America didn't want to deflate sufficiently to keep gold from rising above $35 an ounce. Today, just the opposite problem exists: America needs to inflate the money stock, while devaluing it against gold, so as to keep private sector debt obligations from sinking into a deflationary abyss. And the world needs the same thing: a broad based, wholesale devaluation of all paper currencies versus a basket of globally-traded "stuff."

It is as if in 1971, gold had wanted to trade below, not above $35 an ounce. John Connally, may he rest in peace, would have known what to do. And he would have done it with glee: run America's printing press overtime, putting a falling dollar into the deflationary ears of the other two G-3 members.

Bernanke and Greenspan: Raising Milton
Fed Governor Bernanke made his grand entrance onto the monetary policy stage on November 21, with a tour de force speech before the National Economists Club about the ways and the means, and the will of the Fed to abort deflationary risks: "Deflation: Making Sure 'It' Doesn't Happen Here." I wrote about his speech last month, as did Bill Gross; 5 so no need to replow plowed ground. Rather, I want to focus on Governor Bernanke's little-reported speech a couple of weeks earlier, titled simply "On Milton Friedman's Ninetieth Birthday" (Professor Friedman turned 90 on July 31, and the University of Chicago celebrated him on November 8).

Ben was very understandably honored to speak at such an august event, and paid beautiful tribute to a true giant in the economics profession. I urge you to read the speech, available on the Fed's web site, 6 as there is no way to give it proper due here. The essence of Governor Bernanke's speech, however, was simple: the pioneering work of Professor Friedman and his collaborator Anne Schwartz, in their Monetary History of the United States , demonstrated categorically that the Great Depression was not an act of God, but the consequence of repeated acts of monetary policy folly.

Mr. Bernanke focused on four sets of monetary policy mistakes back then, as detailed by Friedman and Schwartz. In all four cases, policymakers beguiled themselves into believing that there was nothing they could do about deflation. And in three of those four cases, a religious devotion to defending the dollar's exchange value in terms of gold played a nefarious role. Monetary policy makers had the ability to reflate, but not the will; they did indeed crucify the global economy on a cross of gold. The lesson of Friedman and Schwartz's work, Governor Bernanke declared, should be obvious to us all:

"…monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a 'stable monetary background' - for example as reflected in low and stable inflation. Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again."

Last week, Fed Chairman Greenspan proactively brought up the subject of gold as well, right in the opening of his December 19 speech to the New York Economics Club, and was (almost!) as poetic as Governor Bernanke in his tribute to Mr. Friedman:

"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. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation.

With the story of most major economies in the postwar period being the emergence of, and then battle against inflation, concerns about deflation, one of the banes of an earlier century, seldom surfaced. The recent experience of Japan has certainly refocused attention on the possibility that an unanticipated fall in the general price level would convert the otherwise relatively manageable level of nominal debt held by households and businesses into a corrosive rising level of real debt and real debt service costs. It now appears that we have learned that deflation, as well as inflation, are in the long run monetary phenomena, to extend Milton Friedman's famous dictum."

Bottom Line
Economic life within a democratic capitalistic society is not about creditors or debtors winning, but both winning. Or, in the beautiful words of Jackson Browne:

How long have I been sleeping
How long have I been drifting alone through the night
How long have I been running for that morning flight
Through the whispered promises and the changing light
Of the bed where we both lie
Late For The Sky

Paul A. McCulley
Managing Director
December 27, 2002

1 "The Morgan le Fay Plan," Fed Focus, December 2000.
2 "Eight Tracks Don't Fit In A CD Player," Fed Focus, December 2001.
3 "Getting Traction In Your Vision," Fed Focus, August 2001
4 "Necking In The Mezzanine," Fed Focus, December 2002
5 "Questions For The Genie," . Investment Outlook, December 2002.


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