Alan Greenspan’s Solution to Market Volatility: The Gold Standard

by | Apr 26, 2001 | POLITICS

I wrote yesterday that Alan Greenspan’s repeated rate cuts weren’t helping the economy, and that further cuts might not help either. We could find ourselves in the position of Japan, with rates at zero and an economy still spinning its wheels in a deflationary spiral. Deflations — characterized by falling commodity and asset prices, and […]

I wrote yesterday that Alan Greenspan’s repeated rate cuts weren’t helping the economy, and that further cuts might not help either. We could find ourselves in the position of Japan, with rates at zero and an economy still spinning its wheels in a deflationary spiral.

Deflations — characterized by falling commodity and asset prices, and cascading business failures — aren’t fixed with low interest rates. They are fixed with an increase in liquidity that restores the willingness of consumers to spend and investors to take risks. Until that happens, cash is king — in a deflation everyone would rather hoard cash than spend it or invest it.

After yesterday’s commentary, I got dozens of emails all asking the same question: with the money supply expanding at a near-record pace, how can I say the Fed isn’t injecting a ton of liquidity?

It’s true that the money supply is indeed expanding rapidly. Money Zero Maturity, or MZM, is now growing at 12.3% year-over-year, a rate we haven’t seen since August, 1999.

Money Zero Maturity
Source: Federal Reserve Bank of Saint Louis and

That’s a true fact. But like so many true facts in economics, it doesn’t mean a darn thing. Neither the size nor the rate of growth of the money supply are sufficient to tell you whether there’s enough liquidity in the economy. You have to consider the demand for money, too — not just the supply of money.

Think of it like trying to grow a vegetable garden. You may have what you consider an awful lot of water. And it may be enough if you’re trying to grow carrots. But maybe it’s not enough if you’re trying to grow cantaloupes. It might be enough for either of them in the spring, but neither of them in the summer. Or it may be too much. It’s all a matter of matching supply and demand at any given point in time — and the right match changes every day.

The fundamental challenge for Alan Greenspan or any central banker is to match the supply of money with the demand for money. Too much supply in relation to demand, and you get inflation. Too little supply in relation to demand, and you get deflation. It’s a dangerous challenge: if Greenspan makes a significant error in either direction, and doesn’t correct it quickly, he can create monetary havoc that reverberates through the economy for years. Sadly, the Federal Reserve has a long and inglorious history of doing just that, as the long-term record of violent inflationary and deflationary episodes all too eloquently attests.

Free markets have an easy time matching supply and demand. They do it every day in billions of transactions across millions of goods, services, and securities. But government agencies aren’t so good at it. The 20th century’s dozens of failed experiments with centralized economic planning prove that. Yet in America, the world’s most productive and most free economy, we let a committee of political appointees known as the Federal Reserve decide unilaterally how much money there should be. There’s no reason to think they will be any better at it than the Soviet Union’s farm bureau was at deciding how many potatoes there should be.

There’s a very simple way of letting the free market decide how much money there should be to perfectly match its supply with the demand for it — or to put it another way, how much liquidity should be available to the economy without triggering either inflation or deflation. That would be for the Fed to announce that it will forget about unemployment, consumer confidence, productivity, the “wealth effect,” and all the other claptrap that seems to go in and out of fashion in their decision-making process. Instead the Fed would simply target price stability. And the simplest and most effective way to do that would be to target a single price that would stand as a proxy for all other prices: the price of gold.

For millennia, gold has been money. When the paper money issued by governments has been tied to gold, that paper money has held its value. When gold was abandoned, that money always lost its value. Just look what has happened to the US dollar since Richard Nixon severed its last links to gold in 1971.

When the central bank prints too much paper money — or provides too much liquidity to the economy — the price of gold denominated in that paper money goes up. That’s inflation. When the central bank sees the price of gold rising, all it has to do is stop printing money — or withdraw liquidity — until the price of gold goes back down. It works just the same for deflation, but in reverse. If the price of gold drops, the central bank prints more money — or adds liquidity.

All the Fed has to do is pick a gold price. $300 is a nice round number. And if the Fed just followed this simple regimen, then it would be the free market that determined the right amount of liquidity: by setting the price of gold.

And the Fed wouldn’t have to hold a single ounce of gold in its vaults to use this system. They’d simply use gold’s price as a signal to add or withdraw liquidity through operations in the bond markets, much the same as it employs today. It’s that easy. The Fed could fire all those economists and just get by with a single subscription to The Wall Street Journal to see what the gold price is every day. They could probably even get the gold price free from some website, and save the taxpayers the cost of that subscription.

The fact that gold is trading near twenty-year lows is the first and most important evidence that we are in a deflation. The similar collapse in other commodity prices, and in foreign exchange, tell me the same thing. And the dramatically slowing economy and collapsing equity markets clinch it. Greenspan’s rate cuts this year haven’t made a dent in any of it. So I really don’t care what the year-over-year growth rate of MZM is.

Gold has been so thoroughly discredited over the last thirty years by the modern generation of academic economists that I almost hesitate to write about it. But I’ve never been afraid to go against the conventional wisdom, and I’m not about to start now.

“This is gold, Mr. Bond. All my life I have been in love with its color, its brilliance, its divine heaviness.” So said Auric Goldfinger to James Bond.

But gold has more credible advocates, as well — even if the best of them have been driven into deep cover. Consider this passionate pro-gold view:

“The abandonment of the gold standard made it possible for the welfare statists to use the banking system as a means of unlimited expansion of credit… The law of supply and demand is not to be conned. As the supply of money (of claims) increases relative to the supply of tangible assets in the economy, prices must eventually rise… In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”

Who do you think wrote that?

Some obscure 19th century Austrian economist? Or some crazy goldbug survivalist? Hardly.
Those words were written in 1966 by none other than Alan Greenspan. You can read Greenspan’s whole tribute to gold in Capitalism: The Unknown Ideal.

Sometimes the old truths are the best truths. Even in the New Economy, it pays to remember them. I wish Alan Greenspan would.

Don Luskin is Chief Investment Officer for Trend Macrolytics, an economics research and consulting service providing exclusive market-focused, real-time analysis to the institutional investment community. You can visit the weblog of his forthcoming book ‘The Conspiracy to Keep You Poor and Stupid’ at He is also a contributing writer to

The views expressed above represent those of the author and do not necessarily represent the views of the editors and publishers of Capitalism Magazine. Capitalism Magazine sometimes publishes articles we disagree with because we think the article provides information, or a contrasting point of view, that may be of value to our readers.

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