“…When 1971 began, US$35 would buy an ounce of gold. By the end of that year, the same amount of gold cost $70. In other words, the dollar had lost half its purchasing power as measured by gold…”
The Fed and the Nickel Dollar
By Wayne Jett
As poste at Asia Times
When 1971 began, US$35 would buy an ounce of gold. By the end of that year, the same amount of gold cost $70. In other words, the dollar had lost half its purchasing power as measured by gold.
By the end of 1972, an ounce of gold cost $140, and the dollar had lost an additional 50%. So the dollar at that time was worth a quarter of the dollar of two years earlier.
The dollar’s devaluation in 1971 was not announced by then-president Richard Nixon or by the US Department of the Treasury. But the devaluation was real, nonetheless. Just as real, in fact, as when the dollar was officially devalued in 1934 by order of president Franklin Roosevelt from $20.67 per ounce of gold to $35 per ounce.
During 2003, gold cost about $350 an ounce, 10 times the price at the outset of 1971. The 1971 dollar had shrunk to a dime (the colloquial US name for a 10-cent coin) – a major devaluation of the currency. Yet the US government has not issued a single notice of devaluation during the 35 years since 1971. De facto devaluation has occurred, even though it once required a direct order by the president.
In 1973, the dollar’s value was turned over to the Federal Reserve Board by order of Nixon. The Fed, as it is called, has managed the dollar so that its value “floats” in the market. By this approach, the Fed points to the market as determining the dollar’s value. The truth is, however, the dollar’s value is determined by the Fed’s practices, not by the market.
The dollar is neither a commodity nor a product; its value is not determined by the cost of production or by utility. Its supply can be changed at the Fed’s discretion, and demand for the dollar is often affected drastically by what the Fed says and does.
Consider, for example, what has occurred since 2003, when $350 bought one ounce of gold. In spring 2004, the Fed began spreading the word that its interest-rate target for Federal Reserve funds would be raised. Since June 2004, the Fed has raised the Funds Rate target 16 times, from 1% to 5%. This was done, most Fed observers say, to strengthen the dollar.
The rate hikes raised the interest payments made by consumers and by businesses using commercial paper by $155 billion per year. This drain of working capital from productive enterprises meant fewer resources available to hire people and to make products.
This is the Fed’s intent, since the Fed’s theory is that higher unemployment means fewer workers will demand higher wages that might push prices up. In pursuing its rate-hiking regimen, the Fed conveyed a message to the economy – month after month – that production and employment should be reduced.
But the Fed’s rate hikes during this period have not strengthened the dollar. Quite the opposite is the case. Today, one ounce of gold costs more than $700. The dollar is no longer worth a dime compared with the 1971 dollar, as was the case in 2003. In other words, today’s dollar is a nickel’s worth of the 1971 dollar. (“Nickel” is the US colloquialism for the 5-cent coin, which originally was made of one part nickel and three parts copper.)
The dollar has lost half its value over the past three years; and with most of the loss occurring within the past 10 months, the dollar’s fall is getting steeper. The Fed’s theory and performance are failing badly.
Those who contend that the Fed is trying to make the dollar more valuable now urge faster, larger hikes in interest rates. They say the Fed waited too long to begin raising rates, and should be more aggressive. Others argue that a weak dollar allows US exporters to sell more goods and services abroad. They speak as if the Fed has been seeking that objective and is achieving it with the weaker dollar.
Even with its new, plain-speaking chairman, Ben Bernanke, the Fed is not saying whether it is trying to increase or to reduce the dollar’s value. But definitely the Fed is using a theoretical model that intends to reduce price increases (ie, strengthen the dollar) by raising the level of unemployment. The Fed calls it the Consensus New Keynesian Model, but in essence it is the modified Phillips Curve model. The Phillips Curve, named after New Zealand-born economist Alban William Phillips (1914-75), describes an inverse relationship between inflation and unemployment; graphically, this appears as a curve sloping downward and to the right, with inflation on the vertical axis and unemployment on the horizontal axis.
This being the case, the Fed’s theoretical model is most certainly invalid. The dollar’s instant purchasing power relative to gold is the lowest since 1980, which was the dollar’s worst year in history, despite two years of Funds Rate hikes.
The Fed’s rate hikes have weakened the dollar, along with economic growth, by reducing demand for dollars to invest. That creates excess dollars the Fed does nothing to drain. So the Fed itself is causing monetary inflation. This explains the Fed’s reputation for overshooting: rate hikes produce inflation that chases rates higher.
Throughout history, gold has been an unerring measure of a currency’s value. The present high gold price means the dollar is worth very little now. General prices will have to be adjusted higher in the next 10 years, probably more than 5% annually, if the dollar’s value is not restored promptly.
In 1979, gold was at $280 an ounce and rising. Fed chairman Paul Volcker at the time thought the circumstances were so bad he gave up trying to manipulate interest rates to help the dollar. Unfortunately, Volcker chose an unwise theory (monetarism) that made matters much worse.
This year, gold has touched $725 an ounce and is rising faster than in 1979. Again, the Fed must abandon its interest-rate targeting. Time is of the essence. This time the Fed should apply tried and proven classical principles by targeting a value for the dollar as reflected by a price for gold. The Fed can reach the target by selling its Treasury bonds to remove dollars from the economy.
The target price should be between $375 and $450 an ounce, which would cause the least price displacement in the economies of the United States and the rest of the world. The precise gold-price target is not as important as the dollar’s stability. Lack of a floor under the dollar is what dropped the floor from under stock and bond prices during the stock-market crash of 1987.
Wayne Jett is managing principal and chief economist of Classical Capital LLC, a registered investment adviser in Pasadena, California.
Copyright 2006 Wayne Jett