The True Gold Standard (Second Edition)
The Rueffian Synthesis
Previous article: Rueff’s Macroeconomics: Minding Your P’s and Q’s
According to Rueff, “This formula leads to a revised version of Jean-Baptiste Say’s law of markets and the quantity theory of money.
“As regards the law of markets, the formula shows that, at each market session, practically all the demand is indeed provided by the proceeds of the supply during the same market session, as Jean-Baptiste Say had foreseen. But there is in addition to this supply, a term which may be positive or negative, and is a monetary residue: the difference between the overall variation of the circulation of money and the overall variation of the desired cash balances occurring during the same session of the market.
“Thus,” Rueff remarks, “Jean-Baptiste Say’s law was roughly correct, but its exact statement requires that the above-mentioned monetary residue should also be taken into account. However, this residue is always limited, except during inflationary periods, relative to the portion of the demand which is provided by the supply” (“Un instrument d’analyse economique; la theorie des vrais et des faux droits,”  in E.M. Claassen, ed., les Fondements Philosophiques des Systemes Economiques, Payot, 1967, unpublished Lehrman Institute translation).
Next Installment: Rueff Restates the Quantity Theory of Money
Previous article: Rueff Restates Say’s Law
Rueff addresses the Quantity Theory on the same basis.
“In light of the foregoing observations, the quantity theory of money can be stated as follows: the general price level varies only as a result of the difference between the simultaneous variations of total actual cash balances and total desired cash balances.
“As long as the variations of the former [dM] equal the variations in the latter [dL], the general price level is indifferent to supply and demand [dP = 0 for any Q], because if supply increases, demand increases accordingly.
“Similarly the general price level is indifferent to an increase in the quantity of money in circulation so long as such money is desired.” (“Sur la theorie quantitative et le phenomene de regulation monetaire,” Econometrica, July 1949, unpublished Lehrman Institute translation)
This begins to explain how one might use some measure of undesired or “excess” money as a basis for prediction. But it does not settle the question of policy.
“Some people will think that the previous statements settle the problem of the quantity theory and that, by influencing the difference between the amount of circulation and the total desired cash balances, it is possible to cause variations in the general price level, as one wishes. This is the view of theorists who believe that the monetary authorities regulate the price level by causing variations in the quantity of money in circulation [i.e. the monetarists].
“These people, however, are entirely wrong because they lose sight of the basic link which tends to regulate the quantity of money in circulation to the amount of desired cash balances.” (idem,III/5)
According to Rueff, the problem of price stability is not simply a question of abstract monetary theory, but of specific monetary institutions in the real world.
Goldman of Polyconomics, as we will see, argues that what’s wrong with the monetarists is that they focus on the money supply while ignoring the demand for money. In fact, Milton Friedman’s whole theory is basically about the demand for money.
Rueff argued that the real problem with the monetarists is not that they focus too much, but rather too little on the supply of money; namely, they assign too little importance to the concrete mechanisms by which money is actually created. Most monetarists adopt the convention that the government can control the nominal supply of money, while demanders of money control its value. Rueff pointed out that under a properly functioning monetary system, even the nominal supply of money is determined by people’s demand for it.
Next Installment: The Link Between Money Supply and People’s Demand for It
Previous article: The Problem with Keynes
The preceding sections laid out the problems raised by the quantity theory of money, Say’s Law, and Keynes’s theory – the antecedents to today’s monetarists, supply-siders and neo-Keynesians. How does Rueff solve them?
Rueff’s macroeconomics, unlike that of Keynes, starts from the bottom up, not the top down. Rueff begins by noting that the equilibrium of the quantity supplied (s) and demanded (d) in the market for any good can be described
D = pq = s
where p and q are the price and quantity actually exchanged. This is what is described by normal supply and demand curves. We assume that prices are flexible, or that the period under consideration is long enough so that p and q reach equilibrium.
If we sum up the demand and supply of all goods exchanged, we get
D – PQ = S
D is the total demand of money against goods, S is the total supply of goods exchanged, and P and Q are indexes of the average price level and the volume of goods sold in a given period, compared with some base period. (Actually, Rueff’s equation is D = kPQ, where k is a constant relating current dollars to the values of P and Q in the base period. To keep the notation simple, I have omitted k, and in what follows I assume that the price index P = 1 to begin with.)
Rueff showed that when P and Q are weighted by the volume of each good actually exchanged, their value is independent of shifts in demand among the various goods exchanged. And so “the general price level index varies directly with total supply of goods against money, and thereby conforms to the general law of supply and demand, like all particular prices” (Theorie des Phenomenes Monetaires, II/19).
In short, the change in the price level is equal to the difference between total demand and total supply:
D = Q + dP
D – Q = dP
So we find Rueff, in 1927, discarding the quantity theory of money, and speaking in terms of aggressive demand a decade before Keynes. And he points out that the price level is inversely related to the total supply of goods, five decades before the American supply-siders with the “policy mix.”
Like Irving Fisher, Rueff envisions the indexes P and Q as including “the total value of the goods, services, securities or assets of all types, which have given rise to payments during the period of time considered” (idem, I/14).
Rueff remarks: “As a matter of fact, although most civilized countries have established various indices, such as wholesale price indices, retail price indices, cost-of-living indices and, sometimes, wage indices, all of which provide information on changes occurring in a given price group, we do not believe that any country as ever calculated a general price level index” (idem). This is still true today: there are no indexes for such a general price level. However, as we will see, this does not diminish the usefulness of the theory.
Rueff’s relationship between total demand, total supply and the average price level is “static”; it does not explain what causes total demand or total supply to change.
In L’Ordre Social, Rueff showed that a change in the price level (dP) – which is also the difference between total supply and total demand for goods – can be due to only one thing: the difference between the actual supply of money (M) and the amount of money that people wish to hold (L). Or,
D – Q = dP = dM - dL.
If people wish to reduce their holdings of cash below their actual cash balances, they will purchase goods, so that total demand for goods will exceed total supply; if they wish to increase their holdings above their actual cash balances, total demand for goods falls below total supply.
Next Installment: Rueff Restates Say’s Law
Previous article: The Link Between Money Supply and People’s Demand for It
It would seem from all this that the money supply cannot predict inflation. This is true under a gold standard of the kind we have just described, because there is seldom much difference between the supply and demand for money. However, chronic inflation is caused, in Rueff’s words, by a “rupture of the link between the money supply and the cash requirements of the people” (The Age of Inflation, p. x). When this link is ruptured by in convertibility, “Purchasing power has been transformed from effect into cause, and henceforth it will determine the value of purchasable wealth instead of being determined by it” (idem, p. 76, emphasis in original).
What could “rupture the link” between the supply and demand for money? There are two main practical causes: first, monetizing a government operating deficit; and second, monetizing international payments deficits through central-bank purchases of a “reserve currency.”
All money is created by a monetary institution purchasing some asset – usually gold or some sort of financial claim. A key condition for price stability is that, when people’s demand for money falls short of actual money supply, the banking system must be able to remove all the unwanted money, which means demonetizing the assets by selling them for at least their original purchase price. Otherwise, some or all of the unwanted money (dM – dL) cannot be removed from the market. And if the excess money remains on the market, it can do only one thing: cause an excess of total demand over total supply, which drives up the general price level irreversibly.
Rueff points out that the balance of supply and demand for money, and therefore of total supply and demand for goods, is not necessarily altered by a government budget deficit, as long as that deficit is not monetized by the central bank:
“If I had left home this morning with 5,000 francs in my pocket, and wanted to return in the evening with the same amount of cash, I could only have bought as much as I sold, that is, I could demand no more than I could supply. When the same situation prevails for the persons and institution that make up a community, total demand at any given period will be identical with the value of total supply. This would also apply if a political entity such as the government, in order to be able to demand more than it supplied, contrived, through taxes or loans to force other entities to demand less than they supply” (The Age of Inflation,p. 70).
But this equality of supply and demand ceases when the central bank finances the government’s operating deficit by issuing money to purchase its debt. To do this, the central bank must purchase the bonds at a higher price than they would fetch in the bond market (thus at a lower interest rate). But as long as the government is in operating deficit, it keeps adding to the supply of its debt, without adding to its salable assets; so that the central bank cannot resell the government securities except at a lower price – usually a much lower price. So, not as much money can be retired by selling Treasury securities as was originally issued. And of course, as long as the central bank adds new money by purchasing the government’s debt, inflation persists.
Even money created by discounting commercial paper could be inflationary, if the central bank’s interest rate is set too low. (One main reason for the requirement of gold convertibility was to prevent or correct such policy mistakes.) But apart from this, discounting commercial paper need not be inflationary, since the central bank can usually resell it at its purchase price, and so mop up the same amount of money as was issued. The difference is that – unlike the government – private businesses are not legally permitted to operate in deficit with a negative net worth. Businesses which do so are forced into bankruptcy and cease operating. But governments enjoy this legal privilege. And the government’s operating deficits can be financed by money creation when it confers this same privilege on the central bank, by waiving the requirement that the central bank redeem it’s liabilities with an asset like gold which is beyond the government’s control. Money created in this way will be demanded at existing prices only by accident. Other things equal, it adds to the total demand for goods without adding to the total supply of goods, and so causes inflation.
And yet, monetizing U.S. Treasury securities is how most of the “monetary base” – currency and bank reserves – is created by the Federal Reserve.
Next Installment: Reserve-Currency Inflation
Previous: The Rueffian Synthesis
The attack does have a great deal to do with a longstanding debate over monetary policy. The issues in the debate go back many decades; but the debate in question occurred among advisers to Jack Kemp between 1980 and 1988. One on side were Jude Wanniski, his former economist Alan Reynolds, and
I’d like to begin with a brief outline of that debate, and then go on to discuss the ideas of Jacques Rueff, who strongly influenced the thinking of LBMC’s principals. This will explain exactly why the World Dollar Base “works.” But I think the discussion will also shed light on two things; how the economic debate of the 1970s and 1980s was left unresolved; and why the “supply-side” movement seems to be scattered on the hills like sheep without a shepherd.
Now, the essence of the “supply-side” approach to economic policy was that monetary and fiscal policy are inherently separable. The previous neo-Keynesian consensus had argued that both monetary and fiscal policy work in the same direction.
The idea that you can have a different “policy mix” is generally associated with Mundell. As explained by Wall Street Journal editor Robert Bartley: “To combat stagnation plus inflation, you needed two levers: tight money to curb inflation, and tax cuts to promote growth. … In a Keynesian world, of course, tight money would merely offset tax cuts; one would contract aggregate demand while the other expands it. The key was that supply-side tax cuts provided stimulus not by expanding aggregate demand – ‘putting money into people’s pockets’ – but by stimulating supply, by increasing incentives to work and invest.” (Introduction to The Way the World Works 1989 edition, pp/ x-xi).
However, those who agreed on tax-cutting often disagreed about monetary policy. Many of them agreed with Milton Friedman that “tight money” meant controlling the domestic money supply while allowing exchange rates to float. Others argued that this would not work, partly because under floating exchange rates the demand for domestic money is not stable. Instead, this group said, monetary policy ought to be governed by some kind of “price rule” – some mechanism by which the central bank supplies all money demanded at a fixed price. This “price rule” group included Wanniski, Mundell and the current principals of LBMC.
But those who advocated for a “price rule” disagreed about which price rule. And in this debate, there were many throwbacks to a debate carried on during the late 1950s and 1960s, as the Bretton Woods system was crumbling into dissolution. The debate was similar, because the issue was essentially the same.
Two economists – Jacques Rueff and Robert Triffin – had the distinction of correctly predicting, beginning around 1960, that the Bretton Woods system (then in its heyday) could not last. Under the Bretton Woods system, the United States alone maintained convertibility of the dollar into gold, while other nations kept their currencies convertible into dollars. Basing the international monetary system largely on the IOUs of one nation (the United States), Triffin and Rueff proved, was financing a gradual inflation despite a fixed gold price. The monetary IOSs of the United States to foreign central banks kept expanding, but the supply of new gold did not; because rising prices meant rising gold-mining costs, while the output price for gold was constant.
In effect, rising prices were signaling to the gold market (exactly as under a gold standard) that there was too much gold, when in fact the cause of the inflation was too many IOUs. This was not some policy glitch; it was inherent in the “reserve-currency” system itself. Triffin and Rueff predicted that the thing would have to break down. One way or another, the relentless fall in the purchasing power of gold would be reversed – either through a general price deflation (as in the 1930s, when the similar system based on the pound sterling collapsed), or else through a devaluation of the dollar, and of all currencies tied to the dollar, against gold.
To remove the problem, Triffin and Rueff agreed, the international monetary system must be based, not on any single nation’s currency, like the dollar, but on a truly international money. But they disagreed about which.
Triffin argued in favor of a plan originally proposed in 1943 by John Maynard Keynes, which would have set up the International Monetary Fund as the world’s central bank. The IMF would issue its own world-wide currency, which all nations’ central banks, including the Federal Reserve, would be required to use to settle international accounts. All the central banks, in effect, would stand in the same subordinate relation to the new world central bank as a domestic commercial bank stands to its central bank. The original Keynes plan was rejected because of its inflationary potential, but Triffin suggested safeguards to reduce this danger.
Rueff, on the other hand, argued for a return to an international gold standard; the central banks of all nations would settle their accounts in gold, not the currency of any nation or of a world central bank. This, he argued, was a viable system with a proven record of price stability. And such a reform, he pointed out, would remove the defect that had caused both the breakdown of Bretton Woods and had permitted the deflationary collapse of the similar monetary system based on the pound sterling in the 1920s and early 1930s.
In the event, something else happened. Many other advocated “floating exchange rates,” so Bretton Woods was allowed to collapse, unleashing unprecedented world-wide inflation. Yet, against the expectations of many, the system that emerged, though one of flexible exchange rates, was still based primarily on the dollar.
Triffin’s and Rueff’s positions were represented among advisers to Jack Kemp. Lehrman and I, and later Jeff Bell, favored Rueff’s solution, for the same reasons. Mundell had long agreed with Triffin’s and Rueff’s analysis of Bretton Woods. He and Wanniski favored a variation of the Keynes plan, under which the IMF would issue a “gold SDR” (Keynes had called his monetary unit “bancor” – “bank gold”). However, believing that such a plan would be a political non-starter, they fell back on a revival of Bretton Woods. This may seem surprising, since Wanniski’s seminal 1975 article in The Public Interest, “The Mundell-Laffer Hypothesis,” was devoted mostly to explaining why Bretton Woods brok down and to advocating the “gold SDR.” (In that article, tax cuts are mentioned briefly, and the Laffer Curve is literally a footnote.) But in their view, the international gold standard would be a step backward in what they perceived as an inexorable monetary evolution, while revived Bretton Woods would leave the door open for a future world central bank.
A third variation on the “price rule” should also be mentioned. Some have argued that the Federal Reserve should “target” some commodity index or the price of gold. Wanniski argues (wrongly, in my view) that this would be equivalent to a gold standard.
I became interested in Rueff through Lehrman, whom I met shortly after joining Kemp’s staff at the start of 1979. Lehrman had known Rueff well, and was virtually alone in expounding his ideas. Lehrman had started republishing Rueff’s works through the Lehrman Institute, which was the hotbed of supply-side debate in the 1970s and early 1980s.
In 1980, Kemp asked me to draft a bill intended to restore Bretton Woods. I responded with a long memo based on Rueff’s analysis (as well as I understood it), explaining why that would not be a good idea. Many supply-siders among whom the memo was circulated were students of Laffer and Mundell, and most disagreed.
The monetary issue went into abeyance, because for the next few years tax and budget issues were more pressing policy problems. By 1985, however, especially after the Group of 5’s (later, Group of 7’s) Plaza Accord, international monetary reform was again salient. As Kemp’s staff economist, I was tasked to renew the discussion and find a compromise on the monetary issue among Kemp’s advisers. After a lot of debate, we hammered out a compromise proposal which involved a gold standard among the major central banks, but under which smaller nations could still use the dollar if they chose. However, Wanniski objected when Kemp began explaining the idea in Rueffian terms. He withdrew his agreement, and generally did his best (which is considerable) to persuade Kemp to avoid any specific proposals.
All this is why the supply-siders have always sounded an uncertain note on the monetary issue’ some supply-side tax-cutters are monetarists, and those who favor a “price rule” could not settle their differences.
In retrospect, it may seem strange or even amusing that a bunch of guys were sitting around debating the future of the international monetary system in cramped offices or Capitol Hill restaurants. But that’s the way a lot of the most important policy decisions are made. And in this case the issues at stake were important ones.
The debate over monetary reform among Kemp advisers would seem to have ended in 1988, when Bell, Mueller and Frank Cannon (and soon, Ralph Benko) left politics to start LMBC (originally BMC). We were joined by Lehrman as an active partner in 1990, after he left Morgan Stanley. This effectively left the monetary policy field to Wanniski.
The trouble, from Wanniski’s point of view, is that LBMC’s forecasting methods, and the World Dollar Base, grew directly out of Lehrman’s, Bells, and Mueller’s position in the earlier policy debate.
And if LBMC can predict the markets with the World Dollar Base, it strongly implies that Wanniski’s position on monetary policy was wrong.
For example, if monetary policy has its maximum effect on commodity prices more than two years later, then targeting commodity prices, while leaving other monetary institutions unchanged, would destabilize the economy – much like the 1979-82 experiment with targeting the domestic money supply.
Moreover, if increases in foreign dollar reserves are shown to be a cause of U.S. inflation, then a monetary system based on the dollar – which Wanniski has long advocated, if only faute de mieus -- will be inflationary and unstable.
The principals of LBMC have never been at pains to point this out, since we are no longer involved in trying to influence economic policy. Though we give our views when asked, we regard our business as one of predicting, not advocating. But Wanniski spends much of his time trying to influence economic policy, so the issue looms large with him.
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The Rueffian Synthesis