Economic Alzheimer’s

Economic Alzheimer’s
August 18, 2011

James L. Johnston

Jim Johnston is The Heartland Institute's senior fellow for energy and regulatory policy and a... (read full bio)

There are several forms of dementia. One particularly perverse version affects older economists and investment bankers. They lose the memory of everything except the gold standard. See, for example, the article by Lewis E. Lehrman on the closing of the gold window in 1971 that appeared in The Wall Street Journal on August 15, 2011.

The gold standard was popular in the 19th and middle 20th century mainly because it supposedly kept the monetary authorities from devaluing their currencies. But in the early 1970s there was a run of sorts on Fort Knox. The United States tried to hold the value of gold at $35 per ounce, thereby avoiding inflation in the world since other countries fixed their currencies to the U.S. dollar and hence to gold. But other governments sensed that gold was undervalued and sought to buy gold from the United States at $35 and ounce and sell it at the much higher market price.

At the urging of Milton Friedman, his friend George Shultz (who was head of the Office of Management and Budget in 1971) convinced President Richard Nixon to close the gold window on August 15, 1971 and abandon the fixed exchange rates. The logic was simple. The U.S. government should not fix the price of anything, especially gold.

Milton Friedman a few months later endorsed the trading of six foreign exchange contracts on a subsidiary of the Chicago Mercantile Exchange. This provided hedging opportunities for businesses and investors with risk exposure to changes in the values  of currencies. Other nonagricultural futures and options contracts like broad market indexes and interest rate derivatives were subsequently added, as were a long list of commodities, including gold, silver, copper, platinum, crude oil, gasoline, heating oil and natural gas. Volatility indexes for the S&P 500, crude oil and gold are the latest to be included to the list of exchange-traded contracts.

The total volumes of these contracts now amount to trillions of dollars EVERY DAY. This is several orders of magnitude more than was ever traded in the gold spot market when the Bretton Woods agreement was in effect. Moreover, there has never been a failed trade in the 110-year history of the CME.

Thus, we have extraordinarily liquid derivative markets that could guide the monetary authorities in their policies. More importantly, ordinary business people and investors can hedge their inflation and other risk exposures with these contracts.

It is a shame that many economic scholars and former investment bankers are missing out on a lot of very cool market institutions.

Jim Johnston is an economic advisor to The Heartland Institute.

James L. Johnston

Jim Johnston is The Heartland Institute's senior fellow for energy and regulatory policy and a... (read full bio)