One way to look at central bank normalization is to envision optimum monetary and fiscal policy and work backward to what is actually possible. Optimum policy is the magic formula of stable money and low taxes. Stable money and low taxes presume small government, beneficial regulation, and individual freedom over state control. No economy has ever imploded with stable money defined by gold and low taxes. Ever. The Founding Fathers based the U.S. Constitution upon stable money defined by gold, low taxes, and individual freedom. It worked mostly as advertised—the U.S. rose to the pinnacle of global economic and military power—until our slow decline began in 1971 when Nixon ended our constitutionally defined dollar backed by gold.
A global gold standard is the optimum monetary system. Participating countries need only define their currency at their optimum weight of gold where debtors and creditors are in balance. Major powers need a new Bretton Woods-type summit with an international agreement that stabilizes currencies to gold and hence to each other. Achieving the optimum price of gold in all major currencies without inflation or deflation is not a difficult process. Once major currencies are defined with each other at stable, unchanging values, the world can move on from currency manipulation, financialization, trade wars, and conflict and return to global growth.
For the U.S. linking the dollar with gold is easy. The optimum price of gold is currently very close to the market price of gold. The Fed need only define the dollar around $1200 to $1250 per ounce of gold. Once the dollar is linked to gold, it is an automatic process for the Fed to buy assets or sell assets—create or extinguish base money—as necessary to maintain the dollar at the defined weight of gold. In the current case of $2.0 trillion of excess reserves, the Fed would have to make the market acutely aware that it will sell assets in any amount required to maintain the established dollar price of gold. The Fed would no longer manipulate the funds rate, mortgage rates, the yield curve, or inflation rates. Interest rate derivatives along with inflation and deflation risk premiums will disappear under a properly established gold standard. The price of interest would return to a market function. Millions of investors, traders, and producers making decisions every second of the day in the marketplace are much better judges of the true price of interest than a handful of academics.
It is not difficult to see that the Fed selling $2.0 trillion or so of assets would be disruptive. Interest rates would initially rise and distortions from manipulated interest rates would unwind. For the last nine years, central banks have distorted markets with commanded monetary policy. Capital has flowed into maximizing these distortions rather than the productive economy. Central banks have incentivized financialization over productive enterprise. This occurs at the cost of real economic growth and rising standards of living. Unwinding this distortion will result in painful disruption, but it is the only way to return to real growth. The central bank liquidity flood that misallocated capital and propped-up zombie entities delayed economic healing that should have begun in 2008. That healing will still have to occur. It is just a matter of how painful and long the process will become.
To offset the monetary unwind requires fiscal policy that unleashes individual potential and stimulates real growth. Tax rates on capital, earned income, and corporations (corporations are a collection of individuals) should be reduced to the optimum level that balances growth and revenue. Tax policy should return to its role as a revenue source and not a means to enact misguided social policy. Hong Kong has proven the efficacy of optimum fiscal policy with its history of a low flat tax and limited government.
Now this is the optimum situation, an unwind of nine years of distorted markets and capital misallocation with the least economic harm. There will be winners and losers, bankruptcies and pain, but the foundation is laid for a return to real, rapid growth. Crony capitalism, enabled by distortions from constant change in the value of the dollar, will give way to real capitalism.
This unwind is coming regardless. If one can envision that optimum monetary and fiscal policy will be disruptive and painful, then continuing with the current policy will result in another crisis without a prescription for a return to real growth. Greenspan, who has a basic understanding of gold and maintained the dollar close to $350/oz of gold during his Fed tenure—the Great Moderation, recognizes the instability of our global fiat monetary system and is warning, here and here, that central banks will lose control of commanded interest rates. Bond prices will rise. Central banks have no solution in their Keynesian toolbox for another crisis except to continue to monetize debt and flood the world with liquidity. Expect more desperate attempts at what hasn’t worked for the last nine years.
The Fed’s plan is to implement a normalization timeline based upon undefined hindsight data over an indeterminate period. Conceivably this could entail another decade or longer of central banks controlling the price of interest in a slow unwind. The problem, beyond the obvious that central banks have no business commanding the price of interest in the first place, is that the major central banks will have to coordinate policy in the unwind. Other central banks will have to reduce their balance sheet in coordination with the Fed. At the same time that the Fed is softening markets for a coming reduction of its balance sheet, the ECB, BOJ, and SNB continue to expand their balance sheets with mass purchases of government debt, corporate bonds, ETFs, and equities. The ECB’s corporate bond buying program has driven Italian junk bond yields below 10 year U.S. treasuries. This is absurd in any rational free market. It is impossible to envision this global liquidity flood being unwound without disruption to interest rates and markets.
There is little academic or political understanding in our monolithic demand-side world of the classical economic foundation of stable money backed by gold. Reagan and Clinton’s Republican Congress proved the efficacy of tax cuts with two decades of economic growth amid fairly stable money. While this lesson is still fresh, the electorates’s search for leaders who will return to founding principles has widened the divide between the people and state. This gulf exists equally with both political parties. The Deep State (shadow government) has evolved from conspiracy theory to obvious reality. Perpetual war and conflict, funded by manipulated zero bound interest rates, subsume positive political change. Working backward from optimum monetary and fiscal policy to what is actually possible in our intellectual and political environment portends greater disruption ahead. We have no historical reference to guide us. There has never been a period where every nation has disconnected the value of its currency from anything real.