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February 23, 2017

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Greenspan expounds on gold, economics

EDITOR’S note:

The following is an interview with former US Federal Reserve Chairman Alan Greenspan, conducted by “Gold Investor,” a publication of the World Gold Council, a market development organization for the bullion industry.

Q: In recent months, concerns about stagflation have been rising. Do you believe that these concerns are legitimate?

A: We have been through a protracted period of stagnant productivity growth, particularly in the developed world, driven largely by the aging of the “baby boom” generation. Social benefits are crowding out gross domestic savings, the primary source for funding investment. The decline in gross domestic savings as a share of GDP has suppressed gross non-residential capital investment. Lessened investment has suppressed the growth in output per hour globally. Output has been growing at approximately 0.5 percent annually in the US and other developed countries over the past five years, compared with an earlier growth rate closer to 2 percent. That is a huge difference, which is reflected in gross domestic product and in the standard of living.

As productivity growth slows, the whole economic system slows. That has provoked despair and a consequent rise in economic populism from Brexit to Trump. Populism is not a philosophy or a concept, like socialism or capitalism, for example. Rather it is a cry of pain, where people are saying: “Do something. Help!”

At the same time, the risk of inflation is beginning to rise. In the United States, the unemployment rate is below 5 percent, which has put upward pressure on wages and unit costs generally. Demand is picking up, as manifested by the recent marked, broad increase in the money supply, which is stoking inflationary pressures. To date, wage increases have largely been absorbed by employers, but, if costs are moving up, prices ultimately have to follow suit. If you impose inflation on stagnation, you get stagflation.

Q: As inflation pressures grow, do you anticipate a renewed interest in gold?

A: Significant increases in inflation will ultimately increase the price of gold. Investment in gold now is insurance. It’s not for short-term gain, but for long-term protection.

I view gold as the primary global currency. It is the only currency, along with silver, that does not require a counter-party signature. Gold, however, has always been far more valuable per ounce than silver. No one refuses gold as payment to discharge an obligation. Gold, along with silver, is one of the only currencies that has an intrinsic value. It has always been that way. It has been a valuable commodity, since first coined in Asia Minor in 600 BC.

Q: Over the past year, we have witnessed Brexit, Trump’s election victory, and an increase in anti-establishment politics. How do you think that central banks and monetary policy will adjust to this new environment?

A: The only example we have is what happened in the 1970s, when we last experienced stagflation and there were real concerns about inflation spiraling out of control. Paul Volcker was brought in as chairman of the Federal Reserve, and he raised the Federal Fund rate to 20 percent to stem the erosion. It was a very destabilizing period and by far the most effective monetary policy in the history of the Federal Reserve. I hope that we don’t have to repeat that exercise to stabilize the system. But it remains an open question.

The European Central Bank (ECB) has greater problems than the Federal Reserve. The asset side of the ECB’s balance sheet is larger than ever, having grown steadily since Mario Draghi said he would do whatever it took to preserve the euro. And I have grave concerns about the future of the euro itself. Northern Europe has, in effect, been funding the deficits of the South. That cannot continue indefinitely. The Eurozone is not working. In the UK, meanwhile, it remains unclear how Brexit will be resolved. It is very difficult to find any large economy that is reasonably solid, and it is extremely hard to predict how central banks will respond.

Q: Although gold is not an official currency, it plays an important role in the monetary system. What role do you think gold should play in the new geopolitical environment?

A: The gold standard was operating at its peak in the late 19th and early 20th centuries, a period of extraordinary global prosperity, characterized by firming productivity growth and very little inflation.

But today, there is a widespread view that the 19th century gold standard didn’t work. I think that’s like wearing the wrong size shoes and saying the shoes are uncomfortable. It wasn’t the gold standard that failed; it was politics. World War I
disabled fixed-exchange rate parities, and no country wanted to be exposed to the humiliation of having a lesser exchange rate against the US dollar than it enjoyed in 1913.

Britain, for example, chose to return to the gold standard in 1925 at the same exchange rate it had in 1913, relative to the US dollar. That was a monumental error by Winston Churchill, then chancellor of the exchequer. It induced a severe deflation for Britain in the late 1920s, and the Bank of England had to default in 1931. It wasn’t the gold standard that wasn’t functioning; it was that these pre-war parities that didn’t work.

Today, going back on to the gold standard would be perceived as an act of desperation. But if the gold standard were in place today, we would not have reached the situation in which we now find ourselves. We cannot afford to spend on infrastructure in the way that we should. The US sorely needs it, and it would pay for itself eventually in the form of a better economic environment. Much of such infrastructure would have to be funded with government debt. We are already in danger of seeing the ratio of federal debt to GDP edging toward triple digits.

We would never have reached this position of extreme indebtedness were we on the gold standard because the gold standard is a way of ensuring that fiscal policy never gets out of line.

Q: Do you think that fiscal policy should be adjusted to aid monetary policy decisions?

A: I think the reverse is true. Fiscal policy is much more fundamental policy. Monetary policy does not have the same potency. And if fiscal policy is sound, then monetary policy becomes reasonably easy to implement. The very worst situation for a central banker is an unstable fiscal system, such as we are experiencing today.

The central issue is that the degree of government expenditure growth is destabilizing the financial system. The retirement age of 65 has changed only slightly since President Roosevelt introduced it in 1935, even though longevity has increased substantially since then. So, the first thing we have to do is raise the retirement age. That could cut expenditure appreciably.

I also believe that regulatory capital requirements for banks and financial intermediaries need to be much higher than they are currently. Looking back, every crisis of recent generations has been a monetary crisis. The non-financial part of the US economy was in good shape before 2008, for example. It was the collapse of the financial system that brought down the non-financial part of the economy. If you build up enough capital in the financial system, the chances of serial, contagious default are much decreased.

If we raised capital requirements for commercial banks, for example, from the current average rate of around 11 percent to 20-30 percent of assets, bankers would argue that they could not make profitable loans under such circumstances. Data back to 1869 suggest otherwise. The data demonstrate that the rate of bank net income to equity capital has ranged between 5 percent and 10 percent for almost all the years of the data’s history, irrespective of the level of equity capital to assets. This suggests we could phase in higher capital requirements overtime without decreasing the effectiveness of the financial system. To be sure there would likely be some contraction in lending, but, arguably, those loans should, in all likelihood, never have been made in the first place.


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