Amity Shlaes: Contracts as good as gold

By Amity Shlaes
The Wall Street Journal
Thursday, June 5, 2008

http://online.wsj.com/article/SB121262149780346715.html?mod=rss_opinion_...

People these days fear inflation. We also fear changing rates of inflation. And most of the tools we might use to protect ourselves, such as the Treasury Inflation-Protected Securities bond or gold stocks, are imperfect. TIPS are, after all, based on an inflation-measure whose accuracy is itself controversial -- the Consumer Price Index.

So it's worth remembering that, 75 years ago today, President Franklin D. Roosevelt destroyed an inflation hedge that was literally as good as gold: the so-called "gold clause." This helped prolong the Depression and has been causing damage ever since.

Consider an investor in the gold standard era. An ounce of gold was worth $20.67 and you could, at least in theory, trade your greenbacks for gold at the bank. The gold standard checked a government's willingness to inflate, since it started losing gold when it did so. Those who traded bonds knew a confidence we can never know.

Washington, like all governments, could occasionally cheat on the gold standard -- suspend it, limit the ability of citizens to convert paper into gold, and so on. But investors could protect themselves by writing a gold clause into their contracts. Such a clause promised a borrower that he could be repaid "in gold coin of the United States of America of or equal to the present standard of weight and fineness." The gold clause fostered economic growth in the late 19th and early 20th centuries by making it easier for young industries to raise capital. Since investors protected by these clauses knew they would get their money back, interest rates were lower. To finance World War I, Washington even inserted gold clauses into Liberty Loans.

The powerful deflation of the early 1930s gave Roosevelt the excuse to end the gold standard. Dirt-low commodity prices, starving farmers, bank seizures of homes, 20% unemployment: All these miseries shouted, "looser money now!" The agricultural community, including eccentric Agriculture Secretary Henry Wallace, viewed the end of the gold standard as the ultimate revenge of the farmers punishing Wall Street for its 1920s prosperity.

One night in April, 1933, FDR surprised a bunch of advisers, saying "Congratulate me." He'd taken the country off the gold standard, and now planned to personally manage the dollar's exchange rate and price levels. Hearing the news, colleagues "began to scold Mr. Roosevelt as though he were a perverse and particularly backward schoolboy," recalled Ray Moley. Secretary of State Cordell Hull, the great free trader, "looked as though he had been stabbed in the back. FDR took out a ten-dollar bill, examined it and said 'Ha! . . . How do I know it's any good? Only the fact that I think it is makes it so.'"

Congress then drafted a joint resolution declaring gold clauses -- protection against any damage Roosevelt might do -- to be "against public policy." Roosevelt couldn't wait to see the resolution become law. Henry Wallace wrote that Roosevelt "looked up at the clock and put down 4:40 p.m., June 5, 1933 and signed his name."

Randall Kroszner, a governor at the Federal Reserve Board, has studied this period and has noted that the price went up on most stocks and bonds, even gold-clause bonds, when the Supreme Court eventually validated FDR's action. Mr. Kroszner and others argue that the abrogation of the gold clause had some virtue because it reduced the cost and inconvenience of debt renegotiation in a period of credit crisis.

But you can also argue that those price movements were more an expression of relief that a futile battle was over rather than a vote of approval. In my own review of the period I found evidence that snatching away from investors the perfect inflation hedge hurt the economy.

The market rally in the spring of 1933 slowed as investors watched FDR fiddle with the dollar and commodities over the course of the fall. In 1934, FDR thought better of it all and fixed the dollar to gold again, albeit now at $35 dollars an ounce. But the abrogation of the gold clause suggested that Washington had no regard for property rights. The general uncertainty generated by government economic policies did not abate. Capital went on strike. The Great Depression endured to the end of the decade. The positive transparency that the Securities and Exchange Commission or the creation of deposit insurance brought to markets was offset by losses like that of the gold clause.

And from then on, the federal government enjoyed wider license to inflate. Without the gold-clause option, citizens tried out other hedges -- today a line about the CPI may stand where the old gold line once stood. In the 1970s, Sen. Jesse Helms pushed for repeal of the old abrogation, and eventually, with the support of Treasury Secretary William Simon, he won. But the average investor never used the clause to the same extent.

Today, as in the last days of the gold clause, officials like Mr. Kroszner of the Fed's Board of Governors are weighing a difficult choice between efficient crisis management and property rights. People don't talk more about the damage of monetary uncertainty because that damage is so spread out -- harder to discern than, say, a single giant event like the implosion of Bear Stearns. But the old gold clause footnote explains why we may see yet more angst over the Consumer Price Index, the TIPS bond, or even LIBOR, the London Interbank rate. We have lost our bearings and our confidence in money generally.

After a majority of the Supreme Court upheld the constitutionality of the gold clause abrogation, Justice James McReynolds read the dissent. Today McReynolds is generally regarded as an irrelevant reactionary, a footnote himself. But his rueful words ring true for those trying to reckon the dollar's future. It was, he said, "impossible to estimate the result of what has been done."

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Miss Shlaes is a senior fellow in economic history at the Council on Foreign Relations and author of "The Forgotten Man: A New History of the Great Depression," out in paperback this week (Harper Perennial).

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