Greenspan and Those Animal Spirits
Jude Wanniski
July 21, 2004


After watching all of Fed Chairman Alan Greenspan`s congressional testimony Tuesday afternoon and this morning, I cannot say I know any more than I did about whether he would lead the FOMC to another quarter-point increase in the funds rate next month or whether he will kick the can forward while waiting for more information on growth and inflation. He did tell Senate Banking "we know at this stage at 1.25% federal funds rate that we are below neutral. When we arrive at neutral, we will know it." At least I took this to mean that he has not bought into the noxious argument that the funds rate will neither slow the economy nor invite inflation when it is somewhere between four and five percent.  Would he be willing to stop at 1.50% if and when the Fed gets us there?

Nobody thought to ask him what he would look for to tell him if he had hit the right point, or how long would it remain the right point? Would it be six weeks to the next FOMC meeting? If they had, Greenspan might have been drawn into a discussion of the basic weakness of the monetary process that is so uncertain. Rep. Ron Paul [R-TX], the only advocate of a gold standard on the House Financial Service Committee, asked this morning if Greenspan agreed it would be better to return to a commodity standard, with a reform of the domestic and international monetary system. Instead of answering directly, Greenspan said he had at one time believed that a fiat money would be inflationary, but he has been surprised to find in recent years that central banks could "replicate" a gold standard and thereby keep inflation under control.

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GREENSPAN:  Well, Congressman, you`re raising the more fundamental question as to the issue of being on a commodity standard or a fiat money standard.  And this issue has been debated, as you know as well as I, extensively for a very significant period of time.  Once you decide that a commodity standard such as the gold standard is, for whatever reasons, not acceptable in a society and you go to a fiat currency, then the question is automatically, unless you have government endeavoring to determine what the supply of the currency is, it is very difficult to create what effectively the gold standard did. 
I think you will find, as I`ve indicated to you before, that most effective central banks in this fiat money period tend to be successful largely because we tend to replicate what would probably have occurred under a commodity standard in general.  I`ve stated in the past that I`ve always thought that fiat currencies by their nature are inflationary.  I was taken back by observing the fact that from the early 1990s forward Japan demonstrated that fact not to be a broad, universal principle. And what I`ve begun to realize is that, because we tend to replicate a good deal of what a commodity standard would do, we are not getting the long-term inflationary consequences of fiat money.  I will tell you I`m surprised by that fact but it is, as best I can judge, a fact.

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Paul could have asked him why even try to replicate a gold standard when it would be easy enough to switch the Fed`s operating mechanism and target gold instead of the funds rate, but he ran out of time. I reached Paul at his office early this afternoon and suggested he follow up with written questions, because the time is now ripe for this issue to surface, and he said he might do so. Why ripe? Other members of the committees in a variety of ways asked Greenspan why the economy seems to be so hesitant, so sluggish relative to what had been expected from so much fiscal stimulus and monetary accommodation. He acknowledged he did not really know, but cited geopolitical risks hanging over the economy.

The questions really go to the “animal spirits” of the business community, with several questions about business fears of regulatory crackdowns vis-à-vis Sarbanes/Oxley, the SEC and lawsuits by trial lawyers. Greenspan acknowledged that there are these heightened fears, but more or less said they were necessary. It has been our view at Polyconomics that much of the “wrongdoing” by businessmen was fostered by the monetary deflation that caused otherwise honest businessmen to cut corners waiting for a “V-shaped” recovery when it was a deflated “L-shaped” recovery. So much for Greenspan’s “replication” of a gold standard. As he told Rep. Paul: “It is very difficult to create what effectively the gold standard did.” At the very least, it is comforting to know Greenspan is groping for the right “neutrality” in the funds rate. It seems to have eluded him, though, that the animal spirits of the business universe have little choice but to dampen over the prospect of facing higher and higher interest rates in search of the right number.

As I have noted before in my reports on Greenspan’s congressional appearances, there is so much straight thinking we get from him on so many controversial topics that it is difficult to be irritated when he wobbles. His defense of the Bush tax cuts on capital was welcome and so was his dismissal of concern for the “carry trade” argument that interest rates are too low. He blasted the idea of raising the minimum wage when we have a Democratic presidential ticket committing itself to a $7 rate and a Republican Governor of New York toying with the idea of a $7 rate for his state. Several black members of the House Committee this morning anguished over the high unemployment rates in the black community; Greenspan was emphatic in saying a higher minimum will only increase the joblessness among black youths. In his Senate appearance, he gave a vigorous defense of hedge funds and warned about interfering with the flexibility they bring to the financial system. In every policy case except that for which he is most responsible for, he is picture perfect. If he would only throw in the towel on fiat money, we could see a revival of those dormant animal spirits.

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