The price of gold tumbled to $338 this morning, a clear sign of a market demand for liquidity. This is based on our postulate that the Federal Reserve more or less sees $350 as the optimum equilibrium point -- where inflationary and deflationary impulses are in balance. We know this is exactly the right time for the Fed to be buying bonds in the open market, creating new money simply by exchanging cash, which is the non-interest bearing debt of the government, for interest bearing debt. The economy is beginning to pick up, which means there is growing demand for liquidity. Unless the Fed steps up its purchases of bonds or notes, the springtime advance will be muted.
We have further confirmation that this is precisely the time for the Fed to ease from the Forces of Darkness, who are now beginning to SCREAM that the Fed is TOO EASY. In this morning's Wall Street Journal, Alfred J. Malabre, Jr., quotes a gaggle of his favorite economists in a P. 2 article, "Fed Assumes Bigger Share of U.S. Debt; Many Economists Fear Shift Will Spark Higher Inflation." Malabre, a gloomy right-wing Keynesian who we have come to call Al Macabre, notes that "the Fed's holdings of U.S. securities have risen more than 33% in less than two years; in the same period total debt rose less than 10% and federal debt rose about 20%." It does not surprise me that H. Erich Heinemann of Ladenburg, Thalmann & Co., grumps that "the Fed has already passed the flash point of inflation." Unlike stopped clocks, correct twice a day, Heinemann has been systematically wrong for the last 20 years, which may qualify him to be Treasury Secretary in the second Bush Administration. It does surprise me that Edward S. Hyman thinks this addition of debt to the Fed portfolio is a "bad development" because, says Malabre, he thinks it "threatens ultimately to cause steeper price increases."
Alan Meltzer of Carnegie Mellon, who as a grumpy monetarist has also been a Force of Darkness these last 20 years, this morning writes on the Journal's op-ed page. Here, though, on fiscal turf, Meltzer blasts the right-wing Keynesians who worry about the federal deficit instead of investment. His arguments are Keynesian, but at least lead to reasonable conclusions. From his current perch at the American Enterprise Institute, on the other hand, Meltzer is leading the monetarist Shadow Open Market Committee to dire warnings of the growth of the Monetary Base. The banks are flush with reserves. All this M-1 may suddenly explode into SPENDING, for goodness sakes. It must be STAMPED OUT.
Oddly enough, today is the Tenth Anniversary of a historic moment in Supply-Side history, relating to these very issues. On St. Patrick's Day 1982, I was spending a day at Campbell College in North Carolina, leading student seminar discussions. Late in the afternoon I heard on the radio that the price of gold had that day fallen to $310 from $320. Horrified, I grabbed the nearest telephone and called Fed Chairman Paul Volcker, to whom I had not spoken for two years. He came on the line immediately and asked what was up, and I told him he had to stop the decline in the price of gold or he would bring down the international banking system. "What are you talking about?" he said. "I have no authority to buy gold." I told him I wanted him to BUY BONDS, as the collapse in the gold price was signaling urgent demands for liquidity. "Aha, so you want me to inflate," he said. "No, I want you to stop the deflation." My Polyconomics client letter "Deflation," April 2, 1982, was an intellectual breakthrough for me, and Volcker as well. I wrote: "We are on the verge of either economic collapse or the Bull Market we've all been waiting for." And, "With Reagan's economic team hopelessly lost in the deficit squabbles with Capitol Hill, Volcker is not the best hope and while he's getting warmer, he still needs room to experiment."
The great monetary deflation of 1981-82 was of course driven by exactly the same people who are now throwing up warnings of inflation -- demanding the Fed tighten further. Alan Meltzer, Erich Heinemann and Al Malabre were all singing that song on St. Patrick's Day ten years ago, as were all the Friedmanites inside the Reagan Administration. I spoke to Volcker many times in the following five months, which culminated in the fantastic Bull Market in stocks and bonds when Volcker that summer ignored the dire warnings of the monetarists and flooded the banking system with liquidity. That began the "Seven Fat Years," which is the title of the new supply-side chronicle by Robert L. Bartley, editor of The Wall Street Journal and my old boss (who at 54 is actually a year younger than I am). Bartley's account of the period makes it clear that it was Volcker's movement toward ease that brought on the boom, not the 1982 tax increase that occurred at roughly the same time.
So we may ask, is a new Bull Market now in the works? Or will the Fed allow gold's deflation signal to pass without response?
First of all, the arguments now being thrown up by the Forces of Darkness are not taken seriously at the Fed. The idea that the Fed is being "ultimately inflationary" by adding government debt to its portfolio is rejected across the board at the Fed, which makes one wonder why Malabre seems to have made no attempt to get an opinion from the Fed. Even in Keynesian terms, the central bank has to be the lender of last resort. That is, people will want to increase their savings, on the margin, if inflation expectations have actually been expunged. If everyone increases savings, spending falls and so does income. The only way to prevent recession, then, is if the government runs a deficit, increasing its borrowings to accommodate the increased desire to save -- without producing a recession. The deficit is a good thing, which is essentially Meltzer's fiscal argument.
Meltzer's monetary argument about an excess of Ms is as wrong now as it was a decade ago because the end of inflation is causing a dramatic increase in the demand for M. Where the monetarists persist in assuming a constant velocity in the money supply, the end of the inflationary era must be decreasing money velocity. If we remember that every inflation in history has begun by a rise in the gold price and a fall in the international demand for a nation's currency, it should be clear that inflation is nowhere in sight. The banks are flush with bank reserves, but with the revival of the housing market underway, a tremendous increase in liquidity is required in the banking system. (I just bought a new house and sold my condo, transactions that required a veritable cornucopia of Ms to flit through my checkbook and the banking system.) With insufficient liquidity, commodity prices fall, led by gold, and, as in 1982, so do the prices of bonds, especially of longer maturities. In that sense, the Fed is not buying government debt fast enough. If it did so now, increasing the amount of liquidity in the system, the price of gold would rise and so would the price of bonds. The spread between long- and short-term rates would narrow. At least that's our theory, which is more or less shared here and there at the Fed, most explicitly by Governor Wayne Angell. A gold price of $340 would be my lower limit before I'd be collaring Fed governors. I can't say where the gold price kicks in as a trigger for any of the governors, although I'm dead certain they are all watching it, practically hour by hour. They can't let it drift much lower for much longer without clouding the recovery.
It would be nice if there were someone inside or outside the Bush Administration who would now be urging the Fed to ease because of the gold price below $340. Nobody in the Administration, though, has credibility on the issue, because they have been arguing for ease willy-nilly. Secretary Brady's simple model holds that only lower interest rates expand the economy, and that lower interest rates follow declining budget deficits, no matter if the deficits fall because of lower spending or higher taxes. The monetarists are no help either. They have been complaining the Fed has been too tight when the Fed was not too tight. Now that the Fed is too tight, they have decided the Fed is too easy.
It does not help to have a Nobel Prize in economics. MIT's Paul Samuelson and Yale's James Tobin have been raging around in the "Too Tight School" for the last year. I'd be surprised if they now had not switched to neutrality, at best. Even Nobel Prize Republicans can't stand still. I watched Nobel Laureate James Buchanan on the "MacNeil-Lehrer News Hour" last night. What would he do to help the economy? Professor Buchanan offered a variety of opinions, one of which I especially cheered. He would dictate that the Federal Reserve use monetary policy only to maintain the purchasing power of the dollar. Not one minute later, asked if he thought the Fed was too tight, Buchanan said he thought the Fed made major errors last year in being too tight, but is now just about right. In less than sixty seconds he abandoned his principle of price level targeting and criticized the Fed on a principle of GNP targeting! Happy St. Pat's!