President Clinton is surely not sleeping like a baby these days, instead tossing and turning as he wonders how many days, weeks, months or years will pass before he can rest easy again. I'm certain he believes what is happening to him is unfair, that he is somehow caught up in the "Regulatory Reign of Terror" that we began writing about four years ago [February 21, 1990]. Unfortunately for the President, what goes around comes around. A client reminds us by fax this morning that it all began with the FIRREA Act of 1989, designed by none other than Lloyd Bentsen, then chairman of Senate Finance, with the assistance of his hapless predecessor at Treasury, Nick Brady. As I wrote at the time, the Act turned loose the regulatory lions to devour the thrift Christians -- to "solve" the stupendous S&L problem Congress itself had created. I also wrote that the corporate elites were cheering from the grandstands while watching this blood sport -- which among other things temporarily devastated the "junk bond market" and unjustly sent Michael Milken into a federal prison -- but that the lions would soon roam the stands taking bites out of the spectators. President Bush's own son, Neil, was chewed up in the process. The lions are now stalking the President and the First Lady. It is not a pleasant sight and is causing sleepless nights not only in our nation's capital, but also in financial markets the world over. If in the best of times our young and inexperienced President had great difficulty manning the ship of state, how will things be while he is embattled with no end in sight?
My guess is that nobody in Washington worries more about this question than Fed Chairman Alan Greenspan. In the best of times, Greenspan resembles the high-wire artist who must juggle while he walks. These days, he must juggle while he tiptoes on that wire, and we can bet he has his share of insomnia too. What might we imagine is keeping him awake?
1. The administration and the Democratic Congress is trying to strip the Fed of its regulatory independence, with the aim of putting to sleep all lions that eat Democrats. 2. The government bond market, which is the chief measure of his performance, has been sliding since mid-October; if he cannot soon turn it around, he must suspect the stock market will follow, with dire effects upon the real economy. 3. The administration is threatening a trade war with Japan, the biggest buyer of U.S. government bonds. 4. The administration is threatening a trade war with China, the fastest growing economy in the world. 5. There are two openings at the seven-member Fed, maybe a third opening up, and the rumor mill is alive with names of prospects who would have to be, shall we say politely, schooled.
The only thing he can really do anything about is #2, as it is his primary job to inspire the confidence of the bond market. Other Fed chairmen may have been confused on that point, thinking their mission was alternatively to goose the economy and then stop it from growing, but not Greenspan. He knows this Phillips Curve job description was really the root cause of the nation's financial difficulties -- going back to the Fed chairmanship of the late Arthur Burns. Indeed, Greenspan knows the S&L crisis would never have occurred if Burns in 1971 had talked President Nixon out of repudiating the Bretton Woods gold standard. Mr. Nixon, remember, was facing re-election in 1972 and wanted the Fed to goose the economy along. Greenspan knows all of this stuff as well as you or I, and he knows how to get the bond market back on track, which he knows is his primary responsibility. Again and again, in his appearances before the Joint Economic Committee and House and Senate Banking Committees, he has explained all this, yet when the time comes to act, he hesitates.
It was a year ago that Greenspan told the Senate Banking Committee that there was nothing the Federal Reserve could do to offset any deflationary effects of the proposed Clinton tax increase. As we reported then ("Clintonomics Watch: Keep Calm," 2-22-93), Greenspan said it was up to Congress to design its fiscal plan, and if it did a good job its work would be rewarded in the bond market with lower long-term interest rates, not by easy money by the Fed. He told the committee that the nation's creditors are now so sensitized that at the slightest hint the Fed will play fast and loose with them, "the dam will break" as they "dump bonds."
What has happened in the year hence? The administration and the Democratic Congress adopted a budget without the support of a single Republican in either house, one that raised income tax rates on the nation's most productive people. Everything else being equal, this budget could only slow the economy by decreasing the rewards for being productive. As we have argued repeatedly, Greenspan could only have offset this depressing effect by increasing the efficiency of capital -- by reducing the risk of holding dollar assets. If he could reduce the risk of holding government bonds, the risk of holding all other dollar-denominated financial assets would be reduced as well. Did Greenspan do so? Well, no.
By his own public testimony, Greenspan has assured us that he values the price of gold as the clearest leading indicator provided by any commodity as to the future path of the dollar. If inflation will occur in the future, it will occur first by a rise in the price of gold. At the time the depressing budget was being passed last August by a single vote in the Senate, Greenspan was assuring the bond markets that the Fed was not too tight, no matter what the Nobel Prize winners were saying at the time. The price of gold, which has been describing a sine curve around $350 for the last eight years, a price we believe Greenspan thought optimum -- neither inflationary nor deflationary -- closed out the month of September, 1993, at $352. Two weeks later, the 30-year bond price peaked at 5.78%. As the gold price began a steady, glacial climb, which would indicate a decreased demand for dollar liquidity in the banking system, Greenspan's own philosophy should have led him to agree with then Fed Governor Wayne Angell that it was time to reel in some liquidity, to reassure the bond market. This would have meant raising short-term interest rates in October or soon thereafter. For whatever reason, Greenspan resisted, perhaps hoping the price of gold would retreat via an increased demand for dollar liquidity -- as had happened a number of times in the past. Alas, not only was the Clinton budget having its depressing effect. The administration was also gearing up for trade combat with Japan, which could only add another depressant.
As Greenspan had advised Congress a year ago, a market so sensitized to the slightest hint of a Fed accommodation would "dump bonds," and so it has. Greenspan in February tried to talk the bond market back on track, with his marvelous lecture on gold to the House Banking Committee. He then led a quarter-point snugging of the fed funds rate, which arrested the rise in the price of gold, but which also spooked the financial markets. We at first argued that the Fed should have been more aggressive, agreeing with Wayne Angell that Greenspan should have gotten ahead of the curve of market expectations. We soon reversed ourselves on the grounds that it was already too late to undo the mistake of the last quarter, when the Fed should have been holding gold to $350. A sharp tightening might get gold moving in that direction, but it might also deflate those contracts made over the past four months in expectation of rising prices. It would be better if Greenspan for the moment let bygones be bygones, and fixed a ceiling on the gold price instead of driving it to a floor. Because the last snugging took place at about $385 gold, that would be the best place for Greenspan to make his stand.
This is what's keeping him awake nights. If the Fed were to drain liquidity at $385, Greenspan could begin educating the bond market. It should soon resume its secular rally, which really began way back in August of 1982. But maybe it won't? Maybe the bond market really wants the Fed to inflate, as Randy Forsyth inferred in his Barron's column this week -- reporting that bonds rallied when the Fed bought 30-year bonds in the open market last Friday, in effect injecting new reserves into the banking system. No, the Fed today said Forsyth was wrong, which is what we thought all along. Robert Hurtado, the new Wall Street bond writer for The New York Times, Saturday noted that the rally began when the gold price came off its highs of the day. Good work, Robert.
The Fed has its next big meeting next Tuesday, March 22nd. What will it do? If Greenspan wants to get bond yields moving down, which is his job, he has no choice but to rally the troops around gold. If he doesn't, he is essentially telling bond buyers that he was kidding all along. There may, though, be a temptation at the Fed to blame the bond market on Whitewater, on administration bungling in Asia, on bad weather, et cetera. Greenspan, of course, knows this is part of the territory. He has the power to offset any of these other blips. If he doesn't, we all face a lot more sleepless nights.