Rosy Scenario
Jude Wanniski
April 21, 1994


The decline in the price of gold, to $373, and the modest firming of the bond market in response to Alan Greenspan's quarter point hike in the fed funds rate, to 3.75%, opens the possibility of a rosy scenario that includes a major bull move in stocks and bonds in the not-too-distant future. It would mean that Greenspan might be able to avoid the conventional wisdom of raising fed funds to 4%, the number the Clinton administration has advertised as the ceiling for the leeway it has allowed Greenspan. He could keep that last bullet in reserve. This scenario would also mean that Greenspan may have successfully maneuvered through a political mine field without threatening the kind of deflation implied by former Fed Governor Wayne Angell's call for a 4.5% funds rate with a full point hike in the discount rate.

In other words, 3.75% may be the interest rate high enough to slightly starve the growing economy of liquidity, which would mean the price of gold would continue a gentle, gradual slide toward $350, the number we continue to believe Greenspan secretly has in mind as the optimum price. (He wouldn't tell me, so I don't even ask.) The principle difference between Greenspan and Angell is that Angell's target gold price is closer to $325, and I think he'd secretly like it to reach $300, which is why his policy prescription involves such heavy artillery. If gold continues to retreat, we would expect a shift in market sentiment, a sense that the correction has already been completed, and that if gold gets below $350 Greenspan could begin signaling a bias toward ease. How nice this would be for Wall Street! Bonds would soon be trading below 7%, with a chance of getting below 6% before year's end. Stocks would retrace their losses, with NASDAQ especially on a tear. This scenario could be disrupted if the White House imposes trade sanctions on Japan, which would probably force Greenspan to fire his last bullet. If Greenspan knows this will not happen, which would be a confidence he would share with no one, it would make it easier for him to plan his strategy. 

Let's go over the theoretical ground again, to get as close as we can to Greenspan's perspective. First, as the debate has recently unfolded, there has been discussion from both Greenspan and Angell of a "neutral" stance on monetary policy. We note that Yale's James Tobin, who denounces Greenspan's tightening, argues that there is no such thing as a "neutral" interest rate in classical theory. He clearly doesn't know what Greenspan is talking about, but that's why the Keynesians have been such a problem on these matters, seeing no harm in a little inflation. Early in this century, Swedish economist Knut Wicksell wrote in Interest and Prices that "there is a certain rate of interest on loans which is neutral in respect to commodity prices, and tends neither to raise nor to lower them." 

Why is this important? In Greenspan's view, which I think is Wicksellian, a neutral interest rate is one that provides the banking system with precisely the amount of liquidity that it requires. What do I mean by that statement? I mean that the financial service industry which is at the heart of our market economy is every day making myriad decisions on who gets credits and who does not. Those who get credits in this process are those who will most likely produce a positive return on investment. If there are no external shocks from government that affect these investments, the total number of credits issued will produce in aggregate a positive ROI. Those who are turned away would drag down the net return and thus should not be given any of society's precious capital. Once the banking system has made this daily judgment, it totes up its liquidity needs, and if the Federal Reserve is doing its job perfectly, it hands over exactly the amount of cash reserves to finance this level of commerce.

What if the Fed makes a mistake and provides too much liquidity? The banking system has to adjust to this surplus by calling back someone who had asked for credits and was previously turned away as a bad risk. If the amount of liquidity in surplus is small, the best bet will invariably be on someone, Smith perhaps, who thinks the price of gold will rise. Voila! Smith gets the credit, buys gold, and up it goes. Alexander Hamilton explained this process to the U.S. Congress 200 years ago, on why it is better to have a gold standard than to entrust this job to a committee, even one with a chairman as smart as Greenspan. It is so much easier to print money than to raise taxes, Hamilton pointed out, that the temptation is always there. If the government promises to redeem surplus liquidity with gold, he said, when Smith gets the credit, it immediately comes back as a demand for gold. 

When there is no such mechanism and a lot of surplus liquidity in the system, it cascades through gold into all commodity prices, and the banks are on the phone calling back all the bad risks that had been turned away. In 1979-80, when Fed Chairman Paul Volcker presided over a colossal expansion of bank reserves, the price of gold shot up to $850 from $200, and the commercial banks were throwing money to anyone who looked as if they could collateralize the loan with their commodity reserves or farmland. At Citicorp, Walter Wriston had to get rid of so much liquidity, he conceived of the idea of dumping it into foreign governments, like Mexico and Brazil, on the theory that they would have to pay back the loans no matter how onerous the burden. During this frantic period, James Tobin of Yale and his friends in the Carter Administration were complaining that the Fed was too tight, as evidenced by the sky-high interest rates being charged by the commercial banks.

Greenspan does not wish to repeat this process. When he watched the price of gold begin climbing above $350 last summer, he may have thought it would retreat on its own, as it had so often in the last decade, when demand for liquidity picked up. This time it did not, and he knew he would have to act, or the general price level would rise, taxing America's creditors by reducing the purchasing power of their bonds, once again reducing the nation's creditworthiness. To squeeze this new inflation out of the economy would be painful, bankrupting those who were bad risks to begin with, but were invited back to soak up surplus liquidity.

In the Wicksellian world, it is bad for society if the Fed supplies too little liquidity. Remember, at a neutral interest rate, the banks had collected the best bets, those who would in aggregate produce a positive ROI. A shortage of liquidity automatically means a net subtraction from national welfare as some of these best bets do not get financed. At first, some guy named Smith is even willing to sell his gold in order to finance a best bet but, in a general deflation, by definition everything deflates. In this rosy scenario we are painting for Greenspan, he only denies the banks a little bit of liquidity, causing the economy to lose a little bit of GDP on that account. In the process, though, he restores the confidence of the nation's creditors for a bigger financing down the line. Wall Street would happily discount this as soon as it appeared on the scope.

It would help if Greenspan could persuade the President not to beat up on the Japanese, as this also reduces the number of good credit risks available to the banking system on this side of the Pacific. It would also help if he could explain to the President that at least indexing the capital gains tax would sharply increase the number of "good risks," thereby increasing the demand for liquidity -- the optimal way of expanding the economy rapidly without inflation. 

What are the chances of this rosy scenario playing out as described? Is Greenspan a "good risk" or a "bad risk?" In a very troubled world, he's still one of the few good bets available. We hear that even Wayne Angell, who has been betting against him, is beginning to hedge.