Greenspan's Lesson Learned Jude Wanniski February 23, 1995

Wall Street is cheering the signs that the Fed has decided to end its torture of the economy and will now begin to think about lowering the price of credit. Fed Chairman Alan Greenspan wasn’t quite as definite in his Senate Banking testimony yesterday as Vice Chairman Alan Blinder was last week. It does appear Greenspan can now smell the recession he has been trying to stop just short of and may now be able to congratulate himself on the “soft landing” that so many of his predecessors attempted without success. We of course hope he is right, but must remind him that we believe the entire trip was unnecessary. If all the last year of “monetary tightening” achieved was an economic slowdown that stops short of an “official” recession, as defined by the National Bureau of Economic Research, it didn’t do anything that deserves anyone’s applause. We attributed the Orange County bankruptcy to Greenspan’s experiment with higher interest rates. The debacle in Mexico was clearly helped along by the squeeze north of the border. And a great many households and enterprises in the United States have gone through the wringer too. If the doubling of the funds rate served the announced purpose of stamping out inflationary expectations, that would be worth a champagne celebration, but what is the evidence?

Greenspan’s own best indicator of inflation expectations, the price of gold, is almost exactly where it was when he began this exercise in early February last year. It was $384 then and it is $381 now. His second best indicator of inflation expectations, he advised Congress, is the exchange rate, and of course the dollar is 10% weaker relative to the yen benchmark than it was then. The Bank of Japan has not been deflating the yen, we hasten to point out. The yen price of gold has been fairly steady for the last two years, bouncing around, but level point-to-point. What this tells us is that by this guide, and by his third best guide, bond yields, inflation expectations are now higher than they were a year ago! The yakkety-yak on Wall Street is that the economy has slowed and the inflation bogeyman has been dealt with, thank the Lord, but Greenspan did not tell us way back then that his objective was to slow the economy. Quite the contrary, he has consistently expressed little confidence in the Phillips Curve tradeoff between inflation and growth. Meanwhile, former Fed Gov. Wayne Angell continues to argue from his perch at Bear Stearns that Greenspan did not get the job done yet -- he must boost interest rates again and again until the inflation beast is dead. Which we will know when gold slumps back to $350.

Have we learned anything from Greenspan’s experiment with high interest rates? We learned that we have been correct in arguing that raising interest rates would not cause inflation expectations to recede, as low interest rates do not cause inflation. We know of no theory that supports the argument that raising interest rates causes the currency to strengthen. The idea is part of conventional wisdom, because it has been repeated in the popular press for so long and because distinguished public servants, i.e., Greenspan, embrace it as if it were gospel. 

If the dollar is to strengthen relative to gold (or any other reference point), one of two things must happen: The demand for dollars has to increase, or the supply of dollars has to decrease. Increasing the federal funds rate, by any amount, has not the slightest effect on the supply of dollars. Not one dollar is extinguished by an increase in the funds rate. The monetary base remains the same, to the penny. There is an assumption that the market will be more willing to hold U.S. debt at higher interest rates, but so what? By raising the price of credit, the Fed has not changed the amount of U.S. debt in the hands of the public, or its composition. What remains is the demand for dollars. I can understand how a decrease in tax rates may cause an increase in the demand for dollars, if the tax rate is excessive to begin with. I can also understand how the Fed chairman can cause an increase in the demand for dollars by “jawboning,” issuing a statement saying he intends to work night and day until he gets the gold price to a lower target price. Of course, if he then begins raising the fed funds rate night and day, the market will see he doesn’t know what he is doing, and will unload dollars. 

An increase in interest rates, a rise in the price of credit, can not do anything but cause a decrease in the demand for dollars. We have here a second application of the law of supply and demand. An increase in the price must cause a decrease in the demand. As far as I can tell, this case is airtight, and has been airtight for centuries. This leaves the only possible avenue for strengthening the currency, whether the objective is the peso or the dollar or the DM or the yen: The government must withdraw non-interest-bearing debt and replace it with another asset -- an interest-bearing financial asset or some tangible piece of property. An ounce of gold. A barrel of oil from the strategic reserves. A government building.

At this point a year ago, the Fed’s balance sheet was showing year-on-year expansion of better than 11%. After a year of “tightening,” this balance sheet growth has slowed to about 7%. Although this modest contraction in liquidity growth might have been sufficient under certain circumstances to root out existing inflation expectations, we know for certain that it has failed to do so in this case. For over this period, the dollar price of gold has essentially shown no change, after climbing from the $350 mark last seen in September 1993. The chart below contrasts the Fed’s performance in controlling the gold price since then with that of the Japanese authorities. We rate it as no coincidence that in the 17 months since gold last rested at $350, the dollar has declined by roughly 9% against both gold and the yen. 

Does Greenspan have to admit that his experiment of the last year failed? In a perfect world, he would, but we would rather he continue to look forward than agonize about the year gone by. He absolutely, positively knows that if we were pegging gold in September 1993, at $350, the long bond would now be closer to 4% than 8%. If you noticed, he again raised the issue of a gold standard in his Humphrey-Hawkins testimony yesterday. A few weeks back, he told the same Senate Banking Committee, unsolicited, that if we were on a gold standard Mexico’s crisis would not have occurred. He has now done this so many times that at last, this morning, the financial press feels compelled to report on his quaint views in this regard, albeit with a smile.

My guess is that Greenspan now knows that raising interest rates does not cause stronger currencies. He proved it to himself, and now is trying to find his way back to the only previously proven method. If the world can cash in on his experience, it will be well worth the cost.