Executive Summary: The U.S. economy is in better condition today than it was two years ago when Reagan defeated Carter in the sense that the last two years of Paul Volcker's deflation are behind it rather than ahead of it. Volcker himself made the break from the M1 standard and now flies the Fed by the seat of his pants, "the Volcker Standard." Experimentation now produces wild swings in the financial markets, absent a clear Fed philosophy. The stalemate on fiscal policy raises chances that the White House and Congress will soon raise the right questions about money, leading toward reform. Lehrman pushes restoration of dollar/gold convertibility by January 1985. But first, watch for gold price stability between $400 and $450, inviting healthy global economic recovery next year.
The Volcker Standard
In October 1980, in the Reagan-Carter televised campaign debate, Ronald Reagan asked the audience to ask themselves whether they were better off economically than they were in 1976, before Jimmy Carter took over. If President Reagan at his midterm were confronted with the same question, the only positive answer would be: "Yes, because they have the last two years behind them instead of ahead of them."
The answer would be taken as a light-hearted quip, considering the depths of the recession and the first double-digit unemployment rates in forty years. But Reagan would be correct. His first two years were dominated by the last two years of Fed Chairman Paul Volcker's three-year experiment with monetarism, the first year of which helped poison the Carter Administration — as Carter's domestic counsel, Stuart Eizenstat recently observed in the New York Times.
While the first year of the experiment in targeting M1 monetary aggregates at the Fed — from October 1979 to October 1980 — was characterized by a dramatic inflation (the price of gold zoomed from $350 to $850 and hovered over $650 for most of the period), the two years from October 1980 to October 5, 1982, were characterized by the greatest monetary deflation since the decade following the Civil War. The price of gold was cut by 60% — to $21 from $53 in the latter monetary deflation. In Reagan's two years, the price was again cut by 55%, to about $300 (at the depths of the Fed's squeeze last June).
This isn't to suggest Reagan is free of any culpability. In fact he and his team had ample warning from the supply-siders outside the administration that the monetarist squeeze would nullify the fiscal initiatives of 1981. Instead, the White House cheered Volcker from the sidelines during the most destructive period of the deflation, from October 1981 to June of this year, relying on the monetarist promises that prosperity was just around the corner. It was not until Volcker himself took the initiative of edging away from M1, which he had followed to the brink of a major global depression, that the White House also cooled to the monetarist idea.
In retrospect, though, it's hard to argue with the proposition that the monetarist experiment was historically necessary. It's hard to imagine the last two years playing themselves out differently, although there was always the hope that Reagan himself would lead the way toward fundamental monetary reform. It's now clear that Reagan's prejudice for a paper/gold convertibility was given too much weight by those of us with the same bias, and far too little weight was given the influence of Milton Friedman, on the President directly and on the conservative establishment via his students. The GOP political and intellectual cadres — from new rightists to neoconservatives — were paralyzed on the monetary issue, unable to choose between the assertions of the loyal Friedmanites and the loyal supply-siders. Friedman prevailed because of his seniority, until the Volcker move away from monetarism produced the bull market in stocks and bonds.
This is why it seemed beyond doubt in mid-October that monetarism was dead; it had lost its constituency in those GOP power centers that had levered Friedmanites into all the key monetary positions of the Reagan administration. Ed Meese may still have some residual affection for M1, but certainly Reagan's chief of staff Jim Baker does not. Nor do the legions of "movement conservatives" who are normally associated with the social and foreign-policy issues. They had gone along with the monetarists for years, simply because the monetarists had an inflation theory that did not conflict with the interests of the commercial Keynesians — the Herb Steins, the Alan Greenspans, the William Simons — whose ideas of interest rates and inflation turn on fiscal policy. The absence of conflict between these fiscal and monetary demand-siders had been enough to win the allegiance of the Republican political and intellectual cadres. It isn't anymore.
When Volcker observed that it was no longer appropriate to target M1, given the flexibility of the financial markets in creating new measures of money, the move was so clearly welcomed in the financial markets themselves that the monetarists had no choice but to agree with him. For the most part they fastened on the argument of Allan Meltzer of Carnegie-Mellon University, and the monetarist Shadow Open Market Committee, that the monetary base was, after all, a more appropriate target than M1. Friedman himself, never a fan of a monetary-base target, joined in without much enthusiasm in an October interview in Barron's. Perhaps he worried someone would notice that the monetary base in the first half of this year grew by almost 10 percent; if the Fed had targeted the base instead of M1 it would have squeezed far more than it did; we shudder at the thought of the financial collapse that surely would have ensued.
Lengthy rumination on this point is appropriate because there remain widespread apprehensions that the Fed will be drawn back into the monetarist framework. On the surface the White House and the President remain passive on the monetary issue. The official administration line is presented by Treasury Undersecretary Beryl Sprinkel, a devoted monetarist, who accepts the Volcker assertion that the shelving of aggregates constitutes a temporary policy adjustment. Volcker himself put it most recently, in his November 24 testimony before the Joint Economic Committee of Congress: "As we approach the target-setting process for 1983, our objectives will — indeed as required by law — continue to be quantified in terms of growth in relevant money and credit aggregates."
This needn't be taken as a threat. Volcker was careful to insert the phrase "indeed as required by law" into the statement, a reference to the 1978 Humphrey-Hawkins requirement that the Fed establish aggregate targets. The Act does not require that the Fed actually hit the targets, which is of course how the Fed in October was able to announce that it would ignore this year's M1 range of 2 1/2 percent to 5 1/2 percent. And Volcker in his testimony left himself a loophole so wide it might as well be made of elastic:
Unfortunately, the difficulties and complexities of the economic world in which we live do not permit us the luxury of describing policy in terms of a simple, unchanging numerical rule. For instance, the economic significance of any particular statistic we label "money" can change over time — partly because the statistical definition of "money" is itself arbitrary and the components of the money supply have differing degrees of use as a medium of exchange and liquidity ....
We will have to decide how much weight to place on M1 and other aggregates during a transitional period, assuming new accounts continue to distort the data. In reaching and implementing those decisions, the members of the FOMC necessarily rely upon their own analysis of the current and prospective course of business activity; the interrelationships among the aggregates, economic activity, and interest rates; and the implications of monetary growth for inflation. In other words, the process is not a simple mechanical one, and it seems to me capable of incorporating — within a general framework of monetary discipline — the elements of needed flexibility.
This kind of palaver led Rep. Jack Kemp, who questioned the Fed Chairman at length during the JEC testimony, to suggest that we are now on "a Volcker standard." And for his part, Volcker seemed totally relaxed with the idea that he is conducting monetary policy behind a thick veil of cigar smoke, completely free (now that he has M1 off his back) to try any combination of guidelines, signals or standards in deciding the central question of monetary policy: When do you buy bonds and when do you sell them?
How long can this go on? It doesn't seem feasible that it can last for more than a few months and it's inconceivable that it will extend to the end of this Presidential term. It is wonderful that Volcker is free of the constraints of M1, but in the absence of any definite philosophy to replace that specific quantity rule, the financial markets swing violently with every speculative rumor. At the JEC hearings, Volcker complained about the turbulence in the markets (although expressing satisfaction in the upward surges in stocks and bonds). But he seemed genuinely oblivious to the high probability that it is his seat-of-the-pants flying of the Fed that is responsible for the volatility.
Given the fact that 75 percent of world trade is conducted in U.S. dollars, Volcker's freedom from specific rules gives him more raw economic power than anyone else on earth. President Reagan and Congress, by contrast, can paralyze each other in debating fiscal policy. It's only a matter of time before this political imbalance is corrected in some fashion, with the President and Congress pushing their way behind Volcker's smokescreen.
It's also my guess that Volcker doesn't really know what to do with his freedom and wouldn't at all mind official direction consistent with his overall objective of "price stability." Indeed, when asked by Kemp he said he was "not allergic" to the idea of an international conference aimed at stabilizing exchange rates — a process which would per force limit his freedom. And in response to Kemp's asking what legislation might assist him in the conduct of monetary policy, Volcker was surprisingly enthusiastic in putting forth the suggestion that Congress mandate "price stability" as the Fed's primary goal, which I took as implying he would welcome having the aggregates knocked off this primary perch.
The prospect that the President and Congress will soon push further in this direction has improved not only because of the new general awareness of the Fed's enormous power to move the economy, but also because the voters in November managed to stalemate any freedom to maneuver on fiscal policy. Despite the best efforts of the austerity crowd (Stockman, Kudlow, Feldstein, etc.) to revive the Deficit Theory in order to keep fiscal policy at center stage, the idea is moribund. The President is reported to have explicitly rejected the idea that high interest rates are chiefly caused by high federal deficits, and that tax increases and spending cuts can get the economy moving — the essence of the Deficit Theory. Senate Majority Leader Howard Baker, in urging the President to drop his inclination to speed up the July 10 percent tax cut, said "the first thing we ought to address" is the role of the Fed in keeping interest rates high.
There were attempts to attribute the 36-point surge in the Dow Jones Industrials on November 30 to Reagan's decision not to seek the tax-cut speed-up, as if the markets were relieved by the budgetary implications. The markets were not discounting a probability that Reagan could have gotten the speedup if he asked for it, since all evidence was to the contrary. And when the announcement was made, the markets yawned. It wasn't until mid-afternoon of the 30th, when the first rumors of Senator Kennedy's decision to remain out of the 1984 presidential sweepstakes, that the stock market applauded with its surge. Teddy Kennedy has been the only openly anti-growth presidential hopeful on the scene in either party. That cloud is now gone, or reduced in size.
If anything, the markets should be relieved of the fiscal uncertainties that a Reagan decision to re-open tax policy would mean — and the President more or less gave that as his reason for dropping the idea. The Democrats and their Keynesian advisors have been showing signs of support for the speed-up idea, but only in exchange for elimination of post-1985 indexation of the personal tax rates to inflation — a very poor swap. Those who have anguished throughout the last year over the unwillingness of policymakers to examine monetary policy were not at all unhappy with his decision to shut off the tax issue for the time being.
So far, the overt political pressures on the Fed are centered on the idea that it should keep interest rates coming down and certainly do anything to keep them from going back up. This is the posture of Senator Baker and Jim Baker. Behind this crude pressure, though, is no knowledge or awareness of how interest rates can be gotten down and kept down. We can bet they have a picture of the Fed "easing," printing more money. But knowing Volcker and listening to his November 24 testimony, there seems little chance that he would lead the Fed into an "easing" or "reflation" adventure, especially at this stage of his rapidly expiring term as chairman. So we can expect little danger from these kinds of pressures. They even serve the purpose of putting the spotlight on money, where it belongs, so the right questions can eventually be asked and answered.
This was the rationale behind the Kemp-Lott bill, which would mandate the Fed to target some "real interest rate" (some market rate minus some current measure of the inflation rate) by injecting reserves into the banking system, "easing" until the target rate was achieved. Or, if some index of commodity prices rose above some specified ceiling, a "tightening" by the Fed would be in order. Volcker addressed himself to this mishmash with the following:
I realize the several legislative proposals addressed to targeting interest rates would, on their face, seem to call for interest rates as only one of several targets. But interest rates would certainly be the most obvious and sensitive target, and those targets would be difficult to change. Other evidence for a need to "tighten" or "ease" would be subordinated, if not ignored.
In his later suggestion to Kemp that a legislated mandate of "price stability" would be in order, Volcker may well have been offering Kemp a way out of his can of worms with a more direct approach. And Volcker clearly had nothing trivial in mind, going so far as to observe that the Fed's enabling legislation was deficient in this regard.
Had Kemp questioned Volcker directly about which prices Volcker would stabilize and how the price of gold fits into the Volcker Standard as a leading indicator of price impulses, we may have learned much more about what goes on behind the smokescreen. But Kemp chose to make only one oblique reference to gold, almost under his breath, and Volcker responded similarly. We can conjecture that both men know that gold is the ultimate solution, on a distant horizon, but that they are forced to deal in the foreground. Volcker has moved toward gold only in the sense that he has moved away from paper.
In the foreground, which will occupy us until the President gets into the act, we can at least surmise that the Volcker Standard gives heavy weight to some price or prices as a guide to "tightening" or "easing," or he would not make so much of "price stability" as his primary objective. My advice to him a year ago was to heed the September 1981 advice of Jelle Zijlstra, then chairman of the Bank for International Settlements, and stabilize the price of gold at $425. If the Fed had been in a position then to ignore the Ms and do just that, the deflationary recession inflicted upon the global economy would have been avoided.
My most recent advice, which I discussed with Volcker on November 4, is the same as a year ago: Stabilize the gold price at $425. (At the exact time I spoke to him the London gold fix was at $424.75.) The freedom he has behind his cloud of cigar smoke will permit him to do this, and even if he publicly disavows taking any such guidance from the gold price, I offered the opinion that nothing else the Fed could do could prevent interest rates from falling. The price since dropped to $398 on November 12 and then climbed as high as $446 on December 2. But this is broadly the ballpark Zijlstra had in mind. If the price will not drop below $400, say, we need not fear an international banking collapse stemming from the Fed's deflationary policies. And if gold won't climb above $450, say, Volcker needn't fear a reignition of inflation. If, between now and August when his term as chairman is up, Volcker can keep gold within this $50 band, the diminution of monetary turbulence would be felt worldwide in a further decline of interest rates and general worldwide recovery. And I would be astonished if the Fed failed to intervene at the $500 level. It would take major fiscal or protectionist trade errors to nullify the beneficial effects of commodity-price stability.
To move much further along the yellow brick road toward the distant horizon of convertibility requires political support for gold in high places. Lewis Lehrman, now freed from having to go to Albany by virtue of having lost the gubernatorial race to Mario Cuomo, has committed himself to working on the yellow brick road. At a National Press Club breakfast in Washington, November 30, he developed the idea of a Gold Standard Act that would hypothetically pass the Congress next year and point toward restoration of convertibility on January 1, 1985. He's been conferring with the two Bakers, Howard and Jim, and has the ears of others in high places because of his new visibility. But nothing can possibly happen unless Lehrman or someone like him is brought into a key position on monetary policy. The Friedmanites are still in position to block any fundamental reform, and seem appy enough to sit out the remainder of Volcker's term while jockeying for future position. The idea of Lehrman replacing Sprinkel has kicked around the White House, and would be a bullish sign ideed. But nothing big is likely before the turn of the year.
Meanwhile we're on a Volcker Standard, which isn't a bad place to be, considering the M1 alterna-ive. It has given us a wonderful Volcker Bull Market, which may be the first stage of a much bigger vent. The economy is in terrible shape, but in a political sense we're in much better shape than we were when Reagan took office. The last two years are behind us and we're not going to do them again.
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