Executive Summary: Long bonds are approaching their peak of early November. Will they sputter out again, or may we expect another Great Leap Forward? An analysis of the recent gyrations in the dollar, gold and oil markets is consistent with conjecture that Volcker now favors a vague but explicit commodity standard with gold assigned an important role as signal. Gold fell when the Fed would not ratify it at $500. The end of monetarist influence in the populist conservative coalition clears the way for grassroots support for sound, convertible currency. The strength of the recovery pulls supply-side, economic-growth advocates back into favor; the Reagan high-command is listening again. A worldwide intellectual/political drift toward exchange-rate fixity, the decline of floating, suggests the sprouting of policy options that aim toward a 5 percent prime rate, a bull market in bonds.
The Case for Bonds
The high point of the bond market in this period of bullishness was reached last year during the first week of November. This capped a climb that probably began in late March, although backsliding didn't end until late June when the really sharp ascent commenced. At that peak in bonds, gold was at $425. The backsliding in bonds coincided with a climb in the gold price to the $500 level. Firmer footing was achieved in mid-February as the long bonds crept back toward the November peak, gold plunging back to the $425 neighborhood. The price of oil, which was not too high if gold were to have remained at $500, had to work its way down a bit, given the palpable fact that the U.S. monetary authority would not come through with the policies that could sustain $500 gold. What now? Is the bond market going to sputter along, or is it gathering the forces required for another great leap forward?
In making the case for bonds, we have to keep clear the causality in the links between the dollar, the dollar price of gold, and the dollar price of oil. The conventional analysis that has filled the financial press in recent weeks has assigned the OPEC members the dominant, active role—an extension of the idea that the oil cartel caused the inflation of the 1970s. By this reasoning, OPECs internal strife invited the collapse in the gold price in the last week of February by increasing chances of a steep decline in the oil price, an event that "would help hold down inflation and retard any general commodity price rise," as the Wall Street Journal put it. The same analysts were hard put to explain why bonds weakened on February 28 when gold was plummeting by $45. "Although lower oil prices, usually would support interest-rate futures, those prices also fell....Analysts added that the large declines in other markets probably contributed to the negative psychology in interest-rate futures as well."
By reversing causality and seeing gold leading oil, and gold in turn led by the monetary authority's dollar policy (the shared policy of the Federal Reserve and Treasury), it becomes easier to fathom the volatile market forces and cross-currents that are swinging commodity prices and shaping interest rates. And the direction is clear, almost beyond argument. As Robert Mundell asserted in his Wall Street Journal essay of January 31: "The oil price increases of the 1970's would not have been possible without the accompanying rise in the price of gold (hence gold reserves) and foreign exchange holdings. After the price of oil was raised industrial countries and the LDCs faced the prospect of deficits which would have meant either deflation or depreciation of their currencies against the dollar, had the U.S. not provided the reserves upon which the Eurodollar market could expand to finance the oil deficits in the great lending spree of 1973-81."
We say the direction is "almost" beyond argument because the diehard devaluationists and floaters somehow manage to still get a hearing. One such, Professor Peter Kenen of Princeton, writes in the February 27 business section of the Sunday New York Times: "In the 1970's, the banks were part of the solution. If they had not lent large sums to less developed countries, the oil shocks of 1974-75 and 1979-80 would have done far more damage to the whole world economy."
It isn't as if this is a chicken-and-egg issue. First came the closing of the gold window and devaluation of the dollar in 1971 (which Professor Kenen then urged and applauded). Then came the floating of the dollar in the spring of 1973, which Kenen also applauded. The price of gold quadrupled during this period, from $35 to $140 and at times nuzzling $200. The Sheiks were among the last folks in the world to continue selling their goods at the same old price for rapidly shrinking dollars, and the world lined up greedily for bargain-basement oil. The "oil shock" of 1973-74 (not "1974-75" as Kenen recalls) occurred after an explosion of all other commodity prices. Had the Sheiks not gotten oil into line, OPEC's customers would have sucked up reserves at Malthusian rates and who would explore for oil at $3 a barrel when you could be panning gold at $140 an ounce?
The world had developed a great appetite for oil in those $3 days and it was a bit painful to adjust to $12. But the Eurodollar banks were flush with liquidity after two solid years of U.S.-inspired inflation. They could help the Third Worlders with loans to see them through the adjustment process, as Professor Kenen observed. But he and his cohorts, Fred Bergsten and Richard Cooper of Yale (the Ivy League Inflationists), were already pushing for a new round of dollar debauchment, succeeding upon the election of James Earl Carter to the Presidency. By assiduously talking down the dollar and applying steady reflation pressure on the Carter Fed, the inflationists managed to double the gold price to $280 by early 1979, and the slow-witted Arabs (albeit aided by Iran and Iraq) finally caught on with a doubling of oil, the second "oil shock." By this time the Third Worlders were not borrowing to finance more oil purchases as much as they were refinancing past debts.
A third "oil shock" occurred in 1980 after Paul Volcker, in applying the first phase of his monetarist experiment, managed to double the gold price again, running it over $600 for most of the year. But while the spot price of oil came close to doubling again, and certainly $48 oil seemed imminent, the real shock came when Volcker and the Fed in late 1980 began reversing this process with a major monetary deflation. This time, instead of oil consumers having to adjust, the producers—especially the marginal producers who had borrowed to explore for $40 oil—had to borrow in order to adjust to the new reality.
The Volcker deflation of 1981-82 brought the gold price as low as $300 in June of last year. But of course oil did not plunge in lockstep, any more than it went step for step with gold on the way up. Just as Saudi Arabia and the Arab states expanded oil production on the way up to try to steady the price, they trimmed production steadily on the path down to forestall a price decline. But had Volcker not abandoned his monetarist guidelines at midyear, the price of gold would have remained at $300 or gone lower, and the price of oil would have been forced not to $24, but perhaps to $20, overshooting in the process of wiping out the marginal oil producers, then creeping back to about the $24 equilibrium level that $300 gold implies.
To put the picture in familiar terms, imagine Volcker tieing a dog named OPEC to a stake with a 50 foot length of rope and hanging up a beefsteak 60 feet out. With that kind of incentive, it's unrealistic to think the dog won't make a topspeed run at the meat, licking his chops along the stretch of ground, but coming up short in anguish. The agony of OPEC's current price/production decision-making reflects the lag of last year's $300 gold and world recession, not the prospects of economic recovery already underway around the higher gold price. With a fullblown world economic recovery, $30-34 oil is in the ballpark with gold at $425. In other words, if the OPEC nations could afford to wait for global oil demand to pick up just a bit, and if U.S. monetary policy stabilized gold in that range, a vast amount of oil could be brought into world production without putting upward pressure on prices. Volcker seems to have some sense of this. On February 27, in his Meet the Press appearance, Volcker conjectured that it would be good for the oil price to decline a little, but not so much that it wouldn't have to jump up by a great amount down the line. Volcker has commodity price stability very much in mind these days and he is very much aware of the impact the Fed's policies have on dollar commodity movements. It's even possible to say with some confidence that he now thinks about the dollar-gold-oil linkages the way Mundell does, not the way Kenen does. Confidence in this point is critical in making a case for bonds.
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The last time the Fed showed its hand in a way that unambiguously revealed the direction of policy was on December 14, when it surprised the financial markets with a half-point cut in the discount rate, to 81/2 percent. The markets were surprised, remember, because the federal funds rate had been trading that day at 8% percent, a bit higher than a normal signal of an imminent cut in the discount rate. The bond market did enjoy a brisk rally on the news, but it reversed field the following afternoon on reports that the Fed had passed up an obvious opportunity to supply reserves to the banks under cover of a Christmas-season technicality.
From that point, at least insofar as policy is concerned, the Fed might as well have been in hibernation. The price of gold drifted upward, hovering for awhile at $450 before moving above $500 in February. The financial press, especially reporters close to the monetarists, continued to report that the Fed was "pumping money" into the system. But the Fed was doing no such thing. The weekly announcements of increases in the money supply, at times stupendous increases, created the impression that Volcker was "pumping money" into the system and a possibly dangerous reflation was lurking around the corner. But this was private money creation, described by Volcker as innovations in the money markets, mostly due to changes in the banking system. The important point is that the Fed's adjustment of its own portfolio was of a minor and ambiguous nature from December 13 to the present moment. The upward drift in the gold price occurred against an international speculation that the Fed's December 13 signal of direction implied further supportive moves of monetary ease.
The fact is that Volcker was not happy with the price of gold moving into the $500 neighborhood. It isn't possible to say how unhappy he was. But we know that at a mid-December meeting of several House Republicans on Capitol Hill, Rep. Jack Kemp put a series of direct questions to Volcker, trying to pin down the "Volcker Standard" to specific policy guidelines. In his answers, Volcker would not isolate the gold price from commodity prices in general, but did concede that if commodity prices were sliding he would take a $400 gold signal as one suggesting a shift to monetary ease and a $475 to $500 gold price as time to contemplate tightening. To the degree we take Volcker's observations seriously, and we have, the Volcker Standard is now an unspecified commodity standard, to which he is only committed intellectually, and which has in its basket the yellow metal, with gold assigned the important signal role around a $100 band—between $400 and $500.
What's happened since mid-December is not inconsistent with this hypothesis. There were further cuts in the discount rate expected in January or February, given the dismal state of the economy and the climb in the unemployment rate. But the rise in the price of gold almost certainly played a role in discouraging Volcker from easing again. The price of gold rose as speculators expected him to ease, thereby rewarding them with capital gains. But he did nothing. The Fed just watched. And when the end of the limb grew heavy with $500 speculators, unsupported by a Fed reflation that would concurrently help prop up $34 oil, it broke off suddenly and sharply. The gyrations in gold represent the world market's attempts to guess the outcome of the intense OPEC negotiations against the inscrutable policies of the Fed, all of which determine the dollar-gold-oil equilibrium. Our advice to Volcker was the following: The sharp drop in the price of gold frees him to cut the discount rate again, a move that earlier would have been interpreted as an attempt to fan the embers of recovery via reflation. But such a cut should await resolution of OPEC negotiations, lest the move impact the negotiations by driving up the gold price; higher gold encourages arguments for OPEC production cuts over price cuts. The world economy would be much better off if it could recover around a $400 gold/oil relationship rather than have to inflate toward a $500 equilibrium.
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The case for bonds can not rest entirely on suppositions about the predilections of Paul Volcker. Bonds are long-term affairs and Volcker might not be around six months from now, although I think he will be. Even if he isn't, though, his experience of the last three and a half years has been broadly shared. The notion, for example, that the Fed will seriously attempt to hit an "M" target in the near future—say the remainder of the century—is not worth contemplating. Nothing will savage bonds more surely than the assiduous application of monetarism, although nuclear war might prove to be slightly worse. There is now no residual sympathy for the Friedman experiment around the White House and the idea that Volcker must still set up "M" targets to comply with the Humphrey-Hawkins Act is treated as a joke. When Volcker hung up his M1, M2, M3 targets on February 16, along with credit targets and GNP targets, Lee Hoskins of Mellon Bank in Pittsburgh, a devoted Friedmanite, wryly observed that Volcker had "covered the side of the barn with targets," a line that circulated with smiles around the White House. As far as the high command is concerned, if Volcker continues to worm interest rates down he can miss the side of the barn altogether.
A year ago, in January, a group of 60 "conservative leaders" gathered in Washington to privately assess the first year of the Reagan presidency. The consensus was that Reagan had been co-opted by the Eastern Establishment, represented by White House Chief of Staff James Baker III, his aide Richard Darman, and David Stockman. Invited to participate, I offered the view that Reagan's problem was not Baker, et al., but the division in the conservative leadership on monetary policy. As long as the conservative intellectual cadre is divided on paper versus gold, I argued, the President would reflect that division with a bias toward the monetarists, who had become entrenched in the conservative institutions over the years through Milton Friedman's leadership.
On February 17-19 of this year, in Washington, the annual Conservative Conference manifestly ended the schism in favor of gold. Lewis Lehrman, invited to keynote, was enthusiastically received, especially in his vigorous, closing declamations for a gold rule and fundamental international monetary reform. Alan Reynolds dominated the monetary panel. And Jack Kemp, who gave a packed-house speech on populism and gold to the several hundred delegates on the closing day, found little resistance; in a poll on who they'd prefer if Reagan did not seek re-election, 55 percent of the conferees chose Kemp with no other possibility drawing more than 15 percent.
This is all very important to the bond market. These "movement conservatives," who represent the heart and soul of Main Street Republicanism, do not necessarily understand why gold is better than paper. But they clearly understand that paper failed, that the boom in the financial markets and the economic recovery now unfolding could not have occurred if Volcker had not abandoned monetarism last summer. As political activists, they are further aware that the political leadership associated with gold is also associated with the economic expansion now underway, an expansion that seems likely to rescue their hero, Ronald Reagan. There has always been tremendous grass-roots support for a convertible dollar, a gold-guaranteed dollar, but it could not find political expression as long as conservative leadership deferred to the arguments of the monetarists. That barrier is removed now, and grass-roots support for the idea can find a channel to policy.
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One of the Reagan high command asked me the other day how I'd get the prime rate down to 10 percent. I replied that I didn't know how to get the prime rate to 10 percent, but I know how to get it to 5 percent, and if we moved in that direction we'd have to at least pass through the 10 percent threshold. The prime will be at 5 percent on that day in the future, sooner or later, when the government once again guarantees the value of the dollar by offering to exchange it for a fixed weight of gold. When the markets, i.e., the citizens, no longer have to gamble on the daily or future value of the currency—when the government assumes all the monetary risks of inflation or deflation—the prime will fall to 5 percent and we'll have 30-year mortgage money in that range again, I suggested.
Volcker is not in any position to make that commitment on behalf of the government, I continued. He's done all he can as an appointed official. With the dollar afloat, political forces align behind debtor interests and creditor interests, pushing first for inflation, then for deflation; the White House changes hands rapidly to accommodate these pressures. At some point, though, the only elected representative of all people, all debtors, all creditors, must step into the eye of this storm and take political responsibility for the dollar. He must be prepared to draw a line of defense and say that if the dollar rises in value or falls in value, he is to blame. At the moment, though, neither Volcker nor the President is taking any responsibility for the dollar. All the risks are borne by the markets and rates remain high, here and around the world. Because the conflict between debtors and creditors around the world of floating currencies can only be realistically ended by the United States, I suggested the President is the only person in the world who has the power to do this deed. It's not a small thing, either, as Mundell observed in his Journal essay:
Money is more than an economic artifact; it is an idea, a central feature of civilization, the health of which depends, in a liberal society, on the predictability of its value, its stability, not only today but in the distant future. Money is, as Keynes said, a link between the past, present and future, in order that long-term commitments and contracts can be made and kept at interest rates that express the scarcity of capital and the urgency of time, with as little chance of forecasting error as is humanly possible.
There are certainly no indications that President Reagan is about to do any such thing; the case for bonds can't rely on a hope that Reagan will get out of bed one morning soon and decide it's time to do gold. But the worldwide intellectual and political drift is something else again, something that has been picking up strength and speed in a way that is clearly developing the support that a President would need if he decided it was time to step into the eye of the storm. Success breeds success and the economic recovery now underway can feed on itself, as influence and power continue to gravitate back to those ideas that can spawn non-inflationary economic growth.
Gold seems impossibly far away at the moment, just as economic recovery seemed impossibly far away to Marty Feldstein just a month ago. He will be busy adjusting his forecasts as Stockman will soon be forced to adjust his. To use Reagan's metaphor, most of the idea of gold takes place underground. The seed sends out roots and gropes toward sunlight, where the sprout can develop and flourish rapidly. We're closer now than you might think to this stage, but just observe the growing consensus toward international monetary reform, a fashionable embrace of fixed-exchange rates. When Henry Kissinger, Peter Peterson, Felix Rohatyn and Helmut Schmidt are found in a quartet, booing the float and singing the praises of stability, we can be sure it's now safe to join in at any Manhattan cocktail party. The idea has sprouted. By the time the Williamsburg economic summit meeting arrives in late May, the daring, the avant garde among the jet setters in New York and Washington will be mentioning gold. Some will even be citing it as a reason for the bull market in bonds.