The Fed Jude Wanniski November 20, 2004

Memo: To SSU Students
From Jude Wanniski
Re The Federal Reserve

Everyone talks about “the Fed” and practically everyone in the world knows the chairman of the Federal Reserve Board of Governors is Alan Greenspan. But very, very few people know what it does, what it can do and what it can’t do. Today’s lesson is prompted by the remarks Greenspan made Friday at a banking conference in Frankfurt. Here is the lead of the NYTimes account today:

Alan Greenspan came to the home of the euro on Friday and suggested that the relentless decline of the dollar might well continue, offering little relief to those here who worry that the United States is seeking to gain a competitive advantage for its industries from a weaker currency. In a speech to a banking congress here, Mr. Greenspan, the chairman of the Federal Reserve, said that ballooning foreign borrowing on the part of the United States poses a future risk to the dollar's value. He said that foreign investors, who help finance the large American trade and budget deficits by buying Treasury securities and other dollar-denominated assets, would eventually resist lending more money to the United States, causing the dollar to fall further.

When this news hit the wires Friday, the Dow Jones Industrials lost 115 points, the dollar fell sharply against the euro and the Japanese yen, the bond market sank, and the price of gold jumped to $448, up $5 an ounce. Nice job, Alan.

What’s going on here? First of all, the Federal Reserve is the only institution that now has the power to keep the U.S. dollar from losing its purchasing power relative to both foreign exchange and to gold. Popular opinion believes the Fed can “stimulate” the economy by lowering interest rates and that it can slow the economy by raising interest rates. Ask almost any economist and they will say that is so, but that isn’t so. The Fed only has the power to damage the economy by putting more money into the economy than the economy needs or wants or by putting less money into the economy than it needs. When the Fed opens for business on Monday it could keep the price of gold constant at $448, its close on Friday. It would do so by ordering the New York “desk” to sell U.S. bonds from its portfolio to the banks that are authorized to transact with the Fed in this manner, but only if the price of gold trades higher than $448 -- thus withdrawing money from general use and extinguishing it. If gold trades lower than $448, the desk would know enough to buy bonds from the authorized banks, adding “money” to general use.

If this were Fed policy, there would be no inflation and no deflation, and the dollar would not weaken against foreign currencies (unless foreign governments made the mistake of not creating enough money to keep their currencies stable against gold). Greenspan could go back to Frankfurt and tell the bankers not to worry, the dollar would not weaken further and that it would be safe to buy U.S. government bonds. As it is, he did not do the American economy any favors on Friday. He essentially advised the world NOT to buy U.S. government bonds because they will suffer capital losses when they wish to sell the bonds, getting back dollars that are not worth as much as they are now. Nor did Greenspan do any favors for American taxpayers. If interest rates are going to go up and up, the U.S. national debt, now $7.5 trillion, will have to be refinanced at the higher rates, and the budget deficit will climb accordingly.

It sounds crazy, doesn’t it? Why does Greenspan do it? And get a round of applause from all the major newspapers?

The fact is, SSU students, is that we live in a demand-side world, and in a demand-side world the Fed can stimulate the economy by lowering interest rates and weaken it by raising them. In a supply-side world, if the Fed does not fix the price of gold at an optimum rate, it can only make mistakes that show up as a higher gold price or a lower price. There are certainly times that feel as if the Fed is stimulating the economy, but that is always because it has been mistakenly starving the economy of money (deflation) and then errs is the other direction by giving it more than it is asking for.

In December 1996, I began warning Greenspan that the decline in the gold price from $380 oz to $360 indicated a deflation was beginning. The economy was asking for more money and it was not being supplied. He did nothing about it and all over the world people who owed money in dollars began going bankrupt at a greater rate, having to pay creditors with more expensive dollars. At first Greenspan was cheered because prices of oil and other commodities were falling. By January 2001, when President Bush took over from President Clinton, the deflation had spread. With the gold price down to $265 oz., businesses that still had to meet payrolls at higher wages and could not raise prices to cover the costs had to live without profits and hope for a quick recovery. Or, they went out of business, with their workers joining the ranks of the unemployed.

With all this bad news showing up, here came Greenspan to the rescue, lowering interest rates. The Fed hacked away until the federal funds rate (which banks use to lend to each other) dropped to 1% in 2003, the lowest it had been since 1958. Meanwhile, the gold price had begun to climb after 9-11, which caused a decline in the demand for dollars. Because the Fed paid no attention to the rising gold price, it did not realize the deflation was ending. It thus did nothing to keep gold from rising, which was a good thing, although it gave the appearance to demand-siders that the lower fed funds rate was doing the trick. That it was “stimulating” the economy.

* * * * *

Prior to the Great Depression of the 1930s, nobody thought of the Fed as an institution that could or should “stimulate” the national economy, or slow it down. It was only supposed to manage the gold standard, the job it was given upon its creation by Congress in 1913. The price of gold was $20.67 oz., which it had been for the previous century except for the “greenback” years of the Civil War. Prior to 1913, the U.S. Treasury kept the gold price at that rate, issuing new paper dollars when the private banks asked for them in exchange for gold. If dollars became unwanted and in oversupply, they would come back to the banks, which in turn could turn them back to the Treasury for gold. The sole purpose of “monetary policy” was to maintain the dollar at that fixed exchange rate with gold. It was a classical, supply-side world.

The Crash of 1929 and the Great Depression that followed turned that world upside-down. The Crash was caused by the unexpected, anticipated passage of the Smoot-Hawley Tariff Act of 1930 and the worldwide Depression unfolded as countries retaliated with their own higher tariffs, currency devaluations and higher taxes. Because it was not understood at the time why the tariff act had caused the Crash (it was not until 1977 that I made that discovery), conventional wisdom eventually converged on the Fed and its management of the gold standard. The Fed was only doing what it was supposed to do. The demand for dollars collapsed in 1930-32 as the tariff took effect and the Hoover administration raised the income tax to balance the budget. Needing less money as a result of the contraction meant roughly one-third of the money vanished in the bankruptcies. The Fed could not replace it because it was no longer needed, which meant every time it issued dollars, their holders would ask for gold.

This led to the idea that the gold standard was holding back recovery! President Franklin Roosevelt decided to try the idea that with nominal interest rates being charged by the banks as low as they could get, the dollar could be made cheaper by devaluing it against gold. So he simply announced a change in the exchange rate, pushing gold to $35 from $20.67. Sure enough, there was a little immediate inflation, bringing relief to debtors at the expense of creditors, but the Depression only got worse. The little inflation had made the federal income tax even more onerous than it had become upon the repeated increases by Hoover and Roosevelt in their budget-balancing modes.

It was after WWII the idea took hold that the Fed could stimulate the economy by printing more money – actually adding “liquidity” to their member banks that could become “money” once it was loaned and became bank deposits. The Employment Act of 1946, passed out of fear that the Depression would reappear with the end of wartime spending, committed the government to manage the economy as never before during its supply-side history. In this new demand-side world popularized by the British economist John Maynard Keynes, monetary policy as well as fiscal policy would be dedicated to keeping the unemployment rate down and economic growth at the necessary levels. In a sense, all the troubles the U.S. has had with economic growth and unemployment over the last half century can be traced to the Employment Act of 1946.

The fact is, the Federal Government cannot stimulate the economy with either monetary or fiscal policy. It can only make monetary or fiscal errors that cause deflations and recessions or the combination of the two known as “stagflation.” Or it can cause the economy to improve by removing barriers that it had put into place in the mistaken belief that it was doing good.

Which brings us back to Chairman Greenspan’s Friday comments in Frankfurt that shook the financial and gold markets. Remember since June 30 that he and his fellow Fed governors have been raising that 1% interest rate “at a measured pace” to where it now stands at 2%, on the theory that it will eventually reach a point where it will strike a balance between inflation and employment, not too much or too little of either. That’s the Employment Act of 1946 you hear in the background. But what has happened during this quest for this rate of “balance”? Instead of holding back an inflation that might occur if too many people went to work, all the signs of inflation are increasing!!! The dollar is getting weaker against foreign currencies, the price of gold is soaring, and employment is lagging. The stock market doesn’t look too bad, having recovered somewhat from earlier trials and tribulations. But that’s only if you count the broad indices in nominal dollars. If you convert them to gold, they are not recovered at all!!

So what is a poor Fed chairman to do, but pass the buck? It is the trade deficit and the budget deficit that are causing all these bad things to happen, not the Fed’s policy. And hold onto your hats, folks. If this is true, then the Fed will have to raise rates much higher than they are now, and hope that mythical interest rate will be found sometime soon. But what if he’s going in the wrong direction? Remember the definition of a fanatic… someone who doubles his speed when he loses sight of his goal?