Executive Summary: The monetary package announced October 6 by Fed Chairman Paul Volcker gets the blame for the Stock Market Crash of October 8-10. But on the surface, while there is good and bad in the package, it seems to go in the right direction, which is why it was greeted favorably at first by the markets* Indeed, the break from an interest-rate target is potentially bullish, and will be if it leads in the direction of convertibility. Volcker, though, has been sidetracked by the idea that recession and "voluntary" credit allocations are part of the solution, which perhaps explains the market's reappraisal and crash. An anti-inflation strategy must focus on ways to increase the demand for money, rather than ways to contract the quantity of money.
The "Volcker Panic"
The Crash of October 8-10, in which the Dow Jones Industrial Average lost 64 points from peak to trough in interday trading, is broadly attributed to the "credit tightening" policies of Paul Volcker, the new Chairman of the Federal Reserve. There are some serious problems with this conventional analysis, not the least of which is the observable fact that Mr. Volcker's "Saturday Night Special" — the dramatic new actions announced Saturday evening, October 6 — were almost universally saluted by the domestic and international financial communities. Businessmen, bankers, academics and the financial press, here and abroad, led the cheering, and politicians, including the President, chimed in. The Wall Street Journal's lead editorial of October 9 almost demanded that its readers offer steadfast support of the Volcker strategy to tackle inflation.
Then why the crash? Laudatory policies should increase the value of financial assets, right? Even if there is something to the idea that in order to beat inflation things must get worse before they get better, correct policy should still bring a rise in the stock market, which supposedly discounts the future. And if the change in the dollar price of gold is a reliable proxy for the future rate of inflation, why was gold trading at $415 an ounce four days after the Volcker moves when it was $385 just prior to his Saturday announcement? And most importantly, why was there such a lengthy period between the Volcker announcement and the beginning of the Crash, on Monday afternoon of the 8th instead of at the market's opening? Indeed, the market's opening assessment of the Volcker actions was positive. What happened?
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As the International Monetary Fund opened its annual meeting of October 1, in Belgrade, it was plain enough to the 138 assembled central bankers that U.S. economic policy was in need of repair. The dollar price of gold was breaking new records every day (it would trade at $441 an ounce on October 2) and last November's agreement among central bankers to keep the dollar steady against major currencies had finally broken down; Europeans had simply been forced to swallow U.S. inflation in order to maintain the dollar exchange-rate relationship. When Treasury Secretary G. William Miller proposed a new issuance of Deutschemark-denominated U.S. bonds with which the U.S. Treasury would mop up dollars, the Germans scoffed at the idea. The problem is not with surplus dollars spilling around Europe, but with the source of dollar liquidity in the U.S. Volcker agreed with the Bundesbank, and, amid a swirl of rumors of new dollar-propping actions, left Belgrade and returned to Washington. He requested a meeting with President Carter.
According to one unverified account, President Carter and his wife received Volcker alone, except for the presence of White House Press Secretary Jody Powell. Volcker described the actions he wanted to take and explained that he wanted a united front. He wanted the President to publicly endorse his moves, and asked the President to privately call his appointees on the Fed and persuade them to vote with Volcker. In the September vote to raise the interest-rate target, Vocker carried by only 4-to-3 a signal to the market that the Chairman did not have the support of Carter, since the minority had been appointed by him.
During the next three days, Volcker called Jody Powell, according to this account, and each time was put off with the report that a decision still had not been made. On Friday October 5, when again this was the report from Powell, the Fed Chairman threatened resignation. When the rumor of this episode reached the market, the dollar price of gold, which had been falling since Tuesday, began to climb, subsiding again only after a Fed spokesman said the rumor was "absolutely false". The White House, though, had been put into Volcker's pocket, and in an extraordinary Saturday meeting of the Federal Open Market Committee — comprised of all members of the Board of Governors and 5 of the 12 presidents of the Fed banks — Volcker got his unanimous vote. Subsequently, he got his public endorsement from the President.
The "Saturday Night Special" announced by Volcker consisted of "a series of complementary actions that should assure better control over the expansion of money and bank credit, help curb speculative excesses in financial, foreign exchange and commodity markets and thereby serve to dampen inflationary forces."1
First, the Fed increased the discount rate to 12 percent from 11 percent. The discount rate is the fee the Fed charges on loans to member banks. This step was of small importance, but at least in the positive direction in that it at least tends to discourage increases in bank reserves.2
Second, the Fed established an 8 percent reserve requirement for certain liabilities of member banks, including large time deposits, Eurodollar borrowings and certain other funds. The Fed's aim here is to force banks to keep more of their funds in reserve and thereby reduce the supply of money available for loans. The Fed, though, is the source of the reserves to begin with, requiring member banks to hold them without interest; the new requirement is simply a new tax that pushes banking activities away from Fed member banks to less efficient banking systems. It has, from a supply-side point of view, an "inflationary" impact in that it decreases productivity (of domestic banking services) and, with no change in the supply of money, tends to erode the purchasing power of the dollar.
The third change is the most significant and potentially the most positive. The Fed "announced a change in the method used to conduct monetary policy to support the objective of containing growth in the monetary aggregates over the remainder of this year within the rates previously adopted by the Federal Reserve....This action involves placing greater emphasis in day-to-day operations on the supply of bank reserves and less emphasis on confining short-term fluctuations in the federal funds rate."
It sounds very complicated, but as usual in matters economic, the jargon masks the incredible simplicity involved. At bottom, the monetary instrument has only two directions: forward and backward. In the final analysis, Mr. Volcker can do only two things: he can print money or he can extinguish money. All the profound, technical debates over monetary policy focus on that simple realm: when do you print, when do you extinguish?
In classical economic theory (supply-side), it's all very simple. You use the monetary weapon to control the rate of inflation. You print money when you want more inflation. You extinguish money when you want less inflation. The guide, or standard, you use on a daily basis to implement your choice of more or less inflation would normally be a single point, the dollar price of a single commodity that serves as the proxy for all commodities. If gold is used, and the dollar price is $200 per ounce, for example, the Fed can choose no inflation or deflation by printing dollars when the price falls to, say, $ 199.99 and extinguishing dollars when the price rises to $200.01.
In the absence of this classical standard, monetary policy becomes more complicated. This is chiefly because modern economists attempt to hit two targets with one weapon, i.e., print or extinguish money in order to both target the inflation rate and the unemployment rate. The debate over how to conduct monetary policy in this framework has raged for years between Keynesians, who would use interest rates as a guide to reaching a desired mix of inflation and unemployment, and Monetarists, who assert that some "M" quantity of money should be the guide.
The interest-rate school argues that high interest rates imply greater unemployment and thus lesser upward pressure on prices, i.e., less inflation, and that to get higher interest rates you extinguish money, and vice versa. The quantity school argues that interest rates are a poor guide to daily policy, that the Fed should decide on how much "M" it wants, and print or extinguish money in order to attain that quantity. Elaborate formulae have been worked out for various "M"s to instruct the Fed on what each will mean in terms of an inflation/unemployment mix.
On the surface, what Mr. Volcker seemed to be announcing on October 6 was that the Fed was abandoning the interest-rate school and embracing the quantity school. The gold/exchange rate crisis forced a change. In a classical model, the Fed should have been withdrawing reserves from the system, extinguishing dollars, in order to keep the dollar price of gold from soaring. Instead, it was raising the interest-rate target, yet finding that it was still printing money at higher rates in order to hit the target. It would switch to the "M" guide, the "monetary aggregates."
Unhappily, the various "M" guides have become embarrassingly unreliable to the Monetarist school in recent years; the formulae constantly break down as explanations of what is really happening in the world. The classicial economists argue this is bound to happen when you attempt to fix the supply of money, without any regard for the fluctuating demand for it. The quantity of money should be ignored, say the classicists. In today's world, fixing the purchasing power of the dollar would so increase the demand for dollars that a vastly greater "M" quantity of money still would be consistent with price stability.
At the moment, though, the Monetarist model is superior to the Keynesian model as a guide to monetary policy because it happens to overlap with the classical standard. In other words, at the moment, the monetarists and supply-siders would both be withdrawing reserves, extinguishing money, or at least standing aside and doing nothing — as opposed to pumping reserves into the banking system. Indeed, in the first weeks of the new policy, the Fed has mostly stood aside, and when it has intervened, it has been to drain reserves a bit.
The reason supply-side economists view this as being potentially bullish rests on the belief that inside Paul Volcker there is a classical economist struggling to get out. Having torn the Fed away from Keynesian philosophy, he at least has given himself a range of options. As the markets find him picking his way in a manner that suggests intellectual commitment to the classical school, they will rally. First, the bond markets, then the stock market. The markets have been jilted so often in the last dozen years it will take a while for Volcker to be trusted.
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In some unfathomable way, the Volcker moves of October 6 may have brought in their train events that triggered the crash in the bond and stock markets in the following week. But in and of itself, the Volcker package could not have caused the crash, or the markets would not have opened Monday the 8th with such positive signs. "The dollar surged 2 percent on foreign-exchange markets and gold's price slumped more than $17 an ounce as traders gave a hearty greeting to the Fed's anti-inflation moves," The Wall Street Journal reported Tuesday the 9th. The Dow Jones Industrials, however, dropped 13.57 points, and after the close analysts attributed the fall to fears of higher interest rates. But the market had been calm most of the day, falling more than 13 points in the last two hours of trading. When on the following two days the bond and stock markets plunged, gold shot up by almost $50, and confounded analysts could only suggest that the Volcker moves had been re-examined and found wanting.
It is always common on Wall Street during a price break for analysts to argue that "margin calls" are the trigger. But this is only another way of saying the optimists, the bulls, were proven wrong by events. It is the equivalent of a soldier in a foxhole arguing the war was caused by the bullet flying over the foxhole.
Mr. Volcker, himself, scoffs at efficient-market theory, and seems prepared to believe that his policies, in fact, resulted in the contraction, and all of this is necessary. To shake inflationary expectations out of the economy, in this view, requires passing through a pain threshold, a recession that hurts. The market is not even allowed to see beyond the vale of tears to the bright future, discounting that promise into a bullish run-up in prices.
To a devoted efficient marketeer, though, the market must have gotten new information on Monday afternoon that led it to a reassessment of a package that seemed pretty good at first glance. It is tempting to a supply-sider to suggest that continued government opposition to a tax cut played a role in the decline. Both Secretary Miller, at midday on the 8th, and Volcker on the 9th emphatically ruled out tax cuts in addressing the American Bankers Association in New Orleans. According to the Washington Post of October 9, Miller ruled out any general tax cut next year, saying that such "stimulative action" would "merely feed the fires of inflation". And Volcker continues to resist tax-rate reductions until he can see a break in inflationary expectations. But these kinds of statements in the last analysis do not constitute fresh news coming to the market, and must be discarded as triggers of the crash.
There was one new, ominous cloud that did appear in New Orleans, which was the aggressiveness of Miller and Volcker in warning the 9,000 assembled bankers against "speculative lending". On Monday, Miller told a press conference in New Orleans that the measures announced Saturday were designed to "make it uneconomic to use credit for purposes that do not have any economic payoff," which is the rhetoric of a credit controller — although Miller also said the administration was not contemplating mandatory credit controls. The Dow Jones ticker carried this news at 1:35 P.M., which may have had something to do with the 13-point drop that followed.
On Tuesday, Volcker told the bankers:
"One of the glories and strengths of our system is that we rely on private markets and decentralized decisions, responding to market incentives, in pricing and allocating credit. But these decisions have to be made by all of you individually in your own institutions. In a situation in which there could be greater day-to-day or week-to-week volatility in money market rates — not in itself a matter of great consequences for the economy — pricing of your own loans seems to me more than a matter of responsible business judgment than of following a rote formula....The Board of Governors has particularly stressed its own concern that, in a time of limited resources, banks should take care to avoid financing essentially speculative activity in commodity, gold and foreign exchange markets.... This is hardly the time to search out for exotic new lending areas or to finance speculative or purely financial activities that have little to do with the performance of the American economy, and indeed may detract from it."
In other words, the man behind the discount window, Mr. Volcker, wants the 9,000 bankers in the audience to screen out financial activities that Mr. Volcker believes are undesirable. There was little subtlety in this warning, which approached the level of political blackmail as the Comptroller of the Currency, John G. Heimann, weighed in with his forecast of possible bank failures in the coming squeeze. The survivors would be those favored at the discount window, those which had not engaged in "speculation."
In a supply-side framework, any government intervention that tends to reduce the demand for dollars is "inflationary." The visible sign is when people are unloading dollars for other currencies or real assets, gold and such. For Mr. Volcker to tell the American banking community that they should not use the U.S. dollar for transactions he deems undesirable — especially when he is the guy in control of the discount window — is per force a decline in the utility of the U.S. dollar. It is sufficient to explain why the dollar price of gold would soar, and bonds and stocks plunge. At least this analysis has no obvious inconsistencies with the facts of October 8-10 and the classical model.
In any case, it is clear that Mr. Volcker is still carrying a lot of excess intellectual baggage. The real and threatened increased burdens on the domestic banking industry are worse than needless, and make his job of mopping up surplus dollars all the more difficult. Nor does he see that an efficient tax-rate cut, one that expands incentives and productivity and the tax base, would increase the demand for dollars, and thus would be anti-inflationary. On balance, the judgment of the market is that he may have gone one step forward, but he's two steps back. Continued optimism can only be based on the assumption that one of these days, perhaps while he is shaving, Paul Volcker will look himself in the eye and admit he is a supply-sider. As of the moment, he still resists.
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1 See Press Release, Board of Governors, Federal Reserve System, October 6, 1979.
2 See R. David Ranson, "Raising the Discount Rate", H.C. Wainwright & Co., January 27, 1978.