The Mundell-Zijlastra Option Jude Wanniski November 4, 1981

Executive Summary: A decade ago, Robert Mundell anticipated the current clamp down on money, leading to a "squeeze that ends in widespread bankruptcy" Mundell now sees unemployment and the inflation rate rising simultaneously, with the gold solution waiting patiently in the wings. President Reagan's recession announcement was a positive move, submerging the budget-balancers at OMB for the duration. Treasury's Regan continues the year-long monetary-fiscal stalemate in personnel, a bureaucratic gridlock soon to be broken by bad economic news and the impatience of the political clock. Gold seems further away than ever, but the Mundell-Zijlstra solution is only an arm's length from the President.

The Mundell-Zijlastra Option

In April 1971, with the United States already on a de facto paper standard and only months from officially closing the gold window, Professor Robert Mundell (then of the University of Chicago) spoke of the emerging world inflation at the Claremont Conference in Bologna, Italy:

There are two dimensions of this problem. One is the danger that the world money supply is explosive, and is no longer under the control of the monetary authorities of the world. Now, of course, ultimately the base of the system will be high-powered reserve money in the United States, but we have moved into a system where what is ordinary money in the United States — bank money, low powered money, so to speak — becomes essentially high-powered money in Europe, so that ordinary deposits in Chase Manhattan Bank or First National City Bank in the United States form not only part of the money supply in that country, but also the base of a potentially explosive money supply in Europe. We have moved into a system in which the supply of money is almost completely determined by the demand for money, because there are always means by which clever bankers can find ways of turning ordinary deposits in the United States into the base for a much larger monetary expansion in Europe. This means that, at present, there is no effective means of controlling the world money supply.

The second danger is that the United States will clamp down at some point as world inflation builds up, and that we will get a succession of periods, as in 1966 and in 1969, where interest rates rapidly rise to 10, 12, 13 percent in a squeeze that ends in widespread bankruptcy.

Well, here we are, ten years later, and the "clamp" is on. The recession that Fed Chairman Paul Volcker has been straining to reach all year has finally arrived, with a wave of bankruptcies that will probably climb to memorable heights before it crashes and subsides. Even as President Reagan was observing the likelihood that we're in a "slight recession" the Commerce Department reported that in the previous three months there had been 14,600 bankruptcies, a 41 percent increase over the same period in 1980. And because Volcker is determined to keep the clamp on, with the support of the Reagan administration, the bankruptcies should get bigger and the recession deeper than the President now contemplates.

What does Robert Mundell say now? A plausible scenario between now and the end of the year, he says, is the following, which he in fact outlined to me on October 1:

1. The unemployment rate climbs to 8.5 percent by year end.
   
2. Short-term interest rates fall substantially, long-term rates fall sluggishly.
   
3. The dollar falls on the foreign-exchange market.
   
4. The inflation rate accelerates.
   
5. The budget deficit expands as government revenues decline substantially.
   
6. M1 B decelerates despite the efforts of the Fed to prop it up.

And Mundell, who is now at Columbia University, believes that out of this worst of all possible worlds "gold will come to pass." Thus, while the idea of currency reform and dollar/gold convertibility seems to have been shut down for the season, it is in fact waiting patiently on the sidelines, sensing that its time is about to arrive. The opposition is rapidly running out of arguments and the President is running out of time. Thus far he has been led to believe that because of Volcker's ability to keep M1B under control, interest rates will not only fall substantially but stay down for the 1982 elections. The President has even been quoted as saying that Milton Friedman believes interest rates could be down to 6 percent next year. (Did Friedman say 6 or 16?)

The White House will put up with the bad news on bankruptcies and unemployment only as long as it remains persuaded that they are the short-term price to pay for lower interest and inflation rates. But Congress isn't so patient and even Treasury Secretary Donald Regan has begun to nip at Volcker's heels. As winter and the holidays approach, the worsening economic news will certainly be accompanied by louder calls for "reflation."

It was of some importance that President Reagan announced the recession, which signaled that the curtain had closed on any possibility of using fiscal policy to combat inflation. In what had become a wildly confused, even bizarre, theoretical discussion, the budgeteers had somehow managed to snarl themselves in the argument that the recession had been invited by the tax cuts. Senate Finance Chairman Bob Dole and Senate Budget Committee Chairman Pete Domenici had worked themselves into the ad hoc hypothesis that the recession was brought on by high interest rates, the high interest rates induced by the market's fear of increasing deficits, the increasing deficits resulting from a shortage of revenue caused by the built-in tax-rate reductions. The correct solution to the recession, given this convoluted reasoning, is a tax increase, and for a time in late October it looked like Dole and Domenici would try to stand Lord Keynes on his head to achieve that end.

The President's recession statement, though, closed off that talk. Congress is simply not going to cut spending or raise taxes in a recession, no matter how slight, although the Democrats have been aching for the administration to get behind the idea. It's quite possible that the reason Wall Street is said to love the onset of recession is that recession gets the political class to shift attention away from austerity toward growth.

The October 30 rally in the Dow of 19.60 points was universally credited to Henry Kaufman's prediction that the prime rate would fall to 16 percent by year end, from 17 1/2. It is far more likely that the rally followed Secretary Regan's statement before the Senate Budget Committee that a balanced budget in 1984 was "not probable," and that trying to redeem the President's campaign pledge would hurt the economy too much.

After all, why should either the stock market or the bond market, which also rallied, take comfort in the news that the administration would accept a deficit in 1984 instead of cutting spending or raising taxes to the degree required to balance the budget? In the Henry Kaufman model, which is also the David Stockman model, stocks and bonds should have been depressed by this news. As The New York Times explained the rally: "Although Mr. Kaufman's remarks basically reiterated his recently expressed views, they came at a propitious time: Interest rates are already easing and stockbrokers and clients are hungry for any morsel of optimism. The explosion of trading volume in the afternoon underscored the force of investor enthusiasm."

The absolute fact is that the Kaufman forces of fiscal austerity had suffered setbacks from the moment the President called the recession. Secretary Regan's throwing in the towel on a balanced budget, which hit the wires at midday, could not possibly have been interpreted as bullish by Mr. Kaufman or David Stockman, but it was welcomed by the markets.

Stockman has been temporarily stymied by the "slight recession" and its political implications. But he will not give up. He remains trapped in the Kaufman model, which is also the Alan Greenspan model, communicated directly inside OMB by Lawrence Kudlow, OMB's chief economist. Kudlow, who used to sing the praises of tax cuts, the gold standard and Robert Mundell when he was at Bear Stearns on Wall Street (which is why I introduced him to Stockman), has reverted to the mossback, Republican balance-the-budget school. Although he was trained as a monetarist, there is nothing an OMB economist can do on monetary policy but cheer Volcker for hitting his M targets. In his October 20 testimony before the Senate Budget Committee, Kudlow does the equivalent of the "Rosemary Woods stretch" to get from monetarist analysis to fiscal diagnosis.

"Inflation expectations and interest rate conditions should have been improving in 1981 if based on actual money growth. Quite possibly, some of the rise in long rates may reflect a higher risk premium resulting from added market volatility. But the size of the increase in rates on longer-term maturities seems instead to suggest that expectations of future inflation have intensified.

"Since the current period of monetary restraint is unable to explain the rise in longer-term rates, then it seems reasonable to assume that the upward rate movement is a function of market anxieties over future monetary trends. And these fears are a logical outcome of the deteriorating U.S. budget position over a span of many years."

Based on this "reasonable assumption" and its "logical outcome," Kudlow believes it "behooves us" to engage in "revenue enhancement." Kudlow's most optimistic scenario for 1984 — with real growth of 5.4 percent, 5 percent T-Bill rate, GNP deflator of 4.0 percent and unemployment of 6.5 percent — still turns up a deficit of $115 billion.

The reason, apparently, is that the success in getting the inflation rate down prevents the government from gaining revenues via bracket creep. Yet how can interest rates fall to 5 percent if the deficit of $115 billion is feared by the market as representing further deterioration of the U.S. budget position? In any case, Stockman will now push mightily for a new energy tax. Because the President has vowed to veto any "windfall profits tax1' on natural gas, we can expect Stockman and Dole to propose an "excise" tax on natural gas, to raise big bucks. But the very idea that the President and the GOP would ask the electorate in 1982 to vote Republican so their taxes can go up in 1983 is outlandish. At the moment, Stockman seems to have been isolated in the administration, without support at either the White House or the Treasury.

With fiscal policy on the back burner, the administration will only be able to consider monetary policy as a solution to problems unfolding in the economy. There are only two monetary possibilities, "reflation" or gold. As long as short-term rates are inching their way down in the recessionary slide there is no call for the White House or Treasury to do anything at all, of course. The pattern for the next several weeks is wait-and-see.

In the broadest sense, what continues inside the administration is the same monetary-fiscal stalemate that it began with in January, with the supply-siders dominating tax policy, and the demand-siders dominating spending policy and monetary policy. The demand-siders at OMB have just made an unsuccessful run at capturing tax policy for their side, which is how all three viewpoints were represented in the Carter administration. The stalemate can not end as long as monetarists have control of monetary policy, however.

    This is not the view of the supply-side fiscalists in the Treasury. Treasury Undersecretary for Tax Policy Norman Ture and Assistant Secretary for Economic Policy Paul Craig Roberts are essentially uninterested in monetary policy, believing that fiscal incentives alone will take care of the problems of unemployment and inflation. In the November 16 issue of Fortune, Roberts tells us:

"The Reagan Administration's economic program consists of a fine balance between three different points of view, each with a dominant goal. There are the supply-siders in the Treasury, who are primarily concerned with increasing the rate of real economic growth. There are the monetarists in the Treasury and on the Council of Economic Advisers, who are primarily concerned with lowering the inflation rate as fast as possible. And there are the traditionalists at the Office of Management and Budget, who are primarily concerned with making good on their promise of a balanced budget by 1984.

"A great deal has been made in the press of alleged inconsistencies between these points of view ..... In fact the three viewpoints are compatible. Supply-siders realize that inflation could cancel the tax-rate reductions and thereby the supply-side effects that they are counting on to raise the real growth rate. They fully support a policy of moderate and predictable growth in the monetary aggregates. Supply-siders also realize that budget deficits draw down the pool of private-sector savings, offsetting their efforts to raise the savings rate, and so they strongly support OMB's efforts to reduce the growth of spending."

This is all nonsense, pure insider politics, with Roberts schmoozing Beryl Sprinkel in order to keep two sides of the triangle united against Kudlow, who wants to take away Roberts' tax cut. It also explains why there is never any momentum built up for the gold solution inside the administration. Ten years after Mundell observed that "we have moved into a system in which the supply of money is almost completely determined by the demand for money," Roberts is still writing that supply-siders "fully support a policy of moderate and predictable growth in the monetary aggregates."

Secretary Regan, who was the November 1 guest on "Face the Nation" is the victim of this Odd Couple routine at Treasury. The financial markets are throwing off terrible signals and all his lieutenants can advise him is to wait and see, everything will turn out all right. Can Chrysler be saved? Well, said Mr. Regan, if interest rates fall, as they are because of the softening of the economy, they will reach a point where they will attract auto buyers. Which is to say the interest rates have been high because of the demand for credit, which is falling partly because people aren't buying cars in the recession, which will end when people increase their demand for credit and buy cars.

This bureaucratic gridlock will be broken when Secretary Regan discovers that all we have gotten for the "tight money" policy is a recession, and that the economy's emergence from the recession will be accompanied by higher interest rates than we'd seen previously. We won't have to wait-and-see too long, which means that moving toward the gold solution by the first of the year is still a solid possibility.

How would Mundell move toward gold? His idea, known and understood inside the administration as a not impractical one, is to initiate the process by having the President ask his Treasury Secretary to stabilize the dollar price of gold on international markets, between say $400 and $450 per ounce. Treasury has the authority to do so, and the immediate effect, says Mundell, would be to bring down long term interest rates.

If the markets knew the gold price could not move above $450, the U.S. government would be taking that currency risk out of the futures market. The future price of gold would tumble, it being uneconomic for gold to be held at high rates of interest. Interest rates would fall accordingly. There would be some difficulty in stabilizing at $450 if the Fed were determined to undermine the process. But there's no reason to think the Fed would not cooperate and take the gold price and foreign exchange into its policy considerations. The success of this initial step, Mundell believes, would encourage policymakers around the world into the next stages of movement toward' formal convertibility.

The proposal is already guaranteed substantial international support. On September 27 in Washington, at the meeting of the International Monetary Fund, the chairman of the Bank for International Settlements (BIS) invited just such a proposal. The chairman, Jelle Zijlstra, told the IMF:

The present position cannot be termed satisfactory. The central banks of the principal countries hold vast reserves of gold. The Netherlands Bank, for instance, has gold holdings which, at current market prices, account for 66% of its total reserves. It is most frustrating that, sale against foreign exchange apart, there is no systematic manner in which this reserve component can be used. I feel that it is necessary for us, within the Group of Ten and Switzerland, to consider ways to regulate the price of gold, admittedly within fairly broad limits, so as to create conditions permitting gold sales and purchases between central banks as an instrument for a more rational management and deployment of their reserves.

Zijlstra who is called "the central bankers' central banker," also observed with favor the deliberations of the U.S. Gold Commission. "At least gold is no longer a dirty word," he said.

The Commission, unfortunately, is not having the effect of elevating the issues that its advocates anticipated. Of the 17 members, only Lewis Lehrman understands the supply-side arguments and presents a respectable case. And because he is running for the Republican gubernatorial nomination in New York, he is almost wholly distracted by politics. At the October 26 meeting for example, he dominated the morning discussion but left before lunch to campaign. The only advocate remaining for the afternoon session was Rep. Ron Paul of Texas, who is a liability. The system he advocates is extreme to the point of being ridiculous, a "pure gold standard" in which dollars would disappear; the price of a new Chevrolet would be quoted in ounces of gold. Anna Schwartz, the anti-gold executive director, has already announced that she will write the majority report (due at the end of March). Neither Arthur Laffer nor Robert Mundell have been invited to testify during the two days of hearings, Nov. 12 and 13, although our Alan Reynolds of Polyconomics has been invited and will testify. Press attention has dwindled to a vanishing point.

The important thing to remember, though, is that as far away as it seems, the gold solution is only an arm's length from the President. It is not as if he has to move heaven and earth and Congress to get the job done. He merely has to reach for the telephone and instruct Donald Regan to meet with Mr. Zijlstra to arrange a coordinated, central-bank gold-stabilization effort. It would probably be deemed so complicated that the event wouldn't make the CBS Evening News. But we would in fact be off to the races.

Don't count on it happening soon. But don't not count on it happening soon. As the bad news piles up and the clock runs out on 1981, Ronald Reagan might just reach for the telephone.