Executive Summary: Monetarist theory may have been decisively refuted last fall when a Fed shift to monetary ease brought out the bulls instead of the bears. But because Treasury Secretary Donald Regan still employs Beryl Sprinkel and the refuted theory, monetarists retain political power sufficient to throw scares into the financial markets. Secretary of State George Shultz clings to his baby, the floating dollar, giving the monetarists another power base. Reappointment of Volcker would be enough to bury the monetarists for a while, with celebrations in the markets. But the monetarists are out to get him and, with Nixon's old economic team, push for Alan Greenspan. Fed Vice Chairman Preston Martin suddenly comes alive, swatting the monetarists and lifting bonds. Jack Kemp is guest of honor at the Fed's annual banquet. The text of his speech, included here, is must reading.
Monetarists on the Loose
A year ago, the world financial structure trembled amidst the most severe monetary deflation of our time. The global recession was deepening into depression, unemployment climbing, commodity prices tumbling, profits evaporating. In the air and the popular press was excited speculation about a world banking crisis and the potential bankruptcies of entire nations. What would happen if the Federal Reserve would end its three-year policy of trying to control the monetary aggregates?
On June 22, 1982, Irving Kristol asked this question of Treasury Undersecretary for Monetary Affairs Beryl Sprinkel, Milton Friedman's main man in the Reagan administration. The occasion was an Economic Roundtable session at the Lehrman Institute in New York City, with Kristol observing the desperate situation of the world economy and suggesting the Fed simply try a two-point cut in the discount rate to see what would happen.
Sprinkel's observation was that the money supply was in fact too loose, that interest rates had not come down because of market fears of resumed inflation, and that an easing by the Fed would revive new inflationary expectations, send interest rates higher and collapse the bond market.
When the Fed soon thereafter was forced to ease, to prevent further financial chaos, the financial markets reacted euphorically. The crisis had ended, the bull market had begun, global economic recovery could be seen on the horizon. Monetarism not only seemed dead, as the Fed announced in October the "temporary" shelving of M targets. It seemed pathetic in death. Who would ever be interested in Beryl Sprinkel's opinion on Fed policy again?
On October 14, 1982, Kristol felt confident enough to write an obituary to monetarism on the Wall Street Journal editorial page.
The breathtaking response of the stock and bond markets to the Federal Reserve Board's abandonment of a "monetarist" monetary policy suggests just how erroneous that policy was....Monetarism is no longer a key component of "Reaganomics," whatever anyone in whatever high place says.
In effect, we have just witnessed what scientists call a critical experiment, in which monetarist theory was decisively refuted. According to this theory, interest rates were high because of "inflationary expectations." Monetary policy itself, as measured by the various monetarist indicators (M1, M2, bank reserves), was, if anything, a bit on the loose side. The abandonment of monetarist guidelines, therefore, should have inflamed those "inflationary expectations" and brought the bond market crashing down while interest rates soared still higher.
Well, things did not work out that way, to understate the case considerably.
Imagine Kristol's surprise this past Memorial Day when he returned to New York after spending most of the month in Europe. In his brief absence, monetarism had not only sat up in its coffin but was walking about, frightening Wall Streeters and Treasury Secretary Donald Regan and sending the bond market into a nervous slide. M1 was back in neon lights, scaring grown men with its steep climb, the Treasury Secretary burbling about renewed inflationary expectations even as commodity prices sagged. "Monetarism" says Kristol, "has more lives than a cat."
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Just recently, on the afternoon of Friday, March 25, I spent the best part of an hour in Donald Regan's office at Treasury trying to persuade him to replace Sprinkel. I reminded him as well that in a previous visit, in April 1981, I warned him that he had made a "Solomon-like decision" in appointing a demand-side monetarist to the monetary post and a supply-side team to the fiscal positions at Treasury, and that the economy could not advance with policies reflecting this inherent contradiction. He remembered.
Now, I argued, as much as I genuinely like Sprinkel as an individual, a man of honor and integrity, and as much as I dislike OMB Director David Stockman, it is Sprinkel, not Stockman, who is now the single person in the entire Reagan Administration whose presence could hold back the incipient global economic recovery. For the time being, fiscal policy is out of harm's way because the snappy recovery has bolstered the President's confidence in his own fiscal instincts. The main deficit theorists, Stockman, Marty Feldstein and Alan Greenspan, are making a lot of noise about raising taxes in the "out years," but the President isn't interested.
Sprinkel, though, has a pivotal position because the global money issue has come to the fore, and Sprinkel's job description gives him the relevant lever of power in the government. Yet his domestic monetarist model is obsolete. His job calls for an international economist, capable of counseling Regan on global monetary and financial issues and planning the annual economic summit meetings.
Sprinkel, though, is incapable of performing this function. I tried to explain to Regan that at the theoretical level, Sprinkel's single-minded monetarist model blocks out any part of the world economy that does not belong to the Federal Reserve System. Milton Friedman's monetarism is isolationist in nature, a form of economic nationalism. In order to attempt fine-tuning of the domestic money supply, the Fed must be freed of any concerns about the impact such policy may have in the foreign-currency markets. Floating exchange rates are essential to monetarist doctrine.
Friedman (I explained to Regan) had sold floating rates to George Shultz, Treasury Secretary in 1973, with the help of Citibank's Walter Wriston. And although the experiment has been a profound failure, the monetarists in the Reagan Administration retain sufficient political power to thwart reform. If the economic recovery is to continue, the obsolete monetarist model has to be abandoned by the Reagan Administration, internationally as well as at the Fed. Longterm price stability at low interest rates requires stabilization of the dollar/gold ratio— thus stabilizing the value of the world's monetary gold reserves—and a concurrent stabilization of foreign currencies to the dollar/gold ratio. The European Monetary System of fixed rates is inherently unstable, I argued, because it floats against the floating dollar, the invoice currency for 70 percent of world trade.
As long as Sprinkel retains his position, the forces of reform can hardly make headway. The Secretary of State could force the issue, but in this case, with George Shultz at State, Sprinkel's position has actually been fortified. We have the anomaly of a State Department holding an isolationist view on monetary policy, with Shultz clinging to his vested interest, floating rates, his baby. Judge Clark at the National Security Council has enough clout to see the President getting the monetary option. But his chief economist, Henry Nau, is also a monetarist. And Milton Friedman himself still can get the President's ear.
Because Regan gets his international monetary counsel exclusively from Sprinkel and Shultz, the reformers cannot get through to the President via either Treasury or State. The President is being ill-served, I argued, because he is not even getting the option. Only Paul Volcker at the Fed, whose explicit abandonment of monetarist objectives triggered the bull markets and economic recovery, is on the right track. And because he is, the monetarists are hell bent on getting rid of him. (Donald Regan and the top Treasury staff are openly hostile to Volcker. Walter Wriston is practically alone in the banking industry in opposing Volcker's reappointment. The chance that George Shultz has anything nice to say about Paul Volcker is remote. When Shultz was named Treasury Secretary by Richard Nixon in 1972, one condition was that he retain Volcker as Undersecretary for Monetary Affairs. Volcker spent 1971-73 trying to repair the fixed exchange-rate system.)
At the very least, I urged Regan to bring in a group of international academic and bank economists to give him independent counsel, especially in advance of the Williamsburg summit. But I was emphatic in stressing that as long as he relied on Sprinkel's framework and counsel on a daily basis, sporadic outside opinion would have little impact on policy and, in the monetary realm, Treasury would be a part of the problem, not part of the solution.
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As we see, Donald Regan did not replace Beryl Sprinkel. He didn't invite outside counseling from international economists. The Williamsburg summit was a clear victory for the monetarists, the floaters. Shultz and Regan were so aggressive in advance of the summit in denouncing the French position and monetary reform that Reagan was pulled along by the tide. Even so, a Reagan concession on a Bretton Woods study group will keep the idea alive and under discussion; another year and there will be another summit.
Bond holders have every right to be a bit nervous in this environment. Monetarism, which has a proven record of being able to destroy financial values in any country and at any time, is slouching around Washington again. The price of gold and commodity prices in general are signaling that the market is ready for another cut in the discount rate, another spurt of monetary ease. But the key monetary watchers in the Administration are practically demanding the Fed go in the opposite direction, to counter the galloping Ms.
If Volcker were to be reappointed the news would be great for the bond market and stocks. The Volcker Standard, which at least has something of a golden sheen, is far more desirable than a Greenspan Standard. When the value of money depends so much on the whims of a single individual, it's at least nice to have a monetary track record on an individual, as we do with Volcker. We know nothing about how Greenspan would conduct himself over the stretch of track that runs to the horizons of the bond market, except that his economics has always followed the political winds. Two months ago he thought M1 was growing too fast, and after it accelerated he opined that it wasn't growing too fast after all. What we could be more certain of is that this element of unpredictability would be discounted with lower bond prices.
Greenspan, who is supposedly the frontrunner for new Fed chairman, favored over Preston Martin or Donald Regan, doesn't really have any great interest in monetary policy. Fiscal policy, he has always thought, causes high interest rates through the crowding-out effects of high deficits. As Fed chairman, he would use his position to harp for higher taxes in 1985 and 1986 to eliminate the alleged outyear structural deficits. He is said to be the candidate of White House chief of staff James Baker III and he probably has the support of Arthur Burns, Shultz and the rest of the Nixon Administration's old economic team.
Fed Vice Chairman Preston Martin, a Californian backed by the Californians around the President— supposedly including Judge Clark—has been more forceful and direct lately in expressing his economic views. An advisor no doubt told him that he was getting nowhere fast with an obfuscation strategy designed to make no enemies. His recent statements on tax policy, the monetary aggregates and economic growth sound marvelous to supply-siders. When on May 31 Donald Regan sent the bond market into the pits with his anguished cries about M1 growth, it was Martin's Congressional testimony the following day, dismissing concern over M1, that brought relief in bonds. The monetarists will never forgive him.
This gave Rep. Jack Kemp an opportunity to praise Martin. It was certainly timely that the following evening, June 2, Kemp was guest of honor at the Federal Reserve Board of Governors' annual dinner in Washington, at Volcker's invitation. With the entire Fed elite, regional governors and staff included, Kemp showered praise on Martin for his testimony and on Volcker for his leadership in moving policy away from monetarism toward stabilization of the dollar's value. He also pointed out that with the recent decline in commodity prices, gold dropping to close to $400, it is appropriate for the Fed to cut the discount rate now to 8 percent, not to move in the other direction because of the performance of M1. It's hard to say what the impact of the address will have on future policy, although it can be said it was received without visible sign of hostility—and even Governor Henry Wallich asked for a copy of the speech that he could read carefully. But it's clearly significant that Kemp was the invitee, an elevation of Kemp's standing and credibility in Washington circles that will be widely noted. The text of Kemp's remarks are appended to these.
The bond markets still have good reason to worry whenever they see signs of monetarism on the loose. It can do a lot of damage in a short period of time, just by the suggestion it may be coming back into vogue. But it is still hard to see how the monetarists could hold real power anymore, given the fact that almost everyone in the universe knows, as Kristol put it last October, their theory has been decisively refuted. A genuine attempt to get M1 under control would have such instantaneous effects in the markets for commodities, stocks and bonds that torch-carrying mobs would soon be roaming the streets looking for monetarists. They may have more lives than a cat, but they're still running out of these, with each loss bringing another celebration on Wall Street.