Executive Summary: Economic expansions of the last generation have been accompanied by inflations. But as in Mexico, where 1976 and 1982 currency devaluations spurred an increase in "aggregate demand" out of consumer fear, the U.S. recoveries of recent years were atypical relative to those under a gold standard. The greatest threat to the current expansion and bull market in stocks and bonds comes from those economists and policymakers who do not understand this distinction and thus fear growth. The threat has been contained because the President does not share this fear. Paul Volcker is of two minds, but Henry Wallich's shift away from inflation concerns, along with Preston Martin's growth orientation, almost guarantees the Fed will reject "tightening" at the July 12 FOMC meeting. Market jitters about a crunch reflect demand-side economic analysis which dominates the financial press.
Going With Growth
In Mexico last year, in the wake of the latest 50 percent peso devaluation, the New York Times carried an account of the boom in Mexico City's shopping malls and department stores. Shoppers swarmed about, buying with reckless abandon. One couple reportedly bought four refrigerators with cash, saying they would simply store them in their garage. This increase in "aggregate demand" did not last long. When the government devalues its unit of account it can terrify consumers into spending; they get rid of the shrinking currency out of self-defense. It only works off inventories where shopkeepers are quick enough to mark up prices.
On September 21, 1976, I wrote the lead editorial in the Wall Street Journal, entitled "The Nickel Peso," which began as follows:
We were naturally sorry to see that Mexico, which had held the peso at 12 to the dollar for 22 years, finally threw in the towel on September 1 and let it slide to a nickel. Outgoing President Luis Echeverria Alvarez is being credited with courage in approving the devaluation, bequeathing to his successor the "benefits" of a cheaper peso. But it is hard for us to see the move bringing anything but grief to Jose Lopez Portillo, who becomes president of Mexico on December 1.
Ironically enough, for the 22 years of the peso's stability it was almost universally believed that a nation's economy could improve through a currency devaluation. Its export goods become cheaper and more competitive internationally, or so the theory goes. Yet Mexico hung in there manfully, refusing to take advantage of such "beggar-thy-neighbor" policies.
But since 1971, the notion that devaluation spurs production and employment has been so discredited by the record that it's a wonder there are still academics around who are not embarrassed in defending the theory. Yet Mexico has picked this moment to take the plunge, not by a little bit, but by almost 40 percent. It would be easier to credit Mr. Echeverria with courage if he were beginning his administration with this decision.
The instantaneous effect of the devaluation was to wipe out 40% of the financial assets of peso creditors and 40% of the debt of peso debtors. In a strict sense, for every loser there was a gainer, but it's difficult to see how the economy benefits by a one-time government distribution of windfall profits and losses.
Beyond these adjustments in wealth positions, there were the inevitable effects on prices. Californians who rushed down to Tijuana with dollars, figuring on getting 40% off all traded goods in the Mexican marketplace, discovered that shopkeepers were not accepting pesos, but were insisting on payment in dollars at pre-devaluation levels. And further from the border, where dollars are not as widely in circulation, prices in pesos were being marked up by the full amount of the devaluation.
As we can readily observe with some amazement, there is still no shortage of academic economists willing to defend the devaluation theory and sell policymakers and captains of industry on the notion that a reduction in the value of the U.S. dollar would have beneficial effects on U.S. production and competitiveness. C. Fred Bergsten, director of the Institute for International Economics in Washington, has built his entire career out of repeated calls for dollar devaluations. If he were in any other profession, he would be certified a crackpot. But as an economist, his shamelessly obsolete ideas are quoted with stupefying regularity in the nation's financial press.
At the moment, there is no threat of an imminent dollar devaluation. But in an unusually connected way, the devaluation idea has infected the thinking of influential policymakers—including Martin Feldstein and Paul Volcker—and does pose a serious threat to the economy.
We must understand that devaluation (inflation) is one of the tools of Keynesian demand management. It is the "demand managers" who are trained to calculate precisely the amount of current devaluation that will induce consumers into spending more, i.e., how much devaluation will it take to terrify consumers into buying an extra one, two, three or four refrigerators for storage in their garages.
James Tobin of Yale, the Nobel Prizer, has been among the most influential of the inflationary fine-tuners via his advice to Democratic policymakers. For at least a quarter century Tobin has been recommending tax increases and monetary ease as a policy mix. In his model, it's important that there be unutilized capacity in the economy in order to apply the remedy of monetary ease. To use the Mexican example, Tobin would make sure the refrigerator factories were not at peak production. Presumably if the consumer can be induced to buy a refrigerator because of the devaluation, the shopkeeper can order from the factory with no increase in prices. It's all a very delicate matter, though.
It's also from this narrow perspective that the conservative Keynesians like Feldstein get their fear of economic growth. Growth must be carefully managed, restrained if necessary, or it will become inflationary. It does not matter what kind of "demand-sider" you are, the outcome is the same. The liberals would err on the side of growth and accept more inflation as a necessary price. The conservatives would prefer a higher unemployment rate and a fine-tuned slow-growth path in order to avoid a reignition of inflationary expectations.
For most of the history of the United States, economic growth—even dramatic economic growth-was experienced without inflation. But for most of this history, thought was never given to spurring consumers into buying more buggy whips, ice boxes or refrigerators in order to unload a devalued dollar before prices rose. The dollar was defined as a specified weight of gold and until August 15, 1971, its convertibility into gold was guaranteed by the government. Any attempt by the government to employ "monetary ease" to get consumers buying could only result in consumers—including foreign central banks—showing up at the Treasury with the easy money and demanding gold.
The current generation of economic policymakers, middle-aged men like Feldstein and Volcker, have spent their career lives in a different kind of world. In this Tobinesque world of fiscal tightness and monetary ease, it has been the job of the government to manage economic growth, spending more and taxing more and following an "accomodative" monetary policy. For most of the Sixties an accomodative monetary policy could not be more than very mildly inflationary because the gold window remained open. It was at least theoretical that the government would be unable to renege on its own dollar debt by an explicit policy of devaluation. It had to either cough up the gold or issue bonds paying higher interest rates to discourage other central banks from demanding gold. In the last dozen years, though, when economic growth seemed to take place, some part of the "expansion" was simply an inflation phenomenon: Consumers shifting out of financial assets into extra refrigerators. We have become unfamiliar with the kind of economic growth that is facilitated by a stable unit of account. The threat to the economy now comes from those who would shut off real, non-inflationary growth in order to fight the inflation they believe will follow growth.
The nervousness in the financial markets, especially the jitters in the bond market, are directly the result of fears that the weight of the government will be thrown behind anti-growth policies. The fact that the President's chief economic adviser, Marty Feldstein, has an almost pathological fear of growth, combined with the fact that the economy is growing much faster than Feldstein believes is safe or desirable, has fed market fears that a "credit crunch" may be in the cards.
Wall Street's economists, the spokesmen for the banks and brokerage firms, contribute to these fears because they basically employ the same demand model that rattles around in Feldstein's head. If the economy grows, that puts more money into people's pockets and their aggregate spending puts upward pressure on prices. If the government won't tax the money out of their pockets, the Federal Reserve must drain it out by selling bonds out of its portfolio. A "tightening" will cause interest rates to go up "temporarily" but by putting the economy back on a slower growth path there will be less chance of an inflationary comeback.
By himself, Feldstein would not be able to crimp the market's appetite for dollar-denominated debt, government and commercial. But Paul Volcker has been known to express concern about the impact of growth on the labor markets that can only come out of this demand model. In the weeks prior to his June 18 reappointment as Fed chairman by the President, Volcker expressed concern about the lively pace of the recovery and in a June 8 telephone conversation with Rep. Jack Kemp he also expressed concern about the rapid growth of the money supply.
In the supply model, there is of course no need to worry about an explosion in the "money supply" as long as the price of gold and other sensitive commodities remains steady. Indeed, two years ago, in his office at the Fed, I suggested to Volcker that in the first year of a policy aimed at stabilizing the value of money instead of its quantity, M1 would shoot up by 15% or so. Off the top of my head I suggested M1 growth of 12, 9, 6, 4 and 3 percents in the following years, my point being that after all the lost efficiencies of money were recaptured over these several years, money demand would stabilize at the economy's natural, long-term growth rate. Volcker, I'm convinced, appreciates this concept and is "concerned" about the explosion in money supply only in the sense that he's concerned about everything that everyone thinks the Fed should be concerned with.
The only really bad thing about the President's reappointment of Volcker is that it was done in a way that continues uncertainty about monetary policy. The President essentially handed Volcker a blank check, with no public thoughts on how policy should be conducted, and for his part Volcker did not have to commit himself to any standard of behavior on when the markets could expect easing or tightening. The "Volcker Standard" is as obscure now as it was six months ago. Still, the President's decision was a fine one, probably a great one. On June 22 I wrote to White House chief-of-staff Jim Baker:
Congratulations to the President for his Volcker appointment. It's the kind of decision that looks sensational to historians a century out and will help lift RR into the Truly Great category of American Presidents. Congratulations to you for assisting in the process; Kemp tells me of your role.
Jack, you must realize, serves the President well by withholding his support from Volcker and by elevating his differences with Paul in the press. There are two Volckers, one who fears growth as being inflationary and the other who suspects that sound money can in itself launch a non-inflationary boom. Kemp, Lehrman and other supply-siders cannot give a blanket endorsement, but must be free to encourage development of the growth Volcker.
The growth Volcker doesn't need all that much encouragement anymore because he can plainly reconcile rapid growth in a non-inflationary environment by observing the action in the financial markets. Monetarists like Robert Weintraub, senior economist for the Joint Economic Committee of Congress, continue to warn darkly of the M1 bulge turning into an inflationary binge 18 months from now. But if Weintraub and his colleagues are right, the commodity futures market has to be wrong; it sees no inflationary binge. According to Newsweek of June 27:
(Weintraub's) argument remains unconvincing to most economists. Fed governor Henry Wallich, himself a monetary hard-liner, argues that the M1 statistic has been badly distorted by technical factors. "Whatever it is trying to tell us," he says, "almost everything else we watch is telling us a different and more sensible thing." Broader monetary measures are within their target ranges, he says, the price of gold is softening, and the absence of commodity speculation suggests that "money is not too loose at all."
This Wallich quote, which appeared no place else in the press, is extremely important because it reveals that there is now no serious intellectual support for an M1 squeeze by the three most important Fed governors, Volcker, Vice-chairman Preston Martin, and Wallich, the most senior of all the governors in point of service.
There may be a governor or two who is itching to squeeze down the money supply, but without Volcker, Martin or Wallich to rally around, it seems beyond the realm of possibility that the July 12 meeting of the Fed Open Market Committee will be seriously influenced by the monetary aggregates. As long as the gold price remains "soft," well under $450, there will be no vote to raise the federal funds target range, no "tightening." And if gold is below $415, with no signs of heightened commodity speculation in other areas, it would not surprise me to see the Committee lower the target range by the narrowest of margins in order to make clear its intent, i.e., that it is watching prices not quantities.
The reason the financial markets remain as nervous as they are about the possibility of a crunch is that the financial press and news media in general have been reflecting the views of their usual sources, the demand-side economists whose models do not permit non-inflationary growth. A week after Newsweek gave us the critical Wallich quote, Time magazine was rounding up the usual suspects in the profession and postulating a possible squeeze:
Says Norman Robertson, chief economist of Pittsburgh's Mellon Bank: "We have not yet solved the problem of how to sustain a recovery without reigniting the fires of inflation. This will be Volcker's task, and no one has ever pulled it off before . . . ."
Says Lacy Hunt, chief economist with the Carroll McEntee & McGinley investment firm in New York City: "What everyone wanted was a nice, controlled, slow recovery. What we're getting is a fast, potentially disorderly recovery." Stanford economist Michael Boskin is concerned that if excessive money growth continues too long, Volcker will have to tighten abruptly next year and risk aborting the recovery ....
Administration officials last week were publicly and pointedly urging Volcker to rein in the money supply, even if that causes a modest uptick in interest rates. Treasury Secretary Donald Regan, who had reservations about Volcker's reappointment, called for "slow-repeat slow—and steady" money growth.
Though the Federal Reserve's decision making is shrouded in secrecy, some of Volcker's colleagues on the seven-member Board of Governors have privately admitted that monetary policy might be tightened a bit. One member told Time: "There are unmistakable signs of overheating now. The animal spirits are starting to rise. If something isn't done soon, all our progress of the last three years will be at risk." The Fed governor said the Reserve Board might gently nudge up short-term interest rates, now at about 9%, to the 10% range. Many private experts, including Alan Greenspan, who was chief economic adviser to President Ford, agree that the economy can withstand a small hike in interest rates. The recovery could be cooled, Greenspan believes, without being crushed.
A modest uptick in interest rates. A gentle nudge. A small hike. Notice how the anti-growth crowd only wants a teensie-weensie squeeze, not to crush, just to cool! Anything to break the momentum of the recovery. Success feeds on success, and unless the momentum of the recovery can somehow be reversed, even gently and modestly, it will solidify the contentions of those who have argued that sound money can launch a non-inflationary boom. Even the slightest murmurings from Volcker that he may be ready to worry about M1 again send the bond markets into the chute. Imagine if there is a clear signal that the Fed desires a "cooling off" of the expansion even in the absence of the kind of commodity speculation that Henry Wallich is watching for.
The big, big push for an itsy-bitsy squeeze has not succeeded, at least for the moment. The President is happy talking about the "sparkling" recovery and is in no mood to discuss cooling it off. The bond market finally firmed at the end of June after Volcker, in London, spoke of rapid economic growth in positive terms. Donald Regan, the weathervane, put on a jolly face and predicted lower interest rates. And Marty Feldstein was ordered into the White House press room to be cheerful about the recovery instead of inviting a credit crunch.
Volcker could end the suspense by saying the same kinds of things that Wallich told Newsweek. but he got through the reappointment process without having to give up any freedom of movement, and he doesn't seem to want to give up any voluntarily. He will not let the Fed be pulled into an austerity mode in the absence of inflationary price signals in the commodity markets. But he won't commit himself to any specific price targets, no doubt fearing that some unforeseen set of circumstances would force him to ignore his own guidelines and there would be egg on his face and massive confusion in the financial markets.
For this reason we can't really expect the kind of interest rate declines that are associated with fixed commodity standards. Interest rates will move lower as the markets get assurances from Volcker and the President that growth isn't feared per se. But monetary reforms of the kind that will bring another bull market in bonds await the political process, which is as close as the next election year.