What Should Greenspan Do? Jude Wanniski November 30, 2004

If you are reading the European press you will note all kinds of advice being offered on how to halt the slide of the dollar. Every day the Financial Times runs an op-ed or two on the subject, with two today. A fellow named Brendan Brown who runs Mitsubishi’s shop in London thinks Greenspan isn’t raising interest rates fast enough, "Europe must help slow dollar`s decline." A Paul de Grauwe, "Unilateral action can stop the dollar`s slide," an economist at the University of Leuven in the Netherlands, thinks Europe should pitch in by buying up a bunch of dollars. Here is a letter to the editor I just sent off to the FT, addressing the professor’s suggestion, but answering Mr. Brown’s indirectly:

Sir, Paul de Grauwe suggests that Europe support the dollar, with the European Central Bank intervening to buy up surplus dollars in the foreign-exchange market, "Unilateral action can stop the dollar`s slide," November 30. Instead, the ECB should simply call Federal Reserve Chairman Alan Greenspan and suggest he create fewer dollars and mop up the existing surplus by selling bonds from the Fed`s massive portfolio of U.S. Treasuries.

The current account deficit or excessive consumption and insufficient saving in the U.S. is not the cause of the dollar`s slide. It is the result of the Fed`s policy of raising overnight interest rates as a means of slowing the economy and preventing an outbreak of inflation. The policy is at best experimental, as there is no theoretical reason why higher interest rates should stabilize dollar prices -- of gold, commodities or foreign exchange. Since June 30, when the Fed raised the federal funds rate by a quarter point to 1 1/4 pt, the dollar gold price has risen by $50 an ounce, a sure sign the experiment is failing. Further rate hikes will only dampen demand for dollar liquidity, producing more unwanted dollars, higher gold prices, and a weakening against the euro.

The most straightforward solution is to pronounce the experiment a failure and go directly at the problem, draining liquidity from the banking system with a target of $400 gold. If Mr. Greenspan were to simply announce this goal, the market itself would move rapidly in that direction, with the euro and yen falling back to where they were on June 30. That would be that.

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In response to a client, who asked me the other day what I would do if I were Greenspan, I went a little further. I said I would call upon President Bush and tell him that my attempts at a pre-emptive strike against inflation were not exactly working as planned. In as much as the President doesn’t know anything about monetary policy and he looks to Greenspan to handle such matters, the President would ask him what did he propose to do. And when Greenspan told him he planned to target the gold price at $400 oz and let interest rates go wherever the market wanted them to go, the President would turn to Treasury Secretary Snow and ask him what he thought. Secretary Snow, knowing exactly what the President knows about monetary policy, would say he thought it a great idea, as long as Chairman Greenspan would take all the credit if it worked (and all the blame if it did not.)

Would Greenspan think it would work? Of course he knows it would work. He knows the Fed has the absolute power to hit any one target it wishes to hit. He also knows that the market need only know of this target shift, to a reasonable $400, that it would move the price there in no time at all. The price is “reasonable” because it was just there not long ago, so the mini-deflation would benefit a thousand people for every one who had gone long gold and commodities. Now that’s a pre-emptive strike!! Greenspan also knows for sure that if he did this, the dollar would strengthen to 1.20 euros or better and to 110 yen or better. What he doesn’t know is exactly what would happen to interest rates. If I were Greenspan, I’d ask the several hundred Ph.D. economists who work at the Fed what they think would happen if the Fed retraced its experimental steps in this fashion. At least one or two would imagine that the funds rate, now at 2%, would retreat to where it was last June 30, at 1%. The 10-year note, now at 4.25% would drop below 4% and the 30-year bond, now at 5.375% would drop to 4.9%.

Greenspan would not know about the stock market. If bond prices jump that high, wouldn’t equities fall sharply? Perhaps some of the steam in equities is simply the fluff that goes with inflation expectations, and there would be a tendency for the S&P 500 to shed some of that fluff. But at least one or two of the Fed PhD economists would realize that with the risk of inflation removed by this bombshell the commercial world would be thrilled to pieces having a dollar unit of account as good as gold at a fixed, reliable rate. More Americans would see this advantage and call their brokers to buy. And more foreigners, no longer fearing a capital loss by holding dollar assets and seeing the dollar wither on the vine, would be back buying with both hands.  Does it get any better?

Will Greenspan do as I suggest? Maybe not today, but maybe next week. He certainly has heard the news that the Gulf States have decided to diversify their portfolios on reserve assets, moving away from the dollar to a “basket” of currencies including the euro. "Gulf States May Fix Future Currency to Basket Instead of Dollar." If the President would have that little chat with Greenspan on the meaning of all this, the Chairman would tell him the rest of the world was getting antsy with the U.S. dollar. And if we don’t do something about it, U.S. banks will lose a lot of business to the European banks, which seem to be having better luck with the “money” than we are with this experiment that has engaged us since June.

President Bush is a black-and-white kind of guy. He’d say, “Go for it, Alan.”

Wouldn’t he?