A 6% Long Bond: Learning from History Jude Wanniski September 7, 1993

Twenty-four years ago this month, at a 1969 international monetary conference he hosted at Queens University, Ontario, Canada, Professor Robert Mundell foresaw that "The world is moving toward a floating regime. The experience will be so painful that by 1980 it will begin moving back toward fixity." What led Mundell to make such a spectacular forecast, borne out as if he had Merlin's crystal ball? It was because all around him he saw the melting of academic and political support for the link between the paper dollar and gold's anchor to the real world -- a process that culminated two years later, on August 15, 1971, when President Richard Nixon formally severed the link. Both political parties cheered, having been egged on by a commercial establishment that saw a cheapened dollar as a trade advantage with Japan and Europe. The commercial establishment, in turn, had been counseled by the academic establishment, then dominated by MIT's Paul Samuelson and Chicago's Milton Friedman.

Mundell had never lived in a global regime of floating currencies, but he was a student of economic history, which he knew was littered with the wreckage of civilizations and empires that disregarded the importance of money as a unit of account of known and predictable value. As he predicted, the "gains" of a cheaper dollar, predicated on the notion that it would lower the effective cost of labor in the United States, were swamped by the losses to America's commercial establishment that resulted from the rising cost of capital. America's creditors at home and abroad were no longer assured that the debt they were buying would maintain its value, as it does when it is guaranteed in gold. Since a nation's standard of living rises when its capital stock expands, not when its people work harder, the exchange was a painful one. America's capital stock contracted and people had to work harder, moonlighting to maintain the same standard of living. 

Interest rates climbed and the stock market eroded during the Nixon years. He lost his popular support and was expelled (with Watergate as an excuse), but the Establishment had no doubts about the economic advice it had pressed on him. It persuaded President Ford to propose higher taxes in order to halt the inflation caused by the currency float. That finished off Mr. Ford, a two-year president. Jimmy Carter, captured by the manic devaluationists in his party (supported by Big Business), watched the dollar sink to its all-time low in early 1980, as gold traded briefly at $850 per ounce and commercial interest rates topped 20%. As Mundell had predicted, this was the year the world began moving back toward fixity. Ordinary Americans pitched out Mr. Carter and elected Ronald Reagan, who horrified the Establishment in 1980 by saying such things as: "I know of no nation in history that has left gold and has remained a great nation," and by promising to cut by one third the inflation-swollen income tax rates -- which then included a 70% marginal rate on unearned income, as the Ivy League economists then described interest and dividend income.
 
 The Reagan Administration opened with one of the worst recessions in history, as the President was stuck with the advice of Professor Friedman on matters monetary and David Stockman on matters fiscal. The Friedmanites whipped the Federal Reserve into a deflation that saw gold's price fall from $625 per ounce in the autumn of 1980 to $300 only 15 months later. In an attempt to capture more tax revenues, the Stockmanites persuaded the President to delay his tax cuts and spread them over three years. (Contrary to the old wives' tale that the bond market likes economic weakness, the bond market declined as the recession deepened.) The recession ended abruptly when the Volcker Fed abandoned Friedmanism in the summer of 1982, setting the stage for the longest peacetime economic expansion in U.S. history. (Again, contrary to the old wives' tale, the bond market boomed along with stocks.)

President Reagan's most important legacy to President Bush was a Federal Reserve board of governors of his appointment, especially Wayne Angell, in early 1985, and Alan Greenspan, in the spring of 1987. These Ph.D. economists are unusual in that they are more comfortable in the world of finance than in textbook economics. Both see eye to eye completely on the overwhelming advantages of sound money to the everyday lives of ordinary people, as opposed to the supposed gains to be had by manipulating the dollar's exchange rate for trade purposes. The bond market nevertheless struggled in the Bush years, burdened by a Treasury Secretary, Nicholas Brady, who could never understand that his incessant appeals for easy money were a constant threat to the nation's creditors -- its bondholders. Bonds did as well as they did because Greenspan & Co., (joined by Vice Chairman David Mullins, a third Ph.D., a professor of finance from Harvard, and Larry Lindsay, a fourth Ph.D., a professor of economics from Harvard who had renounced "demand management") conspired to resist Brady's exhortations.

Polyconomics had opened for business in the summer of 1978 with not much more than the analytical framework I derived from the writings and exhortations of Mundell and his protege, Arthur Laffer, along with a smattering of political skills and contacts. My first report, "A Bull Market Scenario," imagined a Dow Jones Industrial Average of 3000 by the early 1980s, based on a sharp adjustment of tax rates, a return to a gold-linked dollar and gold-standard interest rates below 4%. At the time, the DJIA was just above 800, and long term interest rates above 7%. The scenario has held up beautifully, but it has taken a bit longer than if it had played out with 100% efficiency. Mundell's forecast ended with his benchmark of "a return to fixity" beginning in 1980.

In December 1991, on the expectation that during the course of 1992, Greenspan & Co. would make major progress toward fixity, a de facto relinking of paper and reality around a gold price of $350, I forecast a 6% long bond by the end of the calendar year. During the year, though, the embattled Bush presidency, looking for a scapegoat, nagged incessantly at the Greenspan Fed; Secretary Brady broke off diplomatic relations with the Fed chairman, ending their weekly breakfast meetings. At the same time, Governor Angell, one of the gold anchors, temporarily anguished over the optimum price of gold, thinking perhaps it was closer to $300 than $350. The creditors of the United States had to wonder what was going on, and the long bond stalled above 7%. Last December, I repeated my 6% forecast for 1993 on the grounds that Greenspan & Co. had not only become more confident in targeting gold and commodity prices, but also that President Clinton and his Treasury Secretary, Lloyd Bentsen, were giving Greenspan and the Fed a wide berth.

There were anxious moments when the gold price climbed above $400 this summer, but I surmised that this was based on global speculation that Greenspan had, in fact, made the deal to lower short term interest rates that had been so widely reported and rumored. Once the speculators saw they were wrong, after the budget deal passed and the Fed stood firm, I advised, gold would return to $350. [It's $353 as I write this.] My confidence in Greenspan was unshakable throughout because of his Senate and House Banking Committee testimony. His finest moment came on July 20, when Rep. Paul Kanjorski [D-Pa] twitted him for having united two Nobel Laureates, Milton Friedman on the right and Paul Samuelson on the left, both of whom had been blasting Greenspan for being too tight. Greenspan smiled, said he thought these two pillars of the economic establishment were fine economists, but "I do think they are wrong." [A number of Fed governors told me they were astonished by Greenspan's casual dismissal of these two titans, and proud of him!]

The financial press hasn't the slightest idea of what has been going on, as it remains trapped in the Friedman/Samuelson demand models. The New York Times this morning leads with an absolutely stupid report, "Investment Soars in Mutual Funds, Causing Concerns." The "concern" is that Americans are taking their money out of safe debt instruments, because yields have fallen, and are putting it into risky equity, thereby driving up the stock market, according to Laszlo Birinyi, Jr., a market analyst in Greenwich, Conn. [Laszlo: If the money that's coming out of bonds into stocks is driving up stocks, why are bond prices soaring?]

In fact, the American people are demonstrating that sound money is an absolutely wonderful thing for the economy. It increases the efficiency of all capital, bonds and stocks. As we have lonesomely been pointing out, sound money lowers the effective capital gains tax on all future gains, which is why NASDAQ is doing better than the DJIA. In the market for U.S. debt alone, in going to a 6% yield from 7%, the price added 12.5% or $500 billion to the nation's capital stock. While this was going on, the Clinton economists were unsuccessfully trying to get a $16 billion "stimulus" package through Congress. Hoo ha. 

Where are we going from here? Further up the sunny side of the learning curve. It's taking longer than I thought, but that's only because so few people are willing to learn from history. They have to watch it unfold for themselves.