Narrowing Gold/Bond Questions Jude Wanniski October 15, 1993

The long bond remains happily ensconced below 6%, closing yesterday at a delightful 5.85%. The bond rally has put renewed sizzle in stocks, especially the low caps that are in the earliest stages of capital formation. But gold has moved up again to $365 from our $350 benchmark, renewing debate inside the Fed concerning what's going on. It's a good time to think about the next stages of discussion, which could put us on an even faster track.

Is the gold market anticipating an easing by the Fed? Or, is the 3% federal funds rate too low at the moment, thus dribbling excess liquidity into the banking system -- which shows up first in a gold price increase? Both interpretations are possible. It could be that the gold market is nervous about the attack on Fed independence by the House Banking Committee and its chairman Henry Gonzalez, and as it sees the attack fizzle out, gold will come back. It could be a very temporary blip in the trading of gold specie. Or, a temporary dip in the demand for bank reserves that will work itself out. Who knows? The fact that we are down to this narrow question is very good news, as it enables the participants in the discussion to see the problem clearly. Fed Governor Wayne Angell, who has in fits and starts led the pilgrimage back to gold, beginning with his Lehrman Institute presentation in 1987, is again raising important questions about the usefulness of gold-price targeting.

In a remarkable speech to the Downtown Economists Club on October 5, "Reflections on Monetary Policy," Angell argued that while the gold price contains important information, the information is primarily related to expectations. He makes no mention of the possibility that gold might also signal surplus liquidity:

To those who are concerned that I propose a commodity price targeting rule, let me reiterate that I consider commodity prices as purely short-term indicators of the unobserved future price level, a signal that must be evaluated in light of other information. Commodity prices contain information about the price level, but they are not themselves the price level. Since commodity prices depend on the behavior of the real rate of interest, an observed change in a commodity price may signal either a change in the expected rate of inflation or in the interest rate. If the Fed were to target a commodity price, it would, in effect, constrain movements in the real rate. The true target of monetary policy is and always should be the behavior over the long term of prices the public understands and deals with every day.

The one flaw in Angell's thinking, I believe, is in his comment that "commodity prices depend on the behavior of the real rate of interest." That's true enough, except for gold, the one commodity that can trade purely as a monetary commodity against dollar liquidity -- which is non-interest bearing debt of the government. The price of gold in the futures market is a precise function of real interest rates, as they are expected to be. In the spot market, it can simply indicate an excess or shortage of liquidity.

Angell seems to be saying he requires more information than the spot gold price, because if he were to target it alone, it would no longer have value as a signal, for it would no longer relate to real interest rates. It would, he says, "constrain" movements in the rate. As I interpret him, he is more or less saying that the market cannot express itself purely through the gold price, by way of letting the Fed know whether it should be buying or selling securities in the open market. This comes as close as he can to arguing against the efficiency of the market without exactly saying so. A decade ago, when Paul Volcker was Fed chairman, he frowned at me and said, "Jude, you want to turn me into a robot." And I said, "Paul, you are exactly right." If the market can perfectly express its liquidity preference through the gold price, there is no reason to fuss with lesser signals -- including  an example Angell offers of the interaction of M2 money supply and short-term interest rates.

Implicit in Volcker's remark about "robots" was a skepticism of democracy, as it might be expressed through the gold market. To Alexander Hamilton, gold was all that was needed to signal a surplus of liquidity. Anyone could vote for or against the government's monetary policy, by demanding gold with specie, or vice versa. If too much paper were issued, Hamilton said in 1790, "it would come back upon the bank." Volcker, and to a degree Angell, expresses a wariness about the ability of the citizenry to function without their wisdom and assistance. They both don't want to be tied down exclusively by the gold signal, although they will agree it is a powerful source of information.

Like a runner in a relay race, Angell has brought gold this far, but now must hand off for the final leg. He could not have succeeded without the help of Volcker, who was in on the early laps of the return to gold, nor of Greenspan, who may be around for the finish. Angell's last vote will be cast at the December FOMC meeting, since his term ends in January. There is some concern that the Fed might weaken without him, but it seems rock solid to me, especially now that Lawrence Lindsey has finally gotten beyond his early doubts about gold's utility as a monetary signal.

There is still much to be gained by sharpening the focus on gold. The cost to the economy of Fed discretion -- even the wisps that Angell would like to retain -- are now visible and exorbitant. We see how excited the broad stock market has become with the long bond fighting its way back below 6% a second time. The blue chips lag, for while they benefit from sound money, they do not benefit the way the young and the restless do. America is bursting with enthusiasm for experiment and innovation, and the increased efficiency of the capital market due to sound money is making all that possible. To take the next steps at the Fed in this historic mission requires a further narrowing of the options, which is the contribution of Angell's October 5 speech. For Greenspan to narrow these options would take so much risk out of capital that the long bond would seem comfortable below 5%, and the NASDAQ would go to the moon. That might, though, take another year.

NAFTA: The announcement that the Administration wants to tax airline tickets to "pay" for the revenue losses resulting from tariff reductions is naturally being seen by NAFTA supporters as a poison pill, designed by the White House witch doctors to kill the legislation even as the President pretends to support it. By the President's own estimates, NAFTA will create several hundred thousand jobs over the first five years. The tax implications of these new jobs would swamp the projected $2.8 billion tariff revenue losses, but the Administration would not count these gains as an offset. Treasury will, though, estimate that, as there will be so much more trade with Mexico because of NAFTA, it will cost the government $612 million in lost tariff revenues in fiscal '98 compared to only $210 million in fiscal '94!!! Republican NAFTA supporters want to cut spending instead, but the White House seems determined to force them to vote for the airline tax if they want NAFTA, as most Democrats, opposing the trade agreement, will gleefully vote against the airline tax. I'm still advised that there will be enough of a NAFTA push from the White House and GOP leadership to get it across the line, but this new wrinkle can only work to poison the tiny reservoir of good will left between the President and the GOP.

CLINTONOMICS: The Clinton economic team is reaching new lows in twisting truth in pursuit of its corporatist power agenda. Remember Lloyd Bentsen two months ago seriously argued that the economy boomed after the Kennedy tax increase of 1964, on the grounds that the top marginal income-tax rate in those pre-inflation days was higher than it is today. Labor Secretary Robert Reich now argues that an increase in the minimum wage will increase employment, because a higher wage will attract the jobless who will refuse to work at the current minimum. Ph.D. economists everywhere would laugh themselves silly if, say, Ronald Reagan made such a dopey argument, but the intellectual climate is so corrupt that we don't even get a smile. Why not raise the minimum to $100 an hour and end unemployment altogether, with everyone working at Pizza Hut? Then raise taxes to $100 an hour and sit back with Lloyd Bentsen to watch the economy boom? Now we hear from one of our clients that Robert Rubin, the Goldman Sachs whiz kid who chairs the President's Economic Council, is telling private audiences that the pre-Reagan 70% tax rate never bothered him or the people he knew, as they just worked harder! Rubin, who supposedly favored elimination of the capital gains tax when he was squiring Governor Clinton around the business community, now insists the tax has no effect at all on the economy. Rubin, who made his fortune as a trader, should be ashamed of himself for letting the President think he knows something about economics and public finance. He reportedly insists there will be no tax cuts no matter how bad the economy, as we must get this deficit down! (Whew, I'm beginning to miss Darman and Brady.)