Market Blowout Jude Wanniski June 24, 1994

The savage beating the dollar and all dollar assets are taking in the world financial markets can only be attributed to the failure of Fed Chairman Alan Greenspan and the Board of Governors to reassure America's creditors that they will not permit the dollar to lose its value. In two days of meetings I had this week in Washington -- at the Fed, the White House, and on Capitol Hill -- the most important discovery I made is that the Fed is unable to interpret the numbers that have emerged from the banking system since the "tightening" program began in early February. I had serious discussions with both Greenspan and Governor Larry Lindsey, who are open to our interpretations of why their strategy has misfired, but who still do not see our analysis confirmed by the data the Fed staff is using to counter our argument. Without a clear understanding of the market's behavior, the anchor that Greenspan has provided to the world financial markets these last several years has been pulling loose. The most dangerous result is that negative forces have pushed their way into this intellectual vacuum. The Clinton Administration has now fallen into the grasp of its Keynesian devaluationists. 

The argument has taken hold that the weak dollar is the result of the U.S. trade deficit, and that an even weaker dollar will cure the deficit! This is the ancient argument that persuaded President Nixon to blow up the Bretton Woods system in 1971, enabling him to devalue the currency by 13%. New York Times financial reporter Keith Bradsher this morning cites the argument floating throughout Wall Street that a currency devaluation will not necessarily be inflationary. That is, if only 5% of U.S. GNP is engaged in world trade, and the currency devalues by 10%, the inflation will be only 0.5%, because that is 10% of 5%. This insane idea would have us believe that when a currency loses 10% of its value, it will still buy 99.5% of what it had bought previous to the devaluation. In fact, the dollar has devalued against gold by more than 10%, and unless it soon appreciates against gold by that amount, the general price level will eventually rise by the same amount, as contracts made prior to the devaluation unwind. The financial markets don't wait around to mark down the value of dollar assets, however. This 10% decline in the value of all dollar financial assets -- public and private -- is a colossal number, at least several hundred billion dollars! Unless the Greenspan Fed can get the gold price back to $350, the value of the $5 trillion U.S. national debt alone will have declined by $500 billion. This adds up to a lot of unhappy creditors.

At the White House yesterday, I met with a very senior official of the National Economic Council, explaining what is going on in the following way. It is the same example I used at the Fed. What is underway is the early stages of the kind of stagflation that was once known as the "British disease," associated with high taxes and easy money. Greenspan has backed into it because of procedural error. 

This is the analogy: Suppose the government wished to get people to use less gasoline for environmental reasons, and announced that the price will rise by 50 cents on July 1. Immediately, motorists tank up to beat the price. The gas stations think people are suddenly driving more, and call for quick shipments from the central supplier. The price rises by 50 cents before July 1. The government, which hoped to drive down the amount of driving, thinks it should have done more, and announces that it may have to raise the price by $1 on August 1. The cycle repeats itself, as motorists find ways to inventory gasoline. The central suppliers are baffled, trying to figure out why, after they have increased shipments, the gas stations are reporting their supplies on hand have actually dropped.

The Fed is in exactly this position. It has been raising the fed funds rate, in order to achieve a decline in the level of bank reserves. Yet it has been pumping liquidity into the system at a record pace -- $15 billion of high-powered money since February, more than a $40 billion annual rate. Yet it has achieved its objective of lower bank reserves, which are now lower than when the process began. The problem is that bank lending is up sharply, a problem the Fed staff explains away by arguing that this is because equity finance is down. In fact, it is because the value of collateral available to borrowers has been rising. It's a perfect match: Banks want to get rid of the reserves faster, because the cost of holding them has risen with the rising cost of funds. Individuals who own tangible assets -- oil reserves, farm land, commodity deposits -- find they are rising in price, which increases their borrowing capacity. This is where the crisis at Continental Bank and Penn Square came from a decade ago. They had lent funds to finance oil exploration and farm loans when the Carter Fed was devaluing the currency. They became insolvent when the Reagan Fed deflated, driving the dollar value up (relative to gold), which drove down the value of the underlying collateral and borrowers walked away from their debts. Bank borrowing is rising now not because "motorists are driving more," but as a result of adding to inventory in advance of price increases.

What should the Fed do? I bumped into Robert Hormats of Goldman Sachs at the Washington airport, and we discussed this matter. I said I thought the Fed had to abandon its attempt to target reserves via the fed funds rate, and had to directly target gold. The open market committee would then have clear instructions to sell government bonds into the open market, to drain liquidity from the system until the target gold price of $350 was reached, a price I assume Greenspan would be happier with. The process would reverse, as it would when motorists would see that the future price of gasoline would decline. The Fed, though, would soon see the data reflecting an increase in bank reserves. It should welcome that news. That is, borrowing for purely monetary reasons would decline. People would run down inventories, the way motorists would keep driving until their gas tanks approached empty. Gas stations would see their reserves climb and call the central supplier to hold back on new deliveries.

The idea of selling more bonds in order to increase their value is counter-intuitive, a point made by Governor Lindsey. Government bonds, though, are not like commodities or private bonds, but interest-bearing debt of the government, which, when sold, exchanges for non-interest bearing debt of the government. If the sale of a government bond removes inflationary, excess liquidity from the market, it protects the value of all other bonds in the market. 

Hormats made the point that it would be difficult, if not impossible, for Greenspan to say he was targeting gold, but that he might more easily arrange to target the Deutschemark, which would have the same effect; the DM has been steady against gold for three years. This is of course true, although the DM target would have to adjust to a $350 gold price, or dollar creditors would have to swallow the 10% devaluation that has already occurred. The bigger problem, I suggested to Hormats, was that I could not imagine the Fed publicly acknowledging that the Bundesbank was a better manager of the DM than the Fed is of the dollar. The sovereignty issue prevents that option. Gold is the only practical target.

Former Fed Governor Wayne Angell's idea of a sharp increase in the fed funds rate in the July FOMC meeting, to 5%, is a terrible idea. A fanatic doubles his speed when he loses sight of his goal. Angell wants the gold price down, as do we, but raising short rates again and again cannot achieve this goal, if it does not cause the Fed to drain liquidity from the banking system. It is almost as useless as the interventions to "support the dollar" on the foreign exchange markets, even as the Fed is pumping out liquidity via the open-market desk in New York. 

What is likely to happen? Unless there is a change in course, the markets will continue to crumble worldwide -- as global commerce in one way or another is hooked into the dollar. Greenspan himself cannot solve the problem, although the power to do so is theoretically in his hands. As Bob Hormats understands, Greenspan in a practical, political sense cannot elevate gold by himself. He has already been courageous in pushing it as hard as he has. He needs help, and it is not likely that he can find it in the White House, where the Kindergarten Keynesians dismiss gold as a Greenspan fetish. It is going to have to come from the Republicans, and it is not all that easy to find Republicans who even want to help Greenspan help the economy, even if they could grasp the essentials of this complex debate. 

The issue is obviously ripening. With Wall Street on the run and the mid-term elections approaching, the politicians at least are pondering the problem. The next week may turn up some potential for a change in course. We will be tuned in to the weekend talk shows, for clues to whether the change will be for the better, or not.