An 8% Long Bond: Greenspan’s Fault Jude Wanniski October 24, 1994

For six months, we have been spinning our "treadmill" hypothesis on why the bond market has been behaving the way it has since early February. Our financial clients have been able to follow our logic and, as far as I can tell, generally agree with us. The variables we are juggling, though, require a certain familiarity with the mechanics and language of Federal Reserve policy, and as a result we have been getting anguished questions from industrial clients about the complexity of our analysis and what it means. The 8% long bond may be forcing all of us to think harder about the future. With Henry Kaufman now predicting that the long bond will reach 9% or 10% a year from now, and Lew Lehrman seeing quickened inflation and $450 gold baked in the cake, it is a good time to restate our position with as much clarity as we can muster.

To begin with, though, we can state in the simplest, clearest terms that Federal Reserve Chairman Alan Greenspan, and his fellow governors, are to blame for the 8% long bond. If they had been doing their job as well as they might have, the long bond would now be at 5% -- an improvement on the 5.78% it was at a year ago when the Fed ran off the track. If I had been Fed chairman, I would also have made the mistake of raising the Fed funds rate to 3.25% from 3%, although I would have made the mistake in October '93, not February '94. The difference is that I would have observed the error and corrected for it, instead of compounding it as Greenspan has by raising rates again and again and again -- and inviting speculation that he will raise them again November 15, after Election Day. The financial press seems unanimous that he will.

The important point to be made, though, is not that Greenspan is to be blamed, but that he has it within his power to simultaneously lower long-term interest rates, increase the value of the dollar on the forex market, and lower the price of gold -- which are the three things he has told Congress he focuses upon in determining inflation expectations. Yes, the price of the U.S. 30-year-bond is influenced by economic growth, by trade flows, by the federal budget deficit, by the willingness of Chinese, Israelis, Cubans, Russians, etc., to hold dollars as a reserve asset, by what President Clinton and Lloyd Bentsen say about the dollar, and even by what Henry Kaufman says -- although in each case the influence may be greater or smaller. Take all these influences, and all the other influences you read about, hear about, and can imagine, and still Alan Greenspan has it in his power to overwhelm them with the raw power he possesses. The independent Fed, after all, has the power to create or destroy a virtually unlimited amount of dollar liquidity!!! 

What is dollar liquidity? It is that portion of the national debt -- about $450 billion, roughly 10% of the total -- that does not pay interest. It is currency and bank reserves -- held either as cash money, or lodged in bank ledgers. Greenspan has the muscle to clobber any combination of influences that attempt to mess with the value of the dollar! His power is so great, and the market knows it's great, that he only needs to lift an eyebrow and the money markets will tremble. Here is what I mean:

*Suppose the Chinese -- either private citizens or the central bank -- are holding $1 billion in U.S. currency and decide to dump it all into the forex market. The Fed can mop up the entire amount in a snap, by selling $1 billion of government bonds from its portfolio to the banks. 

*Suppose the Russians or Germans or Japanese (citizens or central banks) decide this week they would like to hold another $1 billion of U.S. currency, or $5 billion, or $10 billion, and they go into the forex market to acquire it. Alan Greenspan can, between sips of his coffee, write a check for the entire amount. The check will go into the electronic ledgers of the U.S. banks, in exchange for bonds they now hold. If they don't have the cash, and if that's what the Russians prefer, banks will write checks to buy the green stuff from those who do, ultimately the U.S. Mint.

*Suppose the U.S. budget deficit unexpectedly increases, by $10 billion, because President Clinton wants to send troops to Moldava. The Treasury issues the $10 billion in bonds in exchange for the cash or checking deposits, and pays for the expedition. The national debt goes from $4.5 trillion to $4.51 trillion. If the nation's creditors believe this $0.01 trillion will break the camel's back, and cause the U.S. to default on any portion of its debt, they will demand a higher risk premium. The long bond will rise a tick. If it isn't worried about default, the credit line will simply extend at the same interest rate. This is how we put World War II on the tab at 2% interest rates.

*Let's say the Japanese sell us $10 billion more in goods and services than they buy from us. They have a $10 billion trade surplus. They have to spend it on something, i.e., claims on future goods and services. They buy U.S. bonds (and stocks), and are willing to pay up, so long as they need not fear a default -- via a Fed devaluation of the dollar. If creditors believe the trade deficit will cause Alan Greenspan to do some silly thing, like raise interest rates, the report of the trade deficit will cause people to shift out of dollars into, perhaps, yen. When they shift out of dollars, Greenspan need only exchange some more bonds for the surplus dollars, and all is well.

Indeed, as the markets see Greenspan responding to any sign that he will devalue the currency, by instantly mopping up surplus liquidity (which he can do in between naps in his office), they will wish to hold more of these marvelous dollars. They will sell yen and pesos and rubles in order to hold dollars instead, and Greenspan will be able to take longer naps. 

Inasmuch as the dollar price of gold will constantly signal any excess or dearth of liquidity -- because markets have been using gold for that purpose for thousands of years -- Greenspan and his colleagues can all take permanent vacations by instructing the Fed's New York trading desk to throw away all the manuals that now guide them on "How Much Liquidity to Inject Before Halloween," etc., and buy or sell bonds according to the rise or fall of the gold price. (A gold standard.)

Why is it so hard for people to understand how simple it is? It is especially hard for economists to understand the process because they have all been taught in school that when you sell more of a commodity in the market, its price will fall. This is the law of supply and demand. Industrialists who sell commodities also have a hard time understanding the above. This is because, first, the dollar is not a commodity, but a concept -- a promise to pay a commodity. Second, the Fed does not really sell bonds to the banking system; it merely exchanges interest-bearing promises for non-interest-bearing promises. It does so in order to keep the government's creditors happy, for if they are, they will extend credit at low interest rates.

Why has Greenspan been making the mistake of raising short-term interest rates in order to achieve his objective, i.e., to take inflation expectations out of the market in order to sell long-term government bonds at lower interest rates? It is because when you are on a gold standard, raising interest rates is what you do when the market fears you will inflate, i.e., raise the gold price. Once the fear passes, you can lower the rate again.

What Greenspan has been doing is not working because we are not on a gold standard, which means the raising of short-term interest rates is not having the effect of assuring creditors that the gold price will not rise. It is simply increasing the cost of capital in the private sector -- thus slowing the economy and decreasing the demand for liquidity. 

The rest of the world watches dollar promises devaluing and wisely decides to unload dollars, which compounds Greenspan's problem. For every dollar thrown back at us, he must either sell a dollar bond to mop it up, which increases the cost of government debt service. Or he can raise interest rates again to offset the risk to a world wary of holding dollars. 

If I were Fed chairman, I'd persuade my colleagues to exchange bonds for dollars -- as the Fed did once this year, on September 28, and the value of all bonds will rise, as they did on September 28. Why isn't Greenspan doing this? Alas, probably because we at Polyconomics are alone in offering this advice. The rest of the world is encouraging him to raise interest rates again ASAP, even though that move, like all the others, will fail, moving us toward Henry Kaufman's 10% bond. All I can say is, just because we are all alone doesn't mean we can't be right.