Orange County, Greenspan’s Fault Jude Wanniski December 12, 1994

Why Alan Greenspan? The Fed chairman wasn't even seen in the vicinity of the Orange County pension fiasco. Sure, the bankrupt fund would have reported dazzling profits if the bond market had remained healthy during the last year. But isn't blaming Greenspan somewhat like blaming "society" for the criminal behavior of teenage crack dealers? It was Orange County Treasurer Robert Citron who was peddling the dope, so to speak, but he was not operating in the healthiest of environments. In a roundup of the usual suspects, we might as well blame outgoing Senate Majority Leader George Mitchell for Orange County; if he hadn't blocked a vote on a capital gains tax cut in 1989, the U.S. wouldn't have gone into recession. California, hit hardest by the downturn, would have flourished and Orange County, the richest California county, would have overflowed with revenues. Its investment fund would now be gushing forth a surplus. We might as well blame California Gov. Pete Wilson for raising taxes into the teeth of the recession. We might as well blame President Bush for raising taxes when he couldn't get his capgains cut, or fault President Clinton for raising taxes just as the battered economy was climbing out of recession. 

Why, then, focus on Greenspan? If we want to blame monetary policy, you might say we should really reach back to Orange County's most favorite son, Yorba Linda's Richard Nixon. It was, after all, the late President who took the United States off the gold standard in 1971. It was this temporary decision, which was made permanent in 1973 with an official "floating" of the dollar, that has caused almost all the carnage in the capital markets in the intervening years. 

As we have argued many times before, the S&L crisis, which has cost the American taxpayers several hundred billion dollars, would not have occurred if the dollar had remained as good as gold. The thrifts could thrive only as long as it was possible to borrow short and lend long, which they could do only as long as the government maintained the dollar unit of account as a guaranteed weight of gold. The thrifts were financial intermediaries, essentially borrowing houses short and lending them long, using a dollar unit of account legally defined as one-thirty-fifth of an ounce of gold. When Nixon "floated" the dollar's definition, a family that had borrowed a house at that rate, only had to pay back half a house, or a third of a house, or, with gold at $350 per ounce, a tenth of a house. The poor, beleaguered thrift managers, used to making even-money bets that had worked like a charm, found themselves trying to stay solvent in this racy environment by betting on long shots. This is all Mr. Citron was doing in Orange County, borrowing short and lending long, trying to keep the government agencies that relied on his bets ahead of the promises they had made in their pension funds. 

The Orange County agencies, which now face aggregate losses of $2.5 billion, are suing the Wall Street firms that sold Mr. Citron the financial instruments that enabled him to play this game -- which is like a wife suing the clerk at the pari-mutual window for selling her husband a ticket on Glue Factory, at 100-to-1. It makes as much sense for these agencies to sue their sister city, Yorba Linda, for having begat Richard M. Nixon, the real source of their difficulty. Since Mr. Nixon himself is now beyond their reach, the only individual they can blame on the monetary front is the chairman of the Federal Reserve. Indeed, Mr. Greenspan looked like a good bet a year ago, when Mr. Citron was still a hero for having bet on Greenspan in the previous four years. We had done the same, advising our clients that we had observed him steadily regaining the confidence of the capital markets by stabilizing the dollar price of gold at $350. The bond market had weakened a bit, as gold had drifted up to $385 between late September and mid-December, but on the conviction that Greenspan would soon assert himself, we thought bonds would resume their rally and by the end of '94 be closer to 5% than 6%. 

We were correct in our bet that Greenspan would soon assert himself, which he did a month later, on February 4. Our mistake was in believing that a rise in the federal funds rate would cause a "tightening" of dollar liquidity, which would cause the gold price to retreat as dollars became scarce relative to gold. We were as surprised as Greenspan when this did not happen. We soon realized that the raising of interest rates was not causing a tightening of dollar liquidity, because the markets, in anticipating even higher interest rates, were bidding them up. The Fed was caught on a perverse treadmill, forced to add rather than subtract liquidity, and we immediately withdrew our support for any further increase in the fed funds rate. Alas for Orange County, Treasurer Citron joined Chairman Greenspan in believing that the next rate hike would be the last. Instead of inverting his "inverse floaters," Citron took in more funds and doubled up. 

For his part, Mr. Greenspan did exactly the same thing. Instead of retreating from the treadmill that was getting him nowhere fast, again and again he decided to run just a bit faster, goaded by the Bears who are making fabled fortunes by greasing his interest-rate treadmill. Former Fed Gov. Wayne Angell, the lead bear at Bear Stearns, is imploring Greenspan to do it again, next week, when the Federal Open Market Committee meets on December 20. We, of course, hope this does not happen, and we may have Sen. Paul Sarbanes [D-MD] to thank if it does not. Sarbanes last week confronted Greenspan in his appearance before the Joint Economic Committee and asked him if, on December 20, he would be "The Grinch Who Stole Christmas." We've wondered since if Greenspan has noticed, while shaving every morning, how much he resembles the Grinch when he is frowning. This morning, we read in The New York Times that the Fed may put off a rate increase on December 20. The Sarbanes "Grinch" quote is cited. We also note with cheer the last paragraph of the Times story by Keith Bradsher, who may have gotten it straight from the Grinch's mouth, citing Greenspan's belief that a capital gains tax cut would pay for itself!! Now, that would be a Christmas present.

Will the Fed raise interest rates in January? My hope is that Greenspan realizes that Orange County may be just the tip of the iceberg, and that as he raises interest rates from here, all he accomplishes is uncovering more of the iceberg of unfunded pension fund liabilities, public and private. Raising the price of credit in order to slow the economy in order to halt a rise in prices is a ridiculous notion that I've heard Greenspan himself ridicule. If Greenspan knows anything from a lifetime spent studying the economy from the trenches, he knows there are good and bad reasons why prices rise. Price rises are good when prices are too low to provide a positive return on investment. Price rises are bad when they merely reflect expectations of a monetary inflation. In the former case, a price rise calls forth more capital investment, and employs more labor at higher real wages. In the latter, prices rise in order to beat a rise in the general price level, and there is no increase in capital investment and only a brief increase in labor, as workers are hired to transfer inventories from one place to another.

A few days ago, Greenspan asked a mutual friend his opinion on how much of the price pressures seen today are the good kind and how much the bad kind, and the friend answered "fifty-fifty." My own guess is that the mix is more "ninety-ten," with the bad "ten" the inflation expectations reflected by a gold price of $375 instead of $350. Greenspan could squeeze that bad "ten percent" out of the system by selling bonds from the Fed's portfolio. Instead, by raising interest rates, the Fed puts the squeeze on the good "ninety." In other words, the price of gold has been hovering around $350 for the last eight years, while prices of other commodities have sunk to much lower levels during the extended recession. The general price indices in these last several years reflected these depressed commodity prices -- including petroleum, lead, zinc, copper, pulp, paper, etc. Healthy economic expansion requires that these prices recover to levels that invite new capital. As expansion occurs and prices increase, the Fed's response of raising the cost of credit to slow the economy down to prevent prices from rising thwarts economic regeneration. Put another way, Greenspan is keeping the price of pulp from rising by keeping new businesses from starting, which would mean more advertising, which would mean fatter newspapers and magazines, which would mean increased demands on the pulp industry -- which can't add to capacity at the current depressed prices!

All this foolishness ends when we once again target gold, which permits good price increases and prevents the bad. Greenspan can do this by himself, but we bet on him last year, as did the Orange County Treasurer, and will not do so again. The Republican Congress has to force him to do it and sooner or later it will, before we have to confront much more of the iceberg.