Greenspan's Missed Opportunities Jude Wanniski July 24, 1997

Yes, it’s nice that Fed Chairman Alan Greenspan handled himself well enough in his House and Senate appearances Tuesday and Wednesday. He assured Wall Street that he’s not worried at the moment about an outbreak of price inflation or the implications of the continued rise of the stock market. His remarks were credited with the sharp rise in the DJIA and NASDAQ as well as the continued rally in bonds -- although we attribute part of that rise to the President’s conciliatory posture toward Congress on a budget deal. Mr. Clinton displayed that in the morning, and stocks were already flying prior to Greenspan’s testimony at 2 p.m. I’m afraid the budget negotiations are still fraught with danger, though, with the Republicans essentially broadcasting that they only  will  send the President a bill he approves in advance -- which puts Mr. Clinton at the mercy of the liberals who are trying to stamp out any tax cuts that “benefit the rich,” i.e., capital gains.

The problem I had with Greenspan, in his prepared remarks and in the House and Senate Q&A sessions, which I reviewed carefully, is that he really did nothing to move away from the idea of a Phillips Curve inflation/unemployment tradeoff. From first to last, Greenspan’s observations were essentially removed from the classical idea that inflation is a monetary phenomenon. He is firmly in a Keynesian model, in which an increase in aggregate demand causes “inflation,” which has him on the lookout for “strains” in each of the markets, for signs of demand outrunning supply. What distinguishes him from the garden variety Keynesian in his approach to monetary policy is his sincerity in seeing a “strain” in the gold market as the earliest indication of an incipient inflation. He has made this clear again and again, but not one member of either committee chose to exploit that tender spot in his analytical framework -- although we tried our best to find one. On capital gains, no Republican had the wit to ask him if a cut in the capital gains tax was an exception to his general assertion that deficit reductions should precede tax cuts, to which he would have answered “yes,” as he tried to do elliptically, without having the question posed. 

The net practical effect of this failure is to leave the markets just where they have been, forced to  interpret any sign of economic growth as a potential sign of an “inflationary strain.” Greenspan was especially disappointing in noting that the fed funds rate of “around 5½%” would have to be “changed” to fit any new information that suggests early strains in the markets, particularly the labor market. Rep. Frank Lucas [R-OK] was the only member to ask about the $320 gold price, but then withdrew the question by saying Greenspan had already answered his question by referring to how strains in commodity markets in general are inflation signals. This, of course, is not true. The gold price is special, which Greenspan has argued in previous appearances before Congress. His response to Lucas was weaker:

[Commodity prices] become early signals of the process when you begin to see shortages begin to emerge, and you begin to see people starting to trade on those shortages which, if fueled by excess credit, engenders inflation. And the extraordinary decline in the gold price -- which incidentally probably is only in small part, the result of sales by central banks -- what we are seeing now is the obverse, namely increasing sense of the purchasing power of money, of currency, of what for want of a better term, is fiat money. And the implications of that is that inflation expectations generally are falling. In the various surveys which have shown very exceptional increases in consumer confidence in the last year or two, we’re now beginning also to see a fairly marked decline in long-term inflation expectations in those surveys.

This loose formulation leaves Greenspan with the freedom to raise interest rates to fight inflation no matter what the price of gold. In other words, even with gold at $320, he might conclude that strains in any other market may be reason to suppose that the low gold price is an aberration. In fact, when the first news hit the markets of Greenspan’s prepared testimony, the headline focused on the one line about having to “change” the funds rate at some point. The long bond lost a half point in minutes, quickly rebounding and leading the stock market up all afternoon. In answer to questions about how low the long bond could get, Greenspan correctly argued that the markets will not reward the government with the kind of rates we had 30 years ago until they are sure inflation has been stamped out for good. To him, this means not adding excess “credit” when strains appear somewhere in the pricing markets. This mindset, though, is the built-in premium in interest rates. That is, if we have to hedge against the possibility that if Greenspan will ignore the gold signal on the way down -- raising interest rates to keep the labor market fluid -- real economic weakness will occur. He will then have to lower rates and watch gold shoot up by 15 or 20%. 

The essential flaw in his model is that a rise in the measured general price level is not “inflationary” as long as the dollar price of gold remains fixed. If war suddenly breaks out, for example, and the government buys $500 billion of stuff necessary to feed, clothe and arm the military, there will be price strains throughout the economy as demand outruns supply. This is not a monetary inflation, because the private sector will correct the prices by adding supply sufficient to prevent runaway inflation, and when the war ends and the buying halts, excess capacity will cause prices of that stuff to fall until it equilibrates again with gold. In 1917, we entered the war in Europe so quickly that price strains developed rapidly, the government buying with both fists. In 1941, the strains never developed to a point where prices rocketed up as they did in 1917-18, because we were still in the Depression and farmers were being paid not to plant. There was no shock to the system when Uncle Sam saw the war coming and began to buy early.

In his 10 years as Fed chairman, Greenspan has been as successful as he has been because he attributes significant power to gold as a signal of inflation expectations. That’s why he has been able to keep its price wobbling within shouting distance of $350. But he has never shown much interest in money’s function as a unit of account, which would lead him to argue before these committees that optimum policy would be to formally fix the dollar to gold at $350. Liberal Democrats such as Rep. Joe Kennedy, Rep. Barney Frank and Sen. Paul Sarbanes had an open shot at asking Greenspan why, by his personal golden rule, he was not calling for monetary ease now that gold has fallen by more than 15% since November. Sen. Connie Mack [R-FL] began to ask, but like Rep. Lucas a day earlier, let him off the hook. 

As we contemplate the week and the opportunities it presented, we can feel only frustration. Treasury Secretary Bob Rubin began the week by saying a capital gains tax cut would have negative effects on economic growth. Greenspan, who believes the exact opposite, was not asked about his position by the inept GOP committee members. The chance both Republicans and Democrats had to nail Greenspan down to a monetary price rule came and went, and the markets still are informed that too many people going to work will be inflationary. Greenspan no doubt feels wonderful, with Republicans using their time to celebrate him as the greatest Fed chairman in the history of the world. From where I sat, the great man has retreated, to rest on his laurels.