At Last, Greenspan Jude Wanniski September 24, 1998

The most important point about Fed Chairman Alan Greenspan’s testimony yesterday before the Senate Budget Committee, which sent the Dow Jones Industrials up 257 points, is that he asked Chairman Pete Domenici for the opportunity to come before his committee. Domenici a while ago had given Greenspan an open invitation, and Greenspan chose this time on short notice to alert the world that there would be monetary ease at the Federal Open Market Committee next week. Check the newspapers and you will find that as this week opened, conventional wisdom was beginning to opine that there would be no rate cut next week, but perhaps there would be one in November when the FOMC next meets. The first straw in the wind coming from the other direction was in a Bloomberg news item at 9:54 a.m. Tuesday from London, where New York Fed President William McDonough spoke to reporters at a conference on credit risk. The item read: “‘Slowing growth now poses more of a danger to the U.S. economy than inflation...’ McDonough said, suggesting he has become more open in recent days to the idea of a cut in U.S. interest rates.” Only a week earlier, he had been on the wires talking about the strong U.S. economy. Now, he noted the spread between emerging market debt and lower-grade corporate debt on the one hand, and U.S. Treasury securities on the other, has “widened to levels we haven’t seen before.” International capital markets have become “noticeably less liquid,” he said, adding that the FOMC should consider this development when it meets.

Why the sudden shift? We learn this morning that McDonough had been spooked by the illiquidity at Long-Term Capital Management L.P., which the WSJournal reports on page one is a “highflying hedge fund that was on the verge of collapse.” With assets of $80 billion but running out of cash as its highly-leveraged balance sheet has been hammered by the global equity selloff, the fund was at the point of admitting it could not pay its creditors, some of the biggest trading houses and banks on Wall Street. As the Journal reported, McDonough flew back to New York from London Tuesday night for an emergency meeting last night at the New York Fed with some of the biggest players in the financial market. An agreement among the trading firms and banks to lend the fund $3.5 billion to make ends meet appears to have some implicit guaranty by the Fed itself. In any case, this seems to be the kind of crisis we’ve needed to get Greenspan in motion to confront the monetary deflation he has permitted these past 20 months. In 1982, it was the Mexican government that told its bank creditors in California, Texas and New York that it could not pay on its $90 billion in debts collateralized by collapsing oil prices.

In 1982, the monetarists who dominated the Reagan administration insisted that an easing of monetary policy would cause a collapse of the bond market, as their “M” aggregates were showing inflation was the problem. Fed Chairman Paul Volcker had to take the Mexico news to Treasury Secretary Donald Regan and tell him he had no choice but to monetize $3 billion in Mexican peso bonds or there would be blood all over. I’d been advising Volcker since February of 1982 that unless he monetized debt and got the gold price up, he could bankrupt the entire world. When he was forced to do so by Mexico, the gold price ran up from $320 to above $400 as this fresh dollar liquidity flowed through the global financial structure. Not only did stocks roar ahead, so did bonds, to the great embarrassment of the monetarists. Several months later, Treasury Undersecretary Beryl Sprinkel acknowledged that he had misjudged money velocity, which had declined in the gold deflation. Of course it had. Holding cash was producing a capital gain in untaxable purchasing power!

In his testimony yesterday, Greenspan again mentioned the widening spread between high-yield bonds and Treasuries as a reason for signaling a change in position. We still can’t be sure what’s really going on in his head and what he plans to do next Tuesday when the FOMC meets, but he has to begin thinking of the parallel with 1982 if the Fed is going to do more than a teenie quarter-point cut in the funds rate. Jack Kemp, who deserves a ton of credit for publicly criticizing Greenspan for having contributed to the Asian crisis by ignoring the gold signal, now is arguing correctly that the Fed should ignore the funds rate and simply add liquidity until gold rises to at least $325. As it is, David Gitlitz points out that the two-year Treasury is now pricing in a 100 basis point cut in the funds rate. As we have worried all along, we also have to worry that the funds rate mechanism will continue to starve the system of needed liquidity. It is today trading below 5.5% as a result of Greenspan’s testimony as the market now expects to be able to get funds cheaper next week. Because the open market desk in New York has the job of hitting the funds rate spot on, it may now find itself being required to drain liquidity to push the funds rate back to 5.5%, or at least not add as much as the system needs to end the deflation. The positive news this morning, though, is that while funds were trading weak, at 5.43%, the Fed added liquidity, and in minutes funds traded at 5.37%. Gold had already popped up by $3.

It would be nice if Volcker would step forward with the benefit of his experience, but as usual he only answers the questions put to him. Nobody ever asks him about the gold price so he talks in circles about “stability,” which is the word Greenspan used yesterday in circular fashion. I tried to get Domenici to ask him about what gold price would satisfy him, mentioning Kemp and Steve Forbes’s call for gold at $325. But no dice. Instead, we have the academic monetarists and Keynesians joining hands to insist the Fed should not cut rates because the economy is plenty strong. In the September 28 National Review, Milton Friedman says there is no deflation because money wages are still going up! The NYTimes today quotes Allen Meltzer, who in 1982 was predicting doom if Volcker eased, now saying there is no need to ease because the monetary aggregates are strong. Former Fed Gov. Alan Blinder of Princeton, a neo-Keynesian, says the Fed should not cut rates. None have the slightest understanding of gold’s utility as a signal of changes in demand for dollar liquidity. We really need an editorial from the WSJournal.

In addition to the crisis at Long-Term Capital, which is so nice because it is sufficiently scary, Greenspan’s insistence that he had nothing to do with the deflation or the crisis in Asia now has to contend with Wayne Angell’s reversal two weeks ago. Greenspan and Angell have been simpatico since Greenspan joined the Fed in 1987, Angell having arrived a year earlier. At Greenspan’s swearing-in ceremony, the outgoing Volcker told him that he wished he had paid more attention to Angell’s advice. For the last 20 months, since we first began thinking and writing about a possible deflation, Angell had insisted we were wrong, which was naturally a comfort to Greenspan’s own thinking that gold was no longer as important as it had been as a liquidity signal. For Angell to now reverse himself and acknowledge deflation is for that reason immensely important to the monetary plays ahead. Looking back to our January calls, I note my forecast that the DJIA would climb over 9000 but finish the year at 8800. That’s still possible. David Gitlitz on January 26 said it might take six to eight months for the Fed to realize it had to ease. At eight months, Greenspan got that call in right at the wire.