Memo To: House Budget Committee Members
From: Jude Wanniski
Re: Re-Financing the National Debt
With great interest I watched your hearings this morning as you elicited important testimony from Federal Reserve Chairman Alan Greenspan, primary focusing on the deficits that are growing because of Medicare, Medicaid and the Social Security costs that will balloon with the retirement of the baby boomers. The one point I wish to bring to your attention in this memo is that none of you asked him WHY he is raising interest rates when is simultaneously warning that higher interest rates will cause the national debt to climb at ever faster rates. Some of you came close to touching on the inconsistency inherent in current Fed policy to push short-term rates higher and higher with the aim of having long-term rates follow – when long-term rates even by Greenspan’s own testimony always indicate higher levels of inflation.
You are used to dealing in fiscal matters on the Budget Committee, and few of you raised monetary policy as being anywhere connected to the issues under discussion, but I was happy to see Rep. Ander Crenshaw [R FL] raise the issue with Greenspan. He wonders why short rates have been going up and long-term rates have not, i.e., the yield curve has been flattening.
CRENSHAW: I read somewhere that you described that as a conundrum. Conventional wisdom would say that if long rates don't go up when short rates go up that there's some sort of indication of slowing of an economy. On the other hand, people could argue that inflation's under control and the economy is healthy. And I just -- I'd like you to comment on that. I mean, what's your view as the yield curve narrows? I guess it was back at the end of 2001 when it actually inverted and that, kind of, foretold some problems in the economy. But maybe expand on what do you mean when you say it's a conundrum. Is it a short-term aberration or are you concerned at all? Could you talk a little bit about that?
GREENSPAN: Yes, Congressman. The history of most of the programs of raising short-term rates by the Federal Reserve have in the early stages been matched by rising long-term rates... And so the normal expectation is that when you move, you will move the long-term rate if for no other reason than you're moving the average in the very beginning. Toward the end of a tightening period, when it becomes clear that the impact is to restrain inflation -- this is historically – you will find that increasing short-term rates does move long-term rates down. And that's largely because the inflation premium embodied in long-term rates by going down will bring the yield down.
What we've had in the most recent episode, as you point out, is we moved up and long-term rates when down far sooner than is typically the case. And we examined the possibility, one being the point that you make, namely this may be an indication that the economy is about to soften. But if that were the case, we wouldn't be finding a number of other indicators, such as stock prices, going up. And we essentially put that aside as an explanation because it was very evident, as I indicated earlier in my testimony, that this economy is not in the process of moving into a significant slowdown. The result of that is we began to look in different areas as to the potential cause, and none of them was without a qualification, which is the reason I said it is, indeed, a conundrum. Now, I must say, since then, long-term rates have moved up and it's less of a conundrum in that respect. But it is an unusual change in the way markets behave.
Please note that Greenspan does not address the point made by Crenshaw that “people could argue that inflation's under control and the economy is healthy.” If those people are right, and I believe they are and have been making that argument for the last year, then Fed policy is adding to the difficulties you and the administration face in getting the budget under control. I hasten to add that I thought most of Greenspan’s testimony was brilliant, and I did more applauding than not, but on this point I believe he is wrong and that you should press him on it next time you have the chance.
For example, Rep. Jeb Bradley [R NH], you did at least raise the interest-rate issue, which is when we see Greenspan worried about rising long rates:
GREENSPAN: Since I believe that the range of probabilities are such that we can have exceptionally large Medicare bills, then we must assure ourselves that we are sufficiently prudent to enact laws which essentially do not get us into a position where we can do very grave damage to the economy. Because if we do and we effectively create very large unified budget deficits, and we are unable to bring them in in a reasonable period of time, we will find that we will very significantly destabilize the system because, as I mentioned earlier, interest rates would rise as a consequence and we would have very grave difficulties in restoring balance to the American economy.
Finally, I greatly appreciated the question posed by Rep. Jo Bonner [R AL] near the end of the session. It led Greenspan into the inconsistency trap I suggested earlier:
JO BONNER [R AL] [H]ere in Congress interest rates are important, obviously, because they are particularly used to determine the budget that we set aside for debt service. And in a few days, we will be called upon to produce that budget. That being the case, I certainly would be interested in knowing where you could foresee interest rates heading in the next five years. That could be useful information as we go about our work in the next few days.
GREENSPAN: Congressman, if you could tell me where the inflation rate is going to be in five years, I will tell you where interest rates will be within a fairly narrow range. And so I think it is appropriate to rethink the question of where interest rates will be largely in the consequence of the inflation implications of budget deficits and the extent to which they, because they are perceived that way, impact interest rates in advance. Because what we have found is that the history of interest rates has largely been a history of inflation: when it's high, interest rates are high; when it's low, interest rates are low.
I hope you see my point. If Greenspan believes as strongly as he says he does that higher interest rates are a reflection of higher inflationary expectations, and that inflation will surely follow, you must wonder why he wishes to push long-term rates higher. He even seemed pleased in being able to tell Rep. Crenshaw that because long-term rates have risen in recent weeks and there is “less of a conundrum.”
The fact is, ladies and gentlemen of the Budget Committee, since the Fed began raising short-term rates last June 30, the price of gold has risen to $435 per oz from $390 oz, which almost all your constituents will tell you is a sure sign of more inflation ahead. And the U.S. dollar has fallen in value against the Euro and the Japanese yen, another sign of future inflation. The Fed is going in the wrong direction, creating inflation where it did not exist, and now finally seeing “less of a conundrum” as the rising gold price pushes up long-term interest rates.
I’m not making this argument ex-poste, and as evidence you can read the memo on the margin of June 29, 2004, “Message to Fed: Don’t Raise Rates!” which includes a Washington Times op-ed I co-authored with Jamie Galbraith of the University of Texas, he being a liberal Democrat, the son of John Kenneth Galbraith, I being a supply-side Reagan Republican. I’ll have my staff send this to each of you and will personally take the trouble to send it to you, Chairman Jim Nussle [ R IA] and to you ranking Democrat Rep. John Spratt [D SC].