Q&A on Lesson 8 - Growth, Money and Interest Rates Jude Wanniski March 31, 2000

Benefits of a Fluctuating Dollar
What the Fed Controls
Could Greenspan Go on Gold?
Other Interpretations of the "inverted yield curve"
Deflation’s Beneficiaries
Technological Improvements and Liquidity
1987 Crash
Money & Other Debt
Gold Sales & Currencies
Judging a Favorable Interest Rate
Optimal Marginal Tax Rate
Barriers to a Stable Currency


Benefits of a Fluctuating Dollar back to top

Q1: Lawrence Lau. You made the comment that "borrowers, who at the margin had all the capital they need, would ignore [new offers] of capital." However, isn't this assumption of perfect fore-knowledge (knowing precise capital requirements) impossible in practice? Financial engineering is still a bit of an evolving discipline and much of global growth is in developing countries with less than transparent allocation/accounting/banking processes. In short, doesn't a fluctuating dollar support a richer variety of businesses with different range of appetite for risks (compare the ocean tidal zone with greater biodiversity) instead of a monoculture dominated by the biggest firms?

A: Good question. My comment -- really a statement of theory -- was only meant to apply at the margin of an economic system. Individuals in the marketplace make errors in one direction or the other all the time, either asking for more capital than they need, or not enough. But in the broad market, these errors net to zero, and a surplus of capital will be unwanted and untouched at the price offered. It will simply not form. A fluctuating dollar increased the amount of unwanted and untouched capital, because the price at which fresh capital is offered will have to be higher to compensate for the higher risk. The rich variety of businesses with a different range of risk appetite do not need a variable unit of account to satisfy that risk. They can attract debt or equity at different prices and rates of interest. If you know you can make 100% on your investment in 24 hours, you will be willing to pay a 99% rate of interest. If you have a good story to tell the equity market, it will give you capital at a good price. If you can tell an even better story, you can get the capital at an even better price. Changing the dollar’s value in terms of gold, which serves as the best proxy for all commodities, serves no purpose. Of course, if you are in a small economy with a few products that earn your national living by trading with a large economy, you must accept the currency value of the large economy, or your few producers will get wiped out in the swings of demand and inventories in the large economy. If the large economy chooses a fixed dollar/gold rate, you will happily fix to it, because it eliminates monetary risk to your few products -- oil, bananas, cocoa, coffee, etc.


What the Fed Controls back to top

Q2: Thomas Mulligan. It seems to me that the Fed not only controls the rate of liquidity by buying/selling bonds (supply of money), but that it also controls the rate of interest (price of credit). Isn't this true? If so, by what mechanism does it control the price of credit and how does this work?

A: First, the Fed at the moment is attempting to manage the economy’s rate of growth by increasing or decreasing the only market rate of interest it controls, the overnight "fed funds" rate. Remember, if you can only buy bonds or sell bonds, you can only hit one target. When the Fed decides the funds rate should go to 6% from 5.75%, as it did a week ago, its technicians use a formula to determine its additions or subtractions of liquidity. Because the demand for liquidity may change as a result of the higher rate, the technicians may have to alter the mix every day, adding or subtracting liquidity by buying or selling bonds. The Fed has no direct control over the "price of credit." The market determines the price of credit as it assesses capital being offered and capital being asked, against the backdrop of the floating dollar. At the moment, the market is thwarting the Fed’s best laid plans by lowering the price of credit in longer range maturities of debt. The yield on overnight money has gone to 6%, but the yield on 30-year money is trading at a slightly lower rate. This is an "inverted yield curve," which is the market’s way of trying to tell the Fed that it is making an error in raising the funds rate.


Could Greenspan Go on Gold? 

Q3: (Mulligan) Separate from a presidential executive order, could the Fed Chairman voluntarily tie the dollar to the price of gold? If he did, wouldn't this in effect make gold the "unit of measure"? Would the other currencies, already tied to the dollar, be forced to be in effect tied to a gold standard along with the dollar? Why doesn't Mr. Greenspan, who seems to advocate going to a gold standard, do this?

A: If the 12 voting members of the Federal Open Market Committee at its next meeting decided to target the gold price instead of the fed funds rate, it could vote to do so. It would buy and sell bonds to prevent the gold price from going up or down, from its target price. The Fed is a quasi-independent central bank; Congress could pass a law instructing the Fed to NOT target gold. Current law -- the Humphrey-Hawkins Act -- only instructs the Fed to pay attention to "the money supply," but in recent years it has been discredited, and Greenspan practically says so in his twice-a-year reports in compliance with the Act. Because Greenspan is the only Fed member who takes gold seriously, there is no chance the FOMC would target gold. It would have to be instructed to do so by executive order and a following statute. Other currencies around the world would almost certainly manage their monetary policies to maintain their values relative to the dollar/gold rate.


Other Interpretations of the "inverted yield curve" 

Q4: (Mulligan). You contend that the "inverted yield curve" is the market's way of telling the central bank that the economy wants to grow faster without inflation. What do monetarists and Keynesians and Mr. Greenspan believe the "inverted yield curve" is telling them, if anything? Where are they going wrong in identifying the meaning behind it? Also, with all the historic evidence that it IS possible to have robust growth without inflation and with low interest rates, how can so many economists believe otherwise?

A: Greenspan has not been asked about the inverted yield curve. Monetarists haven’t taken a position on it either, as far as I know. Keynesians have been saying the budget surplus is causing a shortage in 30-year bonds, a pretty lame reason given the fact that the last time the yield curve inverted the budget was in deficit and the markets awash with long maturities. Seeing no inflation ahead, the market is locking in longer yields because there is more aggregate capital gain in a 30-year instrument than a 5- or 10-year.


Deflation’s Beneficiaries 

Q5: Dave Crater. You mention that it is rarely in the best interest of the government to deflate because of the tendency of deflation to drive debtors to default, and thereby hurt everyone, including creditors. An additional relevant fact, it seems to me, is that the government is itself the world's biggest debtor. To say it's not in the best interest of the government to deflate is therefore an understatement of gigantic proportion.

A: In that narrow sense, you are quite right. There are, though, several other things that happen when money deflates. One is that the progressive income tax system and the taxing of capital gains becomes less oppressive. Instead of producers being pushed into higher brackets because of inflation "bracket creep," they find the value of their wages increasing even without wage increases. It is kind of a tax cut that has helped much of the economy to grow, although it did outright damage to farmers and other commodity producers whose incomes went down while their debts became heavier in real terms.


Technological Improvements and Liquidity 

Q6: (Crater). What happens when demand for credit/money rises due to new technologies and an expanding economy, but the Fed does not maintain an honest accounting unit and a deflationary situation results?

A: Improvements in technology do not in and of themselves create an increased demand for liquidity, whether the unit of account is fixed in terms of gold or floating without definition. The amount of capital offered to support innovation will increase. If the market demands fresh liquidity in a fiat (floating) system, the Fed will automatically supply it and there will be no deflation.


1987 Crash 

Q7: (Crater). I have wondered from looking at the dramatic market drop of 1987 whether or not it was caused by these same deflationary pressures.

A: Not quite. The dollar price of gold declined in the Reagan years as tax rates were reduced, increasing demand for liquidity, which the Fed failed to supply. Gold’s 1980 average of $625 or so dropped below $300 in early 1985 and slowly recovered to a $350 level by 1987. The 1987 Crash reflected the fact that Greenspan, appointed in July of that year, told the markets in a Fortune interview that the dollar was too strong and would have to be devalued. Simultaneously, Treasury Secretary James Baker III ruptured the Louvre Accord of early 1987, whereby the major currencies agreed to coordinate monetary policies in order to stabilize exchange rates. The sudden shift to an easy money posture by the U.S. government had an instantaneous impact on the capital gains tax structure, which had not been protected against inflation when it went to 28% from 20% in 1986.


Money & Other Debt 

Q8: Dan Kucerovsky. Money can certainly be issued -- and be debt of -- entities other than the government: Consider a dry-cleaning receipt for example. Where do we draw the line? Are stocks money? An IOU scribbled on a piece of paper?

A: You can’t draw the line as long as private transactors are willing to draw up contracts in your currency, in our case the dollar. If you promise to sell me your million-dollar dog as long as you also promise to buy my two $500,000 cats in six months, we can draw up a contract in dollars. We choose the dollar because we have confidence in it as the unit of account most likely to hold its value over six months. If the government were to guarantee the dollar in terms of gold, gold would be the proxy for dogs and cats and all other real commodities.


Gold Sales & Currencies 

Q9: (Kucerovsky). How does gold interact with fiat money? In particular, why does one observe that countries which sell gold usually have their currency decline shortly thereafter?

A: I don’t think there is a good correlation between countries that sell gold and the direction of their currencies relative to those who don’t. When gold was at $385 in 1996, the Bank of Amsterdam sold gold and did so very wisely. Its currency did not decline. On the other hand, Jimmy Carter sold gold during his inflationary administration and the currency declined. There still was no correlation. The chief reason for the collapse was the success of the monetarists in persuading the Carter Treasury department in shifting to a money-supply target instead of an interest-rate target. Fed Chairman Paul Volcker obliged in the fall of 1979 by adding liquidity at a frantic pace. Gold climbed from $240 early in that year to as high as $850 on February 1, 1980. Surplus liquidity is always first reflected in a rise in the price of gold, because gold is the most monetary of all commodities. If there are too many dollars, each will lose nominal value in purchasing power (inflation), so the market first bids up gold, which will not lose value relative to other goods, and gradually all goods will reflect the change in the dollar.


Judging a Favorable Interest Rate 

Q10: Scott Robinson. If an interest rate represents the market clearing price between the desires of lenders to supply credit and the desires of borrowers to use it, what signals do the actors use to know if the price (interest rate) is favorable? Is 4% a "low" or "high" price? Can we use the price of gold (the numeraire) to evaluate this in some way?

A: In 1979, when the price of gold was beginning its rise in the above-described monetarist experiment, I was in the process of house-hunting. My friends and family thought I was crazy when I bought a house in Morristown on 2 ½ acres with an elegant swimming pool. I paid $185,000 for it -- and would have to pay at least $750,000 for it today. My supply-side sense told me I had to act quickly and acquire one of the last 6% mortgages in New Jersey. With my better grasp of economics than the other actors in the market, I more or less "stole" the property. If the unit of account is fixed, this can’t happen. The buyer and seller must assess the price and mortgage rate according to other elements they observe in the surrounding marketplace -- elements having nothing to do with the unit of account.


Optimal Marginal Tax Rate 

Q11: Bob Farmer. What, in your opinion, in today’s economy, is the optimal marginal tax rate to maximize government revenues and maximize economic activity and growth? What is the optimal and/or maximum sustainable growth rate for the U.S. economy without inflation if we were on the gold standard as you appear to recommend. Can Greenspan put us on a de facto gold standard by secretly targeting the price of gold and has he not, in fact, been doing this?

A: Off the top of my head, I would guess a 20% top marginal rate at an income of $100,000, a bottom rate of 10% at $35,000, and a zero capital gains tax would be optimal. The growth rate for the U.S. economy could be as high as 6-to-10% a year for a few years, until the flaws in the tax structure were winnowed out. When the most efficient economy in the world is producing at its limits, growth would not be more than 2% or so, which would reflect technological advances.


Barriers to a Stable Currency 

Q12: Jeff Temple. You offer compelling reasoning, and the data seem to support it. But why has the government not acted to stabilize the dollar as a unit of account, and unleash more benefits on the world economy? What are the barriers? Is it because: a) This line of reasoning has not "won" in the marketplace of ideas, and people reject it for the Keynesian model? b) The political incentives for maintaining the status quo are greater than the political incentives for creating a more prosperous world? c) None of the above?

A: The political forces favoring a currency that can be manipulated are those in the Political Establishment. If the Political Establishment suddenly decided it was better to anchor the dollar to gold, the economists who serve the PE would instantly come up with reasons on why the time is right!!! The people who benefit most from gold reside in the bottom half of the political pyramid, ordinary folk who have no way to influence monetary policy. The Fed as an institution is pure Establishment, which is why even gold advocates like Greenspan become co-opted when they come aboard. The Wall Street Journal editorial page puts in an occasional word for gold, but almost under its breath, because it has become more Establishmentarian with each passing day. The only way to get back to gold would be through a global economic convulsion that would scare the pants off the Establishment. Or, someone who could win the presidency by rallying the ordinary folk to get behind a gold mandate. The only possibility there is Pat Buchanan, who supports gold only in theory and in private, which is no way to get a mandate. Yet another possibility is that China fixes its currency, the yuan, to gold. That would force the rest of the world back to gold, or China would have a monetary advantage which would cause its economy to grow at double digits until it passed ours.

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Good questions, class. Please follow up if you wish... We will have at least one more Q&A this semester. And you can also open a string on TalkShop with specific requests.