Executive Summary: Successful completion of the tax bill frees the Reagan White House to turn to the problems in the credit markets. Supply-siders have ended their truce with the monetarists, who have only months left with their experiment with a managed currency; Reagan's patience with high interest rates will not stretch into 1982. Monetarist tinkerings without a guide to the demand for money are bound to fail. Only a return to a gold/convertible dollar will spark a bond rally of major significance. The U.S. Gold Commission meeting of September 18 provides the platform necessary to generate public education and support; though monetarists want the Commission meetings closed to the public. Fed/Treasury policy sucks capital from abroad while choking domestic credit resources. Interest rates would plunge, worldwide, with a move to dollar convertibility, inviting a scramble into noncallable Treasury bonds. Issuance of another $2 billion in Sprinkel bonds is unconscionable, evidence of intellectual bankruptcy among monetarists.
In the eve of his numbing defeat on the tax bill, House Speaker Tip O'Neill allowed that President Reagan was a "supersalesman" and a master of strategy too: "He puts one ball in the air at a time, and he keeps at it. Jimmy Carter always had too many balls in the air." Three balls in the air by Reagan. Three home runs. First the budget resolution, then the reconciliation bill, then the tax cut. Next, O'Neill figured, the White House would concentrate its firepower on regulation.
No, Tip. Now comes money. With only five months left before the 1982 election year, the White House has no choice but to turn its attention and resources to the abysmal state of the credit markets. Vague hopes that the budget victories would buoy the bond market and bring a steady slide in interest rates have been dashed. There is growing apprehension among the political figures in the White House that the monetarists who now control Fed policy will not be able to "brake inflationary expectations" with high interest rates. The vision of GOP candidates for Senate and House having to defend 20 percent interest rates in 1982 is too awful to contemplate.
The supply-siders, though, are ready to do battle. While they could disagree over the order of battle on fiscal policy - the Stockman strategy of spending cuts first, tax cuts second -- supply-side strategists knew that the money ball could not be put into the air until the tax bill was in the bag. For one thing, the White House did not want a feud with the Fed during the push for a tax cut, and a non-aggression pact was arranged with Paul Volcker. For another, the monetarists in the Reagan administration have no theological opposition to supply-side tax cuts. The supply-siders knew it was important to coalesce with the Friedmanites to defeat the Keynesians on fiscal policy. The entire administration team and the Republican Party was thus solidly united behind the President on the fiscal reforms. A few conservative Keynesians like Arthur Burns, Herbert Stein and Rudy Penner continued to grumble about the tax cuts from the sidelines, but they were always out of the play.
On money, a new alliance is needed. The aim of the supply-siders is nothing less than a commitment from the Reagan administration -- and the Federal Reserve -- to a path leading toward dollar convertibility. Supply-side resources are now freed to shift to currency reform, the restoration of a gold standard. The objective is to win this commitment by the end of 1981, although the process of negotiating and designing a modern international gold standard would no doubt take a year or two. As unlikely as it may seem that such an objective could be met, the chances will improve dramatically this autumn as White House political strategists as well as congressional Republicans observe the continued failures of the monetarists. And the monetarists will now have to withstand the fire of both the supply-siders and the liberal Keynesians. Just as the monetarists have no theoretical problems with tax cuts, Keynesians have no theoretical basis for opposing a fixed dollar/ gold price and international fixed parities of currencies. It was Keynes, after all, who was one of the chief architects of the Bretton Woods system. Monetarists, though, are put out of business by a commodity standard. For monetarists to be able to practice their hand at the management of the currency, the dollar can not be convertible into anything.
August 15 will mark the 10th anniversary of President Nixon's closing of the gold window, which formally opened the experiment with monetarism, a "paper standard." To the classical, supply-side economists the attempt to manage the currency through academic formulae and bureaucratic operating techniques was always seen as being doomed to failure. The chief reason is that bureaucrats are no match for the marketplace in determining the correct amount of money and credit to be supplied by the central bank at any given moment in time.
With a gold standard, the bureaucrats have it easy. They simply watch the gold window, and when individuals line up with dollars, to buy gold, the Fed knows it has supplied more money and credit than the market requires for transaction purposes. When individuals line up with gold, asking dollars, the Fed knows it has not met the demand. In one case or the other, the Fed would deploy one of the four instruments it possesses to regulate the flow of money into the system: 1) open market purchases or sales of government securities; 2) open market purchases or sales of foreign exchange; 3) increases or decreases in the discount rate, the rate at which the Fed lends to banks; 4) raising or lowering reserve requirements. At the end of each day, the net effect of the Fed's actions in each of these four areas would be to satisfy all comers at the gold window, buyers or sellers, and over periods of weeks or months maintain the level of gold stocks so that it neither rises nor falls. The marketplace acts as a vast computer, with all transactors satisfied with the level of money and credit except the man on the margin, who shows up at the window with surplus money or surplus gold.
To the supply-sider, the "discipline" argument is not as important as this "efficiency" argument. Yes, it is easier to print money than to raise taxes, and the absence of gold convertibility removes this discipline from the policymaker. But in the current environment, it is inefficiency that is destroying the currency. Here is how Alexander Hamilton expressed the efficiency argument in 1786:
Among other material differences between a paper currency, issued by the mere authority of Government, and one issued by a bank, payable in coin, is this: That, in the first case, there is no standard to which an appeal can be made, as to the quantity which will only satisfy, or which will surcharge the circulation; in the last, that standard results from the demand. If more should be issued than is necessary, it will return upon the bank.
In the last decade, the Federal Reserve has had to operate without this kind of information and guidance. Transactors need precise amounts of money and credit, in order to effect their exchange of goods and services. The monetarists, though, reject this supply-side view. In their demand model, money is not simply a medium of exchange. It is an article of intrinsic wealth, to be put into the consumer's pocket when the objective is increased demand, and to be pulled out of the consumer's pocket when the objective is decreased demand. Thus, Milton Friedman's "monetary rule." Because production increases by 3 percent annually (when things are going well) the supply of money to support those transactions should increase by 3 percent.
To a supply-sider, the concept is ludicrous, preposterous. The Fed, to better manage the currency, is urged to employ its four instruments in a way that causes the supply of some arbitrary definition of money to follow a targeted path. Because only the consumer exists in this model, there is absolutely no concern for the amount of money that producers desire in order to exchange their goods.
Yet this is the concept that is now in almost total control of monetary policy. Until October 1979, the Fed tried to manage the currency by using interest rates as a guide to its four operating instruments, with one eye on the Shadow Open Market Committee's favorite M target ( the SOMC being composed of Professor Friedman's apostles). Since October, 1979, the Fed bureaucrats have been using the monetarist M guide as the primary target, with pathetic results.
There is now no secret that the Friedmanites are almost wholly in control of the Fed. The trio of Treasury Undersecretary Beryl Sprinkel, Economic Adviser Jerry Jordan and OMB Chief Economist Lawrence Kudlow -- all Friedman apostles -- are the bitter-end monetarists who are now counseling Paul Volcker. After a decade of failure, they still believe that yet another change in operating techniques by the Fed will produce the magic bureaucratic formula. Sprinkel told the House Banking Committee on July 23 that he praised the Fed for its current campaign to slow money-supply growth, but "more precise long-run control of money supply growth would eliminate the kind of interest rate volatility that has occurred in the last two years."
How to get more precision? The Sprinkel-Jordan-Kudlow formula is to: Eliminate the two-week lag with which banks report their reserve positions to the Fed; set the discount rate above the market rate (21/2 percent); and establish a new target, the broad monetary base instead of M1B, which is the measure of cash a " and checking account deposits. The monetary base includes cash and total bank reserves, which is the money the banks borrow from the Fed to meet reserve deficiencies as well as other, nonborrowed, reserves. Earlier this year, Volcker told Congress that a 600-page Fed study showed the control techniques espoused by Sprinkel would cause greater, rather than smaller, swings in short-term interest rates. But with the President more or less standing behind the monetarists, Volcker has his people meeting with them to discuss implementation. Of course, if the monetarist goal is irrelevant, any improvement in operating techniques for achieving that goal is as likely to drive bond prices down as up.
Some weeks ago, I suggested to Treasury Secretary Donald Regan that he had made Solomonic decision" in giving the fiscal side of Treasury to the supply-siders and the monetary side to the demand-siders, the monetarists. He seemed surprised and said he did not think he had cut any baby in half, that he was simply trying to take two forces that are basically compatible and weld them together. I explained that the two forces are basically incompatible, and that the economy will not be able to advance with a demand-side monetary policy. "Your fiscal reforms are encouraging people to increase their production, because you will let them keep more of their output after-tax. But the Fed and the Treasury monetarists see this as an inflationary impulse and are trying to choke off economic activity with high interest rates."
The empirical observation that monetarism shrivels every economy it touches does not daunt its disciples. Israel's central bank, a monetarist outpost, has produced triple-digit inflation. Margaret Thatcher turned the Bank of England over to the Friedmanites, and after two years of "tight money" the unemployment rate is at 11/2 percent and inspiring urban riots while consumer prices over the last quarter rose at a 21 percent annual rate.
Lindley Clark, Jr., who is Milton Friedman's voice in The Wall Street Journal, wrote in his "Speaking of Business" column on July 28 that what now disturbs Friedman is gradualism.
"I have always in the past argued for the gradual approach," he (Friedman) said. "That has seemed to me desirable on theoretical grounds. But I have been shaken in my faith by empirical observation. The successful cases of controlling inflation that I know of have all involved moving at once."
A confirmed gradualist could argue that the Fed is going too far too fast, that it ought to ease up. An empiricist would say that we should give the Fed a chance to see whether, for once, it can't create an adequate scarcity of dollars.
To a classical economist, the notion of "an adequate scarcity of dollars" is absurd. A dollar is nothing more than a unit of account, a benchmark, a "numeraire." Its function is to permit banking efficiencies as the financial intermediaries book contracts between producers in the exchange economy. Money of predictable value improves efficiency, increases the incentive to supply more and better products. The use of money should be encouraged, not discouraged.
In other words, the baker and the dairyman in a barter economy would set the "terms of trade" at one loaf of bread for one quart of milk. In a money economy, there is an intermediary between the baker and dairyman, in a broad sense, "the banker." To keep track over time of the agreements between baker and dairyman, loaves and quarts are converted into units of account. A loaf equals a dollar, a quart equals a dollar. The baker sells his loaves to an intermediary and uses his dollar credits to purchase from the intermediary the number of quarts that reflect the terms of trade. The dollar is a medium of exchange.
To the classical economist, what is now happening in the U.S. economy is the following: Carpenters would dearly love to acquire a new automobile, and would eagerly supply new houses in exchange, with the terms of trade being, say, 10 autos for one house. Autoworkers would dearly love to purchase a new home and would willingly trade 10 automobiles. The problem, though, is that the dollar as a unit of account is now so unreliable, the carpenter and the autoworker must pay enormous premiums to the financial intermediaries and the savers, who take all the risk. That is, over the five years the carpenter works to finance his auto, or the thirty years the autoworker works to finance his home, a devaluation of the dollar means they each pay back less in real goods than they originally agreed upon in the terms of trade. The banker -- or the fellow who deposited savings in the bank -- is stuck.
This is not the way the monetarists look at the marketplace. Nor is it the way the Fed now looks at the marketplace. To them, only consumers exist, demanding goods and services with today's dollars. The Fed is the nation's central bank, yet it no longer thinks of itself as a banker, supplying the self-liquidating bills of exchange around a solid numeraire that enables carpenters and autoworkers to exchange their surplus labor with each other in the marketplace. Instead, Volcker and the other governors of the Fed, without exception, now think of themselves as regulators, particularly regulators of "the money supply." Indeed, Newsweek magazine now describes the Fed to its readers as the institution "responsible for controlling the money supply."
The economy is still functioning, but only because the Fed is not systematically, consciously trying to destroy the dollar; its value ebbs gradually. The accidental effect of current policy is to permit banking of goods and services that are quickly liquidated in the exchange economy. Bakers and dairies do all right. Homebuilders and auto manufacturers suffer. In the back of their minds, the monetarists and Volcker see their policies as causing the carpenters and autoworkers to lower their wage demands as consumers have less money with which to buy homes and autos. The idea is ridiculous and destructive; the terms of trade do not change because the government changes the unit of account.
The analysis of commodity money has made hardly any progress in the last fifty years. Actually, more knowledge was forgotten than was newly acquired. Economists seemed to feel that the books contained whatever there was to know in this field and tended to be bored whenever the subject was mentioned. I think this complacency was not quite justified. In particular, some of the most fundamental and seemingly intractable problems of recent monetary policy were analytically similar to the "classical" questions of the nineteenth century, and some of the leading economists around the turn of the century might have been better equipped to cope with these problems than many present-day experts, raised on models in which currency is printed costlessly and handed out for nothing.
This is an observation from "The Theory of Money" by Jurg Niehans, an eminent economist at the University of Bern, Switzerland. He is exactly right, which is why the ignorance in the economics profession is the only real barrier to the early restoration of gold convertibility. This is also why the meetings of the United States Gold Commission must be made public, so the public, via the press corps, will be able to learn how much nonsense there is rattling around in the heads of the anti-gold, "Paper Bugs." It is also the reason why the Paper People, the monetarists, are exerting every effort to keep the meetings of the Commission closed to the public.
The executive director of the Commission is none other than Anna J. Schwartz, 65, Milton Friedman's co-author of "A Monetary History of the United States, 1867-1960," the monetarist bible. Treasury Secretary Donald Regan is chairman of the Commission, but at its organization meeting July 16, Regan delegated the chair to Beryl Sprinkel. Sprinkel's first request was that all discussion be confined to Commission members, that public comment and debate in the press "wouldn't be seemly," and that the meetings be closed to the public and press because open meetings "could have an impact on the markets." Technically, the Commission is supposed to report by October 7, advising Congress and the White House on what the U.S. gold policy should be. Lewis Lehrman, a pro-gold member, asked for an extension of time so that there could be serious discussion and debate. Sprinkel and Rep. Henry Reuss, a passionately anti-gold Commission member, fought Lehrman's idea until Paul McCracken, who was Nixon's chairman of the Council of Economic Advisers when the gold window was closed, threatened to resign unless Lehrman's request was met. The September 18 meeting will be closed, but at the meeting it will be decided whether or not subsequent meetings will be open.
The decision is of great importance to the financial markets. It is more important that the meetings be open than the outcome of the ultimate decision of the 17-member Commission. Anna Schwartz's knowledge of the workings of a commodity standard in a classical framework is negligible, and Sprinkel knows even less. Ms. Schwartz's July 8 memo to the Commission members, framing the discussion, indicates she equates a gold standard with wooden sailing ships, plying the Atlantic with bullion in their holds to settle payments between trading partners. She ignores the existence of modern electronic banking that instantaneously adjusts international accounts by transfer of debt and equity. And her review of "why the U.S. went off gold" is hopeless: "Disparate inflation rates among the industrialized countries led to the collapse of the Bretton Woods system," which leads her to argue that "before a restoration of an international gold standard could be seriously contemplated, the disparity among rates of inflation would need to be reduced." In other words, inflation ended the gold standard, not the idea that governments -- especially the United States - could regulate their economies by changing the values of their currencies in disregard of the monetary standard.
The U.S. economy can not survive much more of this foolishness, nor can the world economy. As West Germany's Helmut Schmidt put it at the Ottawa "summit" in July, the Western nations are now experiencing the "highest real rates of interest since the birth of Jesus Christ." The United States is sucking short term capital from every corner of the world with the Fed's "tight money" policy. We are inviting global depression as we try to finance our deficits externally, instead of through the release of internal resources that the Fed is strangling with its monetarist formulae.
The goal of the Reagan administration at its outset was a broad, deep bond rally, which the supply-siders see coming through growth and the monetarists see coming through austerity. The problem is to persuade one investor, here or abroad, the man on the margin, to part with $10,000 in resources in exchange for a 30-year bond. Take a guess, which of the following policy changes will do the trick: a) inform the investor that lagged reserve requirements will be ended; b) inform the investor that the Fed will now target the monetary base; c) inform the investor that the Fed will now charge a penalty rate at the discount window; d) inform the investor that henceforth all government bonds will be redeemed in dollars that can be converted at the gold window, each into a fixed weight of gold, say, $300 per ounce.
We do not believe that the kind of bond market rally the White House has in mind can occur unless our man on the margin is given option (d). An announcement by the Fed, backed by the White House, that something on the order of (d) would now be pursued as government policy would be the only reason sensible people anywhere would commit resources for 30 years at 5 percent or 6 percent. It now will take a pledge by the U.S. government, a covenant with bond buyers, that it will end the paper experiment in favor of long-term price stability. Nothing else can work to any satisfactory degree; any decline in interest rates will be small and accidental as long as bond buyers see the monetarists trying to put together 30 years one day at a time. Treasury's prospects of trying to raise $8.5 billion in August and $30 billion to $33 billion in the fourth quarter at lower interest rates are beyond hope, unless an end to monetarism is signaled.
The public flogging of Beryl Sprinkel would do wonders for the bond market, if joined to the 10th Anniversary of the closing of the gold window and an announcement that it will soon be opened. The mad, global scramble to get into non-callable Treasury bonds would drive long rates down so fast that Stockman would be able to balance the fiscal 1982 budget, refinancing the debt at 5 percent instead of putting out another $2 billion in Sprinkel Bonds at 15 percent. Of the $8.5 billion Sprinkel must raise in August, he actually plans to harvest $2 billion in 29 3/4-year bonds at 13 7/8 percent. Hell have to pay 15 percent probably, and because the bonds are not callable before the year 2006, the American taxpayer will be saddled with them for that long. It is Beryl Sprinkel's way of saying that he does not expect interest rates to be lower than they are now until the year 2006. This is one of the finest monetarists on the hoof, we must realize, now essentially running our central bank.
In the sense that it is always darkest before the dawn, this is why we now feel as bullish as we do. The monetarists are now running out of running room. Professor Friedman might signal the troops to run harder and faster "to create an adequate scarcity of dollars," but they will just hit the brick wall that much sooner. It soon will not seem "impractical," as Ed Meese now puts it, to return to a gold standard. A few more notches up the prime rate and the politicians around the White House will take our man-on-the-margin multiple choice exam and get behind the supply-side solution. All it will take is a word from the President, who would love to give it if only he had visible signs of support from the financial community. That, too, can come quicker than now seems possible. We hope we see it in time to get into long bonds, before they're snapped up, but there is no reason to move as long as Sprinkel is in charge. That's our bullmarket signal: Sprinkel down, bonds up.