Executive Summary: Paul Volcker has begun his second term as Fed chairman inauspiciously, sowing confusion instead of predictability. In reviving M1's importance, devaluing price signals, and inviting a global scramble for liquidity by predicting a credit crunch, Volcker has paralyzed Wall Street's bulls. Worse, the intellectual standards of the policy debate have deteriorated to new lows, with anti-growth leader Martin Feldstein supported in his mindless, contradictory assertions by the austerity interests, including Democrats. Chances of another wave of deflation increase as the Fed intervenes to weaken the dollar abroad, but only as an excuse to tighten at home. The House approval of an IMF $8.4 billion replenishment, a fiscal "solution" to the international debt problem, also clears the way for a further Fed tightening. But it's still likely that Volcker will reshuffle priorities to keep gold above $400, a clear signal of which would puncture major deflationary fears and end the bull-market interlude.
A Bull Market Interlude
Paul Volcker has begun his second term as Fed Chairman most inauspiciously. There were almost universal expectations in the international financial community that a Volcker reappointment would be bullish, especially in the bond markets. His integrity, his practicality, his experience, his credibility were repeatedly cited as reasons why the markets would be relieved with news of his reappointment, as opposed to the appointment of some unknown quantity. Indeed, while many supply-siders balked at his fiscal views and withheld support of his reappointment, we were Volcker boosters for most of the usual reasons. But our main reason was the belief that unlike Alan Greenspan, his chief competitor for the job, Volcker would continue to steer the Fed away from deflationary monetarism and assure the markets that he would key policy toward a steady dollar value.
Instead, Volcker has done nothing but sow confusion, breathe new life into the destructive monetarist doctrine by reestablishing the importance of M1, devalue price signals, and "talk up" the dollar and interest rates by warning that both would go higher because of a coming "clash" between public and private credit demands. The bond markets have been in a steady, sickening slide and Wall Street's bulls have turned tail, alarmed at the "medicine" being prescribed to purposely stunt the growth of the economic recovery. But perhaps the worst thing that's happened in the last six weeks is the deterioration of the intellectual standards surrounding the economic policy debates. Grown men who are in powerful or influential positions are choking the media with silly, inconsistent or illogical pronouncements and are being taken seriously by policymakers. What is most alarming is that President Reagan, who had been rejecting the gobbledygook coming out of his economic advisors, seems to have finally succumbed to their arguments that he must pull his attention away from economic growth and fix it on the federal deficits.
In a general sense, people who for whatever reason are unhappy with the pace of economic expansion and want to slow things down are willing to say or do anything to achieve their ends. It's long been apparent that Martin Feldstein, the President's chief economic adviser, is a leader in the anti-growth movement. And if a man of his position, with his credentials, is permitted to make downright foolish statements without being ridiculed by either his boss, the press or the opposition party, it's no wonder that Wall Street economists, editorial writers and politicians can also blather with no sense of shame.
Because of his position and his relentlessness in spouting nonsense in the true sense of the term, Feldstein has become one of the most threatening men in the world. He should have been fired long ago for his ineptness as a forecaster and his determination to contradict his boss publicly, especially in his insistence that new taxes or contingency taxes must be raised. Yet in a perverse way, his influence seems to have expanded, the anti-growth forces recognizing in him the kind of mindless audacity that it takes to sell the idea that growth is bad news, higher interest rates are "appropriate," and the recovery will abort unless taxes are raised. With Ronald Reagan looking ever more like a re-election shoo-in in 1984, Feldstein is the Democratic Party's best hope. If he can make the ridiculous arguments that are necessary in shutting off the expansion, the Democrats will be relieved of that responsibility and will be able to confront 1984 with their growth agenda, such as it is.
In his prepared testimony before the Senate Banking Committee on July 21, which indicates there was no slip of the tongue involved, Feldstein once again reveals a chaotic mind at work on behalf of economic contraction. On page 8, he tells us "the fundamental reason for the high level of real interest rates is the widespread expectation of large budget deficits for the remainder of the decade." On page 12, though, he is just as certain that "only by reducing the growth of M1 can the interest rate be reduced" Which is it?
It is not possible to imagine a concurrent excess supply of dollars and an excess demand for dollars. But Feldstein can. The high interest rates caused by an excessive supply of M1 "have raised the international value of the dollar to an uncompetitively high level." Too many dollars have created an excessive demand for same. And at the same time, the high interest rates caused by a high federal deficit results in an overly strong, uncompetitive dollar. In this model, as Alan Reynolds has pointed out, Italy and France could defend their currencies by running bigger budget deficits.
While Feldstein's pronouncements seem designed to keep the financial markets in a constant state of anxiety, it's at least fortunate that he is one step removed from the important policy levers. Imagine if he were chairman of the Fed—the proposal of The Wall Street journal's monetarist theologian, Lindley Clark, Jr. —instead of merely being the chief economic adviser to the President of the United States!
Volcker, who does have his hand on the lever, is more coherent in his views. But not as much as we should expect from someone who has been working the lever for four years through inflations and deflations. In his own way, Volcker has been even more unsettling to the markets because, for someone with as much power as he now has, he doesn't seem to know what he's doing. In his confirmation hearings and several appearances before Congress on monetary policy in recent weeks, he has sounded like a bureaucrat, ready to confront the "in" basket at the Fed each morning and have it emptied by the end of the day. He seems blissfully unaware that the markets have less feel for the "Volcker Standard" now than they did two months ago, now that he's put the M1 target back on the wall. And he's unaware that he has contributed in a major way to the recent rise in interest rates and slump in bonds—not by decreasing the money supply but by increasing the global demand for dollars, a scramble for liquidity, by his warning of credit crunches and higher interest rates.
The most concise comments we can find that illuminate the shape of his thinking were in his Senate Banking Committee confirmation hearings of July 14. We quote one passage at length:
"...all during this period judgments as to the appropriate degree of pressure on bank reserve positions have been conditioned by available evidence about trends in economic and financial conditions, prices, exchange rates and other factors. Now as the economy has been growing and picking up speed, the broader monetary and credit aggregates moved consistently with the ranges set in February, and prices were relatively stable. Sensitive commodity prices did rise for awhile, but they've been fairly stable for a couple of months. We have had a very strong dollar in the foreign exchange markets. We had these international financial strains. They did not point in the direction of restraint. So for some time, a broadly accommodative approach with respect to bank reserves seemed appropriate, despite much higher growth in M1—alone among the targeted aggregates—than anticipated.
In the latter part of the second quarter, against the background of growing momentum in economic activity, monetary and credit growth showed some tendency to increase more rapidly. And M1 growth did remain particularly high—higher if sustained—than seemed consistent with long-term progress against inflation and sustained orderly recovery. In these circumstances the Federal Open Market Committee, beginning in late May, has taken a slightly less accommodative posture toward the provision of bank reserves through open-market operations, leading to increases in borrowings at the discount window.
Whether viewed from a domestic or international perspective, limited, timely, and potentially reversible measures now, when the economy is expanding strongly, are clearly preferable to the risks of permitting a situation to develop that would require much more abrupt and forceful action later to deal with new inflationary pressures and a long sustained pattern of excessive monetary and credit growth....
Over the more distant future, balanced and sustained economic growth with strong housing and business investment would appear more likely to require lower, rather than higher, interest rates. That outcome, however, can be assured only if the progress against inflation can be consolidated and extended. And considering all these factors, the Open Market Committee basically concluded that the prospects for sustained growth and for lower interest rates over time would be enhanced, rather than diminished, by modest and timely action to restrain excessive growth in money and liquidity, given its inflationary potential. But I must emphasize again that the best assurance we could have that monetary policy can, in fact, do its part by avoiding excessive monetary growth within a framework of a growing economy and reduced interest rates, lies not in the tools of central banking alone, but in timely fiscal action."
Thus we are told that until May, the price signals pointed away from restraint and Ml pointed toward restraint, and the Fed did not restrain. In May, the price signals still pointed away from restraint and M1 pointed toward restraint, and this time the Fed restrained. With this kind of philosophy, we might as well have a monkey flipping a coin and do just as well.
In this assessment, Volcker also sidesteps the fact that the targets for money and credit were set in conjunction with forecasts of economic growth, forecasts of a puny recovery in 1983. Instead of a puny recovery, it has been robust, which in the Fed's own model indicates that the more rapid money growth was appropriate. But in setting a new Ml target range for the rest of the year, nothing has been done to correct for the original forecasting error. What is far worse, though, is Volcker's acquiescence to demands that the Ml fetish be revived at all.
Here is the entire American establishment, liberal and conservative, Wall Street and Main Street, having observed last year that Ml led the Fed to the brink of economic collapse, and that abandonment of M1 unleashed a dazzling bull market in stocks and bonds and a sparkling economic expansion. Yet here is Volcker putting M1 back to work as the financial markets tremble, and we cannot find a word in The Times or The Journal or Time or Newsweek or The Washington Post or the networks commenting on the sheer stupidity involved.
What makes it worse is the fact that Volcker knows Ml has no utility as an analytical tool given that it has "an inherently unstable demand," to use his own words. The point is not even controversial. Academic economists will agree unanimously that if one does not know if the demand for money is rising or falling, one cannot know if an expansion of M1 is inflationary, deflationary or neither. Only if we "assume" a constant demand can M1 become relevant, but demand is inherently unstable in a world where Volcker can talk the dollar up or talk it down. M1 has as much usefulness as a clock in a cave; it can't tell us the exact time unless we know it's a.m. or p.m. It does no good to "assume" either.
In testimony before a House monetary subcommittee on August 3, Volcker insisted that the Fed had nothing to do with the sharp rise in interest rates that began a week earlier. Instead, he argued that the "bump" in rates had been caused by the Federal budget deficit and Treasury efforts to finance it. This again is hardly an intellectually respectable argument from our Fed chairman. The fact is that the bond markets have recently been relieved of Treasury borrowing requirements that the markets had anticipated and of course discounted. The deficit forecast has been as bad as the growth forecast, and markets that had been led to believe Treasury would need $60 billion in the third quarter have now been told the figure is closer to $48 billion.
The only explanation is that Volcker is oblivious to the fact that he and Marty Feldstein have been inviting a liquidity squeeze on the demand side. He can honestly say that the Fed hasn't been squeezing lately on the supply side, reducing the dollar supply by selling bonds and bills out of its portfolio. But by warning of a credit squeeze, a coming "clash" between public and private borrowers, he is telling the world to demand dollars, which they can reinvest later at higher interest rates. Why should anyone be surprised at the strength of the dollar against other currencies given Volcker's rhetorical performance of recent weeks, backed by Feldstein at the White House?
The effect of "talking up the dollar" is not limited to foreign exchange. The clear invitation to corporate treasurers is to draw down credit lines NOW! instead of later, whether or not the funds are needed, putting more M1 into the system and forcing banks to scramble for reserves, putting upward pressure on the fed funds rate. The most charitable explanation of Volcker's behavior is that he really doesn't know what he's doing.
Perhaps his behavior would be excusable if he had not been around the loop so many times before, from every different angle. In the spring, at dinner with Volcker in Washington, we recalled how, in 1971, when he was Treasury Undersecretary for Monetary Policy, he dashed madly around Europe getting foreign central banks to defend the dollar by buying them up with their currencies, but every time he turned around he heard that Arthur Burns at the Fed was voting to ease. How silly it all seemed, and I recalled writing an editorial in The Wall Street journal in which I likened the practice to trying to bail out a leaky boat by throwing the water over your shoulder, from one side of the boat to the other.
But here it is happening again, with the U.S. now intervening in the foreign-exchange markets to weaken the dollar against other currencies. And here is Volcker, now where Burns was in 1971, vowing to "take the technical steps to make sure that the dollars spent to buy foreign currencies did not expand the money supply," as The New York Times reported August 4. What? Is this a bad dream? In its wisdom, our Government is going to buy bonds in Europe and Japan, injecting dollar reserves into the banking system, and it will offset this by selling bonds in New York, draining those dollar reserves from the system.
This is a dismal sign. On July 14, remember, Volcker mentioned the strong dollar as a sign pointing away from restraint. So we can now ease abroad in order to tighten at home.
In the same way, the House vote August 3 to approve an $8.4 billion contribution to the International Monetary Fund helps remove another of those signs pointing away from restraint, "the international financial strains" that Volcker mentioned July 14. With U.S. taxpayers shaken down to relieve Third World debt pressure on our money-center banks, Volcker has one less reason to refrain from squeezing. In lobbying frantically for the IMF replenishment, Volcker predicted that if it were not approved interest rates would rise; we can suppose that he envisioned having to increase bank reserves to avert international financial crisis, with such action igniting inflationary expectations and boosting interest rates instead of relieving deflationary pressures and lowering interest rates.
The August 4 nosedive on Wall Street reflects an incorporation of this madness in Washington. The only thing that stands in the way of the M1 signal dominating the Fed's deflationary bias is the price of gold and other "sensitive commodity prices." But while Volcker has made casual comments about a $400 floor for gold, there's nothing to prevent him from waving that aside by pointing to a selective index of other prices that is on the way up. After spending a year at the $425 level, swinging between $400 and $450, gold below $400 would be crunchy indeed. Yet Volcker could find rationales for $350 gold with no trouble at all, and there are plenty of anti-growth people in the power structure who would applaud his "courage" in doing so. Theoretically, all Americans would love to see a glorious expansion, including Fritz Mondale, John Glenn, Milton Friedman and Marty Feldstein. But they each have short-term political or ideological goals that would be far better served by a collapse.
Will we get an actual crunch as we stagger from week to week watching the M1 numbers and hear clarion calls from Volcker/Feldstein for higher taxes? We've thought not, banking heavily on Volcker's experience and intellectual integrity to prevent a new wave of deflation. But he's gotten off to a bad start in his second term at the Fed, creating more confusion and uncertainty with his great smoke machine.
It's certainly discouraging to see the deterioration of the policy debate. But we've not yet turned bearish beyond the very short term. This is because we still have reason to believe that Paul Volcker is not Marty Feldstein and his recent blunderings have been innocent. When the Chairman of the Fed predicts a credit crunch, whatever his benign motives, he causes a credit crunch unless he immediately accommodates the scramble for liquidity that occurs. In disavowing blame by accusing the deficits of pushing up interest rates, he also whips up support in Congress for a tax increase, another anxiety that the markets have to bear.
Yet as we've been betting all along, we think Volcker will reshuffle his priorities in order to stem a decline in the gold price below $400 and that he will have sufficient support among the Board of Governors to make that turn. Below $400, the pain that softening oil and commodity prices would inflict on the debt-ridden Third World again would build pressure under the Fed to ease, notwithstanding the IMF replenishment. We still would not have a long-term monetary policy, especially since the Fed would probably fuzz up its reasons for turning to ease. But given the current anxieties, there will be rejoicing no matter how it is presented.