Ending the Fed's Deflation Jude Wanniski June 6, 1984

Executive Summary: Monetary policymaking is more confused than anytime in memory, the Federal Open Market Committee steering in 12 different directions. The problem is in economic theory: The concept of deflation as "creditor relief" eludes the central bank. The issue divides the Reagan Administration and The Wall Street Journal, leading to vacillation in support of Volcker's deflation. Continental Illinois, latest victim of the Fed's deflation, forces temporary relief. But what next? The Fed cannot supply "credit" to the markets; only suppliers of goods can demand bonds. The Fed can only increase or decrease currency risks, inflationary or deflationary. Volcker should now see the markets prefer $400 gold as a floor, not a ceiling. The Kemp gold bill emerges, a long-shot "new idea" offered for the COP platform in August. The President wants to, but will he?

Ending the Fed's Deflation

There is now greater confusion and disarray in monetary policy than at anytime in memory. Not only is no clear philosophy at the Federal Reserve Board being communicated to the credit markets, but there are a dozen different shifting and conflicting ideas of how monetary policy should be conducted, as many as there are voting members of the Federal Open Market Committee. In the last generation, the credit markets usually had some confidence that the Fed as a body was being guided by a clear objective, either the management of interest rates up to October, 1979, or the management of monetary aggregates from that date until August, 1982. These were not appropriate objectives for the Fed and had to be abandoned, but we at least knew what they were. Now the Fed could be compared to an automobile with 12 steering wheels, as many accelerators and brake pedals, and a dozen road maps leading to 12 different cities. The Fed is only asked to make one decision, to tighten or to ease, yet each of the 12 voting members of the FOMC is guided by a different standard of behavior. The object for one may be a certain nominal GNP path, for another a certain real GNP path. One may target credit volume, another bank reserves, another one of the monetary aggregates, another foreign exchange lates, another the Consumer Price Index, a cluster of interest rates, or the general "feel of things", Paul Volcker's "intuition."

At the last reported FOMC meeting (March), eight members voted with Chairman Volcker to tighten somewhat; Governors Henry Wallich and Lyle Gramley dissented from the majority on the grounds that the tightening should be more than somewhat. Vice Chairman Preston Martin, the only member who is guided by sensitive commodity prices, voted not to tighten.

What distinguished Preston Martin from his colleagues is his belief that a rise in interest rates can reflect deflationary as well as inflationary forces in the economy. And when the prices of gold, precious metals and industrial commodities are steady or falling even as interest rates are rising, Martin can understand that the problem is deflation — the rewarding of dollar creditors at the expense of dollar debtors. Because tightening of monetary policy under these conditions leads to debtor bankruptcies with some creditors left holding the bag, the Fed should not be steering in that direction.

Conventional wisdom among bankers and their economists, though, is based on an assumption that rising interest rates can only reflect rising expectations of inflation. This is because the deeply embedded demand models of the Keynesians and the monetarists do not contain the concept of deflation as "creditor relief." These models simply view inflation as a "bad" (although liberal Keynesians usually consider a modest inflation as beneficial to commerce) and the opposite of inflation as a "good." The term "disinflation" is used when the Consumer Price Index is declining from previous highs, and "deflation" is reserved for steady declines in the Consumer Price Index. Given the Keynesian view, prices of gold, metals, oil and other industrial commodities can be falling — as they have for the past year — and as long as the CPI is still rising we are in a disinflation mode. 

Whether he knows it or not, President Reagan fell victim to this view of the monetary mechanism when, at his May 22 press conference, he withdrew White House criticism of the Fed and gave Volcker a pat on the back for doing an okay job in keeping the money supply within target ranges. The President's remarks came as a blow to supply-siders, who had for months been galvanizing support in the Administration for the "deflation" argument, which leads to the conclusion that the Fed has not been doing an okay job. Ironically, as we will see, an editorial in The Wall Street Journal on May 21 swung the President to the disinflation argument. An earlier Journal editorial ("Snatching the Punch Bowl" on March 26) had argued in advance of the aforementioned FOMC meeting that the Fed should not tighten — which it proceeded to do — because prices of the precious metals were not signaling inflation ahead. As it happened, two different Journal editors were responsible for the conflicting editorials. 

The issue has divided the Reagan Administration even more sharply than it has the Journal. This is why there has been such vacillation at both the White House and the Treasury in their view of Fed policy. At the White House, James Baker and Richard Darman have supported the supply-side deflation argument while Martin Feldstein and David Stockman have argued against criticism of the Fed on the grounds that such criticism, in itself, drives up interest rates because it leads the markets to fear the Fed will respond to it and inflate. In other words, if interest rates only rise because of inflationary fears, and interest rates are rising as they have been, White House pressure on the Fed to ease contributes to the problem. Fed Governor Henry Wallich, a relentless advocate of this idea, indirectly chastised the White House for its sometime criticism of the Fed. On May 30 he told The New York Times (reported May 31): "People outside can stop pressing the Fed to ease, because that is precisely the situation that the markets fear."

This is of course palpable nonsense. Any hint that the Fed will ease has been greeted with rallies in the bond market as well as the stock market; the devastation in the bond market since January has been accompanied by the Fed's continued tightness and the speculation that it will get tighter still.

Just as supply-siders believed they were getting the upper hand at the White House, with Baker-Darman winning over Stockman-Feldstein in the President's mind, The Wall Street Journal weighed in on the wrong side. In its May 21 editorial commenting on the difficulties of Continental Illinois Bank, the Journal opined that foreign investors might have been influenced to withdraw deposits "not only by judgments of the bank's condition but guesses about the future value of the dollar as well. Imprudent White House complaints two weeks ago that Fed monetary policy was too tight may have encouraged foreign investors to believe that the President was seeking an easier monetary policy and that hence the dollar's value would weaken. The bond market's conniption must have reinforced that view."

The editorial decided the President against criticism of the Fed. It appeared at a critical moment during the internal debate and had a "devastating impact," a senior Presidential aide told me. He added that he didn't know if it was possible to repair the effects. The following day, Stockman and Feldstein used the editorial in helping brief the President for his press conference, and he was swayed with the idea that White House sniping at the Fed was damaging confidence in the credit markets. The markets slumped in the wake of the President's press conference.

As it happened, May 21-22 were the days of the FOMCs regular meeting, which occurs every six weeks. While the Fed will not report on its tighten/ease decision of that meeting until early July, it's reasonably clear from events in the market that the Continental Bank situation forced it to relax its grip, at least for a while. Even as the Fed was forced to interrupt its deflationary policies in August, 1982 to avoid the impact of Mexico's dollar insolvency on U.S. banks, it has been forced to halt the mini-deflation begun last September. Had it not, Continental could not have avoided collapse and at the deflationary level of $375 gold, further bankruptcies would have followed. Domestic and international producers of oil, agricultural and industrial commodities — particularly Third World dollar debtors — simply cannot meet their debt obligations when the Fed has deflated the dollar value of their productive assets, the collateral for their debts.

In this sense, Continental was the latest victim of the Fed's deflationary policies since 1981. It can be argued Continental's managers failed to guess that the Fed's inadvertently inflationary policies of 1979-80 would be followed by inadvertent deflation. But then why should bankers (or industrialists for that matter) have to make business decisions predicated on guesses about the future course of the Fed's inadvertencies? The markets still have no assurance that the latest suspension of deflation will last beyond the July FOMC meeting and no assurances that this vehicle with 12 steering wheels might not accidentally careen into another inflation. Just as I argued in 1979 that Chrysler Corporation was victimized by bad government, not bad management, and could justifiably put forward a case for a bail-out, so now it seems unreasonable to blame Continental's managers, or Mexico's, for being unable to anticipate Paul Volcker's errors in his management of the currency.

We can confidently surmise, for example, that had the Fed last September not resumed deflationary policies out of misguided fear that the economy was showing signs of "growing too fast," and that such growth would be inflationary, Continental Bank would not have experienced extraordinary difficulty last month. The Fed would have been forced to lower interest rates to prevent the price of gold from sinking from the $425 level it had more or less maintained from August 1982 to September 1983. Global interest rates would have fallen in train, as they did in the autumn of 1982. Agricultural, oil and industrial commodity prices would have firmed as the world economic expansion stayed on a higher path. The world's dollar debtors would have been able to refinance at longer maturities and lower rates even as they sold more goods at firmer prices. Continental's non-performing loans would have been more able to perform and so would the seemingly "bad loans" of the other multinational banks. 

Paul Volcker has become a hero to the big bankers because they know he will bail them out of the difficulties he himself has caused them. How much better if he had not inflated or deflated to begin with.

It's hard to be very critical of Volcker, though, when he is in such good company: President Reagan and The Wall Street Journal's editorial page. A year ago, both Volcker and the Journal professed to be watching the price of gold as a leading indicator of deflation as well as inflation. Both had $400 as a floor, below which they would be concerned. When the price did fall quickly from $425 to $375 in the September-November months, and nothing other than a weakening in the bond market occurred immediately, they adjusted their gold ranges downward, at least to $375 and perhaps to $350. It must be said that the Journal was heavily influenced by the arguments of Arther Laffer, who for several years has remained steadfastly uncritical of Volcker and the Fed. Because Laffer does not have deflation (as described here) in his model, there are no adverse consequences to a decline in the price of gold until it reaches the $250 level, which is seen as the optimum price. As a result, he was forced to argue that the 1982 recession was caused by the phasing in of the Reagan tax cuts. Now, he explains the rise in interest rates as a fear of future devaluation and consequent inflation, although this does not explain why gold and commodity futures seem not to have this fear. Another supply-sider, Lewis Lehrman, has consistently made the deflation argument, suggesting an optimum gold price even higher than $425. 

The clearest way to think of the economic debate as it now stands is to realize that most conventional economic analysts visualize government and corporate demanders of credit (issuers of bonds) competing for a fixed supply of credit. From this vision it logically follows that interest rates must rise to ration credit with the government "crowding out" private borrowers. For interest rates to fall, either the government must reduce its borrowings by cutting spending and/or raising taxes, or the corporate borrowers must reduce their demands on the credit pool, which involves slowing the economy's economic growth by allowing interest rates to rise in the rationing process. This is the view of Volcker, Wallich, Henry Kaufman, Alan Greenspan, Feldstein, et al. Liberal Keynesians have the same picture but would have the Fed simply pour more credit into the pool by monetizing debt and accepting the consequent inflation. 

Supply-siders, on the other hand, argue that the credit pool is not fixed, nor can it be filled by debt monetization the way Keynesians, either liberal or conservative, imagine. The Fed cannot "supply credit" to the bond market, because the only thing that a seller of bonds will accept in exchange for a bond is goods. Otherwise, why issue bonds? The Fed produces no goods.

The supply-sider thus visualizes the credit pool as expanding or contracting as suppliers of goods or potential suppliers of goods increase or decrease their demand for bonds. If the attractiveness of bonds can be increased, individuals who are prepared to produce more goods in exchange for more attractive bonds will do so and the goods produced will flow into the credit pool.

One way to make bonds more attractive is by reducing the tax rate on bond income. If Jones, who produces both widgets (consumer goods) and widget-machines (capital goods), is willing to exchange either for bonds that produce future income, he will be willing to produce more of both in exchange for more bonds if the government agrees to lower the amount it takes from the interest and capital gain on bonds. This process may not lower interest rates even though more goods flow into the credit pool because, in foregoing tax revenue, the government may have to issue more bonds.

In looking at suppliers of bonds, Jones and other suppliers of goods also worry about monetary policy. If they produce and give up widgets for a 30-year bond, what are the risks that the government will inflate the unit of account in which the bond is denominated? Any inflation that occurs will reduce the number of widgets or widget equivalents that the bond will buy when cashed in 30 years. Such inflationary expectations are built into the interest-rate structure, a process that Keynesians and monetarists do not dispute.

What they do not see is that Jones and other potential demanders of bonds for goods supplied are also concerned with a government deflation of the dollar. Jones and others will remain on the sidelines, not offering goods with which to demand bonds, if they have no guarantee the government will not deflate, on the margin causing debtors to bankrupt. The marginal supplier of goods for bonds will exact a deflation premium to offset the risk of bankruptcy in a potentially deflationary environment. And the marginal demander of goods in exchange for bonds (Continental Illinois, most recently) will gladly pay the higher interest rate in order to remain solvent. The argument that government bonds have little risk of bankruptcy is of no moment because the government is not the marginal issuer of bonds. It takes the first cut. But it must pay the market rate of interest as established in the global market for dollar-denominated private bonds. In this sense, the government is "crowded up" into paying higher interest rates by the needs of the corporate and household sectors.

With this complete picture of the interaction in the market for goods and the market for bonds, it's easier to understand the struggle between the Growth forces and the Austerity forces. The Austerians wish to contract the demand for goods on credit. The Growth forces wish to increase the demand for bonds.

This brings us to the gold standard. There may be differences among supply siders on the optimum price of gold, but there is universal agreement that a credible gold standard — which largely eliminates all inflationary and deflationary risk from the currency — would increase tremendously the demand for bonds. It would do so by pulling individuals and corporations who are now wholly or partly on the sidelines, uninterested in producing goods for bonds, into the productive arena. Current conventional wisdom holds that there is an upper limit on industrial-capacity utilization. Eighty percent? Eighty-one percent? And then inflation ignites through increased wage demands and a bottleneck in goods. But with the risk of future currency inflation and deflation removed by the government, Jones is willing to produce consumer goods and/or capital goods in whatever mix the marketplace is signaling it wants. Commodity prices would rise, to meet the equilibrium gold price if the standard were set at $425. But this would merely rebuild the value of debtor collateral that was eroded in the deflation experienced since last September. The cost of credit or capital would decline in the bidding for bonds as these new productive resources were pulled into play.

It's not possible to say what part of the interest rate structure represents inflationary expectations and which part deflationary. Laffer is certainly right in suggesting that fears of future dollar devaluation are part of the interest rate calculus. But when interest rates fall with either an explicit easing of Fed policy or market calculations that the Fed will ease because of the debt problem, we have to surmise that deflationary fears outweigh inflationary fears at the moment. It should also be clear to Paul Volcker, the second time around, that the financial markets are happier when $400 gold is a floor rather than a ceiling. If he would now act on that empirical observation, as we thought he would the first time around, the financial markets would be even happier and the bull market in stocks and bonds would resume. 

Within the framework of the "Volcker Standard", a day-to-day steering of monetary policy, it is at least more likely now that policy will be easier than it has been and the markets can breathe easier. But what of the prospects of replacing the Volcker Standard with institutional reform, a gold standard?

There is, to begin with, a "gold plank" in the most recent draft of the Republican Platform. This is due to the efforts of Rep. Trent Lott, chairman of the Platform Committee, Sen. Bob Kasten of Wisconsin, chairman of the economic subcommittee of the Platform Committee, and Rep. Jack Kemp. If the plank survives and becomes part of the party agenda for the fall campaign, this in itself would be very significant and bullish for bonds. But the President's aides, even those sympathetic, argue that it would be a tactical error to have the GOP Convention endorse such fundamental monetary reform if the President himself has not, in advance, given his blessing to the idea. Can this happen?

The President himself is biased in favor of the idea. We know that two months ago he specifically asked Treasury Secretary Regan when he might see the possibility of an international monetary reform with gold convertibility, and that Regan replied, "Down the road, Mr. President, down the road." We also know that Assistant Treasury Secretary Manley Johnson supports the idea. And Sen. Paul Laxalt of Nevada, the President's closest friend in Congress, chairman of the Reagan-Bush Campaign Committee, has from time to time publicly expressed support for a gold-based monetary reform. The Wall Street Journal is also back on track lending its considerable weight to this effort. 

There is also a "gold bill" about to emerge from the Congress, drafted at the request of Kemp specifically to elevate the discussion in advance of the convention. 

The bill is not complete in all particulars, but it essentially provides for three key elements. First, it directs the Treasury Secretary to define the U.S. dollar as a specified weight of gold within at least a year of the date of enactment. Details are left to Treasury, including the specific weight, the gold price in dollars, expecting there would be an international conference that would precede such determination. Second, it directs Treasury to arrange for the convertibility of the dollar into gold, leaving details to Treasury on the minimum weight at which the government would be obliged to convert. Thirdly, it directs Treasury and the Federal Reserve to establish the procedures that would be required to carry out the provisions of the legislation. This prevents the Fed from acting independently in ways that would undermine the system, as it did in the last years of the Bretton Woods system that was suspended in August of 1971. The Fed would still have a vehicle to drive, but it would have only one clear objective, not twelve.

When the bill is introduced this month, it will serve the White House as a trial balloon and provide congressional critics of the Fed a focal point for discussion of fundamental monetary reform. The test of the strategy will be whether or not President Reagan offers sufficient encouragement to have the promise of reform become a campaign commitment. The 1980 convention endorsed a "monetary standard," but was sufficiently vague to be meaningless in terms of campaign politics. This year may be different if only because Ronald Reagan, who would like to leave a legacy of enduring monetary reform, will not have a third term. This is it. At the moment, it's still a long shot, but chances are much, much better than they may seem on the surface. If a few key pieces fall into place this month, against the continuing backdrop of disarray at the Fed, the long shot may come in.