Raising High Real Interest Rates? Jude Wanniski June 23, 1998

Memo To: Sen. Paul Sarbanes [D-MD]
From: Jude Wanniski
Re: High real interest rates

[I originally sent this memo to Senator Sarbanes, a Democratic member of the Joint Economic Committee, on June 16. I halfway expected some sort of reply, and requested a call from his staff aide, a Mr. Gruenberg, but I assume it went into their circular file. So I’ll post it here to see what you think.]

I sympathized with you as I watched a C-SPAN review of Alan Greenspan’s testimony before the Joint Economic Committee last Wednesday [June 10]. You are absolutely correct in pointing out that we are experiencing extraordinarily high interest rates. You also are absolutely correct in noting that the Fed is contemplating a tightening in order to shut off economic growth just as the benefits of expansion are reaching down to the lowest income classes. Greenspan, of course, did not give you a straight answer, but simply said that if it is his sense that inflation will occur in the future, it may be necessary to raise interest rates however high real interests seem to you or how much the increase will deny employment or real wage increases to people at the bottom.

The problem we now face is that Greenspan has put himself in a position where he can do whatever he pleases, because there is no rule of any kind that he need adhere to. After years of telling Congress he watches the gold price most closely for inflation signals, he now tells Congress there are no rules that are reliable -- and he must be free to raise interest rates even if all the available inflation signs he has used in the past are dormant. You should know that if the Fed were required to follow a commodity price rule in determining when it would tighten or ease, there is no possibility that it would be thinking of tightening or even voting to tilt in that direction. Indeed, if the Fed had been required to maintain the dollar price of gold at $350, which is where it had seemed to balance the interests of debtors and creditors during the last dozen years, there  now would be no Asian crisis. When gold hit $350 early last year after spending three years at the $385 plateau, we urged Greenspan to add liquidity to prevent gold from falling. The reason it fell was the success of the budget deal and its several important tax cuts, which increased the demand for liquidity in the banking system.

If you mention this memo to Senator Torricelli, he will concur that I warned him last summer of the effects of the Fed’s dollar deflation. I was sufficiently worried that I asked if he would arrange a meeting for me at the White House to discuss the matter with Erskine Bowles. He called Bowles and Bowles asked that instead I meet with Larry Summers, the Deputy Treasury Secretary. Summers dismissed the argument that the declining gold price was relevant but said he would be happy to review further information I might pass on. I sent several reports to him as the deflation deepened in Asia, exacerbated by multiple errors by the IMF’s team. Late in the year I met with Summers again and gave him a paper I’d written in 1995 on the systemic problems of the Japanese economy, which have never been addressed and are now threatening the regional economy and ours as well. Summers has come around to see that the problem lies in Japan’s tax system and has nudged his boss, Secretary Rubin, into urging tax cuts in Japan. The specific tax  that Japan needs to cut, even eliminate, is the capital gains tax on real property, which can run as high as 67%. Because people who own property assets of any magnitude will not sell unless they are desperate, the government gets no revenue from this tax source. It would cost the government almost nothing to eliminate it and it would immediately send the Japanese stock market up by several thousand points, out of harm’s way to the banking system.

I take the trouble to send this note, Senator, because I have seen how close you have come to realizing the essence of the problem. We have with a dollar that floats in a world of floating currencies. We had one set of problems as the dollar gold price moved up from $35 thirty years ago to as high as $850 in the Carter administration. It took a great deal of pain to bring it down to $350 by a series of tightening episodes by Paul Volcker. It is creating an entirely new set of problems now that Greenspan has permitted it to fall to levels it has not seen in 20 years. I’ve had several discussions about these points with Rep Barney Frank, who had become familiar with many aspects of monetary policy during his service on House Banking. He’s also aware that I have been issuing these warnings as the crisis has deepened. Jack Kemp, who I have been advising for 22 years, has been practically alone among political leaders in connecting the Asian crisis to the Fed’s deflation.

There really is no way to solve the problem without bringing gold into the equation, seeing its dollar price decline as a clear sign of monetary deflation that would precede declines in oil and then all other commodities. Unless Greenspan is forced to do that which he has said for decades he would prefer to do -- establish an official dollar/gold link -- we have to wait for enough breakage to occur in the real economy so the Fed has no choice but to add sufficient reserves to meet the demand for liquidity. It is always too late to fix breakage once it occurs.

I’d be happy to come to Washington to meet with you and your staff and any other Democrats who would like to learn more about these observations. Again, Senator Torricelli will vouch for my bona fides.