The Reserve Takes Flight Once Again
BROCKAY, GEORGE P.
The Dismal Science THE RESERVE TAKES FLIGHT ONCE AGAIN BY GEORGE P. BROCKWAY On July 20, Federal Reserve Board Chairman Alan Greenspan announced a fundamental change in the way the august body he...
...Milton Friedman, the leading monetarist, wanted Ml to grow annually between 3 and 5 per cent...
...In order to buy, it offers a high price, which is the same as a low interest rate...
...Naturally, if he raises the Federal rate, he effectively raises others, including those that are far from negative...
...But who cares...
...Milton Friedman has long contended that the Federal Reserve Board has used its great powers so erratically in the past that it should be put under strict statutory regulation...
...So many radical rethinkings in so few years suggest an unseemly flight-iness in an institution whose primary excuse for existence is to provide financial stability beyond the turmoil of partisan politics...
...At 6.5 per cent, the interest expense is up to $650,000—an increase of 8.3 per cent in cost, and a decrease of 8.3 per cent in the amount of money the mousetrap company can afford to borrow...
...According to Greenspan, "one important guidepost" of the new indicator will be the so-called "real" interest rate: the actual rate minus the rate of inflation...
...The interest rate, not the money supply, is what the Federal Reserve Board can control directly and assuredly...
...You would think that by this time we might all agree to stop fretting over the money supply...
...Putting consumers and speculators aside for the moment, consider a company with plans for a better mousetrap, requiring investment in a factory, equipping it with machinery, buying supplies, hiring workers...
...For the rest of Volcker's term, the nation was forced to rely on seat-of-the-pants judgments of officials whose cerebral judgments had proved sensationally wrongheaded...
...If you yearn to know more about P-star (as their equation was called by insiders), I refer you to "The Reserve's Silly New Equation" (NL, June 12-26,1989), in whose last sentence I wailed, "How long must we allow ourselves to be deluded by silly equations...
...Monetarism clearly missed the call, and missed badly...
...Expansion beyond 5 per cent, he claimed, would cause inflation—instantaneously if the expansion was anticipated, or with a lag of a year if it was not...
...The capitalist system turns on borrowing, however, and borrowing depends on the interest rate, and the lower the rate the greater the economy...
...For the next six or seven years we heard a great deal about Ml and its velocity...
...If no one wants to produce a better mousetrap or buy a better automobile or take a flyer in the stock market, bankers must sit on their cash...
...Because if he buries his money like the slothful servant in the Parable of the Talents, he will still have his $1,000 but his purchasing power will shrink to $965...
...In case you've forgotten, Ml is cash and traveler's checks and checking deposits...
...Nine days later, the official number proved to be 1.6 per cent...
...It feels it can just about swing it...
...M2 is all that plus most savings accounts, money market funds, and other odds and ends...
...What Greenspan is threatening is a Cost of Living Adjustment (cola) for bankers...
...On October 6, 1979, Paul A. Volcker, the then new chairman, revealed that thereafter the Reserve would "be placing greater emphasis on day-to-day operations of the supply of bank reserves, and less emphasis on confining short-term fluctuation in the Federal rate" (the rate at which banks borrow reserves from each other overnight or for a day or two...
...Not only that, but the bond market would fall, as it necessarily does when interest rates rise...
...Anyone lending $ 1,000 at 3 per cent gets back $1,030 at the end of a year, but his purchasing power will have shrunk to $993.95...
...By 1986, expansion beyond 5 per cent was surely anticipated by all rational economic agents, because it had not been below 5 per cent for 10 years...
...The company figures all that to cost $10 million...
...3) Make do with lower profits, which would make future borrowing still more expensive...
...Of course, the money supply never was a reliable indicator, for the simple reason that no one can say what it is...
...In a word, they aren't, and they cost the economy (that is, you and me) about $500 billion a year (see "Bankers Have the Classic COLA," NL, January 9, 1989...
...He has mentioned only one aspect of his new one (and that I will discuss presently), but he has used it with results that can hardly be called encouraging...
...The Dismal Science THE RESERVE TAKES FLIGHT ONCE AGAIN BY GEORGE P. BROCKWAY On July 20, Federal Reserve Board Chairman Alan Greenspan announced a fundamental change in the way the august body he heads looks upon the economy...
...If investment is as important as everyone says it is, and if stable prices are as important as the Reserve says they are, Greenspan's half point adjustment would be bad for every company and for the whole economy in one of the ways I've noted, and quite possibly in all three ways...
...Yet in 1986, when M1 jumped 16.8 per cent (and M2 jumped 9.4 per cent), the Consumer Price Index (CPI) rose only 1.9 per cent —its smallest rise in 22 years...
...It is the second such revision in Greenspan's six and a half years as chairman, and the fourth in something under 14 years...
...The stock market would surely follow later, for the same reason—and, considering its present fragile highs, could very well crash...
...Yet the Reserve, perhaps for ritualistic reasons, has adopted a new target for M2 growth (1 -5 per cent), even though it acknowledges that hitting (or missing) the target won't indicate anything special...
...Not only that, but the inflation would accelerate without limit...
...Well, the Reserve seems at last to have abandoned this equation, or the theory behind it, which, Greenspan said last month, "has been downgraded as a reliable indicator...
...For convenience, let's say it can borrow at prime, currently 6 per cent, for an annual interest expense of $600,000...
...It was valid enough when money was something rare and tangible and not readily reproducible, like gold or silver...
...It is well understood by bankers and economists that colas on workers' wages are inflationary and should be resisted...
...Now suppose Greenspan gives bankers a one-half percentage point cola...
...If all this activity increases borrowing, as it is likely to do, it will increase the money supply, because money is negotiable debt...
...Even rich companies that do not need to borrow must consider the opportunity cost of using their own money instead of lending it out...
...This is not merely a tactical shift, as from easy money to tight money?although the Board's volatility on the tactical level is bad enough—but a basic rethinking of how the economy works and what the Board should therefore do...
...Friedman once said the number used did not matter, so long as one stayed with it...
...These options are faced every day by every company, large or small...
...I think I can promise you that the new indicator will continue to get things wrong...
...Although bankers do most of the talking about the interest rate, their role in lending is comparatively passive...
...Greenspan thinks that's unfair and hints about raising the Federal rate one-half a percentage point or more to make things even...
...2) Raise prices to cover the added cost...
...The company then has three options: (1) Abandon or scale down the expansion and the jobs it would have created...
...The Federal Reserve Board was left without a theory—that is, without a coherent idea of what it was doing or why...
...How are bankers' colas different...
...Since the tracks of the different aggregates have been substantially different, it would appear to have made some difference...
...Also, true to the teachings of Ayn Rand, he cut expansion of Ml and M2 back below the 5 per cent target...
...When, as now, the Federal funds rate is about 3 per cent and the CPI rate is about 3.5 per cent, the "real" Federal funds rate is negative 0.5 per cent...
...How long must we allow ourselves to be deluded by archaic ideas...
...And what did the CPI do...
...It sets the Federal funds rate and the discount rate, and it controls them by buying or selling Treasury bonds on the open market...
...It surged ahead 4.4 per cent in both 1987 and 1988...
...The banks that sell bonds thus increase their cash reserves, putting additional downward pressure on the interest rate...
...The Federal Reserve owlishly publishes aggregates it calls M1, M2, M3, and L. Lis about six times M1...
...Monetarism had taken charge...
...In the spring of 1987, Alan Greenspan succeeded to the chairmanship and at once set three economists to work on an equation intended to use M2 to prophesy the price level two or more years ahead...
...That there is a determinate money supply, and that its size determines the price level, is an old mercantilist idea...
...But he would regulate the growth of the money supply within a narrow range, even though he doesn't know what the money supply is, and the Board has shown it doesn't know how to control it, whatever it is...
...It is the interest rate that matters to the economy, and it is through stabilizing the rate at a low level (about half what it is today) that the Reserve could (if it would) do its bit to stabilize the economy...
...Let's look at the record...
...He may be right...
...In his July 20 testimony before Congress, he forecast a second quarter growth rate of 2.5-3.0 per cent...
...Nevertheless, on June 13, 1989, the Reserve went to extraordinary lengths to publicize what two years of labor by those three economists had produced...
...So why should he lend...
...The downgrading of M2 does not mean the Chairman is without any indicator...
Vol. 76 • September 1993 • No. 10
