Viewpoint: Has the Dragon Been Slain?


I suggested in this space three months ago ("A $600 Question," May) that we may now be looking at an end to inflation because the Federal Reserve, although disposed to be irresponsible, has responsibility thrust upon it by the financial markets. People operating in those markets are so alert to the hazards of inflation, I suggested, and so ready to take evasive action against it, that the Fed can only reignite inflation if its board members abandon reason. Policymakers are cheerfully immoral but rarely irrational.

In a nutshell: Yes, the Fed is capable of expanding the money supply at an excessive, inflationary rate. If debt monetization is excessive, then inflation psychology will return, the "money supply" will begin to circulate more rapidly, all prices will tend to rise, and—I argue—interest rates will go up. Not down, up.

Borrowers will swiftly demand and receive higher rates to protect themselves against inflation. (If they don't, they will be givers, not lenders, as indeed was the case frequently in the 1970s.) Thus the Fed, by pursuing too-expansive a policy, would succeed only in driving interest rates up, thereby hurting the economy. Conclusion: the new market sophistication exacts good behavior from the Fed. Therefore we may expect a period of monetary stability.

I have received a fair amount of comment on this thesis. Lewis Lehrman, who ran for governor of New York, is not too enthusiastic about it. At the "pre-Williamsburg" monetary conference in Washington put on by Jack Kemp and Robert Mundell, he told me that he thinks it's a mistake to believe that just because lenders deserve an inflation premium, the market will give them one. Lehrman is suggesting here that some people will be prepared to lend money at a loss, underselling those who want a profit. I disagree with Lehrman that money losers will be able to set the market price of credit, but readers should be warned: Lewis Lehrman knows a lot more about the bond market than I do.

Lending some support to Lehrman is Alan Reynolds of the economic consulting firm Polyconomics. Reynolds asks in a letter: "Suppose the supply of some relevant measure of money greatly exceeded demand, and the bond and mortgage markets collapsed. Why should we suppose that the Fed would pay attention to this market information when they have not done so for at least a dozen years?" R.W. Bradford of Port Townsend, Washington, concurs, saying that "inflation has never worked as long-term policy, but it does 'work' in the short run, and those in power have limited terms." Prof. A.E. Fekete, visiting research fellow at the American Institute for Economic Research in Great Barrington, Massachusetts, also disagrees with me: "As long as the Fed keeps buying bonds," he writes, "bond prices will go higher and interest rates will go lower."

I am a great admirer of AIER's research reports, but I disagree with Fekete's views (and they are his). So, I believe, does former senior Treasury official Norman Ture, who once told me that the best way to get interest rates down would be for the Fed to sell (sell) $10 billion worth of bonds "to show the markets it was serious about fighting inflation." In reply to Fekete: throughout the 1970s the Fed did "keep buying bonds"—and interest rates went higher and higher.

I spoke to J. Anthony Boeckh, editor of the Bank Credit Analyst in Montreal, and he is in partial agreement with me. At least, he concedes that market constraints on the Fed are now severe. He thinks that we may now be in a period of declining inflation, with each new inflation peak lower than its predecessor. (He says the 1974 inflation peak was higher than in 1979.)

Also on my side is George Gilder, the author of Wealth and Poverty, who believes the Fed has lost power. He thinks the present situation is analogous to the failure of the "Phillips curve" (when inflation goes up, unemployment comes down). As long as workers were deceived by "money illusion"—"higher" wages that, however, turned out to buy the same goods (or less, because the workers were in higher tax brackets)—unemployment could be reduced by inflation. But one day the workers learned what was happening to them. They started to demand real pay increases, and at that point inflation could no longer "solve" unemployment.

In the same way, as long as the lenders of capital were content to receive a negative return on their money, it made perfect sense for the Fed to erode government debt by stealth, buying it up bit by bit, week after week, with brand-new money created for the purpose. As Bradford says, this did indeed "work," if only in the short run.

And that is my answer to Alan Reynolds. The Federal Reserve did not entirely ignore market signals during the 1970s. It no doubt took grim satisfaction in noting that lenders could frequently be fooled into accepting interest rates that turned out to be lower than the inflation rate. By 1980, however, the game was up. (By this time workers could no longer be fooled by inflated paychecks, either.) Interest rates rose to 20 percent or more, well above the inflation rate. They have stayed that way.

My main point, and Gilder's, is this: It takes people time to learn. But once they have learned, they remember. Markets are rational, but not instantaneously so. People have now learned about inflation, and they will not soon forget the lesson. The "short run" mentioned by Bradford used to be perhaps a couple of years. Now, I think, it is down to a month or two—too short to be of any use to the inflationists.

A final point: one or two who responded may have been offended by my suggestion that we can have stable money without a formal role for gold. In fact, the gold price plays a crucial role in this system of "market control." The Fed must respond to a rapidly rising gold price by tightening money. This puts the country back on a price rule and circumvents the main defect of the quantity rule (monetarism), namely, fluctuating demand for more money.

Shortly after I last wrote, the gold price fell abruptly by $100 an ounce and since then has stayed in a narrow range ($410–$440). So the Fed may already have switched to a price rule, without admitting it.

Tom Bethell is a free-lance writer, a contributing editor of the Washington Monthly, and a columnist for National Review.