Monetarism, as we have come to see it practiced by the Federal Reserve Board since October 1979, died on Tuesday, Oct. 5. The event was celebrated on Wall Street in the days that followed with euphoric leaps in the value of the nation's stock, and the party has spilled over into this week with another dizzy climb.
In the weeks ahead, as we get confirmaation from the Fed that the monetarist experiment has been buried for good, we can expect more rejoicing in the financial markets. This would merely continue the bull market that began in early July with the first signs that the three-year experiment was coming to an end. The good news promises a dramatic expansion of the U.S. economy, indeed the global economy.
The news leaked to the markets on Oct. 6 that the Fed's policy-making Open Market Committee had the previous day decided on a "temporary policy adjustment." It would let the weekly money supply expand more rapidly than previously planned while it sorted out "changes in financial institutions' deposit flows." Last Saturday, Fed Chairman Paul Volcker publicly revealed the "temporary" obsolescence of the M1 measure of money.
The suggestion that this may be "temporary" is a fig leaf that Volcker tossed to the monetarists who have dominated monetary policy in the Reagan administration, and who continue to expose the president to the charge that the boom on Wall Street and all that it promises is only a temporary political maneuver that will end after the November elections. In fact, the M1 target is going into the Smithsonian.
This does not mean that inflation will soon rear its ugly head. If it did mean that, we would not expect to see declining interest rates and life again in the long-term bond markets. The death of monetarism simply means the end of an experiment with a central-bank quantity target.
The Fed's objective is to provide a dollar that holds its value over time, so that people who make contracts in dollars don't suffer windfall losses or gains because of unexpected changes in its value.
The Fed wants to prevent inflation, a condition that means the dollar is losing value, rewarding debtors and punishing creditors. It also wants to prevent deflation, a condition that means the dollar is gaining value in terms of real goods, thus punishing debtors and rewarding creditors.
The most important way the Fed has of controlling the value of the dollar is to buy or sell government bonds with dollars. Bonds are interest-bearing debt of the Fed; dollars are the Fed's non-interest-bearing debt. By changing the mix of bonds and cash on a daily basis, the Fed aims to provide a money as free as possible of inflationary or deflationary surprises.
When does the Fed buy or sell bonds? That's the central question monetary policy must always address. And there are only three basic options the Fed has as a guide to open-market purchases or sales of bonds with cash.
It can target the quantity of some measure of money, a quantity rule being that which we have come to call monetarism. It can target the price of credit, buying or selling bonds to keep a specified interest rate within a specified range. This was the dominant guide to Fed policy from August 1971 to Oct. 6, 1979.
Or it could target the price of money itself, which is its purchasing power in terms of real goods. From 1792 until August 1971, the banking system in the United States used gold as a proxy for the value of all real goods, buying or selling bonds to maintain the value of the paper currency in terms of gold. Theoretically, other proxies could be targeted in keeping with this "price rule."
The problem is that you can only hit one target with the monetary instrument; the other two have to be free to fluctuate.
The monetarists, backed by the Reagan administration, say we should buy bonds when an "M" quantity of money is falling below some specified range and sell bonds when it is rising above that range. Keynesians, backed by Democrats, say the Fed should buy bonds when the specified interest rate rises and sell when it falls. The supply siders associated with Rep. Jack Kemp and Lewis Lehrman, the GOP gubernatorial candidate in New York, say the Fed should buy bonds when the price of gold is falling and sell them when it is rising, a "gold standard."
The supply siders observe that since the Fed began targeting the money supply three years ago the price of gold -- the most monetary of commodities and thus the most sensitive -- has swung wildly between $298 and $850, and interest rates have swung wildly as well. By contrast, from 1792 to 1971, the price of gold did not vary by more than $20 (including the Civil War greenback period) and long- term interest rates almost never exceeded 5 percent.
President Reagan's supply-side tax incentives could not possibly work amid this monetary chaos. The halving of the gold price from election day 1980 to the spring of this year compared to the worst monetary deflation in our history. That is, the sharply appreciating paper currency squeezed all debtors, but especially those who had borrowed heavily at the top, in 1980. Mexico, for example, was among the biggest dollar borrowers in the world in 1980 in order to develop its oil fields when oil was $40 a barrel, but it has to pay its debts with deflated $28 oil.
Had Volcker this summer held gold below $300 in pursuit of M targets, the bankruptcy rate would have accelerated here and around the world. Gold at $250 suggests an unemployment rate of 15 percent; at $200 the rate would probably approach 20 percent. In shelving M as a target, Volcker has brought vast relief to the financial market and to the economic system itself.
Chances are that the Fed will now once again target interest rates as it had prior to October 1979, as the Democrats have urged, but with an eye on the price of gold as a reliable signal. If interest rates alone are pegged while the value of the dollar is free to vary, credit has to be rationed, at great risk to efficiency and liberty.
Targeting the gold price in its current range would leave interest rates to allocate credit; the quantity of money would fluctuate in step with the market's demand for money at a constant price level. In January 1981, Lewis Lehrman told the White House transition that such reform would yield a 6 percent prime rate in 18 months and the greatest bull market in stocks and bonds the country has ever seen. We are moving in that direction.
But if, after the November elections, we find that the temporary holiday from monetarism was indeed just a holiday, the Fed's intervention will unwind the gains of recent weeks and abort recovery. The exuberance of the market is suggesting that Wall Street believes it's permanent. The end of monetarism is here. Someone should tell the president.