Appeasing Bond Holders, But Where’s the Inflation?

Federal Reserve Chairman Alan Greenspan finally stopped teasing the financial markets last week and raised interest rates. The action came after months of “will-he, won’t-he” speculation, and some up-and-down dithering in the stock and bond markets.

Although the stock market tried to slit its wrists Thursday, Greenspan’s action was extremely modest. A quarter of a percent on the overnight rate, after all, is not much. Even though most banks immediately pushed up their prime rate by the same amount--that’s the rate they charge to their best business customers--the actual economic effects are still trivial. A company with $100 million in prime-based loans outstanding, for example, will see its costs go up by $250,000 a year. Most companies could find that much in their president’s travel expense budget.

What counted was the symbolism of Greenspan’s action: It was of a piece with his recent jawboning of the stock market. Though the economy may be picking up steam, inflation pressures are still nowhere in sight, and there seems to be plenty of industrial capacity. But by acting now, well ahead of any obvious pressures, Greenspan hopes to squelch even the hint of economic exuberance. “Look how tough I’ll be if inflation really takes off,” he’s telling investors.

Not since the 1950s, when William McChesney Martin was at the helm of the Federal Reserve, has there been such an obsessive focus on inflation, such a fear of too-rapid growth, so much anxious sniffing for whiffs of boisterousness. Presidents John F. Kennedy and Lyndon B. Johnson liked money easy and rates low; Richard M. Nixon and Jimmy Carter worked the money presses like a fire hose. Money was tight when Paul A. Volcker ruled the Fed, but President Ronald Reagan, and later George Bush, eased the pressure by running up huge fiscal deficits.

But now, in a second-term Democratic administration, from the party traditionally associated with easy money and low interest rates, there is not a hint of unhappiness with Greenspan’s pre-emptive actions. With Robert E. Rubin, the former Goldman, Sachs chairman, at the helm of Treasury, the administration is committed to “sound money” to a degree that old J. P. Morgan would have approved. What happened?

The answer, as with so much else, lies in the Reagan-Bush fiscal policies. In 1980, total federal debt was only $700 million--or about a quarter of annual gross domestic product. Now it’s $5.4 trillion, or nearly equal to annual GDP. When a business gets in trouble, it’s the bond holders who dominate the creditors’ committees and call the financial tune. And that’s what happened in America. A $5-trillion bond-holder interest is just too powerful to ignore, and will be calling the financial tune well into the next century.

When interest rates go up by 1%, a long-term government bond loses about 40% of its value. (To understand why, assume the government has promised to pay you $5 a year forever. If interest rates are 5%, that promise is worth $100; but if rates rise to 50%, and you need to sell your contract, it will be worth only $50.)

Most government paper is held by financial institutions that have to “mark to market” daily. If an investment bank holds $100 million in long-term bonds, and the bonds lose 10% of their value because of a rise in rates, the bank has to reduce its recorded profits by $10 million, even if it continues to hold the bonds.

It is perfectly understandable, therefore, that bond holders are in terror of instability. Rising inflation hits the bond market especially hard because long-term investors can’t be sure what level of interest rates to charge. Increased uncertainty tends to push rates up extra fast, generating big “mark-to-market” losses. Bond holders, as one might expect, hate uncertainty.

“Slow and easy” is the bond holders’ universal prescription. Growth is good, but never so much as to create instability. Much better to have recessions than inflation, because recessions won’t cause rates to go up. Greenspan’s pre-emptive action is in perfect accord with the bond holders’ view of the world. A quarter of a percent rate or so increase now to keep the lid on, to dampen down the economic engine, is far preferable to a possible big jump in rates later.

Since debt service is now such a huge chunk of the federal budget, and since government bonds are such a huge component of the Social Security trust funds, even a Democratic administration has to dance to the bond holders’ hornpipe. And that’s why, at bottom, there is such little fundamental difference between the administration and congressional Republicans on spending and budgets.

The rules, in fact, are simple. You can start as many new government programs as you like--just as long as they don’t cost any money. The current level of federal debt is fine--in fact, the bond community probably likes it because it gives them such leverage--but you can’t let it grow any more. And no matter what you do, President Bill Clinton, keep your eye on interest rates, because that’s the only number anyone really cares about.

Who knows, the new economic dispensation may even be good for the country. One thing for sure is that it will be extremely dull.*