Economist's Commentary: March 20, 2008
Conversations with Dr. Daane
By Lawrence Yun, Chief Economist
As a guest speaker to Vanderbilt's Owen School Lecture Series, I had the pleasure recently to spend a day with Dr. Dewey Daane, a professor at Vanderbilt University and the former Federal Reserve Governor from 1963 to 1974. This was my second engagement at the school, and I was quite honored to be re-invited considering other speakers have included Paul Volker, Donald Kohn, Richard Fischer, Roger Brinner, Lawrence Meyer, and other esteemed economists.
It was nearly a year ago at my first visit where Dr. Daane raised alarm bells about too much debt leveraging in the U.S. financial system and the potential for a major liquidity crisis should there be unwinding and the meeting of margin calls by even just one Wall Street firm. With so much borrowing on top of borrowing and more borrowing by Wall Street firms, there was no doubt one of the companies would inevitably face up to the credit risk of holding onto a large amount of bad debt. This credit risk, and massive debt, invites a quick unraveling of the liquidity risk. As Bear Stearns just recently was going belly up, I immediately recalled his great concern.
Today, he is very alarmed about inflation. He applauded Richard Fischer (the Dallas Fed President) and Charles Plosser (the Philadelphia Fed President) for voting against the 75 basis point cut in the Fed funds rate this week. Wall Street wanted, and was pricing-in according to, a future contract on a 100 basis point cut. Dr. Daane said even a 50 basis point cut would have been a difficult decision if he had the FOMC vote. I think he would have preferred no cut at all.
Dr. Daane also emphasized the importance of a stronger dollar to keep inflation under control. Though inflation is lurking, he would sell gold at this point because the run-up in gold prices cannot be explained by fundamentals or by inflationary pressure. The government may actually make money for taxpayers if it sold gold now and then repurchase later — after a price decline, which will surely happen. He knows something about gold as he was the governor assigned as the chief spokesperson with international bankers in early 1970s when the dollar was getting de-linked from gold.
In a further anecdote, he also showed bravery back then on behalf of the U.S. while at an international bankers' conference in Spain. An anonymous person, through a loudspeaker, accused him of U.S. gutlessness and challenged him to fight a bull. Dr. Daane quickly donned a matador costume and entered the bull rink, to the amazement and horror of the American contingent. The New York Times ran a front page photo and article of Dr. Daane being lifted by a bull's horn and of Fed Governor taking "irresponsible" risk. He was uninjured. No other international banker, including from the host country, entered the rink.
I partially agree with his assessment. I believe the Fed rate cuts up to now have been appropriate in the current environment. However, any further rate cuts from this point onwards may not be helpful. The adjustable rate mortgage will move in same direction as the Fed funds rate, but many consumers strongly prefer the fixed rate over adjustable rates in light of the current subprime loan implosion. Given that 30-year mortgage rates will not measurably fall from this point, perhaps the Fed should stop cutting rates. There is indeed a greater possibility of an increase in mortgage rates if inflation takes off. The current Fed funds rate of 2.25 percent is very low. Surely, it should not fall to a 1 percent rate as back in 2003 and 2004 when deflation, not inflation, was the worry. The Fed seriously needs to consider a public announcement that the cycle of interest rate cuts has reached its end.
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