Market "Corrections" Jude Wanniski November 22, 2000

As we noted in “Murphy’s Law” earlier this month, there are several reasons why the bears are rampaging on Wall Street, only one of them having to do with the uncertainty in the presidential election. It is, though, the most immediate problem, as we believe the equity markets had priced in the supply-side tax cuts that await the lame-duck session December 5. The tax cuts may seem small to demand-siders, but they would fuel capital formation by eliminating the capital gains tax on annual investments of $5000, the amount in the new Roth IRA. Multiply that by tens of millions of taxpayers who qualify and you are talking real money. This is clearly the reason the market is declining as much as it is, we think, because as the conflict over ballots in Florida continues on the ground and in the courts, there is a dwindling chance of action in the lame-duck session. Senate Minority Leader Tom Daschle last weekend said he saw a 50/50 chance the tax bill could pass with the increase in the minimum wage, but as it appears that the nasty struggle for the White House will continue into December, there is increasing talk of a permanent continuing resolution that would simply end the 106th Congress with no further action. There is so much bipartisan support for this legislation and the other pension changes in the bill that it would make it into law next year, whether it is signed by President Bush or President Gore, but the effective dates would be in the year 2002 and the economy would lose a year of the capital formation the changes would invite.

Once the market has priced out tax cuts for 2001, that correction would be over and we would have a new floor on which to build going forward. But there is another bear force working on the equity markets that is not being addressed at all. The dollar earning reports that are coming in almost solely are due to the monetary deflation that began in December 1996, when the price of gold began its slide from the $383 plateau. Gold is now at $266, which is 7.6 times its price of $35 when the Dow Jones Industrials briefly touched 1000 in 1966, before the Vietnam taxes and dollar devaluations crippled the economy. Everything else being equal, that would mean the DJIA would have to be at 7600 to be on a par with the 1966 peak. Does this mean the DJIA will have to fall to 7600 from its current level of 10,000+ to get back into equilibrium? My guess is that it would not have to fall all that way back, but it certainly is being pulled in that direction -- by the inexorable Law of One Price. Those economists who do not want to use gold as the starting point for following the logic of the Law of One Price do not want to talk about it, because nothing comes close to gold’s efficiency in serving as a proxy for all prices. Nobody understands that better than Federal Reserve Chairman Alan Greenspan, but Greenspan gave up on that aspect of the gold signal when he did not see dollar prices falling as quickly as he had expected. Maybe gold does not work anymore, he postulated.

When gold was climbing rapidly in the early 1970s, though, it took several years before other prices followed in train and in the same proportion. There was an adjustment process which saw corporate earnings rise and the work force go on strike for higher wages, even though the unemployment rate was climbing. Workers’ wages were losing purchasing power relative to the commodities they needed for daily living -- for food, shelter, gasoline and fuel oil, and medical care. That is what happens in a monetary inflation, one that is driven by a paper currency’s loss of value relative to gold. In a deflation, the process reverses, but it still takes time for the adjustment to occur, and it now is showing up in disappointing corporate earnings. The dollars the corporations are earning are worth more, because they have greater purchasing power in commodities that have deflated. But debtors who thought they would be paying back dollar debts with the equivalent of the cheaper dollars they borrowed are finding it harder to do so with more expensive dollars. The one thing deflation has going for it is “backward bracket creep,” as the workforce is willing to accept lower wages at the margin because they get to keep more after-tax as the dollars buy more.

Still, unless there is an upward correction in gold price, to at least $300 and perhaps more, the forces that make the Law of One Price work are grinding away in trying to reach the level which is consistent with $266 gold. It would be a very painful process, as workers who have taken on debt against their prospective income stream would be unwilling to allow their nominal wages fall in line with declining corporate earnings. Check out the deflation of the 1870s and you will see how much social turmoil it produced. And that was done purposely, to push the dollar gold price back to its pre-Civil War level of $20.67 from the level to which it had floated, a bit over $40. It does appear accidental now, but perhaps Greenspan thinks it is a good thing. It is taking down equities, but it is pricing up bonds. Our Michael Darda observes today: “The bond market is rallying today on a report that unemployment claims jumped unexpectedly. If we see an actual increase in the unemployment rate itself, which is highly likely in the current environment, Greenspan should be able to nudge the limits-to-growth crowd into a rate cut by December. First it was the ‘wealth effect’ then the ‘pool of available workers’ for justifying super high rates. With both arguments now pushing in the opposite direction, it only can be a matter of time before the Fed reverses course.” Japan has been on this road for years. It has deflated so much that the yen gold price now is up only 2.3 times its 1971 level, compared with our 7.6 times. The Nikkei of course deflated too, which is chiefly how it got to 14,000 from 38,000.

Can we expect an end to these “corrections” once the presidency is decided? As neither Messrs. Bush and Gore nor their economists have shown any interest in monetary policy, some external force will probably be required to bring it to their attention. Which of the two is more likely to get it? I don’t know. The two men may be facing opposite directions, but they stand back-to-back, right at dead center. I’m being asked lately about my thesis that the best man always wins, so which is it? I have to point to my “chicken-duck-parrot political model” in Chapter I of The Way the World Works. Elections are like the game of charades, where the voters know what they want in the aggregate and the candidates have to figure it out. The voters want chicken. On election day, though, one candidate says “duck” and the other “parrot.” The voters pick the “duck” candidate, because it is closer to “chicken.” This year, Mr. Gore and Mr. Bush “triangulated” so they would get as close as they could to each other on the issues. And they both said “parrot.”

Under the circumstances, either one will do. My personal preference is for a President Bush, which is how I voted, but the electorate did such a perfect job in balancing out the House and Senate as well as the Electoral College that I am not sure it will make any difference on how policy is shaped for the next two years. The monetary deflation is the biggest problem the country faces, but it easily could be arrested if the Fed Chairman decided to do so. The Maestro, as Bob Woodward calls him in his interesting new book, will have no trouble getting either man’s attention.