Thinking about Prices III Jude Wanniski January 26, 2001

We think about prices all the time. All the time. Prices are expressions of relationships, the ratios of one value’s relationship to another. The dollar price of a baloney sandwich is a ratio of the value of the dollar to the value of a baloney sandwich. Two dollars per sandwich. One dollar per half sandwich. Actually, it gets more complicated. The price of a baloney sandwich is a ratio of two ratios. The value of a dollar is determined by the supply of dollars relative to the demand for dollars. Baloney has its own supply/demand ratio. The reason your head hurts when you try to fathom why the Dow Jones Industrial Average goes up and the NASDAQ goes down is the same reason our heads hurt at Polyconomics when we ponder questions about diverging and converging prices. There are more ratios than you can shake a stick at, as my father used to say.

The initial reports in this three-part series on prices was sent you last July, which may be worth a second look. There is not an economist in the world, even Paul Krugman of the NYTimes, who does not know that accurate prices are extremely important in the broad marketplace. Accurate prices signal people with surplus capital to invest more in those goods or services where prices are rising and to invest less in those things which are falling in price. If this price signal is not accurate, the market cannot function the way it is supposed to. For example, I had a question this week from a client who was puzzling about the dollar/oil price relative to the dollar/gold price and what would happen to oil if the gold price were to stay at roughly $265: “What do you think about OPEC price-fixing? From a geopolitical/economic standpoint, how should the price of oil be determined in coming years?”

The problem posed by the question involves the foundations of capitalism. If the price of gold and the price of oil were in their traditional relationship (15 bbls. of oil per gold oz.), the price of oil would fall below $18 a barrel over time, or the price of gold would rise above $400. Those are big differences, but that’s what the capital markets have to ponder as they try to decide which way things will go. If we knew gold would stay at $265 for the next 20 years, the reckoning would become easier. The problem for the energy industry, though, is that the cost of producing oil and getting it to market may now require a higher dollar price to yield a positive return on investment. In other words, the wages of the people employed and the prices of capital goods may be just right to produce a positive return at $30/bbl, but not $18. The markets know more about the law of one price than any one of us does, so they will hedge in expanding the world energy industry until the nominal price of the factors of production decline, so a profit can be turned at $18/bbl. When Prof. Robert Mundell says the Federal Reserve should now be adding sufficient liquidity to push the gold price to at least $310, he has this painful adjustment process in mind. The “energy” crisis of today, including the squeeze in California, was created by monetary errors by our central bank, not the greedy Arabs or the stupid California utilities. For that reason, there should be a federal solution proposed by President Bush, a California “bailout” if you will. Bailout??

The first client I had at Polyconomics in the summer of 1978 was Chrysler Corp. I was asked to help the brass figure out how to get a federal government bailout, to prevent Chrysler’s bankruptcy. My “free market” friends were horrified. My strategy was aimed at persuading Republicans to support the bailout, on the grounds that the government was responsible for the auto company’s financial squeeze. It had done so by imposing uniform environmental regulations on GM, Ford and Chrysler, and where the biggest of the Big Three could handle them easily, and the second biggest could do so with difficulty, the smallest was crushed. It was like a poll tax. The strategy was adopted and Chrysler got its bailout, but Lee Iacocca, who arrived late on the scene, took the credit and canceled Polyconomics’ contract.

Some are horrified now when I point out that I supported Treasury’s “bailout” of the Mexican government in 1995. On the same philosophy, I argued the U.S. Treasury, under acting Secretary Larry Summers, had invited the Mexico financial crisis by promoting the peso devaluation with Summers’ pals at the IMF. When Fed Chairman Alan Greenspan was asked at Senate Banking hearings if the problem could have been avoided, he said it would not have happened if we were on a gold standard. The only place that comment was reported was by Polyconomics, as I was sitting in the third row during the hearings. It went right over the heads of the financial press and none of the Senators bothered to ask what he meant.In the scramble over who will control the Treasury slot for International Affairs, to which we have alerted you, it is that arch-foe of gold, Milton Friedman, and his monetarist merry men, including George P. Shultz and Alan Meltzer, who are denouncing the idea of bank bailouts, by the United States or by the IMF. I would agree with them completely if we were on a gold standard, because bankers would than have a unit of account that would enable them to assess credit risks. As long as private U.S. banks are not provided such an anchored standard of value, they are forced to bear all the risks of the money side of a price ratio. How do farmers and miners and independent oilmen get capital to provide the energy the economy needs if our markets have no clue as to where the price of gold will be a month from now or a year from now? When Penn Square and Continental of Illinois fell victim to the deflation of the early 1980s, I was in their corner supporting federal assistance. Why should they pay for the costs of our experiment in monetarism? Professor Friedman might say it is their fault for not watching the ups and downs of M-1 and M-2 and other aggregates. Not I.

President Bush thinks we might ask Mexico to supply us with energy, but President Vicente Fox has an even worse problem than we have. His central bank is trying to keep its eye on the dollar value of the peso and the government’s finances are dependent on the world dollar oil price. If we suddenly dive into recession because there are no counterweights to the drag of the monetary deflation, the price of oil will dive too. Fox will have Mexico’s high taxes and a big budget deficit. Our new President instead should think about prices and how critical they are to the efficient functioning of capitalism or any other economic “ism.” Since I first met Greenspan in 1973, he has insisted you can’t have a gold dollar in a welfare state or under communism, because they don’t have market prices. Ah, but they still need gold as a guide for the unit of account their central planners use to set wages and prices. In a recent note to you, I pointed out that our deflation crisis ended in 1982 when we had to bail out Mexico by monetizing their peso bonds against monetarist advice. Maybe the crisis in California will save us this time around. Let’s hope so.