Thinking about Deflation XVI Jude Wanniski March 14, 2001

We began writing about monetary deflation four years ago, when the price of gold began falling from its 1993-96 plateau of $385. It is surprising that so many people, including clients, still have difficulty grasping the concept. When Wall Street Journal editor Robert L. Bartley wrote Monday in his weekly column that Fed Chairman Alan Greenspan still has to be concerned with inflation, and thus has to keep a grip on money, but as the economy is weakening, the answer should be a nice, fat tax cut, I decided I had better give a refresher course in deflation. If you understand it as I do, you will see that neither tax cuts nor interest rate cuts will arrest the decline in the stock market when gold is at $265.

First, let us remove gold from the playing field so you are not confused into thinking deflation can involve only gold. Imagine the dollar has been floating for the last 30 years, with the Federal Reserve trying various experiments to fit assorted economic theories. It has tried the addition or subtraction of liquidity to keep overnight interest rates at a particular level, with the aim of managing national output. It has tried targeting the monetary aggregates to suit the formulations of the monetarists. It has tried to manage the Phillips Curve trade-off between inflation and unemployment, by more or less targeting the length of the unemployment lines. It has even used its powers to add or subtract liquidity by trying to manage the exuberance on Wall Street. Now it has decided to target commodity prices, but it does not know which to target. It can, for example, choose between an Apple Standard and an Orange Standard. For the sake of argument, let us imagine the normal price of an apple or orange is $1 each, but because of a severe frost in Florida, which has wiped out the entire crop, oranges are selling for $20 each. Under these circumstances, we probably would decide not to choose an Orange Standard, not simply because they are expensive, but because of the adjustment problem.

With oranges at $20 each and guaranteed by the U.S. government, people would begin growing oranges everywhere. Apple trees would be uprooted and orange trees planted. The price of oranges would not come down on the futures market because they would be guaranteed at $20 each. As a bumper crop of oranges appeared, the price would try to fall because of the glut, but the Federal Reserve would have to prevent that decline by adding liquidity, which makes oranges scarcer relative to dollars. The added liquidity would course through the banking system and the economy, causing dollars to become abundant relative to oranges. The net effect would be for oranges to stay at $20, because they could go no higher. If they went up by a penny, the Fed would have to drain liquidity to prevent that from happening. In order to return to the normal one-to-one relationship with oranges, apples would rise to $20 each, and all other prices in the dollar orbit also would rise by 20 times. The central bank would have to supply the dollars to undergird that rise in apples if it wished to prevent the dollar orange price from falling. It would be much neater and cleaner, you can see, if we wished to go on a commodity standard, to choose an Apple Standard, because oranges could come down to the universe of prices instead of the universe moving to oranges.

Now imagine that we do not like the idea of an orange standard or an apple standard, because there are too many disruptions that can be caused in either, through frosts or bugs or blights. Suppose we decided to go on an oil standard, oil being durable. If oil were in a normal relationship with apples and oranges and the universe of prices, we could go on an Oil Standard, even putting up with the fact that there are variations in oil from different fields that make it more or less valuable. The Fed would add or subtract liquidity to keep some benchmark oil price from rising or falling in dollar terms. But suppose there had been recent convulsions in the price of oil, because the Fed had starved the economy of liquidity and made the dollar so valuable relative to oil that it had dropped to $10 a barrel. If the world wants more oil but the Fed is determined to keep the price at $10, when apples and oranges still are selling at $1 each, then the Fed would have to withdraw liquidity as oil tried to rise in price. The scarcity of dollars would then force apples and oranges down to 50 cents, and the labor required to develop oil fields would have to be cut in half to make oil production profitable. The scarcity of dollars in the system would force all prices to equilibrate with $10 oil.

We really should think, though, of bringing gold back into the conversation because all the kinks have been worked out of it as a monetary commodity over the last several millennia. It is compact, not bulky like oil. It can be refined so that a precise weight and fineness can define it in terms of money in every corner of the world. It never tarnishes and really cannot be destroyed. The problem remaining would be figuring out the right price. If it is now too low because of deflation errors made by the Fed, it should be adjusted upward before being fixed, or the universe of prices will have to adjust downward to fit the scarcity of liquidity at the current price.

Why do all dollar prices have to adjust to gold? Because the gold price continues to be the markets’ best gauge of inflationary and deflationary error by a central bank. The gold signal is the most monetary of all signals in the universe of dollar prices, so it is better suited to serve as a guide to the dollar than oil, apples, or oranges which vary in their monetary characteristics. Gold has the most monetary properties of any internationally-traded commodity, in large part because its total above - ground supply is so large relative to annual production and consumption. This means the gold price is the first price to adjust to an inflationary or deflationary error on the part of the Federal Reserve, while the pace and magnitude of adjustment will be different for oil, apples, oranges or haircuts. Going back to the 1500s in England and the early 1800s in the U.S., as University of Berkeley Professor Roy Jastram proved in his book, The Golden Constant, the entire price level of a country reverts to the gold price in its currency over long stretches of time.

The deflation problem cannot be solved by cutting tax rates or by cutting interest rates. The WSJ's Bartley should see that now, right? Indeed, cutting tax rates or interest rates, to the degree they increase the demand for liquidity, only will cause the gold price to decline further, and the drop in the universe of prices and wages must be greater. My barber, Elio, who has no training at all in textbook economics, understands this immediately. When I ask him to imagine the price of gold falling to $1 an ounce, he immediately sees he could no longer charge $13 for a haircut, which could not be the equivalent of 13 ounces of gold. A little quick arithmetic and he sees he realistically could charge only a nickel. But if everyone else adjusts, a nickel would have the same purchasing power as it has now. A new, small car would cost no more than $30. There would even be benefits, as he would take-in only $1 a day over 250 days a year, and he would not have to pay income tax!! It is also clear to Elio that getting from here to there would be a nasty process, as the entire work force would have to go through the meatgrinder.

Finally, in this quickie lesson, remember that inflation is a decline in the monetary standard, characterized by a rise in the price of gold followed by other commodities, a process which then translates into a rise in the universe of prices. Things that come out of the earth go up first. Things that come out of the intellect go up last. In a deflation, the reverse is true. Oil and commodities went down first and the intellectual producers enjoyed the euphoria. How nice it was for NASDAQ and the New Economy, where value-added is piled onto a grain of sand. Now it is the intellectual producers who are having to adjust. As long as this adjustment process is underway, and it only now is beginning, there is little reason to be holding equities, which are priced in dollars. On the other hand, as the experience of the 1980-82 deflation demonstrated, once the government is forced to make the dollar more plentiful relative to gold, the equity markets will respond immediately with a great sigh of relief.