Thinking about Deflation XVII Jude Wanniski March 15, 2001

Questions have been coming in since “Thinking About Deflation XVI” was sent yesterday, along with the JWBrief on how to solve our deflation and Japan’s with a simultaneous devaluation against gold. The most frequent comment is that it is not going to happen because President Bush would never do such a thing, involving gold. My response is that now that we have a nice little crisis, fear is finally on our side in getting the attention not only of the government, but also of Wall Street. You may remember my report that in early January I spent several days in Washington, prior to the inaugural, drawing circles and arrows for various officials who would be in the new administration. The circle represented the stock market. A big arrow pulls the stock market down toward the $265 gold price, representing the deflation. Little arrows pull the circle up, these representing any tax cuts or interest rate cuts in the offing.

Among those who expressed interest in the depiction was Dick Cheney, whose staff has been attentive to these arguments ever since. In addition, a number of other high officials at Treasury and in the White House have become attentive. At our client conference earlier this month, I explained the problem to Sen. Chuck Grassley [R-IA], Sen. Bob Torricelli [D-NJ] and White House Counselor Karl Rove, so they at least know of it. As I advised Cheney at the time, there is nothing that could be done until there is a crisis of some sort, which would mean sufficient attention could be brought to bear on the problem. When that happens, it will become clear that only an inflation -- a devaluation -- can reverse a deflation. Tax cuts and interest rate cuts, as nice as they might be to increase the efficiency of the economy, will have no effect on the deflation. I also assured him and the others in the administration who heard me out that while the economic problems headed our way would be severe, they could be ended instantly with a stroke of the President’s pen, an executive order that would revalue the gold reserves at a price that would rebalance the interests of debtors and creditors. Otherwise, as in Japan where the same problem has been unfolding for several years as the yen price of gold has come down by more than 50%, debtors will be unable to pay with the “heavier dollars” resulting from the deflation, and our banks will have to swallow significant losses.

Another question: Does that mean that we have to return to a gold standard? No, it does not. Our recent paper illustrating the parallels with the 1980-82 deflation showed the massive injection of dollar liquidity to deal with the Mexico debt crisis did not involve the price of gold, but the process sent gold soaring by $56 in one week -- a signal the monetary deflation had ended. Once the Treasury and Fed teams accept the deflation theory, they have more than enough expertise to engineer the solution, with or without bringing gold into the picture. This really has nothing to do with the dollar/yen exchange rate in the forex market. These are domestic problems in the Japanese and U.S. economies. Gold is still the best signal of the small monetary errors that creep into the economy as central banks on a daily basis add more liquidity than the market needs (an incipient inflation) or add less liquidity than it needs (an incipient deflation). As these errors accumulate over weeks and months and years, the general price level has to adjust to these changes. If we are not to see the stock market and dollar economy continue to weaken, there must be a rebalancing of these deflationary errors that have crept into the Japanese economy, our economy, and the economies of China and Hong Kong, which have imported our deflationary errors by pegging to the dollar.

Who is to blame for this situation? As a true monetary deflation is a very rare malady, the only fault lies in the economics profession, for not being able to diagnose it as early as we did in 1997. Even Nobel prizewinner Robert Mundell paid little attention to the decline in the gold price, instead assuming that deflation would not occur until the price indices turned negative. Mundell had written in 1971 that inflation was a decline in the monetary standard, by which he meant a rise in the price of gold. This enabled him alone to predict the inflation of the 1970s. He did not address the topic of deflation, though, a concept I find clearly addressed only in the writings of Ludwig von Mises. If the dollar/gold price rises from $35 to $350, Mundell sees that as inflation. If it then falls to $270, Mundell and most other economists see the decline not as deflation, but what they call disinflation. Von Mises would see the decline in gold from $350 to $349 as the beginning of deflation, with immediate consequences to transactors who made contracts at $350. The Wall Street Journal, which follows Mundell, not Von Mises or Polyconomics, has dismissed our arguments out of hand for the last four years and this morning says the stock market’s gyrations are related to the debate over taxation and have nothing to do with monetary policies. The fact that House GOP leaders now are talking about cutting the capital gains tax is of course great news for the market and the economy, but even if it happens, it cannot offset the deflation.

We continue to get questions from longtime clients who still think maybe if we cut interest rates to zero, the monetary deflation would end. I asked my colleague, Mike Darda, to answer this question, hoping his different word pictures would help you understand where I have failed:

High real interest rates in a deflation are a function of the dollar unit of account expanding -- the opposite of an inflation in which the unit of account shrinks. This implies nominal interest rates can be zero, or even negative for a time, while real rates remain positive because debtors have to pay back heavier bucks. This situation is impossible to solve with the fed funds rate, though, because each and every time the rate is dropped, the opportunity cost of holding cash declines. The demand for money rises. And we stay on a perpetually deflationary treadmill until a crisis knocks us off or our political leaders wake up. A deflation is self-perpetuating unless there is a monetary response to stop it that includes providing more high-powered money to the banking system than it wants, irrespective of overnight interest rates. Yes, the Fed has used its fed funds target since 1982. Interest-rate targeting is preferable to M targeting, which never works. But it has been FISCAL policy, not monetary policy, that ended the inflation of the 1970s and ushered in the deflation of 1981-82 and 1997-01. The last two decades have seen only two dramatic reductions in tax rates: 1981, which was followed by a deflation in 1982, and 1997, followed by another deflation that plagues us to this day. The first of the supply-side tax cuts passed in 1975 paralleled a brief period of “tight” money as the Fed had begun to be steered toward the monetary aggregates. Unless monetary policy is linked to something tangible, which automatically provides the exact amount of money the market demands, fiscal and monetary policy will continue to pull in different directions. And that is the problem we face now.

Please keep the questions coming as our responses will be shared with the political community and the Fed.