How We'll Hit Bottom Jude Wanniski April 4, 2001

I’m unable to report conclusively that the stock market is approaching a bottom, but we should know when it happens: when the gold issue surfaces at the highest levels of government. That should happen soon. Theoretically, if the dollar continued to strengthen, made scarce by errant Fed policy, gold could return to its Bretton Woods level of $35 and the DJIA would retreat to the neighborhood of 1000. The chances of this happening are as close to absolute zero as you can get, because so many political people are now paying attention to the deflation argument. All it takes is for one senior figure in the government to take the lead in arguing there must be a change in Federal Reserve procedures so liquidity is added until the dollar gold price climbs over $300. It could happen as early as this weekend, if the right man is invited on the right talk show and is prepared to make that argument. The cat would be out of the bag! We can continue to write about the issue until we are blue in the face, but the news media must have someone with political power put that ball in play in order to carry the story along to a natural conclusion. The financial markets would not go lower once they saw that possibility, because investors would not want to miss the Wall Street boom that would accompany the change at the Fed.

What we see turning the trick is the realization that the allegedly easy Fed policy since early January has not been easy at all. The Fed’s balance sheet now is smaller than it was on January 3rd, which is exactly what we predicted before the Fed sliced 150 bps from the fed funds rate. This is the reverse of the “treadmill effect” we saw played out in the fall of 1993, when the gold price began its rise and the Fed tried to puncture inflation expectations by raising the funds rate. Gold moved to $385 from $350 and sat there through six consecutive increases, as the Fed had to add liquidity to hit the funds target. One of our clients, Chuck Kadlec of J.W. Seligman, is a regular commentator on the CNBC “Squawk Box” and Fox’s Neil Cavuto show. He remained skeptical of our deflation argument until he had the indisputable evidence of this shrinking balance sheet. He thereby shifted his on-air argument Monday to saying the Fed must expand its balance sheet to get gold to $275, because the fed funds target has led to an unintended tightening. Neil Cavuto called it a “stealth tightening.” It, of course, also has helped that we have staked our reputations on the argument by advising the incoming Bush administration from January 7 that the stock market would decline until the deflation was arrested. The losses of the first quarter, the worst in 23 years on Wall Street, were satisfying to us only in the sense they proved us right. As it is been my practice to pick our asset managers from our client base, and never bother them, we have been hurt by the decline even though we saw it coming, mindful that of our five asset managers, there were varying degrees of acceptance of our ideas. We could not appear to be trying to gain by the market decline.

In our conference call this morning, I made the point that decisions like these are made by a very small number of people. There may be nine people at the Bank of Japan discussing policy, going from unanimous to a 5-to-4 argument for interest-rate targeting. From there it only takes one man to switch sides and make it 5-to-4 for easing bank reserves. The changes thus far have been microscopic, but the center of gravity has shifted. Our Nathan Lewis downplays reports that both the White House and Japan’s government are officially opposed to a yen weakening against the dollar on the grounds that the political leaders must do so pro forma, and then explain the markets are doing it, not they. This kind of movement, which affects our industries and Japan’s, can lead to the kind of discussions which produced the Plaza Accord in 1985, where the five major industrial countries agreed to keep their exchange rates in line and have a little inflation together. The objective, we continue to argue, is to rebalance the interests of debtors and creditors in the respective countries, as imbalance benefits no one when debtors cannot pay creditors.

The context of any discussion cannot be zero-sum, which is why Robert Mundell argues that great care be taken not to disrupt the forex markets. If there were a quiet deal cut between Euroland, Japan and the United States, Japan and the U.S. could make the case for a devaluation against gold while the euro stands still. This is because the eurocrats have kept the euro from deflating while the Fed and BoJ have not. We might imagine a euro/dollar rate at 100 from 90 today, a dollar/yen rate where it is today, and a dollar/gold price of $325/oz. This would be positive sum, with benefits all around the world, the only “losers” being the folks who are shorting gold and those who do not realize the equity bears will be overwhelmed by the bulls in the stampede for stocks that follows. It may not happen right away, but not because it is too difficult. Tax and spending policies are very hard to alter, but monetary policies can change when a bunch of guys sit around a table at Camp David and decide to do it, which is how Nixon went off gold in 1971.

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CHINA: In the conference call, I mentioned the flap over China and the possibility that good will come out of a diplomatic resolution. The problem is that at the end of the Cold War our “warrior class” introduced the concept of “moral equivalence,” which is that some countries are more “moral” than others. We are of course the most “moral.” The concept is not needed in wartime, when anything goes to win the war. But in peacetime, warriors become uncomfortable with the “Golden Rule,” which is that you do unto others as you would have them do unto you. For example, we should be able to fly spy planes to within 12 miles of the China coastline, but Chinese airplanes must observe our 200-mile coastal limit or be shot down, as they do not have moral equivalence. Secretary of State Colin Powell may be right that we do not have to “apologize” for the obvious accident, but we should be prepared to replace the Moral Equivalence doctrine with the Golden Rule. The bombers at the Pentagon won’t like it, but it would be very salubrious not only for our relationship with China, but with all the countries of the world. The Golden Rule also cuts in both directions, as it was the argument I used with my Chinese friends a few years back when the issue of intellectual property rights came up. They could see that while they now have very little intellectual property, they may in the future as they expand. This at least is the path I hope is taken. The alternative is to up the ante and sell Taiwan all the weapons they say they want. Not good.