Contraction Rally Jude Wanniski April 10, 2001

Our call last week that we may have hit bottom on Wall Street was predicated on the sense that the monetary deflation may soon be dealt with, as Senate Majority Leader Trent Lott has made it clear to us that he now thinks it is a serious problem. His floor statement last week on “deflation” was shoe-horned into the debate over tax policy, but we did have indications from his office that he would return to the subject after the Easter recess. We think he will, but if he decides not to do so, we would have to expect new lows, especially in the Dow Jones Industrials. The rally we have been experiencing is related to the other problem in the economy, which relates to tax rates being higher than they should be and a federal funds rate higher than it should be. As the markets see promising developments on the tax front, we get the rally. At the same time, though, treasury yields backup because the markets must assume the Federal Reserve will delay cuts in the funds rate if they see stocks becoming rationally exuberant. The 30-year bond yield has moved almost in train with the Dow stocks since January 3. The Fed President who we thought might be best on the deflation issue, Robert McTeer of Dallas, a week ago was not ruling out an inter-meeting rate cut, but with Wall Street doing a little upturn, he has backed away. He does not have a vote at present, but what counts now are the intellectual winds that are blowing.

Bursts of good news about taxes and budgets that reach the financial markets do frighten the bears and encourage the bulls, but we take no encouragement from them as long as the dollar deflation drags down all dollar prices. The Wall Street Journal editorial page continues to kid itself into thinking whatever problems exist in the world economy are the result of vague errors made by President Clinton and his team. In his weekly op-ed column, Editor Robert L. Bartley dismissed the deflation argument by citing the recent CPI increase of 3.5% as an inflation sign. We have been trying to persuade Bartley for four years that this deflation is serious, and that the current CPI numbers reflect the early collapse in oil to $10 a barrel coming back to haunt us. Oil now is out of whack with gold on the upside, which is feeding through the price stream. If gold were out of whack, then commodities would be tracking oil. But they are not -- they are tracking gold. Our concrete proof of deflation is the fact that cotton, corn, soybeans, wheat, lumber and copper are at longtime lows while the dollar is at all time highs. After seeing Bartley’s column yesterday, I wrote a memo to other supply siders about its flaws, which you can read in our website client room. It is being posted there this afternoon. These theoretical debates are of great importance, for as you might imagine the White House and Treasury secretary read the WSJ editorial page and when they read all problems continue to flow from Clinton, they may tend to relax and wait for the “V” shaped recovery that cannot occur at $257 gold.

With the prices of things that come out of the earth reaching new lows, there is a temporary euphoria in those economies which exist on intellectual value added. American farmers and miners are in the former category, however, and they are running out of whatever they have left in their savings cushion. Adjustments to the high cost of energy are going to make Treasury Secretary Paul O’Neill happy he decided to sell his Alcoa stock, as we may get to the point where aluminum plants are forced to curtail operations. Bauxite, the stuff which becomes aluminum when electricity is added, is the most common commodity in the earth’s crust, about 12% of the total, if I recall correctly. It uses more power to become aluminum than anything else of value to humanity, which is why some call it solidified electricity. Either the price of oil is going to fall, because of global recession, or the price of gold will rise, rescuing commodity producers from a second round of deflation -- when the U.S. economy has not even caught up with the first. When inflations occur, they occur in spirals. That’s the same way deflations happen in mature economies where debt structures are lengthy and require time to unwind.

We remain bullish on bonds because there are only two ways the deflation can play out. It may continue without being addressed by our policy makers, in which case the stock market will resume its downward trek. This will invite a lower funds target as McTeer, who seems to be the man on the margin at the Fed, crosses back into bearish territory. Or, if the deflation is addressed and the dollar/gold price rises, bond yields will tumble as the Bush administration leads us to the kind of gold stabilization necessary to straighten out the world economy for the long haul. There is really very little reason for the kind of great inflation that would cause bond yields to soar as they did in the early 1970's. We are struggling now with the other side of the inflation/deflation mountain. If gold began to surge, there would be universal agreement to halt any rise at $350 tops by political means, i.e., changing the operating mechanisms at the Fed by a White House/Treasury/Fed accord and draining dollar reserves from the banking system.

Of course, if we decide to go to war with the People’s Republic of China, who knows what might occur? But the way President Bush is handling that issue has been greatly encouraging... another reason why Wall Street seems comfortable today. The NYTimes has a front-pager about how little room there is for maneuver with Beijing. My advice to my friends in the Chinese Foreign Ministry is to release the airmen now and continue negotiations on the modalities of our future relationship. I’ve believed from the outset that this is exactly the kind of incident that lends itself to positive diplomatic solutions. The fact that we are in Easter week, when families across the nation come together for holiday dinners, should be taken into account, as no matter how nice they are to the men and women detained, the detainees now are beginning to appear to all concerned as hostages. If the situation were reversed, we would do exactly as the Chinese have done to this point, taking their airplane apart and putting it together again, while detaining the crew members. But at a secondary point, public opinion here would support return of the Chinese crew. The only way to resolve these disputes is by application of the Golden Rule, the gold standard of politics in a world at peace, if it wants to stay that way.

Enjoy the market rally while it lasts, and please note how rapidly the NASDAQ high tech stocks can leap ahead once again, if conditions are right. I’m impressed that T.J. Rodgers, CEO of Cypress Semiconductors, has taken the lead in arguing for a simplification of our monetary system, doing so in a New York Times op-ed last Saturday. He doesn’t mention gold, but it should not take him that long to see that it does not get any simpler than gold. When I met with Treasury Secretary O’Neill a week ago, I told him he was a natural supply-sider, given his mania for simplifying systems at Alcoa in order to increase productivity. It is encouraging to know there are several supply-side maniacs still operational and that while none of the old-time supply-siders have found there way into the Bush administration, there really are several second- and third-generation supply-siders in the government. The NYTimes has another story today, on the first business page, about the return of the supply-siders after 12 years in the desert. Another good reason for this contraction rally.