Thinking about Deflation XVIII Jude Wanniski April 18, 2001

Once Wall Street realizes that today’s big surprise from the Fed provides only a little upward tug on the deflationary lead balloon still with us, it again will grind away at the numbers until there is more evidence from policymakers that they have had enough. Today’s move by Fed Chairman Alan Greenspan came out of the blue, as the futures market saw only a 40% chance of a 50 bps cut in May, for goodness sakes, and it got it in mid-April. For those who continue to believe that cutting the funds rate will provide sufficient liquidity to solve the deflation problem, please note the price of gold fell by a dollar to $260 on the news. The long bond at first swooned, to a yield of 5.73%, but when gold turned thumbs down, the yield trekked back toward where it started the day, roughly 5.65%. It is certainly nice for the Fed to be recognizing the underlying weakness in the economy and trying to pump it up with lightning bolts like today’s. But with two ailments in the economy -- one of high interest rates and tax rates, the other of monetary deflation -- we still cannot see how producing the solution to one also solves the other. Our monthly strategy paper today ballparks the Dow Jones Industrial Average at 8600 a year from now, if nothing is done to alter Fed policy in a way that boosts gold above $300. Because the DJIA is so heavily weighted to six defensive stocks whose earnings represent 50% of the index, the DJIA is responding to deflation very slowly.

On the other hand, we did say we thought the bottom might have been hit in this long slide on the day the bottom was in fact hit, “Is This the Bottom?” 4/5/01. This was when Senate Majority Leader Trent Lott, after hearing us out on the deflation a few days earlier, made a brief floor statement expressing his concern. Lott, who like so many others may have thought more rate cutting by the Fed would raise the gold price and end the deflation, has been out of Washington during this Easter recess -- and is now in Europe. He’s key to any policy change. Jack Kemp of Empower America, a very close friend of Lott’s, was on CNBC’s Hardball last night, anguishing about the deflation and citing gold’s 17% decline this year as a sign inflation is dead. However, Kemp also seemed to think aggressive rate cutting by the Fed would “get ahead of the curve” and turn things around. We keep thinking Wayne Angell of Bear Stearns (who has been a primary source of this thesis for the WSJournal, Kemp, and other supply siders) would admit outright that we have to target gold directly. Not yet. We already are hearing from clients that if only Greenspan had done 75 bps today he would have gotten “ahead of the curve.”

For the Fed to target gold directly would mean we were on a gold standard, adding liquidity when the gold price tried to fall, subtracting liquidity when the price tried to rise. There is now no standard at all, in the sense that Greenspan & Co. decide from day to day on where they would like to see the overnight funds rate, but have no guide to when they should add or subtract liquidity. The last time we had such a guide was when the monetarists persuaded the Carter administration and the Volcker Fed to add liquidity when the monetary aggregates fell and subtract liquidity when the aggregates rose. This turned out to be one of the worst ideas in American history when it turned out that the monetarist assumption that money velocity would remain constant blew up, and with it the Carter administration.

We now actually are closer than we have been since the early 1980s to a gold standard. The fact that nobody at all is talking about it, except me, is no evidence I’m wrong. Six weeks before Nixon broke the gold link almost 30 years ago, Milton Friedman said he did not expect to see the dollar floated in his lifetime. This is why I have spent so much time recently with old supply-side allies discussing the role gold played in the 1920s and 1930s. It has been my contention for 25 years that neither the Federal Reserve nor the gold standard played any negative role at all in the Great Depression. Because there was no economic school of thought that attributed the Crash to the Smoot-Hawley tariff and the Depression to the Hoover/Roosevelt tax increases that were piled atop the tariff, the Keynesians, the Monetarists and the Austrians wound up blaming either gold or the Fed or both.

If President George W. Bush were to ask any of his economic advisors about gold, for example, they would tell him it would provide “discipline,” but would tie the Fed’s hands if the Fed had to flood the market with liquidity in order to pull us out of an incipient recession. These were the arguments of the professional economists who pushed Richard Nixon into going off gold (after they earlier talked him into raising taxes) and pushed Jimmy Carter into his cheap-dollar policy of 1979-80. These are still the arguments of the Monetarists and Keynesians who believe you can inflate your way out of a recession driven by errant fiscal policy. In a floating greenback world, inflation only makes sense as it does now, to offset the advantage that creditors have been given over debtors by the Fed’s deflationary errors of the last four years. It also makes sense for the Bank of Japan to inflate for the same reason, which has been obvious for several years. Instead, they have tried “easy money” through interest-rate cuts, which do not solve the problem even if they get to zero.

In a memo today on our website, welcoming the new Chinese ambassador, Yang Jiechi, I note the crushing deflation that his country’s peasants have felt as a result of Beijing’s well-meaning attempt to keep their currency as strong as the dollar. China’s nominal GDP grew last year because it is concentrated in the industrial sector, but the fall in commodity prices has impoverished the farm economy. The people turn to religion and “cults” for solace, and a nervous government in Beijing cracks down on them, when it should be devaluing. The whole world is afflicted in one way or another with the absence of a monetary standard in the United States. Our own farm sector has been savaged by the deflation, but our farmers have had a cushion of savings which they have now run down while the Chinese peasants had no cushion. Some significant part of the tensions we have with the PRC can be traced to the economic difficulties in Asia tied to the U.S./Japanese deflations.

As bearish as we are on a scenario where the political establishment remains bemused by this situation, we are even more bullish in the scenario where serious political and business leaders have light bulbs suddenly going off over their heads -- seeing the wisdom in going back to a gold standard, at an appropriate price, pronto. Sanford Weill of Citigroup, the most important banker in the world, already has been scratching his head in public, wondering if the dollar has gotten too strong. If Trent Lott throws the switch, Weill and other bankers may see the light. It really only takes a few people to get this job done, but they have to be the top people.