Thinking about Deflation XIX: A Deflationary Spiral Jude Wanniski April 24, 2001

It is now four years since I asked for a meeting with President Bill Clinton to warn about monetary deflation and was invited instead to talk to Deputy Treasury Secretary Larry Summers, now the president of Harvard. Even earlier, I began warning friends and clients that the falling gold price was a sure signal the Federal Reserve was not supplying the market’s liquidity needs. Why has it been taking so long for others to see what we have seen throughout? The main reason, I think, is because the deflation is in a slow spiral, just as the inflation that began when President Richard Nixon took us off gold led to an inflationary spiral. There have been inflation spirals many times in history, but what we are going through now seems unique. The 1980-82 monetary deflation did teach us some lessons, but there was an important difference in that 1980-82 saw an abrupt decline in dollar prices. The Reagan tax cuts called for liquidity the Fed would not supply causing gold to fall to $310 from $620 in 18 months. The other factor that made it different from the current deflation was that the monetarist inflation which preceded it was even more abrupt. Gold climbed to $620 from $240 in 18 months as the Fed flooded the banking system with liquidity, trying to hit the Friedmanites’ “M” targets.

I have written dozens of times in these last four years about how the deflation is a slow, grinding process. This is because the gold-price decline has been gradual and because the preceding period, from 1986 to 1997, was relatively stable on the monetary front. Gold began 1986 at about $350 an ounce and it began 1997 at roughly the same level. In between there were moderate swings, but nothing to cause a monetary deflation’s primary damage, which is to bankrupt debtors. When I try to describe the problem to someone in person, I hold my arms straight out and identify the left hand as the creditor class and the right hand as the debtor class. When you are on a gold standard, the Fed can make no inflationary or deflationary errors. The market gets exactly the amount of liquidity it wants and needs, and if more is supplied than is wanted, the gold price trends up, requiring the Fed to withdraw liquidity. If less is supplied than is needed, the price trends down and the Fed knows it must add liquidity. The monetary system is always in balance.

With the dollar floating, there are no market signals which the Fed must observe. It can add liquidity to hit an “M” target or subtract liquidity to hit an “unemployment” target or “stock market” target or a “forex” target. While it is doing so, it can get away with minor errors as long as the price of gold remains steady. But when there are tax increases that reduce demand for liquidity, and the Fed does not drain liquidity by selling bonds, the gold price rises and debtors benefit at the expense of creditors. This is what happened in 1993-96, with the Clinton tax increases. Gold rose to $385 from $350. To illustrate, I lift my right arm a bit and drop my left arm a bit. The financial system is out of balance. Deflation produces the opposite effects. As the economy moved toward the 1997 tax cuts, increasing the demand for liquidity, the gold price began to decline. My left “creditor” arm moves up and my right “debtor” arm moves down. I began warning that we would overshoot financial balance in the other direction when we went below $350 gold. As we did, my left “creditor” arm rose above the level, my right “debtor” arm dropped below horizontal.

My warnings became more intense when I saw that Alan Greenspan, who watched gold on the way up, did not seem to worry about its decline. Nor did my old supply-side allies, who dismissed the gold decline as irrelevant, perhaps having to do with central-bank gold sales. Wayne Angell of Bear Stearns, a former Fed governor, did not buy that idea, but he did argue the gold price should be closer to $320, perhaps even $300. We went to these levels by the end of 1997, when the tax cuts did pass into law. The result: Personal bankruptcies rose to an all-time high in 1998, 1.5 million households and businesses. At the same time, my warnings that oil and commodities would follow gold down became reality.

This happened slowly enough so that there could always be an ostensibly plausible excuse from those who were ignoring the warnings. The Asian crisis was the biggest excuse, but of course it only worked if you had rejected our argument at the time that the Asian crisis was caused by the Fed’s deflation: The Asian central banks had glued their currencies to the dollar when it was steady or slightly inflating, then were hammered as the dollar deflated. If you still are surprised that you do not read about this in the financial press, it may be because the opinion leaders I have been warning all these years would have to confess error in not having spoken up. Jack Kemp is the sole exception. For the first time last Sunday, Kemp publicly announced that the Fed had to add sufficient liquidity to get gold over $300. There is dead silence from most supply-siders, including the WSJournal editorial page.

And deflation is not over. The long, slow grinding process works in a deflationary spiral to mangle debtors, just as inflation worked upward in mangling creditors. Remember workers in the 1970s only demanding 10% wage increases, plus fringes, plus automatic cost-of-living increases, even though gold had gone up 400%? They could make ends meet because the maturity of contracts enabled them to pay mortgages and leases with cheap dollars. But as it then cost a carpenter much more to hire a plumber or a lawyer or a doctor, the work force had to make another upward wage push. Economists called it “wage inflation,” but it was simply the economy having to live with the cheaper dollar. The pushing and shoving more or less came to an end in the years after we leveled out at $350 gold, made possible by the Reagan tax cuts. We are now in reverse and have not really adjusted to $300 gold, let alone today’s $263.

Our guess is that a year from now the DJIA will be at 8600, unless there is a policy change to restore debtor/creditor balance. And that’s not the bottom. At $263 gold, the DJIA would continue to decline to fit inside the tighter monetary material until it got to 7000. How are the major corporations going to fund their pension plans when they are in debt to their workers in nominal dollars that are harder and harder to find with profits? It is too soon to start discounting that horrific picture into equity values today, but we are moving in that direction. Workers who have gone through bankruptcy court once will find themselves having to do it again, as we slide down the spiral. The bankruptcy law has gotten much tougher, though, which makes it tougher for people who need credit to get it. The downward spiral is nicer only in the sense that the problem is the result of an economy that wants to do more, because of the lower tax rates already passed and those to come. Workers will always be able to pick up another job when their employer has to fold because the adjustment problem is overwhelming. Or, they could negotiate “give-backs,” as they did in the 1980-82 deflation, taking lower wages and fringes as they see their dollars progressively buying more. It is at least time to worry about this.