Deflation: What Else Could It Be? Jude Wanniski June 12, 2001

If you have been skeptical about our deflation argument, you must now ask yourself what else could possibly be dragging on the economy and equities. We stated in our March 7 letter, “No Reason to Hold Equities,” that the monetary deflation that began in the commodity universe in early 1997 had reached the broader economy and would bring down dollar values of prices, profits and wages to equilibrate with $270 gold. On March 30, I reported on my five days in Washington, where I laid out the arguments to senior officials of the Bush administration and to members of the House and Senate in both parties, including then-Senate Majority Leader Trent Lott. On April 10, we noted that Lott had taken us seriously and inserted remarks about “deflation” in his comments on the tax bill then before the Senate. We said:

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.

As it happened, Lott thought about saying more, but became uncomfortable with the idea. He indicated he would follow the lead of his friend Jack Kemp, who has been making the deflation arguments in his private conversations in Washington. Almost a month ago, Kemp sent an op-ed to the Wall Street Journal advocating a gold standard to end these inflation/deflation swings. But Robert L. Bartley, editor of the WSJournal, has sided with Fed Chairman Alan Greenspan on this issue. He turned down the Kemp op-ed, which means there has been nothing about the deflation in the world’s premier financial newspaper, with unfortunate consequences on those corporate leaders who are now feeling the pain of deflation and have no idea what has hit them. Kemp and Lott now seem at a loss on how to start a “conversation” that could lead to a solution. It has been more than three years since I’ve been able to crack the WSJ editpage on this topic and the NYTimes rejected the one op-ed I submitted on deflation. It did run as an op-ed at Investor’s Business Daily, but I don’t have sufficient standing to get the deflation conversation on a roll.

Because monetary deflation chews away slowly at the economy’s foundations, and because the financial markets and economy can rally in its face when there is good news on taxes or interest rates, it can be dismissed easily. The cumulative effects now should be forcing the Political Establishment to wonder why their mainstream economists cannot explain the nature of the malady they are facing. The monetarists can’t complain that the money-supply aggregates are too low; indeed, they are so high (and meaningless) that Friedmanites predict inflation lies ahead! The conservative Keynesians, who believe lower interest rates are the answer, now have 250 bps in cuts since the beginning of the year, with only wishful thinking that “they will kick in sometime later this year,” because it takes six months for “monetary policy” to work. We once thought Dallas Fed President Robert McTeer could help, because he openly watched gold. Now he thinks we may have overdone the “stimulus” with the rate cuts and the Keynesian tax cuts, which will put big rebate bucks into people’s pockets as the year unfolds, also with no effect on deflation. Other supply-siders have a variety of excuses on why an economy that worked just fine when interest rates and tax rates were higher and the budget was in deficit now is struggling with lower interest rates, lower tax rates and a budget in surplus. If you do not accept the deflation argument, you are forced into all sorts of intellectual contortions.

The WSJ’s Bartley, we understand, now insists we can’t be in a deflation because prices are still rising. This is a common confusion as long as you cannot separate deflation impulses from contraction impulses. Deflation, like inflation, is a monetary phenomenon. Deflation occurs when money is scarce relative to gold and inflation occurs when gold is scarce relative to money. The Fed controls the money, by adding or subtracting liquidity to the system, so it can prevent inflations or deflations by targeting gold. U.S. price indices are still rising because oil has become scarce relative to other commodities -- which happened because of the first phase of the monetary deflation. When the deflating dollar dragged all commodity prices down in 1997-98, oil came with it, dropping from $25 bbl to $10 bbl. The world stopped investing in new oil production capacity, causing oil to become scarce relative to all other commodities, and pushing its price up to $30.

Other commodities have not rallied with oil because other commodities are produced by multitudes of individual producers. Not many of them stopped planting or mining when prices fell. Beneath the statistics, though, are the tragic stories of tens of millions of farmers and ranchers and miners around the world who have been crushed by the dollar deflation, especially those whose governments have maintained a dollar peg. One of those countries is China, which now is openly admitting having to face riots in the countryside, with peasants unable to pay their taxes or their debts and still have enough to eat.

All debtors in dollars or dollar-pegged currencies are in the same fix. Ludwig von Mises called monetary deflation “creditor relief,” at least for those creditors who get paid. In this morning’s NYTimes, a page-one headline advises, “More Falling Behind on Mortgage Payments.” Inside we find: “Office Rents Fall for First Time Since 1993,” and a story about a bipartisan Senate push to tighten bankruptcy laws, urged by the banks and credit-card companies. On the WSJ front page: “WARNACO FILED for Chapter 11 bankruptcy protection... battered by $3.1 billion in debt and a dismal retail climate. Shares, which hit a high of over $44 in 1998, closed Friday at 39 cents.” The story says Warnaco’s “Linda Wachner couldn’t manage to pull off one of her famous saves,” and I wondered if she would have been helped if she read about the deflation in the WSJ.

A client who gets our sector analysis and says “I have to be in equities” complains that we find no positive sectors of the 87 in the S&P. We looked harder, but still could not put in a truly good word for any, although we try to scale them from most worst to least worst. The gold sector is the least worst, we think, because of all the sectors, it has absorbed all the deflation at its current price. Of course, if Trent Lott delivers a capgains tax cut this summer, as promised, gold would decline and the sectors would scramble up and down, but only for awhile. Like justice, the wheels of deflation grind very slowly, but exceedingly fine.