Thinking about Deflation XX: Myriad Scenarios Jude Wanniski July 12, 2001

In the never-ending staff discussions we have at Polyconomics about the deflationary drag, the negative scenarios we come up with are almost wall-to-wall. They stretch from, on one extreme, an adjustment so gradual that no action is ever taken to offset the drag to, on the other, a sudden judgment by Wall Street that only a major decline in equities -- a thousand points or more of the DJIA in a day or two -- will shock the political class into action. The chance of a “Crash” is small because there are always positive forces moving in the opposite direction. When I used the old saw this morning, “One step forward, two steps back,” Mike Churchill suggested, “How about one step forward, one-point-one steps back?” When I met with Vice President-elect Dick Cheney on January 7 and explained the deflation drag to him, I said nothing could be done unless things got so bad that the political class feared a meltdown, and decided to find a way out of the accumulation of monetary errors that constitutes the deflationary process. I’m sure he remembers me telling him that the tax cuts and Fed interest-rate cuts would have no effect on the deflation, which could only be “solved” by an equal and offsetting inflation. Treasury Secretary Paul O’Neill was given the same warnings, so perhaps they will at least move in the right direction if and when the White House decides policy has to change from simply waiting for things to get better.

A foreign-debt crisis pulled us out of the 1982 deflation, when Mexico threatened default on its loans from U.S. banks. The Fed was forced to inflate just enough to cure the deflation and the markets boomed. Argentina currently is undergoing a meltdown, caused by the Fed’s deflationary errors. Could it provide the spark? We have been warning Argentina for several years that their currency board was importing the Fed errors, compounded by IMF-forced tax increases. When taxes and money are both pulling in the same downward direction, it gets ugly. In the U.S., where the deflation originated in the wake of the 1997 tax cuts, the real economy is struggling to grow and the monetary economy is forcing the adjustment to a lower numeraire. Argentina could default on its $130 billion in foreign debt, but we think Economy Minister Domingo Cavallo will do everything he can to squeak by for as long as possible, scrounging up the payments at exorbitant rates. His problem could be solved by the Fed monetizing a few billion dollars of peso bonds, which is how we fixed Mexico, but the underlying deflation problem would continue there and here if the Fed were to sterilize the fresh liquidity by mopping it up in New York. Greenspan could also take the bear by the ears and devalue the dollar to $325 gold, the number Jack Kemp put as the optimum rate in his WSJournal op-ed. The peso would thus import a dollar inflation to offset the deflation to date and it would become clear to the markets that Argentine debt could now be paid. We discuss this today on our website.

At the core of the U.S. debate is the growing realization that lowering the funds rate is having no positive effects on the struggling economy. Lowering interest rates corrects a problem caused by high interest rates, but a deflation can only be cured by a round of inflation. The source of all this difficulty can be traced to Greenspan’s experience in 1993-94, when he believed raising the funds rate would cause the gold price to decline, ending the incipient inflation. With each rate hike, gold remained stuck at the $385 level, and gradually Greenspan became persuaded that gold no longer served a useful function as a guide to monetary policy. The issue became more complex when former Fed Governors Wayne Angell and Manley Johnson argued that gold was still relevant, but that it would not respond unless the funds target was raised dramatically, that little quarter-point adjustments would not work. We argued at the time with both Greenspan and Angell that only by directly targeting gold/commodities, by draining reserves, would the inflation process be arrested. Gold finally came down when the 1997 tax cuts loomed, expanding the demand for liquidity which the Fed did not supply. But as this deflationary process continued, with gold going lower and lower, Greenspan remained persuaded that gold no longer counted, and Angell remained persuaded that only by cutting rates sharply could the Fed get ahead of the market. We have had a discussion among supply-siders this week by e-mail, with Angell participating.

Because Greenspan slammed the door on Polyconomics in 1997 when we irritated him with our persistent warnings of deflation, we have no idea what is going on in his mind. I’m sure, though, that if the lightbulb ever goes on in his head that gold is not the problem, and that it is the Fed’s operating mechanism which is at fault, he then would be scrambling for a policy change. The only person he respects enough to get that message may be Angell, or perhaps his predecessor Paul Volcker. I think only Angell is close to conversion, but he still is hoping another cut or two or three will do the trick. I know there are serious debates going on within the administration on this issue, with Secretary O’Neill more correct than Larry Lindsey, the President’s closest economic advisor, who is also a faithful Greenspan ally. At this point, the debate is misplaced around foreign exchange -- weak dollar vs. strong dollar. The NAM and AFL-CIO would like a weaker dollar, conservative Republicans line up with a strong dollar. Another stalemate discussion.

We continue to insist the problem is the integrity of the unit of account itself. If all economic transactions on earth took place in the spot market, there would be no need of a commodity money to provide a fixed standard of value. But because the foundations of the world economy require contracts for delivery over time and space, a floating unit of account makes it difficult for even the most secure enterprises to defend against currency losses. It is impossible for the weakest producers to do so, which is why the floating dollar is the primary source of global poverty. A presidential executive order to O’Neill to stabilize gold at $325 -- or somewhere between $300 and $350 -- would invite sharp declines in interest rates and sharp increases in equity prices around the world, as risk would be sharply reduced in the world’s key currency. Kemp is making that argument, but Robert Novak tells me he has never seen a greater hostility toward gold in political circles than he finds today. Please note that Arthur Laffer, once an unashamed advocate of a gold standard, is now insisting there is no deflation, that Greenspan is doing a fine job in managing the dollar, and we no longer need a gold standard! Robert Mundell, who I’d expected to be out front with his Nobel Prize championing a gold-based international monetary reform, is now silent, except where he is advocating currency boards, as in Mexico.

Plenty of scenarios are possible, but it is hard to remain optimistic that resolution can occur without a painful one, especially when those who we might expect to be with us are against us. But who knows? Maybe Greenspan, the Maestro, will wake up tomorrow with a lightbulb over his head. It really can’t happen without him. That’s the happiest scenario of all.