Fighting the Tape Jude Wanniski November 28, 2001

Whether bull or bear, it is not easy to be in the position of fighting the tape, as we have been doing for the last few weeks. Yes, it was nice to call the bottom of the 9-11 trench in the market on the specific grounds that Secretary of State Colin Powell had gotten the upper hand in the administration's handling of the war against the Taliban. On October 4, we were “Bullish Up to a Point.” By getting Pakistan to fully cooperate, Powell was able to keep the entire world in the global coalition. Instead of carpet bombs, the Northern Alliance/U.S. Air Force combination was able to surgically remove the Taliban cancer with minimal collateral damage. On the other hand, by October 18 we thought we would soon see a resumption of the deflationary trend in the financial markets that has led into the current recession. Instead, Wall Street has been rallying for no apparent reason -- other than an expectation that the worst was over and we could now expect and discount an economic recovery by next spring. The Dow Jones Industrials are still 100 points above their level of September 10 -- with a parallel percentage rise in the S&P 500 and a more robust rally in the NASDAQ. All this bullishness has led several supply-siders who had been riding the deflation bear to stop fighting the tape and announce good times ahead.

We see no reason to do so and remain persuaded that until there is a break in monetary policy, the deflationary adjustment process will resume and carry the DJIA below 9000. The economy WANTS to grow and the equity markets WANT to see it growing, and the demand-side economic policies being thrown at it do have positive effects. The Fed’s lower interest rates are better than higher interest rates and Keynesian tax cuts are in many cases better than no tax cuts at all. The auto industry is helping the economy by selling cars at a loss, which is part of the deflationary process. But it cannot keep up that kind of help forever. Eventually auto workers have to be willing to take cuts in their wage/benefit packets for automakers to show profitability. Housing is still pulling against the tide, largely, perhaps, on the more favorable treatment of capital gains on homes -- but we cannot see housing escaping the mandates of the inexorable deflation.

In fact, we have no confidence that any sector can build equity prices under these monetary circumstances. Remember, though, that equity values can increase even while the price of a dollar asset remains constant. If dollars are gaining in purchasing power as the deflation process unfolds, so are all dollar assets. If a share of General Motors, now at about $39, is still selling for $39 when the deflation process is completed, its owner would have a 20% capital gain and owe no taxes on it. In an inflation, even if GM stock rises, and inflation rises faster, it might go from $39 to $59, and the purchasing power of the underlying dollars would not only be less, but the owner would have to pay tax on the $20 increment.

One of the analytical challenges we face is that we can find no time in history that matches this particular kind of monetary deflation, which began with tax cuts not matched with the monetary liquidity necessitated by the tax cuts. The 1981-82 deflation comes closest because it was generated by the Reagan tax cuts, but it ended so abruptly in August 1982 that it did not produce enough of a record to give us a sense of the pace of its deflationary spiral. Japan has given us the longest look at a gradual deflationary spiral, one now running eleven years, but it was concocted by an odd combination of errant monetary and fiscal policies. It could now end its deflation simply by devaluing the yen against gold by 20%, and there are those in the Japanese government who would love to do exactly that. The U.S. economic establishment, already facing zero profits, would go bananas in the face of what they would see as a “competitive devaluation.” That is why it would be best if the relevant players in the dollar, euro and yen areas would have a secret meeting in some nice hotel and coordinate a joint devaluation against gold -- which is what I have been suggesting to those U.S. government officials who bother to ask.

If all transactions in our exchange economy were in the spot market, there of course would be no pain in a deflation adjustment of the kind we are now experiencing. All wages, set daily, would go down in 24 hours, and workers would not face debt payments contracted at the higher dollar levels. This was the essence of the German economic miracle that I spotted when researching The Way the World Works in 1977. Everyone knew Ludwig Erhard had a monetary reform that went from a greenback Reichsmark to a gold Deutschemark, but I noted that because the progressive income-tax system was not changed, the net effect was to instantly push the entire work force down the progressive tax ladder. This was a huge tax cut that spurred the demand for the new DM and made the monetary reform work. When U.S. economists predicted Egypt was doomed because Anwar Sadat made a deal with Israel in 1979 and the oil-rich Arabic countries punished Sadat by cutting off his cheap oil, I discovered Sadat was planning a tax reform similar to that of Erhard. He left the rates the same but raised the thresholds by a factor of ten. Egypt grew like crazy but the same terrorist outfit responsible for September 11 assassinated Sadat.

Because we do not live entirely in the spot market, the trouble we face from the deflation that lies ahead is in the mounting bankruptcies of debtors and their creditors in the contract market. If debtors cannot pay, they go bankrupt. And when creditors do not get paid, they go bankrupt. It is painful for those forced over the edge into bankruptcy, but unlike contractions caused by higher tax rates or tariffs or regulations, there is no permanent damage to the financial system. The same ideas that fueled a dot.com that could not survive the deflation are in the heads of men and women who can try again with new corporations. That is, if they can get the financing from debt or equity creditors. I think this may be what Wayne Angell calls a “jobless recovery” that he predicts for 2002, as GDP resumes a positive growth track but with higher levels of joblessness than during the long expansion. I hear that illegal immigrants are already heading home, with better prospects in Mexico than here, and black teenage unemployment continues its rise.

I am pleased to note that Larry Lindsey, the President’s right-hand economist, did discuss the possibility of deflation when asked about it by Tony Snow on "FoxNewsSunday." He even made clear that while consumers might like lower prices that lower wages were part of the process. But then he dismissed the notion we are in a deflation, because the price indices are still in the black, which no doubt reflects Fed Chairman Alan Greenspan’s view at the moment. At least the topic is being discussed, though. As the terrorist threat seems to recede along with chances that we will leap out of Afghanistan into Iraq (thanks again to Colin Powell), maybe the President himself will begin asking questions about what is holding back the recovery. Another few down days on Wall Street like we have had this week and who knows, maybe he will even ask me.