Enron, O'Neill, Iraq and the Yield Curve Jude Wanniski and Michael Darda November 30, 2001

ENRON: In case you have not thought about it, Enron is a victim MAINLY of the monetary deflation we have experienced for the last five years. Yes, it has had management problems, but those problems were magnified every step of the way by the convulsions in the global energy markets. If the dollar had been linked to gold at the end of 1996, before it began its decline from the $380 plateau, oil and natural gas prices would have remained relatively stable, with little temptation for an Enron to play the energy market instead of meeting customer demand.

O'NEILL: The Wall Street Journal takes a cheap shot at Treasury Secretary Paul O'Neill in its lead editorial today, comparing him to former President Bush's budget director Dick Darman. The new editorial-page editor, Paul Gigot, probably wrote the editorial, which complains that O'Neill has not been pushing cuts in marginal income-tax rates hard enough and has been spending too much time talking about "tax relief" for low- and moderate-income workers and accelerated depreciation for business. In 1993, we argued the Clinton income-tax increases on the top rates would not have a terrible effect on the economy because the lower brackets were left alone and so was the capgains tax. Similarly, a lowering of those top rates by a few points would have almost no effect on growth, especially against the drag of the monetary deflation which the Journal editors ignore out of their affection for Alan Greenspan. O'Neill's prescriptions are at least as positive and are politically sound, in that low- and middle-income workers are being crushed by the Greenspan deflation and need relief in paying debts.

IRAQ: The big push by the Republican armchair warriors to take on Baghdad as soon as Osama bin Laden is found and disposed of is going nowhere, thanks to Russian President Vladimir Putin, who we also thank for talking President Bush into hanging on to the ABM treaty. The United Nations did approve extension of the sanctions on Baghdad for another six months, but have eased them somewhat at Putin's urging. More interesting is Bush's willingness to discuss with Putin the possibility of lifting the embargo on Iraq if Saddam Hussein allows inspectors back in to look around for weapons of mass destruction. Iraq has always been willing to do this deal, but if it can be made to look as if he is knuckling under to pressure from George and Vlad, so much the better. On the ABM delay, Putin is not only representing the interests of Russia, I believe, but also the interests of Beijing, which is not a party to the treaty but whose interests are protected by it. Here too, the GOP warriors are being outgunned intellectually by Secretary of State Colin Powell, who is driving them nuts.

IRAN NUKE? All the talk of Russia supplying Iran with materials that could translate into an Iranian nuke fails to note that Iran is signatory to the Non-Proliferation Treaty, which means it must permit inspections in every nook and cranny of its territory if the Vienna-based International Atomic Energy Agency says it has reason to suspect something funny is going on. This new protocol was added after Iraq was forced to admit in 1991 that it had a clandestine nuke program from the time Israel blew up its nuke power plant in 1981. Twice in the last year, the IAEA has asked Iran to let it look at suspicious activities spotted from the sky and both times found nothing to worry about. It is extremely difficult to actually hide a nuke weapons facility, I'm told, because of the infrastructure involved -- especially the power lines necessary to feed it the huge amounts of electricity needed to run the centrifuges. Thus far, Iran looks innocent. Iraq let the IAEA inspectors into a site in January, where it found nothing untoward. It is now stonewalling the IAEA, which wants to inspect again. The reasoning is not clear, but the protocols do require something more than a fishing license. (JW)

DEFLATION AND THE TREASURY YIELD CURVE: The following is a response to a client inquiry about why the yield curve is so "steep" even though we are ensconced in a monetary deflation with strong dollar demand and falling dollar velocity. We thought it would be instructive to post the reply here, as it bears directly upon recent bond-market activity:

In a monetary deflation, there is a "deflation premium" attached to non-interest bearing debt (liquidity) because it appreciates against real goods. In other words, money demand outstrips money supply causing the purchasing power of the monetary unit to rise in value. Thus, the deflation "premium" and declining velocity. By contrast, the "interest-rate premium" that investors demand to hold 30-year treasuries vs. 2-year treasuries is reflected in the spread between these two instruments. The reason for the wide spread is that the market expects the Fed funds rate to fall to 1.75% in the next month and then begin rising next year -- by more than 175bps according to the eurodollar futures market. We expect this interest-rate risk to be wrung out as expectations of a strong recovery are dashed, which should allow yields to fall further along the entire treasury curve. Just this week, comments from Fed Governor Lawrence Meyer about the need for aggressive rate cutting have pushed expectations for a rate cut on December 11 to more than 90% from below 40% prior to the speech. Of course, there is always devaluation risk at the longer end of the curve. The last two episodes of deflation (1982 and 1985) were ended with the dollar eventually pitching into inflationary territory, a perennial risk in a fiat monetary system. In Japan, where the economy has labored under a decade of monetary deflation, the 2-year JGB note yields 0.15% and the 30-year JGB yields 2.44%, also a wide "positive" spread in an overtly deflationary environment. (MD)