Key to 2002: Pricing Power Jude Wanniski December 28, 2001

As we ponder the prospects for financial markets in 2002, we find ourselves confronting one critical question: Will the Bush administration and the Federal Reserve change monetary policy in order to reverse the dollar deflation? If they do, we would expect the markets to end the year slightly higher, perhaps with the DJIA at 11,000, provided that there is no broadening of the war against terrorism into Iraq, and no additional terrorist acts of the September 11 variety. If the deflation is not rectified, we would expect the markets to end the year lower (DJIA 8,600, or worse). As we approach year-end, markets are rallying despite the absence of any hard evidence of an end to the deflationary recession in sight. This rally has policy consequences because, in order for there is to be a change of heart in the Bush administration, there really would need to be a fairly large stock-market decline first in order to dislodge Washington's confidence that the existing monetary and fiscal measures will spark recovery. As a practical matter then, we would not expect any monetary policy change until at least the second quarter. We are hopeful that 2002 will be the year when the deflation is fixed, but we cannot guarantee it. A reading of this morning’s front-page leader in the WSJournal about intellectual conflict inside the Federal Reserve between Chairman Alan Greenspan and Fed Governor Laurence Meyer tells us deflation is not even a topic in that circle. Of course, we could be wrong but we do not think so. For the economy to grow in nominal terms, incomes and profits have to grow in nominal terms, but without producer pricing power that simply can not happen. Inventories have been reduced by aggressive discounting, and vendors who need to turn a profit in the new cycle will be looking for lower prices, when they restock. This will put producers in a squeeze, not least because many face higher wage and pension costs in 2002.

Is the financial market irrational? Not at all. It discounts the future and at the moment there are incipient expectations the economy is bottoming out and a normal cyclical recovery will appear in the first, second or third quarter. As we have noted before, the markets do not get ahead of themselves in this discounting process. We are prepared as always to fight the tape because our analytical framework gives us information not yet available to the broad market. As a perfect example, we have for three years been advising clients to get out of Argentina because they have been caught in a worse bind than we have here -- a monetary deflation compounded by IMF-imposed tax INCREASES. Our last client with substantial investments in Argentina finally conceded six months ago that we were correct and sold off his positions with losses small relative to where they would be now if he had held. The solution to the chaos in Argentina is a discrete 20% devaluation of the peso to gold, but as we were not able to persuade anyone in Buenos Aires or Washington of that prescription, the economy now faces total collapse, with Steve Hanke’s currency board closed down, a third funny-money currency introduced, and the peso currently trading at a 56% discount in the open market.

The U.S. economy is doing better than Argentina's because the deflation here was caused by tax cuts, which pull in the positive direction. Lest we forget, as 2002 opens, there will be small changes in the tax law that will tug in the right direction, including the first phased-in cuts of the first Bush tax bill passed early this year and the new opportunity for investors to max-out on their Roth IRAs, which is an annual event of each new year. Greenspan & Co. also can keep trimming the funds rate, which also tugs in the right direction, but none of these moves will be able to deal with the pricing-power issue. More companies will have to lay off workers and more will have to go bankrupt when they exhaust their capital in order to pay fixed pension costs, at which point pensioners get little or nothing in the bankruptcy courts. Social Security recipients are still doing well, as their monthly checks will go up in January even as each dollar buys more. The CPI would not have been so generous if statisticians added the discounts to the sticker prices. And because of the way the law is written, government pension checks do not shrink even if the CPI declines, which will happen in the next stage of the deflation if nothing is done to resolve it in the meantime.

Our modestly-bullish scenario for the year overall does require such resolution, which means leadership must appear in Washington where there is none now. We have continued to hope that Treasury Secretary Paul O’Neill will be ready to step into the breach, and we have been pleased at Treasury’s signals to Japan that it will be okay if the yen weakens relative to the dollar. The wind has shifted in Japan as a result, with the yen sinking from 119 several weeks ago to 132 today. The Nikkei should begin to show signs of life as the deflation pressure eases and the exchange economy can get back to business. O’Neill is surely keeping an eye on that dynamic, but as long as hope for recovery keeps the DJIA above 10,000, there is no point in his doing anything but watch. We are not going to guarantee that O’Neill will step up to the plate either, although we believe he at least partially understands the deflation arguments. The kind of leadership needed now is rare in history, as it would mean walking into a mine field of opposition. It almost takes the kind of self-assurance Alexander Hamilton had in resolving the financial chaos in the early days of the Republic or the confidence Ludwig Erhard had in straightening out post-war Germany. O’Neill has brass, but I would guess he would have to have Greenspan’s support. Otherwise, he will be happy to leave the problem to his successor and our moderate bullishness for 2002 will evaporate.

When Congress returns in another four weeks, it will have more information available on what kind of tax package will be necessary. Treasury projects there now will be no budget surpluses until 2005, given the sharp decline of revenues as a result of the weakening economy and the outlays associated with September 11. Normally this would mean talk of federal tax increases, but there is enough respect for supply-siders in both parties to shy from such talk in this election year. It is almost certain there will be a tax bill to cover the tax breaks that lapse on December 31 because the “stimulus” package failed earlier this month. The right kind of supply-side tax package would have the effect of bolstering the economy, even against deflation’s drag.

If gold were to climb to $325 or so, there would be no problem with pricing power. As in Japan, the winds would shift away from a scenario of lower wages and prices to a scenario of stable instead of falling wages, and prices high enough to restore profitability. Commodity prices would climb out of the cellar, but oil would stabilize about where it is, as OPEC would be able to make up on volume what they are losing now on global economic weakness. Note the White House has just added $75 billion to expected outlays for farmers in the next decade, a sum that would be unnecessary with a rebound in farm prices. Instead of falling in the months ahead, the DJIA would climb to at least 11,000. To get much higher this year would require real leadership from O’Neill and Greenspan to lock-in a stable dollar/gold price. This would mean a big bond rally atop the rally in stocks. A global economic expansion would be thrown in for good measure as the billions of producers around the world would have a dollar anchored to gold, against which they could key their own currencies. Professor Hanke could put his leftover currency boards in mothballs.

One of the remaining sources of optimism we have tucked away is the influence of Russia on the play of forces in the world political economy. We have made President Vladimir Putin our Polyconomics “Man of the Year,” not only because he is now the leading supply-side political leader on the planet, but also because of his restraining influence on our President. It is because of Putin that we think Bush will side with Colin Powell on Middle Eastern issues, which takes a major negative off Wall Street’s economic risks. Take note that Russia’s stock market has doubled since the first of the year. It could double again in 2002.