The Mechanics of Monetary Deflation Jude Wanniski January 8, 2002

Two months ago, on November 6, I tried to explain the process by which monetary deflation works its way through the economy. It is not an easy concept to understand, which is why Polyconomics remains the only consulting firm that continues to insist we are in the thick of it – and that there is no escape without a climb in the price of gold. Now that Argentina has fallen victim to the dollar deflation, as we have been warning for almost three years, going through the mechanics again may help you understand the difficulty inherent in forecasting a time line for our deflation. Note the WSJournal news section this morning makes the connection between Argentina and Hong Kong, another country whose currency is linked firmly to the U.S. dollar. The WSJ editorial page, by contrast, still refuses to admit Argentina’s woes were caused by the U.S. dollar deflation, as its editors in 1997 decided there could be no deflation as long as the price indices were still rising. Its lead editorial today, “Who Lost Argentina?” blames Argentina’s woes on Brazil’s devaluation of January 1999!!! Brazil, of course, had to try to escape the dollar’s deflation, as almost everyone else in the world did.

Thailand was first to get whacked, in early 1997, as it valiantly tried to keep the baht tied to the dollar. It was the first domino to fall, we noted at the time, because it was the first to take seriously Paul Krugman’s warning against welcoming “hot money” investments. Krugman had toured Asia after Mexico’s peso devaluation in December 1994, arguing Mexico could not keep foreign equity investments from fleeing when problems arose. Capital flight would not have happened in Mexico, he said, if the foreign investment had been direct. This is nonsense economics, but the Thai government bought it and imposed capital controls, making it harder for foreign investment to flee. The point is that when there are many countries who tie their currencies to a deflating dollar, they each will follow a different time line in reacting to the deflation. By now, with Argentina finally throwing in the towel, only China and Hong Kong are left with dollar pegs. Japan, which went into its monetary deflation in 1990 under pressure from the previous Bush administration, seems to have gotten permission from this Bush administration to finally escape. It had been able to keep its economy close to stable for seven years by government public-works spending, running its national debt up to staggering levels financed with near-zero interest rates, a combination not supposed to happen in any economic textbook.

Hong Kong has been able to cling to the dollar peg because it has a terrific tax system, one of the world’s best, and because it has no commodity production, the first sector to take deflation’s punch. Its production is all intellectual, as it serves as Asia’s premier banking intermediary. But with revenues in decline (it services a region that still has not fully recovered), it is hurting to the point where increased taxation is being pondered. Taiwan did pull out of the dollar link, even though it had mountains of hard-currency reserves, but China itself has hung on by taking the deflation punch in its vast farm sector, borrowing and spending as Japan has, and continuing the regulatory reforms it began in order to qualify for membership in the World Trade Organization. To complete a deflation cycle, wages have to come down to equilibrate with the heavier numeraire, and with a great pool of labor, wages had not climbed that far in China under the lighter numeraire.

What is so hard for professional economists to accept is the idea that a change in the value of the unit of account can NOT change the terms of trade. This is practically the first lesson in economics I got from Art Laffer in the summer of 1971, when the conservative Keynesians in the Nixon administration and the liberal Keynesians in the Congress decided the dollar had to be devalued against gold in order to make our exports to Japan cheaper and our imports from Japan more expensive. Laffer argued it would not work. If a bottle of wine trades for a loaf of bread when the unit is “one,” it will also trade for a loaf if the unit is “two.” Keynesians found plenty of examples when the trade balance shifted to the devaluing country, but a few years later Laffer and one of his students, Marc Miles, did a study of 101 currency devaluations and found the trade balance worsened in 51 cases and improved in 50. To this day, Laffer correctly argues that devaluation will not improve Argentina’s terms of trade with Brazil. Argentina’s problem with its dollar peg has not been in foreign exchange, but with the skewing of contracts between Argentine debtors and Argentine creditors. When debtors cannot pay, they go bankrupt. When creditors do not get paid, they go bankrupt. This is happening in this country now not because tax rates or interest rates are too high, but because the terms of trade are still adjusting to the decline in the gold price that began in 1997.

The adjustment mechanism is as elementary as the law of supply and demand. If apples become scarce and trade for ten oranges instead of one, more capital will be directed at producing apples and less at producing oranges until the exchange rate is once again one apple for one orange. If the dollar becomes scarce because the Fed does not supply enough dollars, the first exchange rate to change will be gold, which of all commodities is most like money. Gold becomes “cheaper,” not only in dollar terms but in terms of everything else. It would be cheaper than oil, for example, simply because the unit of account had changed. This means there will be less demand for oil or more supplied until oil falls in dollar terms to again equate with gold. Apples and oranges and other internationally traded commodities must then become cheaper to return to equilibrium with gold and oil. If gold had fallen to $275 from $375 over five years and other commodities had not budged, we could say gold had simply become unfashionable, like high-button shoes. But the mechanics of deflation have worked according to the classical laws of economics (i.e., commodities fall in train with gold). They will continue to clank away until all prices and wages again return to their market determined terms of trade at the new, heavier numeraire.

If you can understand this mechanism, you can see how easy it has been for Polyconomics to have been making our forecasts for the last five years, based on our sense of where we have been in the deflation cycle. If the Fed had not cut interest rates 11 times in 2001, we actually would be further along in the cycle. But the lower rate structure stretched out the deflation, the way Argentina compressed its deflation cycle by raising tax rates while handcuffed to the dollar. We can of course escape the deflation cycle by raising taxes, because the dollar is not handcuffed to anything. Higher tax rates would simply collapse the demand for liquidity and when the Fed did not mop up the surplus, the surplus would take up the gold price and the terms of trade would follow for everything else. We would have a contraction masked by rising nominal prices and the Fed presumably would raise interest rates to stop the “inflation.” President Bush says taxes will be raised only over his dead body, but of course state and local governments can make no such promises. A serious wave of tax increases across the nation would also cause a rise in the dollar/gold price. Such a dreadful scenario is too awful to contemplate, and we do see glimmers of hope for policy change, especially in the collaboration of Treasury Secretary Paul O’Neill and Glenn Hubbard, the chairman of the President’s Council of Economic Advisors, in their helpful counsel to Japan in dealing with its deflation. But Wall Street will have to get whacked some more for the Bush administration to take our homegrown deflation seriously.