Thinking about Deflation XXI Jude Wanniski May 23, 2002

The last report in this series ran last July 12 when I discussed several scenarios on how the monetary deflation might play out. It’s a good time for some new general thoughts. With gold now steadily making its way up the dollar scale, at $318 yesterday, one of our clients tells me this morning that it is almost at its eight-year average of $322. This fact bears significantly on debtor/creditor relations, as most contracts have been made in this period. But if my guess that $350 gold was close to an equilibrium price for the dollar over the years since the link between the two was severed in 1971 at $35, we still have a way to travel if there is to be no net deflation adjustment in other spot prices and wages. The other supply-siders who have been writing recently on the WSJournal editorial page have been jumping the gun on a bull market because they do not take this aspect of deflation into account. This is a reminder that there are several effects to changes in the value of the dollar relative to gold. In some, there are investment opportunities appearing if you can keep track of the variables.

One of the major reasons we have been high on Asia in recent months is that while the gold price is rising in dollars for negative reasons -- higher implicit fiscal taxation and terrorist threats -- the same negatives do not apply in Asia. Japan’s equilibrium gold price, we have been estimating, is about ¥42,000 per ounce, which explains why the dollar is “weakening” against the yen. As the dollar/gold price has been rising over the past several months from $265, the deflated yen price of gold has been rising from a low of ¥28,000 to almost ¥40,000 today. The Bank of Japan has been alarmed by the yen’s “strengthening” against the dollar in the last few weeks and has been trying to reverse the process by having the Bank of Japan sell yen for dollars. That method doesn’t work, though, because the market unwinds such transactions. The BoJ would have to push fresh liquidity into the banking system in order to reach an announced target, and it is not doing so. Nor does it  have to, because it is so close to a yen/gold equilibrium anyway. This balance permits producers and financial intermediaries in Japan to work through their problems without deflation pressures; the net result is a gradual, healthy stock market advance. The Nikkei is 12,000 and headed higher as Japanese politicians toy with the idea of supply-side tax cuts.

China has been burdened with a deflated yuan, the result of its determination to keep it fixed to the US dollar. The decline in dollar commodity prices we’ve experienced since 1997 has of course been matched in China, where the great majority of the 1.2 billion people are dependent upon commodity production. Beijing has been swallowing the costs of adjustment with giant deficits. By not raising taxes, though, it has at least avoided the double whammy Argentina experienced in its peg to the deflated US dollar and IMF-imposed tax hikes. As deflated commodity prices begin to make a global comeback -- as they must -- the social and political pressures Beijing has been facing will recede. With Japan and China in expansion modes, a general expansion is now underway. Only Hong Kong in all of Asia still faces small deflation adjustments with its dollar peg [it is not a commodity producer]. We are fairly confident this will continue as long as the region avoids major military conflict. Nobody needs a nuclear exchange between India and Pakistan, especially the economies of the Eastern Hemisphere. It would be nice if a supply-side influence spread over the subcontinent to relieve conflict over cultural differences, but the legacy of the British and London School of Economics remains stubbornly affixed to the region.

In our own markets, there are still no general sectors that seem good bets, but within each our analysts are increasingly finding individual prospects to recommend; more will appear when the last of the deflation drag is wrung out. Gold shares and bullion, of course, have the upward bias that will eventually finish off the deflation. At 5.64%, the 30-year bond remains a reasonable bet, as its yield still compensates for any small downside risk that we see because of possible errors by the Fed in trying to manage the real economy and the yield curve. There is some concern among our clients, and the market, that as gold rises indicating an incipient inflation, the long bond will be priced down to reflect that. When the 1981-82 deflation ended, though, gold shot up and so did equity and bond prices, as the relief from the unfolding deflation overwhelmed the mini-inflation that stopped it. My best guess today is that gold could climb to $350 without the long bond going above 6%. If we lighten up on bonds in our model portfolio, it would be because of more attractive equities we spot here and in Asia.

In earlier parts of this “Thinking of Deflation” series, I generally separated out the tech/dot.coms as special cases within the overall adjustment problem. In the first phase of a deflation, the producers of commodities get whacked and the producers of intellectual goods get the benefits. Even Fed Chairman Alan Greenspan understood this much, although he – and many supply-siders – somehow believed there would not be a phase when the producers of intellectual goods would face the adjustment process. Part of the NASDAQ “bubble,” at least, reflected these forces at work, but a greater part, I think, was the inability of the market to quickly sort out the entries in this New Economy. The example I used was of newborn babies, hundreds of them squalling in their cradles, asking for capital, the mother’s milk of entrepreneurial enterprise. I compared this phenomenon to the earliest days of the auto industry, when there were a thousand automobile manufacturers, and nobody really knew which of them would make it out of the cradle into short pants and then which of those in short pants would make it into long pants. The market did not know what to make of the dot.com babies, so it supplied capital to all of them, spilling a lot of it along the way. Individual portfolios were built out of different baskets of dot.coms, hoping the gains would offset losses when experience and history would demonstrate which would be fit enough to survive.

This may be helpful to you in approaching the technology sector as the deflation ends. Those enterprises that have been able to hang on to date are the kids that have made it to short pants. The New Economy is a real phenomenon, but it will be several more years and all the attacks of influenza, measles and polio before we can be sure of the mature corporations that will survive the next few generations...until a new batch of babies are born. Something to think about.