The Model: Still Working Jude Wanniski June 20, 2002

Those of you who have taken our deflation arguments most seriously must have noticed that our judgment of a Dow Jones floor of 9500 has been holding up, with some temporary dips and dives into the netherworld. Last Friday`s midday collapse to 9300 would have scared me a bit if it ended the day at that level, but the afternoon rally brought it back within 28 points of the "magic number." The run-up earlier this week was characterized by some as a "dead-cat bounce," and so it now seems it was, with the poor kitty sprawled back on the floor. With gold at $325 or so, there is no monetary reason for the nominal values of equities to decline further. And if gold rises further because of a ratcheting up of the terrorist tax or worsening deficit problems, the DJIA floor would rise, even with continued mixed reports on corporate earnings. If the price of gold shot up to $1000 per ounce, the DJIA would rise too, although it would not triple. Although income-tax has inflation protection, capital gains does not, so there would still be a major haircut in nominal terms.

It is now more than five years since we began explaining this process to our clients, to politicians, and anyone else who would listen. Jim McTague, who is the Washington bureau chief of Barron's, called some weeks ago with the idea of doing a story about me – having decided that I have been pretty good at predicting one thing and another over the past few years. Yesterday he asked when I first made the deflation call and if I thought the deflation was over. I dusted off the files and then e-mailed him back:

In a fax, I warned Greenspan to start worrying about the decline in the gold price on January 3, 1997. The first written warning that mentions "deflation" was in a letter I wrote to Gene Sperling on Jan. 23, 1997 and cc'd to Greenspan:  "The President has been saying he believes in a strong dollar, which is one of the reasons he was re-elected. I see him repeating his statement in today's Wall Street Journal. Please be aware that with gold dipping below $350 today, the dollar is beginning to get into deflationary territory, where its strength will cause real problems for everyone who owes money in dollars.... Market chatter is still focused on the strength of the economy, which could easily be unsettled if the gold price decline is not arrested."

The first client letter we published that called for the appreciation of the dollar was on November 20, 1996, when gold was at $380 and falling. On January 23, 1997 I wrote a memo on the margin to David Wessell of the WSJ who wrote that day: "If you want to see people with egg on their faces, take a look at the currency forecasters: Only three weeks ago they were either proclaiming the dollar could never climb as high as it has, or that the ascent would be slower." I added, "No egg here at Polyconomics." I met with Larry Summers in Treasury in April 1997, as gold continued its decline, after first asking to meet with Clinton to warn him of the deflation. Erskine Bowles asked Summers to talk to me and after a half hour chat, Summers essentially said he did not take gold seriously as an indicator. And that was that.

Is the deflation threat over? Of course not. With gold at $320, it is still $30 below what we reckon to be the equilibrium price of $350. It represents a constant drag on the economy. At $320, though the financial markets are roughly in equilibrium, which is why we have advised our clients for the last few months that at this level the DJIA would more or less bottom at 9500. It has gone below that number a few times, but has always bounced back. If gold goes lower, there would be a new bottom, below 9500.

The reason I take your time with this material is to both assure you that our analytical framework is still working as it has for 24 years, and that its forecasting power is now being noticed – which on the margin is a prerequisite for policy change. Just as a trip of a thousand miles begins with a single step, politicians will not take the first step toward fundamental reform unless they can be assured they will be rewarded for initiating a change that actually works. It was only when I made the case for tax cuts on the WSJournal editorial page in the 1970`s that political people decided to take a chance on the idea. The Mayor of San Juan was the first, elected Governor on the Laffer Curve in 1976. Jack Kemp then began winning his House seat in landslides after embracing the Curve. Practically everyone around Ronald Reagan tried to talk him out of the Kemp-Roth tax cuts, but he was comfortable with the idea, and his campaign manager, John Sears, understood their power at the polls.

There has to be a similar reform in the monetary realm, and this time it cannot start in Puerto Rico. It has to be in the United States, which still has the key currency, the invoice currency for gold and oil. The reason a return to gold seems so far away is that the politicians have been persuaded that anyone who mentions such a reform will not only suffer defeat at the polls, but will be ridiculed in the process. It is in the interest of demand-side economists, whether Keynesian or Monetarist, to discourage all aspiring Democrats and Republicans from doing "gold," which they do by saying that a gold standard would cause great pain and suffering. Milton Friedman has been saying for 30 years that a gold standard would be best of all, but that politicians will not be able to live within its discipline. That`s all Senator Claghorn has to hear and he runs from gold as if it were the plague. The Austrian school is pro-gold, in the classical tradition of Ludwig von Mises, and Rep. Ron Paul [R TX] promotes the idea. But by insisting it can only work by blowing up the Federal Reserve and going to a 19th century free-banking system, with 100% reserves, he does more harm than good.

So it is critical that our analytical framework continue to work, and finally be noticed by Barron's, inasmuch as the WSJ editorial page decided in 1996 that I was wrong and Greenspan was right. I don`t know yet when the story will appear, but McTague has also been interested in why I became a dove when the Cold War ended, how I decided Louis Farrakhan was not a bad fellow, my 1998 prediction the World Trade Center would be blown up, and various other twists and turns. My basic answer is that I`ve had to dig deeper and ask more questions and read more than the average journalist because I`ve promised my clients to give them the best analytics I can – whether bullish or bearish, liberal or conservative, hawk or dove, Arab or Israeli, Democrat or Republican. This means nobody with a vested interest really trusts me, but as long as we keep our clients happy, that`s all that counts. Harry Truman had it right when he said if you live in Washington and want a friend, get a dog.