Wall Street Wobbles on Taxes, Gold and Oil Jude Wanniski November 12, 2003

There are several other reasons why Wall Street has sold off a bit and now treads water waiting for direction, but there are three that have our primary attention. The FSC legislation is the most likely culprit, as we think the market had been discounting passage of a halfway decent bill this year to comply with WTO demands. Passage would have kept the rally going, but perhaps there will be no action until February when Congress has time for it. There also are the steel tariffs, which violate WTO rules that must be dealt with this week in order to avoid a trade war with Europe. It is most likely that the White House will find a way to comply, as it privately acknowledges the tariffs it imposed to help the steelworkers have caused more damage to other sectors of the economy that have been stuck with higher steel prices. A decision to comply would be a plus.

The price of gold, at $395 today, continues to worry us. The continued upward crawl is certain evidence that we are on the edge of inflationary forces that would spell trouble of that kind -- replacing the welcome end of monetary deflation that has been helping move equity markets here and around the world. The spring tax cuts on capital combined with gold moving above $350 released us from the deflationary bear market and continue to provide a positive influence on the economy. The increased demand for dollar liquidity on that account, however, obviously is being overwhelmed by other forces. As gold has climbed from its low of $255/oz. in the summer of 2001, the negative forces we identified of course included 9-11, which sent gold on its climb due to the added geopolitical risks to commerce. The Sarbanes-Oxley legislation that imposed hard corporate governance demands on the business community was next in line in 2002, nudging gold higher. This year, we identified the provisions of the Patriot Act as inviting a shift to the euro away from the dollar. We also have entertained the idea that the 1% funds rate is leading to surplus liquidity, as the gold move has continued into the teeth of a major pro-growth tax cut and a gigantic rally in speculative grade investment vehicles.

The decision to go to war with Iraq was not immediately accompanied by noticeable effect on gold, as it came simultaneously with the positive movements in Congress on the cuts in capital taxation. The markets at the time also expected a quick war with little major damage to the Iraqi oil fields would bring fresh crude into the tight world oil market; Vice President Cheney promising at least 3.5 million bbl./day by October. That projection went up in smoke with the realization that the guerrilla war in Iraq would keep blowing up oil pipelines every time they were repaired. The oil market has been tightening further with economic growth in hot spots such as China and India. It has also confounded Bush Administration plans to have receipts from the Iraqi oil pay for the occupation and reconstruction. The $87.5 billion now added to the federal budget deficits to make up the difference can in no way be considered a positive development for the economy. All business decisions involving long-term investments having to factor in the possibility of higher taxes and/or a monetary inflation to dissolve some of the national debt.

If the Federal Reserve were on a gold standard, the effect of higher oil prices would have no inflationary effect. The higher prices would reduce the demand for liquidity as enterprises or households at the margin would not be able to pass on those higher costs to consumers or absorb them in the household budget. The Fed would be required to automatically drain the surplus liquidity in order to keep dollar/gold price constant. The economy would repair the problem by having the higher oil price attract more capital investment into the production of oil, which would bring oil back into its normal relationship with gold. Since 1971, the markets have had to deal with a floating dollar in making these capital allocation decisions. This at times has meant that an inflating dollar has been followed by an inflating oil price, which in turn caused a decline in the demand for dollar liquidity and another rise in the price of gold. In other words, it was a vicious cycle, with oil chasing gold and gold chasing oil. This was how gold jumped from $35/oz. in 1971 to as high as $850/oz. in 1980. It was the Reagan tax cuts that broke the vicious cycle by dramatically increasing the demand for dollar liquidity, which in the absence of a gold standard sent gold into the sharp decline of 1981-1982.

Middle East oil now very much figures into this equation, with oil moving up again in recent weeks since Al Qaeda has been targeting the House of Saud. With prospects dimming of Iraqi oil flowing freely anytime soon, we are back to relying on a world reserve of no more than 3 million bbl./day and perhaps as little as 1 million bbl./day. That small amount against world consumption of more than 75 million bbl./day is scattered around the world, but for the most part world consumers of oil rely on that Saudi surplus in the short run. The Al Qaeda terrorist attacks are so far small, but it already occurs to the political class and the oil industry that the Saudi oilfields must be tempting targets for Osama bin Laden. If the House of Saud could be toppled, Osama would get a two-fer, control of “Arabia,” sans “Saud,” and convulsions in the world economy. In a nightmare, worst-case scenario, oil and gold would chase each other to $40 or $50 bbl or higher with gold jumping over $600 an ounce. Contemplating the “nightmare” of a Riyadh controlled by the fundamentalists, the New York Times Tuesday assumed U.S. troops would be sent to get control of the oil fields in the north. Hmmm.

There are a dozen other pieces to the puzzle, which we must watch for signs good and bad. Peter Bremer rushing back to Washington from Baghdad to discuss a new political deal for the Iraqis is promising, but so far inconclusive. The warhawks at the Pentagon continue to threaten action against Iran on empty charges it has a secret nuke program, which is bad. But the Russians who send their oil to the market via Iran in a partnership, know the charges are empty and have worked with the French and Brits to resolve that fracas, which is good. There is a new peace initiative between Israelis and Palestinians and an olive branch from Yasir Arafat, which is good, but no sign from Ariel Sharon that he wants anything to do with it, which is bad. Etcetera.

What we look for on the domestic front are any signs of economic sanity among the Democratic presidential hopefuls, especially Howard Dean who will probably be the nominee. The markets would like to see more diplomacy, less force in US foreign policy, but are very nervous about a President who is bent on balancing the budget with higher taxes on the rich. We also look for any signs of monetary sanity at the Greenspan Fed, still tangled up in Keynesian output gaps and Phillips Curves when it should be discussing a commodity price rule. A CPI rule doesn’t cut it. We also await word from the new governor of the fifth largest economy of the world, out there on the West Coast. (By the way, I will be the lunch speaker December 4 at the San Francisco Financial Analyst Society and the dinner speaker December 9 at the Los Angeles FAS. If anyone asks, I will suggest that Governor Schwarzenegger eliminate the capital gains tax in one swoop.) If you have any other ideas on what we should be worrying about, please let us know.

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