General Confusion over Inflation Jude Wanniski December 18, 2003

If you caught ISI’s Ed Hyman on CNBC late this morning, you will have noted how befuddled he seemed in offering a forecast for 2004. Like the rest of Wall Street, I have great respect for Hyman as being one of the best in the business, but his hedges and fumbles on questions about inflation and growth illustrate just how difficult it is for clear thinking analysts to figure out what the heck is going on. When asked why he doesn’t think inflation is a problem when gold, oil and gas and commodities are rising as fast as they are, he chuckled and said that maybe he should change his forecast. When he did respond, it was to argue that China is the culprit, buying commodities hand over fist to feed its expanding economy. That is to say, there is no dollar monetary inflation, only an increase in real demand that will be adjusted as price increases bring forth increased supply. He thinks GDP will grow by 4% in 2004 and equities still will be attractive, but worries that if GDP grows by 6%, there would be serious inflation. Larry Kudlow doesn’t have any worries at all, writing in his column that 2004 will be a boom year all the way around, without any inflation, as the recent reports on almost zero increases in producer and consumer prices show inflation is under control. 

As far as I know, Polyconomics is the only research firm that has been identifying the damage done to the dollar as a “unit of account” as the source of the difficulty in trying to use any of the inflation indices as a guide to policy. That’s because both the Keynesian and Monetarist models in standard use downplay the importance of gold as a “unit of account” in a floating paper universe. In his early writings, Robert Mundell always cited money’s role as a unit of account in a primary position, as did all the classical economists from Adam Smith to Karl Marx. In recent years, though, Mundell treated the dollar as a true accounting unit, even though it was no longer defined as a specific gold weight. It was for this reason, I have long believed, that Mundell missed the monetary deflation of 1997-2002, as did the late Robert Bartley at the Wall Street Journal editorial page. It also continues to perplex the Federal Open Market Committee as much as it does Ed Hyman and Larry Kudlow. 

In their flawed model, the economic growth we will see in 2004 is “real,” with increased spot prices for commodities bringing forth new supplies as the “dollar” guides the allocation of fresh capital to the higher prices. That’s the way the market worked when it revolved around a commodity “unit of account” like gold, or gold and silver prior to the 20th century. In that market, when the price of oil declined in dollars, capital investment in the oil industry would decline, and when demand caught up with supply, the oil price would rise and capital would return. There was no misallocation of capital. In the monetary deflation we have just been through, we warned from early 1997 on that the decline in the “gold” price was a true indicator of monetary deflation and that it would soon be followed by a decline in the dollar/oil price. When the oil price did fall, its influence on the price indices was overwhelmed by still robust increases in the prices of “intellectual goods.” Investment in the oil industry did fall off the cliff as oil went to $10/bbl. and below, but capital continued to surge into the “new economy,” misdirected by the floating unit of account as the terms of trade temporarily turned against internationally traded commodities. The price indices continued to fool analysts when the world economy turned around and demanded more oil, after three years of little or no investment. The oil price shot up even as most other prices were still sliding. 

In using only the oil price as an example of the misdirection of capital with a floating paper unit of account, I did so only because it is the second-most sensitive to monetary inflations and deflations. All other less-sensitive goods and services are victimized to some extent by the failure of the dollar to efficiently allocate capital. The dollar/gold price continues to climb because the Federal Reserve board of governors is looking benignly at the statistics that merge previous inflation and deflation movements in the dollar/gold price. Inflation will not be a problem as long as there is an “output gap,” which means enough unemployed workers to prevent upward pressure on wages. In a recommended reading we posted Wednesday on our web site by Bloomberg’s Caroline Baum, the “output gap” that the Fed observes does not seem to work in specific industries. Workers being paid in inflated dollars are resisting wage cuts and even demanding wage hikes to make up for the real inflation already being felt in the economy as a whole. It is no surprise that the “output gap” model continues to fascinate Fed Governor Ben Bernanke, as he came from academia. However, it is discouraging that Alan Greenspan still is being fooled, as he came from the real world and for most of his life took the gold signal seriously. 

The late Herbert Stein liked to say when he was Nixon’s chief economic advisor that the aim was not to have inflation or deflation, but to have “flation.” That’s what we have now, if the to impulses are merged, but “flation” continues to misallocate capital. It now is directing more to commodity goods than would be necessary if the dollar/gold price had been fixed at $350, where we think it is optimum. A correction will have to take place eventually, but depending on how high gold goes, the correction will be a sharp one or part of a “soft landing.” 

We don’t necessarily disagree with the various forecasts of an expanding economy and rising stock market in 2004. As the dinner speaker at the Los Angeles Financial Analyst Society meeting earlier this month, after I went through all the factors bearing on the world political economy, someone flat out asked where I saw the Dow Jones Industrial Average headed next year. I admitted I had not thought in those terms, but as long as I had to confront it cold, on the visceral spot I said I thought it would wind up between 12000 and 12500. That would be quite a handsome addition to the 2003 market advance, but some of it would be in slightly inflated dollars. My belief remains that policy actions by the Fed and the Congress will eventually pull the gold price below $400 and the Euro below $1.20. It would help greatly if people like Ed Hyman could see the source of their bemusement and worry about it more than they are. That might get the Fed’s attention where our warnings still do not. 

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