Client Q & A Jude Wanniski April 7, 2004

Here are some questions that have come in recently from clients, with our answers. Please query us whenever you have questions about the work you receive from us, or anything on your mind about the doings in the U.S. or world political economy. We will not identify you in the Q&A, so do not worry about asking silly questions.

Q. Why would Fed tightening now, which brings rates higher, not cause equities to decline?

A. If raising the funds rate will produce superior monetary policy (i.e., a non-inflationary dollar), equities will have less risk on that account and more reason to increase in value. When the jobs report showed a healthier economy, equities rallied sharply and gold fell sharply, the latter an indication that the market knew the Fed would be more likely to raise the funds rate if necessary. With some poor earnings numbers out today, equities slumped and gold popped back up to $422.

Q. Will the Fed raise rates if the next jobs report is as strong as the April 3 report?

A. I tend to think that it would only if the price of gold is on the rise. If gold stays below $420, the Fed can leave the funds rate at 1% to see what happens next. There would be no reason to raise the funds rate if the gold price gradually declines with demands for liquidity increasing during the expansion.

Q. Do you think that the 10-year Treasury will level off at 5%?

A. If the funds rate stays at 1%, the 10-year shouldn’t go much higher than it is, especially if gold behaves. If the Fed has to go up a quarter point, the 10-year might have to go to 4.5%. A 5% rate implies a weaker economy and a decline in the demand for liquidity.

Q. When the market rallied with the jobs report, was it because of the improvement in jobs or because of the decreased likelihood that Kerry would be elected?

A. Almost certainly the jobs issue. At this point the market, which is apolitical, probably does not care who gets elected President and probably sees no threat from the next Congress.

Q. The Wall Street Journal reported on April 6 that during the 1995-1996 boom, 60% of major corporations in the U.S. paid no taxes on profits. Considering this and that corporate tax rates are at their lowest in generations, is fighting to lower rates further worth the political capital to Republicans?

A. The corporate tax cuts the GOP snuck into the highway bill –- on expensing and the corporate AMT -– are focused entirely on small businesses and will be popular with Democrats when it comes down to a final vote. Major corporations that pay little or no taxes at the corporate gate were doing well enough to pay their employees and suppliers funds that were taxed at the personal tax gate. It’s all one big mosaic.

Q. Why don’t you endorse Bush, as he is so clearly better for the economy than Kerry?

A. I only decide my vote in the last week of the presidential campaign, especially when there are people in both parties who are asking my advice on economic issues. If Kerry would flip-flop on economic policies, I might even vote for him. There’s always the libertarian, too.

Q. At what point do higher commodity prices make their way into higher PPI and CPI numbers?

A. They are creeping in already and may soon add to the Fed’s concerns about inflation and force its hand on the funds rate before a decline in gold, and oil, cut back in the other direction. There still is the rear-view mirror problem at the Fed.

Q. I am not old enough to remember the 1972 campaign, however, it does seem that the parallels are striking. Was Vietnam at that point considered a quagmire? Nixon won in a landslide over a very liberal opponent. In the spring did it seem that the election would be close? I am just having a problem believing that if the economy seems to be rolling that Bush is vulnerable no matter how bad things seem to be going in Iraq.

A. There is no parallel. Voters in 1972 considered Vietnam a Kennedy/LBJ war that Nixon was phasing out through diplomacy, especially his opening to China. Nor was Vietnam an American pre-emptive “war of choice,” but a stand against Communist aggression from Hanoi. George McGovern was seen as a cut-and-run President whose economic ideas were as bad or worse than Nixon’s. If the economy is going well in November, the electorate might feel it has the luxury of turning out a President who has thoroughly botched foreign policy in the Middle East, if that seems to be the case come November.

Q. Is it true that China has needed to print Reminbi to keep its stronger currency on par/pegged with the weaker US dollar the past couple of years? If true, hasn`t such money growth in China (related to keeping the peg) contributed to strong Chinese GDP growth? Furthermore, would it also be true that a counter trend rally in the dollar would thus result in less of a need to print Reminbi? Therefore, could this result in a slowing of Chinese monetary growth and thus slower Chinese GDP growth?

A. Yes, but remember China had to choke off liquidity growth to keep fixed to the dollar while the Fed was deflating, which cut into its nominal GDP growth. Some of its rapid GDP growth is now related to the reflation of its money, but most of it is due to Beijing’s supply-side fiscal and regulatory policies. There’s no reason to worry about renewed deflation in China unless we see the Fed lead the way, which isn’t likely.

Q. In a gold standard, can`t you have an ever-increasing quantity of money per ounce of central bank gold (Bank of England)?  Why doesn`t the increase in this ratio matter?

A. A gold standard only prevents an economy from inflationary growth. That is, a nation`s central bank (the Fed) cannot use its monetary levers to help the U.S. economy grow when it is on a gold standard. If it tries to print more money than the economy can use productively, those holding the surplus dollars will present them to the U.S. Treasury asking for gold from our reserves. If there is no more gold in Fort Knox, the only way to avoid bankruptcy is for the Fed to stop printing more money than the economy needs or wants, and reverse the process. It then sells bonds, which pay interest, and takes in the surplus dollars, which pay no interest.

Q. What happens in a gold standard if the economy has the urge to grow faster than you can mine gold?

A. A gold standard does not require "tonnage" of gold in order to grow faster. An economy that is growing at a subpar level because its tax rates are higher than they need to be can solve that problem by lowering the tax rates. This will increase the demand for liquidity in a way that does not cause the Fed to print more dollars than can be used productively, so the "money supply" can increase without any increase in the nation`s gold reserves. In classical theory, David Ricardo argued that when money is working at its peak of efficiency, the central bank does not need to hold any gold. The market would be assured that the bank would never print more money than could be productively used, so there would be no need for the bank to sock away bullion in its vaults. In the 19th century, the private Bank of England ran the gold standard that was emulated by the U.S. and the rest of the world, yet it held almost no gold in its vaults. A good modern example is Japan, which grew like mad between 1950 and 1971 keeping the yen pegged to the dollar at ¥360/$. It had scarcely any gold in its reserves through that period, and it still doesn't.

Q. Isn’t is true that under a gold standard you can’t run a trade deficit like we are now without losing all your gold and causing your money supply to contract?

A. What you are describing is a theoretical description of the classical gold standard, which was called the "price specie-flow mechanism," which supposedly worked as you describe in your query prior to the Federal Reserve Act of 1913. That is, if we bought more stuff from Europe than Europe bought from us, we would have a trade deficit, and it would be covered by an outflow of gold. Actually, the mechanism worked without gold transfers, because Europeans would make up the difference by accepting equity in U.S. stocks and bonds. Remember when Hamilton put us on the gold standard in 1891 we not only did not have any gold in the U.S. Treasury, we owed many millions of dollars to creditors at home and abroad. Hamilton simply promised that as the new nation developed, it would pay off its debts in gold or gold paper equivalents (dollars as good as gold).

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