Wall Street and the White House Jude Wanniski October 21, 2004

The continuing slide on Wall Street with Election Day just around the corner is not what the Bush team expected or needed at this point. Even if the stock market stayed flat these next few trading days, Senator Kerry is now in a position to win in the Electoral College while perhaps being edged out in the popular vote – according to the experts who watch the polls most closely. Should the slide continue right up to November 2, it can only hurt the President’s re-election chances. The electorate is clearly telling <I>all</I> the pollsters that the country is not going in the right direction and it only approves of the job Mr. Bush is doing by less than 50%. John Zogby, whose polling was said to be pro-Bush in the 2000 election and whose methods have held up the best of the bunch in the years I’ve been following him, has been saying for some time that given these numbers, the last minute decisions by the undecided should tilt the race to Kerry.

But why is the stock market declining? The most prevalent answer is the price of crude oil. The NYTimes reported Wednesday that with “everyone screaming for oil,” the 1,500 oil tankers at sea are completely booked. On this account, shipping rates have doubled in recent weeks -- which makes it appear oil might well keep climbing until the price causes enough global economic weakness to equilibrate supply and demand. That process is of course going on under our noses, which is why equity values are in decline especially in oil importing nations. What could an American President do to straighten this out? If Senator Kerry had an answer that has been overlooked by Mr. Bush, it would be even easier for him to win -- in popular and electoral votes. Indeed, there are a few who are attributing the weakness on Wall Street to the increasing chance that Kerry will defeat Bush on November 2. Even with a GOP Congress, this would at least create uncertainties over taxes and regulations, given Kerry’s promise to raise taxes on capital on the top 2% of income earners.  The Times lead editorial this morning chides Kerry for being so weak on tax hikes and urges increases on the top 25% of income earners. Hmmm.

The real source of the problem is not being discussed at all, which we continue to point out lies in the realm of monetary policy. As I concluded in a commentary I wrote earlier this week for Al Jazeera: “Why is the price of oil so high? It is because the US dollar is floating, free of gold or any commodity anchor. As long as it is, the entire world will be forced to somehow accommodate this wholly unnecessary volatility in energy supply and price.” The dollar price of gold, which has climbed right behind oil, trades today at $425 oz., $45 higher than it was when the Federal Reserve decided last spring that it had to stop fighting deflation and start fighting inflation.

As the oil price rises, I point out again, the demand for dollar liquidity weakens and because the Fed is paying no attention to the gold price, it does not drain surplus liquidity. This is what makes the dollar/gold price climb right behind oil. To at least some degree, exporters of oil who are getting dollars in exchange discover the dollars are not worth as much in purchasing power as they did last week. Importers of oil who pay in currencies that have not lost ground against gold can compete more effectively for each scarce barrel against the dollar. It also means countries that are not importing the U.S. inflation – Japan, the EU, Brazil, for example – have that competitive advantage. China and Hong Kong, whose currencies are fixed to the dollar, have to pay more for oil imports. They also have to deal with the other consequences of inflation, which upset the relationships between debtors and creditors.

It appears to be a vicious cycle, doesn’t it? If you think back, this is how the gold price climbed from $35 oz in 1971 to the $600 oz average of 1980, with oil and gold leap-frogging each other throughout. That vicious cycle was broken by the Reagan tax cuts, which increased the demand for dollar liquidity, brought down the gold price, and stabilized oil.

How will this cycle be interrupted? Well, there are those who believe that the dollar price of gold has been rising since last spring because the Fed has been timid in raising interest rates. If it had raised the 1% funds rate by 100 basis-point increments instead of 25, funds would now be trading at 4% instead of 1.75%. We don’t believe gold would have stayed at $380 oz, but it at least would have induced a sharp decline in the stock market and a much weaker economy than we are currently experiencing. This would mean the U.S. would be using and importing less oil – a reminder that one way of interrupting the cycle would be to induce a recession.

It also tells us that we should be grateful to the Fed for proceeding at a measured pace. We note that Pimco’s Bill Gross and Paul McCulley, widely watched because they run the biggest bond fund, have now decided that the Fed has raised rates just about as much as it needs to. They think it will add a quarter point “for good measure” at the November FOMC and stop at 2%, holding back on further moves until the employment market overheats, which may not happen in 2005. If the forecast proves correct, and we of course hope it will, the oil price would come back down on that account and gold would come off these dizzy heights. The futures market seems to agree with that assessment. So does the bond market. With gold at 25% above its equilibrium level, which is roughly $350, we would expect the 10-year yield to climb as the implied inflation is realized. But the bond market knows it takes quite a while for the general price level to adjust to a persistently higher gold price, because there is no guarantee it will persist. When gold doubled in the last five months of 1971, to $70 from $35, it took a few years before oil began to play leapfrog with gold, bonds finally getting whacked. The 10-year note at 4% would be just about right with a permanent 2% funds rate.

Unfortunately for President Bush, all that good stuff would occur after November 2. There’s nothing much he can do between now and then that he hasn’t already done. There would be a break in the oil price if there were something good happening in the Middle East. The stock market would give him a last-minute boost. But it does not seem like anything good can happen on that account either, at least not until the dust settles after Election Day.