Discounting a Serious Deflation Jude Wanniski October 27, 1997

In the absence of any recognition by the powers that be of the monetary deflation staring the world in the face, Wall Street has been forced to discount a world recession. At $312, the price of gold is signaling serious problems ahead for dollar debtors. If the gold decline continues, there will be a serious recession, as the problems increase at an exponential rate. Gold is 19% below its $385 of a year ago, before it began its slide. It is 11% below where it should be, at $350, to prevent the consequences of monetary deflation on the world economy. Early in the month, on October 3, gold had moved up to $335 from the low $320s, and we were counting that as a reflection of the signs there would be no tightening by the Fed to the end of the year. At that moment, there was nothing negative coming to the dollar markets from Hong Kong, which seemed to survive the currency turmoil afflicting the region; a minor run on the HK dollar was stomped out by the locals and by Beijing. The sharp decline in the gold price last week, from $325 on Monday to $309 on Friday, was almost certainly directly related to the dollar liquidity squeeze in Hong Kong. It may be that the slide the week earlier, to $325 from $335, was due to the renewed speculative attack on the Hong Kong dollar.

In our analytical framework, the dollar price of gold will move only by pennies per day or week as a function of the supply and demand for gold specie; by far the greatest influence on the gold price is in the supply and demand for dollars, relative to gold. The decline in gold last week was almost universally ascribed to a committee of the Swiss government, which was said to be thinking of selling 1400 metric tons of gold from its monetary reserves. Never mind that the price of gold would not decline by one penny per ounce unless the gold were actually put on the market at takeaway prices. The government has been talking about selling 400 tons over a period of several years, presumably when the price is right. -- not 1400, which is half the Swiss reserves and 50% of annual world gold production. The Swiss government again has made this clear. Prices of base metals dropped sharply in London today in the wake of the gold-price plunge. Copper for three-month delivery fell $34, 1.7%, to $1,992 per ton. Three-month aluminum also dropped $34, 2.1%, to $1,562 per ton. Lead fell 3.6%, $22 per ton, to $589. Prices of zinc, tin, and nickel also were all in decline.      

No, gold is falling in price because of an excess of demand over supply of dollars. We don’t have to know where the imbalance is coming from, or whether it is permanent or temporary, only that it exists, and that the only direct solution is an increase in dollar liquidity by the Federal Reserve. We are sure Fed Chairman Alan Greenspan knows he should be increasing dollar liquidity, to prevent the slow implosion of the world economy, but the Fed funds rate of 5.5% does not permit him to add liquidity, that being the official policy target. If the stock market falls another 500 points, he will be begged to open the spigots, as he did during the Crash of 1987. The problem with that is he should not be easing to help the stock market, but to correct the deflation, the opposite of the ’87 problem he faced. He now could rationalize this decline as a welcome correction to the “irrational exuberance” we have seen to date. He can’t rationalize deflation and can properly cite his lectures on the gold signal as reason enough to ease.

My suspicion is that the shortage of dollar liquidity has been caused by the Hong Kong currency board. I’ve never liked the idea of currency boards, because they require the holding of dollars or dollar assets in reserve to the full amount of the local currency in circulation. There is an automaticity to it that makes it preferable to a free-floating currency, with assurances to holders of HK dollars that they can get dollars or DM or yen on demand. But like the kind of a punishing gold standard that requires an ounce of specie in Fort Knox for every $350 of paper in circulation, the currency board starves a country of liquidity by forcing it to extinguish its own paper even when there is obvious, non-inflationary demand for it. In other words, if Hong Kong had been on a gold price rule last week, as it was exchanging hard currency for the HK dollars coming in, it would also have been putting enough fresh reserves back into the banking system to prevent the Hong Kong gold price from falling. By protecting the currency’s value as a numeraire, a hard unit of account, it would not need to hike interest rates to defend the currency.

Why is Greenspan silent on these matters of grave concern to the markets? We might also ask why The Wall Street Journal is silent. When there is no crisis at hand, monetary philosophers can expound on why the gold price is the best signal of incipient inflation or deflation, but when something has to be done, excuses are easily found on why that philosophy should be ignored. Greenspan’s excuse may be that in his 10 years as Fed chairman, he never has observed a monetary deflation up close. The last was in 1982, when Paul Volcker was chairman. On St. Patrick’s Day, 1982, I called Volcker from a college in North Carolina where I was lecturing, having noticed the price of gold closing at $310 from $320 the day before, down from $600 only 16 months earlier. I told him he had to stop the price of gold from falling or he would bankrupt the world economy. He replied that he had no authority to buy gold. I said he should buy bonds. “Ah, you want me to inflate,” he said. “No, I want you to stop deflating,” I replied. “This is disinflation,” he said. “No, it is deflation, and unless you get gold up, you will bankrupt everyone in the world whose debt is in dollars.”

Volcker was then bound by Milton Friedman’s monetary targets, which were starving the economy of legitimate liquidity demands. At the least, he understood my arguments, and my insistence that if the Fed inflated back toward $350 or even $400, the bond market would boom and so would stocks. The Friedmanites in the Reagan administration insisted the bond market would collapse. Volcker got his chance to try the inflation route when Mexico informed its creditors in the United States -- the major banks -- that it could not pay interest or principal on its loans. After informing Treasury that he had no choice, Volcker had the Fed buy $3 billion of Mexico peso bonds, adding that substantial sum to dollar liquidity. Gold shot up over $400 and stocks and bonds began the long bull market that has continued to the present.

If Greenspan were to inject liquidity into the banking system with both hands, not to lubricate the stock market decline as he did in 1987, but to end the gold deflation, there would of course be no worldwide recession ahead. The stock market declines around the world reflect fear that nothing will be done and the spiral will continue. His liquidity injection in 1987 was not to change a monetary policy stance. At the time, the problem was inflation, not deflation. He simply cushioned the decline and let the markets know that he would retrieve the liquidity as soon as the crisis ended. Is Greenspan up to it? My guess is that he is not going to do anything unless he has the political backing he needs from the White House, and the White House won’t budge without the Republican leadership in Congress taking the lead. Treasury Secretary Bob Rubin does not have the slightest idea what’s going on, telling all who ask that the IMF and World Bank are in charge. Greenspan is scheduled to appear before the Joint Economic Committee on Wednesday. If he doesn’t say the right things, he could personally throw the circuit breakers again.