Thinking about Deflation Jude Wanniski December 4, 1997

It now appears we have to learn to live with deflation. Fed Chairman Alan Greenspan makes it perfectly clear he is determined to stamp out a non-existent inflation with whatever monetary deflation he deems necessary. His speech to the New York Economic Club Tuesday night was his latest word on the subject, a total whitewash of his responsibility for the wreckage in the emerging markets of Asia and Latin America. Greenspan not only is chairman of the world central bank, he also has the unqualified support of our political and business Establishment. As long as this lasts, the world has no choice but to think about how to defend itself.  Because this particular kind of deflation has never occurred before, there is no book we can turn to for guidance. In all previous periods of monetary deflation we can find in history, the phenomenon was limited to a country or a group of countries while the rest of the world’s money remained fixed to either gold or silver or both. In this case, no money is anchored to the real world in any way and all countries, whatever they do to defend themselves, are still at the mercy of the Fed’s dollar policy.

In thinking through the pros and cons, we have in the past touched on some positive forces that might occur incidental to this unique deflation -- and will do so again. Our only brief experiences with deflation in this floating world were in the roughly 18 months from January 1981 to August 1982 and again from early 1984 to March 1985. The first Reagan deflation was extremely painful but brief, because the inflation it was correcting mainly occurred in 1980. That is, the dollar/gold price doubled in 1980, and oil, other metals, and farm prices followed to a lesser but significant degree. In the mania of that year, the idea that oil would ever fall below $30 a barrel was not on the scope. Banks everywhere were prepared to accept as collateral future income streams of inflated oil and copper and wheat and corn and the land that produced them, here and in the commodity countries of Asia and Latin America. When the Fed kept the screws tight as the Reagan tax cuts were screaming for more liquidity, gold fell from $600 to $300 and other prices followed in train. This brought Penn Square and Continental of Illinois to their knees, along with hundreds of little banks caught in the squeeze. That brief deflation ended when the Fed was forced to monetize Mexican peso debt, which flooded our banks with liquidity and sent stocks and bonds straight up as gold jumped back to $400.

That “monetarist” deflation, which was guided by the Friedmanites, was then followed by the Keynesian deflation of 1984-5. It was Keynesian in the sense that the decline in gold, from $400 to $300, was led by Paul Volcker and those of his colleagues who believed the economy was overheated at more than 5% annual GDP growth. The deflation was excruciating for the rest of the world because the Reagan tax cuts were offsetting the pain at home. From March 1985 onward, monetary ease was dictated by exchange rates, and as gold climbed to $350, the rest of the world enjoyed expansion too. The slight distress of that experience enabled Volcker to lower the gold plateau to $350 from $400, and there gold remained until its run-up to $385 in 1993.

Of these two brief isolated deflations, clearly the pain was sharper in the first because of the magnitude of the correction and the fact that the 1981 tax cuts had been deferred. The second deflation was less onerous because the tax cuts were in full effect and its magnitude was smaller. For discussion sake, suppose Greenspan is bent on deflating to a plateau of $300 gold. What kinds of forces will be at work here? First, while the magnitude is again small, now the period is quite long, covering the 18 years that gold has been above $300. There are also two steps to the deflation, the first bringing the gold plateau from $385 back to $350, which caused some distress among commodity producers and dollar debtors, but certainly no “Asian flu.” The magnitude was small and the period it covered, three years, not that long. The hardest part will be the 15% price deflation from $350 to $300. On the monetary side, the first effects have already produced the “Asian flu,” especially in those countries that have large outstanding dollar debts based on commodity collateral. Gold deflation first drags down oil, then metals, soft commodities, real estate, finally wages -- the reverse of the inflation train. The longer gold stays at the $300 level, the more pressures will occur here, especially as it reaches real property and wages.

The stock market sees more damage ahead for younger, more vulnerable enterprises, but it is still not discounting a complete $50 gold deflation, which might take a few years. In other words, the market still calculates that as pressures build up, the Fed will take actions that will bring gold back to some less painful level of adjustment. The lower the gold price that will avoid great stress to our industrial and financial universe, as it adjusts over time, the heavier the debt burden will be felt by dollar debtors. The U.S. government, the world’s biggest dollar debtor, a year ago had a national debt of $5.2 trillion, which today is $5.4 trillion, a 3% increase. But when we convert to gold, we observe that the debt has grown by 28%, from 13.5 billion ounces to 18.7 billion. And by the way, 13.5 billion ounces was roughly our national debt at the end of WWII. When President Clinton took office, the debt was 11.4 billion ounces, which means it has increased enormously on his watch, by 60%. This puts a different perspective on the numbers we throw around, although it means as little as it does for Clinton to take credit for reducing the annual budget deficit. 

At $300 gold, real property would fall by 15% over the several year adjustment, but if gold were held at that plateau, real long-term interest rates would fall too. Tax liabilities on inflated capital gains would fall as the gains declined, although the real value of property would remain the same. Wages would have to fall nominally by 15%, but purchasing power would remain the same as the cost of goods and services would fall too. The real minimum wage would increase, causing unemployment problems unless offset by lower tax rates on capital. The wealth of dollar creditors of course increases in real terms, and while high-income wages come down, their tax liabilities fall faster. They creep down the brackets instead of up. The problem in several of the Asian countries, such as Korea, is that their devaluations are propelling them up the brackets while we creep down.

The losers through the process, who bear the greatest burden of adjustment, are private dollar debtors. These are the folks who have contracted to pay their debts in nominal dollars that will, over the period of adjustment, be harder to earn. To the degree there are now mechanisms to lower finance costs in a deflationary environment, that problem is offset. Finally, another loser may be the Fed. Greenspan can pretend he didn’t have anything to do with the wreckage around the world, but we can expect the rest of the world is going to build defenses against the dollar. At the moment, China is in the best position to fix its currency to gold, although it would have more credibility if the Islamic world joined in. These are new thoughts, still half formed, but you will be getting more of them as we proceed into this uncharted territory.