Thinking about Deflation II Jude Wanniski December 11, 1997

On Monday of this week I had lunch with Jack Kemp in Washington, around the corner from his office at Empower America. I told him how discouraged I’ve been lately to find myself making the same arguments about deflation that I’d made 15 years ago, as if nothing had changed since then. (I wrote a client letter, “Deflation,” on April 2, 1982.) Kemp said he recalled asking Art Laffer, long ago, when could we all stop talking about taxes and move on to other ideas, and Laffer said it never ends... each new generation has to learn it all over again. Sadly, my point was not that I’m discouraged about having to teach a new generation about deflation, but that the last generation has forgotten what I thought it knew. Here we are, in a 13-month period seeing a decline in the price of gold totaling $100 an ounce, to a $285 level that we have not seen in 18 years, and as far as I can tell Polyconomics is absolutely alone among supply-siders in having predicted not only the economy’s deflationary path to this point, but also its consequences to this point. On the day we had lunch, for goodness sakes, Kemp’s staff economist of 15 years ago, Bruce Bartlett, had written in the Washington Times that the price of gold no longer meant anything, because it had been demonetized! Larry Kudlow, chief economist for Skandia Insurance and a client of Polyconomics, is all over the tv talk shows announcing that paradise has arrived with gold at $285, that there ain’t no deflation. 

Wayne Angell, who was one supply-sider I thought could never be budged from his confidence in gold’s price signals, has totally crumbled. The former Fed governor, now chief economist at Bear Stearns, not long ago insisted that gold was inflationary at $385 and would still be even at $350, but would be fine at $325. He is now to be found almost daily on MSNBC’s business commentaries and the financial wires, delighted with gold at $285 and predicting that the Fed will stick with the 5.5% federal funds rate through 1998! Eighteen years ago, Laffer said he would be happy with gold at $250, and I’m told by Kemp’s staff that he now apparently sees no need to change his mind and is not concerned about deflation. Lewis Lehrman and John Mueller, who were part of the Kemp team and now run Lehrman Bell Mueller and Cannon, not many years ago argued that the gold price had to be above $500 or their “global monetarist” model showed dire consequences. LBMC, I’m told, is happy as a clam with gold at $285 and sees no deflation. The Wall Street Journal editorial page, which for 25 years has been the bulletin board for supply-siders, some months ago warned the Fed not to allow gold to slip below $300, but now remains blithely unconcerned. By general agreement among practically all my former supply-side colleagues, the economic wreckage around the world that we attribute to the Fed’s deflation is being attributed to a general outbreak of stupidity among Asian and Latin bankers. Oddly enough, of the early supply-siders, Paul Craig Roberts, the one most skeptical of my deflation arguments 15 years ago, has been alone this year in accepting them. 

The reason for the disconnect, I think, is that Bob Mundell, who first raised the question about the “optimum price of gold,” never developed a hypothesis on where to find it at any given moment. Laffer’s hypothesis was, and presumably still is, that if we were to fix the dollar gold price, the Treasury and Fed should announce that wherever it is on a day certain in six months would be optimum, as debtors and creditors would fight it out in the meanwhile. Mundell never bought that idea, but instead argued that as long as it were not too high or too low, almost any point would do. The benefits of doing so would greatly outweigh the costs of not getting it exactly right. Prices would adjust over time. I’ve been trying to get Mundell, now 65, to spend some time thinking about the issue, but he is on sabbatical at the University of Bologna in Italy, far from the concerns on Wall Street. He tells me by e-mail yesterday that he has just become a proud papa again, with Nicholas Robert Mundell weighing in at 7 lbs. early Monday morning, and Valerie doing just fine. “Will get back to other matters soon!,” he promises, although last week he e-mailed: “I would always want to look at the gold price, and act on the information contained in it. When the dollar was rising and the gold price was falling, there was good prima facie evidence that money was too tight. Greenspan was worrying about the wrong market, the stock market, and he invented his own worries about an outbreak of wage explosion.”

In the absence of a satisfactory hypothesis from others, I hit on the idea at least a dozen years ago that the price can’t be too high, or it will be too hard on creditors, or too low, or it would be too hard on debtors, but that we should look for the optimum price at a level where it has been for some period of time. When Angell became a Fed governor almost 12 years ago, the price was $350, and it has fluctuated around that price ever since -- until it broke through $340 while heading much further south last spring. It is now beginning to dawn on the markets that there will be further adverse consequences to the problems in Asia. The idea has yet to take hold that the deflation began here, which means we can’t avoid the consequences. It was especially relevant to see Oracle battered on Tuesday, with NASDAQ and the Russell 2000 closing in on their October 27 lows. The Greenspan deflation that Asia imported is now being fed back to us and it is lapping over our shores into Silicon Valley. Microsoft is well above the waterline, but the longer gold stays in this range, the higher the water gets. If Angell’s prediction is right about the funds rate staying at 5.5% through the end of 1998, the waterline will get much higher. The Dow Jones Industrial Average will also get soaked.

These are easy “predictions,” unless those who argue that gold has been demonetized are correct, and they aren’t. When the air temperature hits 32 degrees (F), water freezes. When the dollar/gold price falls, all other dollar prices eventually follow. Unfortunately, the longer the deflation continues, the harder it is to correct or avoid its consequences. Even Europe must eventually feel its effects, although the Bundesbank has avoided a separate Deutschemark deflation. It has done this by allowing the DM gold price to fall only by 11% during the past year while the dollar gold price has fallen by 25%. If the dollar/gold price had fallen by only 10%, it would be where it should be, at $350. Europe is not immune to the dollar deflation, though. It will get wet too, just a little later and a little less. Once again, I quote Ludwig von Mises:

People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation... But the statesmen who were responsible for the deflationary policy were not aware of the import of their action. They failed to see the consequences which were, even in their own eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them. 

In November 1981, as I anxiously watched the price of gold tumble from its heights of the previous year, I wrote in desperation to President Reagan to warn him of the consequences. On December 17, he wrote back that he had distributed my letter “in house,” but then said: “I know there is a great difference on this subject among top economists, even with one of my favorite people Milton F. opposed, but I’m looking hard at it. As you know, I have a task force studying gold, so I will refrain from comment until they report in.” The “task force” was headed by Milton F.’s partner, Anna Schwartz, and the 1982 recession was as ugly as they come.