Thinking about Deflation VI Jude Wanniski May 26, 1998

When Fed Chairman Alan Greenspan last week told Congress that we still may feel more of the effects of the Asian financial crisis here, we can be sure that is the argument he used last week inside the Federal Open Market Committee to argue against an increase in interest rates. What might he be seeing? For one thing, we suspect the Fed has been collecting data showing that some of the current import numbers represent a resale of goods to our market that previously had been purchased and counted as U.S. exports. Certainly heavy capital equipment that was still sitting in packing crates throughout southeast Asia is now wending its way back to the states, or from whence it came. All of Asia is pulling in its horns, including China, and these are the first effects we see here. My surmise is that the high-technology sector was battered around last week as part of the same phenomenon: Goods counted as being as good as sold, ready to be snatched off the shelves and sucked out of the warehouses, are looking like dead meat spoiling in the sun. An exporter can keep goods that won’t spoil or become obsolete locked up in inventory until the worm turns. Everything with an expiration date on it has to be brought home and hurled into the home market.

While we put some of the blame on Greenspan for allowing the dollar deflation that dragged down the Asian market and now has created new weakness in Russia, we must be fair in noting that he can’t make policy all by himself. When the dollar gold price dropped below $350 a year ago at this time, our outfit in Morristown was the only place in the world that worried about its deflationary effects. Our supply-side friends pooh-poohed the decline and said it would be a good thing. Yet Greenspan knows that if the dollar were tied to gold at $350, the Fed would have been required to add liquidity to the banking system to keep it from skidding as far as it has. There would have been no Thailand crisis, no stupid interventions by the loose cannon on the global deck -- the IMF -- and now no second-order effects on the American economy. Indonesia would be bustling ahead, living standards continuing to climb as they did through most of Suharto’s 32-year reign, and no despair among those U.S. export companies that were counting their chickens to the bottom line and now discover they will not hatch in Asia -- at least not now.

Still, Wall Street continues to do well enough, with the DJIA hanging in there above 9000. Please remember there would have been no dollar deflation -- and hence no Asian crisis -- were it not for the 1997 budget deal and its supply-side tax cuts. Gold would still be at $383, the DJIA at 8000, and Suharto on top in Indonesia. Understanding this is critical to seeing the present and future as much as the past. I hate to complain about the extra thousand points on the DJIA, but it is how we got there that bothers me. This deflationary trip could have been avoided entirely, with the DJIA and the NASDAQ higher than they are, without putting several hundred million people on the other side of the world through the wringer and risking a downturn from this level instead of a higher one. It never has made any sense to me that we should “let some air out of the bubble now” to avoid having to let it out later. If it were necessary to fall by 10% from the climb we’ve been making, I’d rather it be from 10,000 than from 9000. London’s Economist magazine, which made this silly argument last month, still doesn’t know why the DJIA has climbed to where it is from 4000 just a few years back.

The people really responsible for the mess in Asia, at the U.S. Treasury and the IMF, are now spreading the word through their pals in the press corps that the shakeup has had these most desirable effects of punishing Asia’s crony capitalists by forcing them toward a more democratic future!  The IMF’s Michel Camdessus and Stanley Fischer would have us believe they are building character around the world by forcing ordinary people to learn how to live in misery. Do Treasury Secretary Bob Rubin and his sidekick, Larry Summers, expect a Nobel Prize for the incredible amount of character their policies are building around the world? Even the NYTimes has been catching on to the dark side of the IMF. In a remarkable lead piece in Sunday’s “Week in Review” section, NYT Treasury reporter David Sanger put his finger on the primary source of Indonesia’s recent convulsions: “Who would have bet that the triggermen in this Javanese shadow play would include a bunch of Ph.D. economists at the International Monetary Fund?” Sanger’s theme is that the U.S. economic weapon is a crude one that more often than not these days tends to backfire: “Almost simultaneously, the White House backed down from threats of sanctions against European firms for doing business with Iran and Libya. Those threats sounded tough: Any global company doing deals there was put on notice that it would suffer sanctions in America. The strategy backfired. Rather than create an alliance against terrorist states, it created an alliance against the American assumption that Washington can set foreign policy for the world.”

The world will allow Washington to set foreign policy for the world only if that policy is fair and just and takes into account world opinion. To me, this surely means the United States will have to guarantee the world that the dollar will be fixed to gold for the imaginable future. I still believe this will be necessary to get the financial world through the Y2K computer chaos. Even if it were not, the deflationary experience of the last 18 months should persuade more economists and policymakers that the independence the Fed has in being able to manage the dollar’s value is not worth the cost. The prices of apartments in New York City continue to climb in relation to equity values on Wall Street as the country’s promising fiscal position is discounted. The decline in commodity prices elsewhere is being accompanied by declining land values, however. This is why Greenspan can still collect the votes he needs at the FOMC to stave off the hawks. Regional Fed presidents in the midwest and southwest are now feeling this deflationary undercurrent and have switched from hawk to dove.

We have been foretelling a trading range for the 30-year bond since December, and it has bounced back and forth in that narrow slot between 5.8% and 6%, give or take a few ticks. In a non-inflationary environment, these would be incredibly attractive yields. If the market knew the gold price would not climb much above $350 for as long as the eye could see, a surefire 6% yield on a 30-year bond would be a fabulous buy. The market has been seeing much higher real returns on equities in recent years as Wall Street has surged, but under normal conditions we should never expect equities to compound at much more than 6% in real terms. With gold at $300, the DJIA is about where it was in 1966, before the federal government began adding policy burdens to the national economic engine. In normal times, the big money on Wall Street is made by those who are gifted in spotting winners and losers and place their bets accordingly. For those satisfied to protect their wealth instead of beating average equity growth, bonds are the place to be.

The most likely reason to expect a rise in the gold price to levels that would flatten the bond market would be a tax increase. When the Clinton tax hike of 1993 went into effect, remember, gold climbed to $383 from $350 as dollar liquidity came into surplus and was not mopped up with bonds. Can we see this happening again anytime soon? No, not with these embarrassing surpluses appearing at all levels of government. It is far more likely that there will be a series of supply-side tax cuts as we move into the “Politics of Surplus,” as we called it in our April 30 letter. These would tend to increase demands for dollar liquidity and deepen the commodity deflation. It’s hard for us to see much of an upside risk to bonds given this broad collection of favorable news. Even bond bears now are forced to spread the word that the Fed will not tighten, maybe, until the August FOMC meeting. By August, though, there will be even less support in the regions for such a move and bonds should be higher.