Thinking about Deflation VII Jude Wanniski June 12, 1998

Twenty years ago, Kidder Peabody had a popular Wall Street economist, Sam Nakagama, who built his brief period of fame on a monetarist framework. In 1983, when all his predictions went awry, he quit monetarism on the grounds that it didn’t work. Several months later, Sam was back watching the M’s, explaining to a financial reporter that he had to make a living and it was the only model he knew. Milton Friedman’s monetarism should be in the running for the worst new economic idea of the century -- specifically the notion that you can tell anything about the course of the economy by knowing the supply of money without knowing the demand for money. Yet here we have reports that the president of the Cleveland Fed, Jerry Jordan, believes interest rates should be raised to prevent an incipient inflation, which he spies in the money supply numbers. In the same way, Henry Kaufman’s fame as chief economist at Salomon Brothers crashed on his idea that you can predict long-term interest rates by observing the federal government’s demand for credit via its budget deficits. This dreadful capital “crowding out” idea was responsible for the deepening of the Great Depression in the mid-1930s, as President Roosevelt raised taxes again and again to balance the budget. Yet here we are in 1998, and the International Monetary Fund still uses it as its primary tool in forcing one country after another into bankruptcy via currency devaluation. It is also the idea behind Rep. Mark Neumann’s drive among House Republicans to use the budget surplus to pay down debt.

In thinking about what’s going on in the world today, it’s important to remember that as bad as they are, these ideas are dominant because they are the only ideas known by the people in charge. The malady that has struck the world economy has never before appeared in this form, to this degree. Never before was there one nation dominant on the planet, with its currency dominant, in a system of income-tax progressivity. When Bretton Woods broke up in 1971-73, it was the first time the world experienced a general inflation amidst near universal tax progressions. Because it was not in the textbooks, only two economists, Robert Mundell and Art Laffer, saw what was happening and explained it to me. Now we are going through the first sustained rise in the value of the world’s key currency amidst near universal tax progressions. With Mundell and Laffer having gone in different directions in the last 20 years, we at Polyconomics have been alone in sounding the deflation alarms -- although The Wall Street Journal has now climbed aboard, as evidence by its lead editorial today, “The Yen Dilemma.” The most pregnant point the Journal makes is that “its certainly time for [Fed Chairman Alan] Greenspan and the rest to think more deeply about the world-wide impact of their domestic policies.”

In other words, here is Greenspan sitting on top of the global pyramid, the world’s central banker, looking around and seeing the best U.S. economy in his 50-year experience as an economist. It does not occur to him -- or he does not want to admit -- that the financial turbulence throughout much of the rest of the world is because of his errors at the Fed. In some ways, he has helped fix the economy here at the expense of the developing world, particularly those that produce commodities to make a living. The reason Greenspan became angry with me last autumn and asked that we stop sending him our client letters was that I openly chastised him for deflationary monetary policies that were causing pain and suffering to literally hundreds of millions, if not billions, of people on the planet. He can officially excuse himself for responsibility to the world; the Fed chairman is not given those responsibilities. I cannot excuse his failure to share his life-long learning with our political leaders, so they might realize the extent of the damage deflation has done to our economy as well as the rest of the world. In private, Greenspan  continues to cite gold as an important guide to inflationary expectations. With gold now at $285, from $385 18 months ago, he should be screaming about the need to add dollar liquidity to a world that is crying for it. Instead, when Chairman Jim Saxton of the Joint Economic Committee Wednesday asked him about commodities and foreign exchange -- the guides he cited in the past that now clearly point toward ease -- Greenspan downgraded them: “I recommend being careful about relationships because one of the things that we have learned about our really quite unusual technologically-based economy of recent years is its adaptiveness to various different events, which it was unable to adapt to previously. And that means that you often find that indicators which worked exceptionally well in the past, do not work and have not worked in the most recent past.” 

Oh, my. Greenspan clearly is saying there is no deflation because unemployment is down and Wall Street is up, therefore gold isn’t working the way it once did. In this unique period of economic history, though, the monetary deflation has been offset by major supply-side tax cuts of 1997 (which helped cause the deflation by increasing demand for liquidity Greenspan refused to supply). If the Fed last spring had supplied liquidity at $350 gold, to keep it from falling, the U.S. and the world economy would now be much stronger, but without truth serum you could not get Greenspan to admit that. The recent strength of bonds and the weakness of stocks on Wall Street reflect the delinking of debt and equity. In my last “Thinking About Deflation” letter, May 26, we made the case for higher bond prices breaking out of the 5.8 to 6.0% trading range we correctly foretold in December. The inflationary bubble that crept into the dollar financial structure when gold temporarily bumped up to a $385 plateau by now has been winnowed out with a year in this lower range. Except for the monetarists who only look at M, that inflation bubble has now disappeared from the Fed’s radar screens. 

With it has gone the threat of a rate increase, thus boosting bonds into a higher trading range. Sadly, the decline in stocks is part of that story. As long as the President says there won’t be tax cuts this year because Social Security has to be saved, and the Republican leadership runs for the hills in fear, the equity markets and the future economy will have to carry the burden. Greenspan’s assertion that this is the best economy he has seen in 50 years was a gift to the Democrats and to the GOP budget balancers. Why do we need a tax cut if all it can do is make trouble? Reigniting wage inflation? Using up Social Security money for dubious supply-side claims of growth? The equity markets now have to factor in this rosy glow, because it means trouble for any meaningful tax cuts. If the Democrats had control of Congress, you could be sure the President wouldn’t be hoarding the surplus and would even offer tax cuts that he and his party would take credit for. The reason liberal Democrats like Barney Frank are standing still with Clinton’s policy of hoarding -- when they would much rather spend -- is that they sense Clinton is right about the November elections. As long as Republicans remain divided between tax-cutting and hoarding, the electorate will have a better chance of growth giving Clinton the House and the Ways&Means Committee. This is why the only Republican really making a fight for tax cuts inside the Congress is Chairman Bill Archer of Ways&Means. With Jack Kemp’s help outside.