A Supply-side Guide to Global Chaos Jude Wanniski August 31, 1998

It is impossible to understand the continuing meltdown of the world economy unless you start with the proposition that the global market uses gold as its primary measure of financial integrity. It is in this sense that the world has remained on a gold standard since 30 years ago when the governments of the world decided to break loose from the discipline that gold imposes on modern central banking. Polyconomics is alone in the world in acting on that proposition, which we have been doing for 20 years. We were the first to warn of monetary deflation 18 months ago, the first to understand why Thailand was the first sovereign nation to suffer because of U.S. central bank policy error, and the first to term the global implications of that policy error as the Asian Flu. Our error in judgment was to believe that Fed Chairman Alan Greenspan would see his error and correct it, as only the Fed can bring an end to the meltdown that now has our own financial system and national economy in its deadly grip. Two weeks ago, in an open letter to Greenspan in the WSJournal, Jack Kemp clearly spelled out the need for added liquidity sufficient at least to lift the gold price to $325 from its then $290. When it hit $275 last week amidst the carnage on global stock markets and Wall Street, The New York Times finally urged the Fed to lower interest rates. This was the only encouraging sign I saw last week, during a vacation in Amsterdam I’d planned early this year. Only a handful of people know the source of the global chaos, but I could see no evidence that anyone in Europe connects either the market convulsions or the political chaos in Moscow to the Fed. Instead, the victims are being blamed for the meltdown. Here is a quick guide to the global chaos we still face:

$275 GOLD: In a world of floating currencies, gold is a “safe haven” only during inflationary turbulence, when paper money loses its value relative to gold. When the central bank is denying the world dollar liquidity, the dollar’s scarcity gives it greater value than gold. If there is no correction, the process feeds upon itself. More chaos produces a greater demand for dollars and a lower gold price, which spreads to all commodities and all other prices, until everyone is bankrupt. At $275 gold, the financial meltdown in global equities not only will continue, but also will feed into an even lower gold price, which will deepen the level of bankruptcies. If Kemp were President at the moment, he would simply direct the Treasury to fix the dollar price of its gold reserves at $325, and world markets would scramble madly to unload dollars to buy gold. Commodity prices would rise in train and stock markets around the world would rise sharply as debtors would be able to pay their obligations to creditors. The U.S. 30-year bond, instead of falling in price, would rally with stocks, seeing President Kemp was not inflating, but merely ending the horrific dollar deflation.

RUSSIA: President Clinton leaves for his Moscow summit today, with no one in his entourage who understands that the Fed’s monetary deflation is the source of Boris Yeltsin’s problems. The breakdown in Russia’s infant financial system could not withstand the collapse of commodity prices that are the government’s main source of hard-currency earnings. The IMF and Clinton’s Treasury want Russia’s Duma to legislate higher taxes and interest rates. The only source of common sense left in Russia is in the Communist Party, which refuses to consider such a satanic threat to the masses of ordinary people. If Kemp were President, he would urge Yeltsin to float the ruble against the dollar but peg it to gold, at 2000 rubles to the ounce, which would make the ruble more valuable than it is now and prevent the chaotic inflation that will occur if the government does not fix its money. This, by the way, is what Alexander Hamilton would advise Yeltsin to do. It also is how Ludwig Erhard ended the financial chaos in Germany in 1947. The Russian central bank has the absolute power to add or subtract ruble liquidity to maintain the 2000 gold peg, while it is powerless to maintain a dollar peg during a dollar deflation. As 75% of transactions in Russia now are managed in dollars, not rubles, the gold peg would cause an immediate flight from the dollar to the ruble, and the government, ironically, quickly would accumulate the dollars required to meet its obligations to western banks. Nobody is thinking about this simple, classical solution because it is not in any of the standard Keynesian or monetarist textbooks. If President Yeltsin listened to President Kemp, the Moscow stock market would regain its stupendous losses in a matter of days. With a gold unit of account, the best buys would be Russian bank stocks. 

JAPAN: With the Nikkei below 14,000, Japan’s banks are in terrible trouble, especially as the Fed continues to strangle world commodity prices. If gold were back to $325, the Nikkei would easily be above 18,000 again, as Asian debtors could then meet their obligations to Japanese creditors. Otherwise, the only other solution is the elimination of the capital gains tax on real property, which would liquify these massive capital assets. Cutting income-tax rates or the sales tax would have trivial beneficial effects on the economy, as neither addresses the double-barreled blast the Japanese financial system has been getting from the Fed’s dollar deflation and the crushing tax liabilities hanging over the economy because of the capgains tax on real property. Kemp two months ago made these arguments to the Japanese Ambassador, who assured him they would be passed on to Tokyo, although we see no signs that they were. 

CHINA: The Beijing government gamely hangs onto its commitment to maintain the dollar/yuan peg, determined to keep its currency as good as the dollar even amidst the global dollar deflation. At $275 gold, its patience is being sorely tested, especially as it observes the Hong Kong dollar attacked daily by the biggest guns among Wall Street’s investment banks. The world financial press is shouting at Hong Kong to stop using its dollar reserves to support its stock market, but what are reserves for, if not to be used in a time of crisis? Technically, China would solve several problems by devaluing the yuan to offset the domestic deflation it has caused by allowing the Fed to make its monetary policy. With its own massive dollar reserves, though, Beijing has decided to arm-wrestle the Fed to see who screams first. The Fed of course could destroy China by deflating gold to $200, but the wreckage on Wall Street would not be a pretty sight either. And China could offset much of its own pain by using some of its $140 billion in reserves to eliminate its capgains tax on real-property leases, an idea Kemp and his staff conveyed to the Chinese Ambassador when they met with him in June. 

EUROPE: Until July, Europe had skirted the global meltdown by keeping its own currencies more in line with gold than with the dollar. The crash in Moscow and the Nikkei slide in Tokyo now have pulled the Europeans into the maelstrom, although they haven’t yet figured out what hit them. The finance ministers of Germany, France, Italy, and Britain issued this weekend a joint statement insisting Moscow drink the IMF’s poisonous brew, which in my opinion would amplify the financial crisis into a geopolitical crisis. The Russian Communists believe there has been a conspiracy to give it the worst possible economic advice to keep it impoverished. They are absolutely right. And Moscow, unlike Beijing, doesn’t have the strength left to arm-wrestle the Fed.

OUTLOOK: The most dangerous man in the world at the moment is Alan Greenspan, finally displacing the IMF’s Michel Camdessus on our list of the Top Ten. If he continues to pretend that the Asian crisis was caused by crony bankers and the Russian crisis is the natural result of a crooked oligarchy and that U.S. farmers, small banks, miners, and oilmen are to blame for not shifting to software production, then we are in for a truly discouraging experience. Last week’s bloodletting was helpful, though, if the least it produced was a change of heart at The New York Times. The good news is that at least we know why all this is happening, and how to fix it, which was not the case in 1929.