A Kick in the Pants Jude Wanniski September 1, 1998

In thinking about the deflation, we concluded months ago that the market would have to fall to a point that would satisfy Alan Greenspan that unless he eased, the unemployment lines would get longer than he desired. By all accounts today, Wall Street’s kick in the pants yesterday probably was sufficient to get the Fed Chairman into a mood to ease. All we need now is a clear signal from him. It may also be what Republican leaders in Congress needed to get them into motion on tax legislation when they return from the August recess. This optimistic appraisal suggests only a sluggish resumption to the bull market, with the pace of the advance to be determined by the actual scenario that will play out. Some points to consider:

The objective is not only to end the deflation at the current gold/commodity prices, but to get sufficient dollar liquidity into the system to push the price of gold to at least the $325 level. Conventional wisdom is not even thinking about gold, but at least is persuaded that the Fed must cut the overnight federal funds rate that stands at 5.5%, higher than the 30-year bond’s 5.3%. The best-case scenario would be if Greenspan were to publicly state that he thinks gold would begin to worry him if it climbed above $325. This would alert global markets that he will not worry short of that number. That itself would cause the gold price to be bid up. Chances of this happening are small, though, as Greenspan has been in a state of denial about the wreckage he already has created in the world economy by ignoring the gold signal he watched like a hawk while it was rising. A week ago, he responded to Jack Kemp’s open letter in the WSJournal of August 17, which challenged Greenspan on the gold issue. Greenspan simply stated that he no longer thought gold that important. In other words, it becomes important only on the way up.

If the Fed cuts the funds rate at its earliest opportunity, which could follow a conference call of the members of the open-market committee, we would suppose they would do a quarter point, to 5.25%. How much new liquidity would this bring to the market? The problem with trying to get the gold price up by jiggling the funds rate is that we would not be able to judge market behavior. If the demand for dollar liquidity increases because of the quarter-point drop, the added supply only may offset the added demand, and the gold price would remain constant. A happier assessment would be that the markets would assume the quarter-point drop would be followed by others. Even so, the path that would get dollar debtors and creditors back into balance might be a long and stony one. This is why we said in our "Global Chaos" report of early yesterday that a “President Kemp” would simply ask Treasury to fix the dollar gold price at $325 or so. There would be no long and stony path.

Fed Chairman Paul Volcker faced an almost identical problem in early 1982 -- after the Fed so starved the economy of demanded dollar liquidity that gold had fallen below $300 from $600 only 15 months earlier. That deflationary problem was solved when Mexico informed Volcker that it could not pay interest or principal on its roughly $90 billion in dollar debts to U.S. banks. Volcker solved the problem by buying $3 billion in Mexico peso bonds for the Fed’s portfolio. Mexico met its interest payments with this fresh liquidity in the system, and the liquidity sent the gold price soaring, at one point topping $500 an ounce. Oil prices rose in tandem with gold, and Mexico was quickly solvent again, in a position to buy back its peso bonds. Gold settled back down at $425, the international banking crisis was over, and the Reagan boom years began.

If Kemp were President today, in Moscow at a summit with Boris Yeltsin, he would make an offer similar to that which solved the 1982 deflation (which everyone called “disinflation” in those days). If Russia would float the ruble against the dollar, but peg it to gold at a rate of roughly 2000 rubles per ounce, the President would be in a position to ask the Fed to buy $3-4 billion of Russian ruble bonds, for its own portfolio. Russia then would be able to pay interest on its hard-currency debt. It would also encourage the Russian people to convert the billions of U.S. dollars they now hoard and use for barter trade into gold/rubles. The Russian central bank would be knee-deep in dollars and earning a fortune in seignorage by printing new gold rubles. In short order, it could easily buy back the ruble bonds from the Fed’s portfolio. Just as in Mexico, the Fed’s open-market operations in ruble/gold bonds would course through world markets, pushing up the gold price and pulling commodities along too. That’s how we most easily could get gold above $325.

The idea causes several other good things to happen. For one thing, the Russian Parliament is deeply suspicious of any advice it gets from Americans. When they first started getting advice in 1989, the ruble traded on the black market at 4-to-1. After several rounds of Harvard-MIT-NYTimes “shock therapy,” the ruble now trades at the equivalent of 11,000 to one. This takes into account the three zeroes knocked off last year to neaten up the unit of account. The ruble/gold peg liberates the Russian government from the sovereignty problems associated with the dollar, which means the Duma would embrace the idea as passionately as it rejects the IMF austerity brew. The Duma is dominated by the “Communist” Party, which in my experience would be more clearly identified as a Populist Party. It would relish the independence of a ruble/gold peg. The idea the Duma would accept “dollarization” of the Russian economy, which the WSJournal today recommends, seems preposterous. If Boris Yeltsin’s pick for prime minister, Viktor Chernomyrdin, pushes “dollarization,” the Duma will never confirm him and Yeltsin will be forced to send up another name or call new elections.

It also may seem way out for us to be discussing the idea of a gold/ruble peg. But over the last decade, in dozens of meetings I’ve had with Soviet and Russian officials, I always found a great eagerness to contemplate a gold ruble. Karl Marx would never have contemplated a socialist experiment without a gold standard. Every economist in Russia knows the high-water mark of Leninism in the 1920s coincided with a gold-backed currency, the chevronets. If Kemp can get the idea in circulation, starting with a letter to President Clinton, there is an excellent chance it would become a live topic of discussion in Moscow. This is no small thing. If the ruble became more attractive than the dollar to Russian citizens, the global supply of dollar liquidity would be washing back at the Fed’s doorstep. When former Fed Governor Wayne Angell and I visited Moscow in 1989 at the invitation of the Gorbachev government, Angell told anyone who would listen that unless they fixed the ruble to gold, the USSR would split into pieces in the ensuing inflation. Gorbachev was dissuaded by the promise of a massive aid package from the IMF, which never materialized. Gorbachev was thrown out and the USSR splintered as predicted. Angell and I also advised our audiences in Moscow and (then) Leningrad that if the ruble were fixed to gold, it would force the United States onto a gold standard.

In any event, the market may have hit bottom, but only if our Political Establishment is sufficiently frightened about an even bigger kick in the pants than it got yesterday. A reasonable expectation is an extremely sluggish bull.