Fedwatch: Tokyo on the Potomac Jude Wanniski September 30, 1998

The most discouraging aspect of the Fed’s quarter-point cut in the funds rate was not its small magnitude. As we said Monday, we expected Fed Chairman Alan Greenspan would most likely be satisfied with a quarter and begin making the case for another cut at the November meeting. We did hope the Fed would include in its announcement concern about commodity prices, which it did not, instead fussing some more about the strength of the economy and other Phillips Curve effluvia. The objective, remember, is not to lower interest rates to expand the economy, but to raise commodity prices in order to put debtors and creditors -- here and around the world -- back into equilibrium. You still will find none of our arguments in the financial press or mass media, because the professionals continue to equate “easy money” with low interest rates. The world financial crisis will not ease until more liquidity is added to the banking system than is currently being demanded, with the objective of having the surplus push the price of gold up to at least $325/oz., preferably $350, but no higher. This reflation would enable commodity producers to pay their bills, their debts and their taxes, thereby avoiding the domino effect of having the whole world topple into bankruptcy.

As the Japanese have demonstrated to the world in the past three years, the central bank can lower its basic rate again and again and again and again, and the price of gold will not change. As David Gitlitz recently pointed out in a paper to our Global 2000 clients, when the BOJ cut its overnight rate to 0.25% from 0.5% on September 9, “to prevent the economy from falling into a deflationary spiral,” the supply of fresh liquidity was exactly matched by an increase in the demand for liquidity. The yen gold price did not budge from ¥39000 when it should be at ¥44000. The Fed’s current mode of fighting deflation is the Japanese model. That is to say, the FOMC can meet in November, December, January, February, and March, and cut the funds rate each time, but unless the open-market desk supplies more liquidity than is being demanded, the deflation will not end -- here or around the world. Contraction will continue until all dollar prices adjust to the gold price, most painfully when it comes to requiring labor to accept pay cuts and give-backs to complete the deflation process. In the September 28 National Review, Milton Friedman says this is not a deflation because nominal wages are still rising. Alas, nominal wages of commodity producers are disappearing. Average nominal wages continue to rise because people who make their livings by taking things out of their heads, instead of out of the earth, are in a rising tide put in motion by the 1997 tax cuts and the reform in telecommunications.

What the crisis in Long-Term Capital Management supplied was a quick decision by Greenspan to wring a quarter-point cut out of an FOMC worried more about wage inflation or the “inflationary” money supply than about the foundations of the world financial system. Those who understand least what is going on are filling the op-ed pages of the major newspapers with chin-pullers about how nice it would be if the Fed could have two monetary policies -- one for use at home, one for use abroad. We could then, it is argued, keep interest rates high here and lower in the rest of the world. Men and women are actually getting Ph.D. degrees in economics and finance for this kind of rigorous thinking.

In Washington this week, I patiently explained in several meetings that of the billions of people on earth who work for a living, there is a broad spectrum of those who do so by taking things out of the earth and those who do so by taking things out of their heads -- and a mixture of everyone in between. In an inflation, the earth people benefit first at the expense of the intellectual people, but because it is a zero-sum game, they eventually must give back all their gains until parity is reached at a new general price level. In a deflation, those who add value with their minds at first benefit by lower commodity prices, but they also have to give back everything they gained as equilibrium is reached at a new general price level.

A United States Senator gave me 20 minutes of his precious time to have me explain this, and because he is from a state that earns its living more by earth than mind, he got the gist of it. I told him that the adjustment process in a monetary deflation is remorseless, like the ocean’s tide going out. All kinds of things that must be in water to survive will die as they become exposed. Long-Term Capital Management -- a victim of the monetary deflation -- became exposed, and it now has its fingers crossed that the Fed’s quarter point will bring liquidity. Sorry, folks, it won’t, and as the tide goes out, others will show up one at a time. We welcomed the crisis, as we did Mexico’s crisis in ending the last major monetary deflation of 1981-82, but remember we made it clear that it will have to produce sufficient monetization of debt to get the gold price up above $325.

One possibility to produce this kind of liquidity would be Russia. Jack Kemp, who urged President Clinton to recommend a gold/ruble link to Boris Yeltsin when he was in Moscow earlier this month, this morning met with the Russian ambassador and explained how the reform would work. It would work with or without foreign assistance, Kemp explained, but it would be easier if the United States assisted in the reform in the same way we helped Mexico in 1982 -- by monetizing ruble debt. The injection of dollar reserves into the global banking system in 1982 sent the gold price to $425 from $320 and brought dollar debtors and creditors back into balance. To do the same thing now, before the end of the year, would guarantee the success of the effort. As in Mexico, once the crisis passed, Russia’s Ministry of Finance would be up to its ears in dollar liquidity, paying its hard-currency debt and having a surplus to build up dollar reserves. Asked what it would take to make this work, the ambassador said it would take only “trust.”

We are, of course, not going to remain in the Japanese mode for the next several FOMC  meetings. With Kemp making a nuisance of himself throughout the political establishment, little by little his arguments are being heard and understood. An op-ed he wrote in Tuesday’s Washington Times on “Driver’s Ed at the Fed,” could not be clearer on why the Fed has to steer by gold, not interest rates. One way or another, by crisis management or a sudden burst of intelligence at the Fed, liquidity in excess of demand will flow into the banking system and gold and all other commodities will rise in price too. All the countries that are still trying to maintain a dollar peg of some sort and are being hammered for their resolve will feel the relief -- Brazil, Hong Kong, and China in particular. The U.S. economy will not overheat, as long as the easing stops short of a new inflation. How easy it would be for Greenspan to say he would be comfortable with gold at $325 or $350, but no higher. Somebody, please ask him, on the record.