Thinking about Deflation XV Jude Wanniski August 10, 1999

During my client conference call last week, I was asked about monetary deflation with a question about liquidity. If the banks are starved for liquidity, why is it that they are flush with liquidity? There is no shortage of bank credit available for loans, properly collateralized of course. The same is true of the deflation in Japan, where banks have plenty of money to lend, but not as many takers as they would like. The answer is that monetary deflation is characterized by a decline in the price of gold, which occurs when the monetary authority does not supply sufficient liquidity -- non-interest-bearing debt in the form of cash and bank reserves -- as is being demanded. Paper becomes scarce relative to gold, which is why the ratio that expresses the dollar/gold price changes. If the system does not supply the amount of PAPER liquidity demanded -- which means the Federal Reserve must buy interest-bearing debt from the banks with NEWLY CREATED MONEY -- then the existing liquidity has to work harder. Every dollar of liquidity must support all the transactions of the day before, plus all the new transactions that are being starved. From gold at $385 to gold at $255, each dollar of liquidity is supporting a third more transactions in the exchange economy. This is obviously the opposite of an inflation -- where each dollar of liquidity does less work -- where there is a surplus in the system given the level of transactions demanding them. The paper becomes less valuable relative to gold, which is the proxy for all real things.

The surface damage being caused by the deflation is limited in the United States to the farm and mining sectors -- although there is a temporary rise in the oil price as expectations gather for Y2K inventory accumulation. OPEC countries can keep a lid on fresh production as long as price expectations hold up, a process that will reverse when expectations decline and the OPEC countries must sell more to buy less. Otherwise, commodity producers continue to be squeezed, with farmers forced to demand cash handouts from Congress in order to pay their creditors. As long as the dollar remains as valuable as it is, workers are enjoying wages that have higher purchasing power and are subject to lower tax rates, at least at the margin. These are positive ancillary effects to the deflation, which is a big reason the employment rate is so high. The $6 hourly wage of two years ago is now worth $8 in purchasing power with no increase in the percentage of income tax. But if and when the economy unwinds -- with Y2K being the most likely candidate -- the price of gold will rise as surplus liquidity appears. The 6.26% rate of the 30-year bond is warning us this will happen sooner, rather than later.

Some of the rebound in gold and commodities that would automatically follow would be helpful. The full effects of the deflation have not yet been felt, so a rise in gold above $300 would change market expectations sufficiently to bid up prices of the row crops, giving farm families and the communities that serve them some breathing room. Otherwise, there will be more urgent demands for relief from the farm sector, which the President will insist means there is no room for tax cuts. Instead of getting lower tax rates of even a small degree January 1, to increase rewards to capital formation as Y2K hits, we would get a monetary inflation to expand the economy. Workers now getting higher real wages would get invisible pay cuts. The last thing this scenario needs is an increase in the minimum wage, which would send the unemployment rate of black teenagers soaring. (I've pointed this out to Rep. Charles Rangel [D-NY] of the House Ways&Means committee, and a stalwart in the Congressional Black Caucus.) How far will the gold price shoot up? That depends upon how far it falls as the yield of the long bond rises. There still is no mechanism in place for supplying liquidity on demand, if demand continues to rise, and no mechanism to drain it if it suddenly comes into surplus. Instead, Fed Chairman Alan Greenspan is worried about "wage inflation," which is an oxymoron. There is no such thing.

With a constant gold price, wages can only rise if there is sufficient increased productivity to sustain them. Greenspan believes wage increases can cause inflation because he remembers periods of his own life when workers were demanding higher wages and employers had to raise prices in order to pay them. In the period immediately after WWII, when Greenspan was in college, he experienced rising wages and consumer price inflation, even with gold at a constant $35 per ounce. It never occurred to him, and still does not to this day, that the general price level still was adjusting to the 67% devaluation of the dollar in 1934, when Franklin Roosevelt simply decreed that gold would be priced at $35 instead of $20.67. Because the average maturity of dollar contracts then was measured in decades, not years, it took until the 1950s before the price adjustment was complete. And most of the union-led wage pushes were simultaneously dividing the productivity increases that accompanied an end to wartime taxation and the expansion of free trade. In the 1950s, in Japan, when workers struck ferociously every year -- with tear gas and police clubbing them down before the employers gave in -- Greenspan assumed there was an inflation there. But the record shows there was none. There was an explosion of productivity after the American occupation ended and the Japanese Diet began its annual tax-rate reductions.

Only when the gold price rises can there be a rise in the general wage level without accompanying productivity increases. When Nixon left gold in 1971, the move was accompanied by wage and price controls, but when gold rises, it becomes physically impossible to hold back inflation. In the period from 1971 through his chairmanship of the Council of Economic Advisors in the Ford Administration (which employed "Whip Inflation Now" buttons), Greenspan also observed the inflation rate rising as the unemployment rate climbed. This was not supposed to be able to happen, as a matter of Keynesian doctrine. Keynes also argued that wages could not fall, because while they went up easily, they were "sticky" going down. Workers would refuse to take pay cuts. Of course this also was wrong. As the gold price came down to the $350 level from the $600 range where Jimmy Carter left it for Ronald Reagan, labor unions were forced to negotiate "give-backs," or see their employers go under and leave them with no jobs that paid a lot. At least farmers and their bankers now are beginning to understand that Greenspan's flawed understanding of inflation has led him onto this destructive path. Notice the nice little rally on Wall Street today when William McTier of the Dallas Fed, who has a vote on the FOMC, came across the wires with a shout against another rate increase. McTier is a friend of gold who had been quiet.

There are only two ways to get the gold price up, so that relief to commodity producers would follow. One is a recession, with prices going up but sales down. The other is a presidential decision, which the President could easily accommodate with an executive order -- of the kind Jack Kemp asked of him in his June 11 letter. The Fed would not even have to add liquidity. Expectations would change and commodity prices would rise. The existing amount of liquidity would not have to work so hard. The straw poll in Iowa this weekend takes on market significance, as Dan Quayle and Steve Forbes are criticizing Greenspan on these points, while George W. Bush is urging his immediate reappointment. Iowans should be able to figure it out.