The Drag of Monetary Deflation Jude Wanniski February 7, 2001

Memo To: Paul O’Neill, U.S. Treasury Secretary
From: Jude Wanniski
Re: A Friendly Warning

After being thoroughly impressed with your Senate Finance confirmation hearings, I’d hoped you would bring into your Treasury team a supply-sider who understands the drag of monetary deflation. It is the most serious affliction now gripping our national economy, a cancer that is slowing eating away at us, but very few economists recognize it. So far you’ve added some nice people, bright and pleasant, but they all are trained in a demand-side model which does not even address the concept of monetary deflation. Both liberal and conservative Keynesians mix up “contractions” and “deflations,” so unless your team has figured out the fundamental difference between the two kinds of economic events, you’ll probably make the mistake of treating the wrong illness. It was encouraging to hear you acknowledge there may be something to the weakening economy that is more than a simple inventory correction, so at least you might be open to the concept. To tell you the truth, Mr. Secretary, most supply-siders think I’m making too much of the decline in the price of gold over the last four years, to the $265 level from the $385 level, but my concern grew out of independent analysis. It now is conventional wisdom to say that Alan Greenspan and the Federal Reserve may have been too tight last year in fighting an inflation that already had been defeated.

It is worse than that, by which I mean the Fed caused BOTH a contraction and a deflation. By raising interest rates unnecessarily when long-term interest rates were already lower than short-term interest rates (the “inverted yield curve”), the Fed slowed the real economy, bringing about the contraction from the higher growth rates the economy had been enjoying. At the same time, by not supplying sufficient monetary reserves to meet the legitimate demand for money by American enterprises and households, the Fed also caused the deflation we see evidenced by the declining gold price. The contraction part can be overcome by lowering short-term interest rates or cutting marginal income-tax rates and capital-gains taxation. The deflation part of the problem can only be rectified by having the Fed add sufficient liquidity to cause gold to climb back over $300. Otherwise, there will be an slow, grinding, downward adjustment of all dollar prices -- the mirror image of the slow, grinding upward adjustment of all dollar prices that we knew as the inflation of the 1970s.

In early January, I spent a day in Washington, D.C. drawing circles, trying to explain the monetary deflation to several people who may have some influence on policy in the new administration. I told them the financial markets and the economy are being dragged down by a monetary deflation. Unless this is fixed, it will be a constant drag on the Bush/Cheney administration for the next four years. The circles I drew here and there around town represented the stock market -- which in turn anticipates the health of the economy. Think of the circle as a balloon being dragged down by an arrow pointed down to the price of gold, which is now at $265, where its average price over the last decade was $350. I drew three little arrows pointing up -- one toward tax cuts, one to interest rate cuts, one to regulatory relief. Think of these as birds trying to pull the balloon up while the arrow is a lead weight pulling it down.

I explained that the gold price -- over time -- determines the general price level. When it was at $35 per ounce in 1950, a suburban tract home sold for $10,000. When it went to $350, the same tract home sold for $100,000. The average gold price over the last decade is $350. If prices have to adjust to $265, the adjustment will require a series of declines in corporate earnings, bankruptcies, layoffs, unemployment, until the whole economy is adjusted to the lower gold price. Unless the problem is fixed, it could drag the administration down with it.

How to fix it, they asked? Most quickly by a Bush executive order, instructing Treasury to stabilize the dollar value of international gold reserves (in Fort Knox) at perhaps $300 or $320. I agreed this would not be as easy as it sounds because it would upset a lot of economists who prefer a floating currency, including all those who advise Mr. Bush. But it will have to be done sooner or later or the new President could be a one-termer. Greenspan may not want to admit it, but he understands the issue, I think, and would cooperate if he were approached by folks who came to terms with its implications. I hoped those who grasped what I was talking about would somehow bring the concept to you. What was their response? All I can say is nobody laughed. I got a respectful hearing from several people I have known for a long time, but could not tell how much they bought, as there is virtually no discussion of gold in political circles.

I saw in the papers yesterday that you start the day at your Treasury office checking out the metals markets in London, an old habit from your days at Alcoa. I’d suggest you put the London gold price at the top of the list. It will be hard enough for our economy to adjust to $265 gold in the next few years. If the President is successful in pushing a retroactive tax cut into law, especially if a capital gains tax cut to 15% is included, I’d expect an increase in demand for dollar liquidity. If the Fed does not supply that demand, the gold price will decline further and the deflation adjustment will be all the more painful.