Deflation and Rising Prices?
Jude Wanniski
March 7, 2001


Memo To: Martin Wolf, Financial Times
From: Jude Wanniski
Re: Gold and Oil

I'm delighted to have your question about how we could be experiencing deflation when price indices are still rising. You are easily my favorite economic commentator at the Financial Times or Economist, the two publications I regularly see from England.

The deflation began in December 1996 when the demand for liquidity began to increase as a result of the anticipation of supply-side tax cuts in 1997, which did take place that summer. Gold was at $385 when the deflationary process began. In our classical framework, inflation begins with a rise in the price of gold and deflation begins with a decline in the price. There is no such thing as "disinflation," the term modern Keynesians have developed to account for a mixture of prices falling in one area and still rising in another. A balloon inflates, as the influential British economist A.C. Pigou advised early last century, or it deflates. That's it. We are most definitely in a monetary deflation, although prices are higher for the moment because of the disturbances in oil caused by that deflation. Bear with me:

We have been experiencing deflationary polices that could be felt in early 1997, when gold was at $360. If we would have been on a gold standard, the Fed automatically would have had to increase liquidity to prevent gold from falling in price. I'd urged U.S. Federal Reserve Chairman Greenspan, whom I have known since 1973, in December 1996 that this was going on and that he had best begin talking about it to educate the political class so there could be a change in the Fed's monetary target. When he did not do so, I asked for a meeting with the President to warn him of what was ahead. The White House instead had Deputy Treasury Secretary Larry Summers call me. I met with him in April 1997, but while he treated me with respect, said he could not buy my gold argument. I'd told him we could expect a decline in the oil price, then farm prices, just as we had been warned in January 1972 by the 1999 Nobel Prize Winner Professor Robert Mundell to expect a rise in oil prices and other commodities. You know what happened.

The first rupture began when Thailand, which had inflated to keep the baht tied to the dollar when gold was rising to $383 from $350 in 1993 (when liquidity demand declined because of the Clinton tax increase). As the gold price declined, the Bank of Thailand had to drain baht liquidity in order to keep its dollar peg. This wrecked the Thai banks as the economy became illiquid and loans went bad left and right. The wreckage spread through Asia as the Thai economy crumbled further under the savage ministrations of the IMF. I called it the Asian flu as the dominoes fell in Malaysia, Indonesia and Korea. Taiwan wisely devalued to prevent the deflation from wrecking its economy and Malaysia wisely put on exchange controls while it repegged at a less deflationary rate. We advised our clients at every step what was going on and could of course document this.

The world oil industry, which had become euphoric with the inflated dollar, now experienced a collapse in demand, and oil fell to $10 bbl from $25. For more than 18 months, all investment in the global energy industry stopped. The most important commodity in the world, of course, is energy, for without it, all commerce ceases and eventually, all life. (Global cooling!) When the Asian economy began climbing out of its ditch last year, it began calling for more energy, but was advised by the world BTU industry that it had been on vacation for two years and would have to have higher prices in order to catch up. A contributing factor was the blunder made by the International Energy Association in Paris, which had overestimated global supplies by 2M bbl per day. So the oil price goes way up and of course begins feeding into all prices, of all goods and all services, and then the price indices.

You see, Mr. Wolf, it is very difficult to have a market economy with a floating unit of account. Capitalism does not work nearly as well with a floating dollar as it had for centuries with a gold dollar. You ask what kind of inflationary policy I would urge upon Greenspan. I suggest that unless he adjusts the dollar gold price to a level closer to an appropriate level, somewhere over $300, but certainly not more than $350 at the most, all nominal dollar prices will have to gradually decline to a level consistent with gold at $263, where it is now. Of course, if we now experience a further increase in the demand for liquidity because of tax cuts that further expand the economy, and the Fed does not produce the necessary additions, gold will fall further and dollar prices will have to come down to that new, lower level. This is what happened to the unforunate Japanese, when they did not recognize a yen deflation that began at Y65,000 per ounce and has carried to the present Y26,000. When you make your money scarce relative to gold -- the proxy for all commodities -- you deflate. They once taught that in London, but have not for more than a half century. Perhaps you can help revive classical theory. Keynes always could be taught in a course of economic history.

You will recall that when the Bank of England "devalued" the pound sterling a few years ago, there were expectations of rising "inflation" as a result. Polyconomics advised its clients that the BofE was no longer willing to follow the Bundesbank's lead when it was making the mistake of draining Deutschemark liquidity on the theory that unification with East Germany would be inflationary. You simply adjusted sterling to a more appropriate rate -- one that would not further distress the nation's debtors. The Bank of Italy had made a similar adjustment with extremely good results. The "British Disease" of the postwar era was caused by the BofE devaluing against the dollar/gold of Bretton Woods, when it should have been peeling away the insanely high income-tax rates that were originally passed in the first World War. Do you agree with me on that point?

If I could win you over to at least considering my thesis, and you write about it for the FT, we would stir up a sensational debate, wouldn't we? I am of course not a "gold bug," a fellow who simply wants the price of gold to go up so my gold holdings would appreciate. I have none. It was Bob Mundell who taught me many years ago that there is an optimum price of gold, which would be Pareto Optimal. I took it upon myself to reckon that the optimum price would be exactly at the center of gravity between debtors and creditors. As that center changes all the time, I now believe it may be as low as $300 and as high as $325. Mundell told me yesterday he would like to see the dollar/euro rate fixed at a parity of 100, which would mean the price of gold would have to rise by 10%, to $300. If you agree, we can help change the history of the world, for the better. Mundell, who helped inspire the revolution in monetary thinking that brought about the fixed-exchange rate system in euroland told my client conference in Florida Sunday that it is insane to advocate a floating currency or flexible currency in this world. If you disagree, please tell me why, and I will bring Mundell into our discussions to figure this out. We can't proceed and get very far without the help of the most important economic commentator in Europe.