How to Freeze a Frog Jude Wanniski March 13, 2001

Memo To: Treasury Secretary Paul O’Neill
From: Jude Wanniski
Re: A Little at a Time

Back in the mid-1970s, when I first began to understand the concept of monetary inflation, I realized that very few people knew what caused “inflation.” The American people had not experienced an inflation since the Civil War years, with “greenback” money, and after 100 years without inflation, it was natural that there was so little memory of it. As a matter of fact, in the first two years after President Nixon closed the gold window, on Sunday, August 15, 1971, there was almost no sign of what we think of as “inflation,” because Nixon also had instituted wage and price controls. You remember all that, Mr. Secretary. You were the whiz kid at the Office of Management and Budget, a senior staffer at OMB to director George Shultz. When the wage and price controls were lifted, wages and prices began responding to the fact that the dollar price of gold had doubled and then doubled again, to $140 per ounce in 1973 from $35 in 1971.

The conventional wisdom was that the Organization of Petroleum Exporting Countries (OPEC) had caused prices to rise. Then the idea took hold that greedy workers were responsible for rising prices as their higher wages had to be factored into prices. Wages of skilled workers would cause wages of unskilled workers to rise. We called this “wage-wage inflation.” Remember? It was in the mid-1970s, after meeting the Canadian economist Professor Robert Mundell, who had predicted the inflation, that it dawned on me the inflation was taking place so gradually that policymakers were bemused about its origin. They were like the frog who was being boiled very, very slowly. You remember the story: If you throw a frog into a pot of boiling water, it will jump right out. But if you put it in pot of cool water, raising the temperature by one degree every 15 or 30 minutes, the frog will never notice the incremental difference. Cool water would warm, eventually simmer and then boil. The frog would be overcome. So it was I thought the American people were being boiled by an incremental inflation, never realizing where it had come from. Nor did they notice that the inflation was pushing the entire work force into higher tax brackets, tax rates climbing higher and higher without having been legislated, pushing rates past the point of diminishing returns as they undermined economic activity. It was Mundell, watching from across the Canadian border, who was the first to recognize this process and to argue that it could only be halted by cutting tax rates back to where they were before the inflation began and also stabilizing the gold price so that no new inflation would occur. This was the beginning of what I came to call “supply-side economics.”

Mr. Secretary, now the tables have turned. Beginning with the election of Ronald Reagan, economic policies followed the Mundellian prescription. The Reagan tax cuts of the 1980s adjusted for most of the inflation, although they never corrected for inflationary capital gains. Monetary policy tightened and the price of gold began its descent from $620 an ounce, when Reagan was elected. The boiled frog began to thaw and for the several years, with gold at $350, the frog was back to good health and Fed Chairman Alan Greenspan got most of the credit for ending the inflation with his “strong dollar policy.” Alas, Greenspan did not know when to stop. Since November 1996, the temperature in that pot has gotten cooler and cooler, one degree at a time, and nobody has been noticing the frog has been freezing. Gold is down to $270 an ounce, a sure sign that the Federal Reserve has been making deflationary errors, making the dollar scarce relative to gold, which is the proxy for all commodities. Greenspan himself does not understand how he has gone too far with his strong dollar policy and now seems to think the frog can be warmed up with tax cuts or lower interest rates. As our new Treasury Secretary, you have stated that you favor a “strong dollar” policy, but how strong? If it remains as strong as it is relative to the price of gold, our economy will continue to freeze up and President Bush and the Republicans will get the blame. I recommend you study this matter carefully. The problem is very easy to fix once it is understood.