Jude Wanniski
March 14, 2001


Memo To: Fed Chairman Alan Greenspan
From: Jude Wanniski
Re: What you are doing to Wall Street

This is a Polyconomics client letter I sent out last week, March 7, when I finally gave up on any hope you would recognize the errors you have made in the past few years and advise Treasury Secretary Paul O'Neill that basic changes have to be made in Fed policy. I'd made this presentation at our annual client conference at The Breakers in Palm Beach the previous Thursday, March 2. You've known me for almost 30 years, Alan, and you know how hard it is for me to be pessimistic about the future. As hard as I've tried to warn you and President Clinton and now the Bush administration about the monetary deflation that is eating away at our economy, there has been no response. Worse, our mutual friend Bob Bartley, editor of The Wall Street Journal writes in his weekly column that we should not bother you, that a nice tax cut will fix us up. It won't, nor will your nibblings on the fed funds rate fix things. You have to go for the gold. Nothing else will do.

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At our client conference last weekend in Palm Beach, I made this statement to emphasize as clearly as I could the severe nature of the economic forces bearing down on the equity markets. Unless and until the Federal Reserve changes its operating mechanisms in a way that will cause the price of gold to rise at least above $300, I said we cannot expect a meaningful turnaround on Wall Street. The fact that we have had a three-day rally on Wall Street is of little consequence, except to remind us that there are positive forces trying to lift the markets, and that we will have a succession of mini-rallies as the secular bear market moves forward. Look at the graph showing the Dow Jones Industrial average and the NASDAQ during the last monetary deflation: In September 1980, gold was at $620, but began to slide as the demand for liquidity rose in anticipation of a Reagan win and the Reagan tax cuts. The market slid to August 1982 when Mexico's insolvency forced Fed Chairman Paul Volcker to flood the banking system with liquidity. Over that stretch, the graph shows mini-rallies that peter out, as the phased-in Reagan tax cuts are overwhelmed by the need for prices and wages to adjust to the smaller money stock.

For several months now, we have been suggesting a rough rule of thumb that the DJIA would eventually head toward a new equilibrium of 7500, but as gold continues to slide in the face of interest-rate cuts and prospective tax rate reductions, the new equilibrium must fall further. We easily could be too low on that round number because of the positive side effects associated with the end of the Cold War, the end of the inflation and bracket creep, and the decline in national debt. But we agree on the general direction and would not make such dramatic statements if there were disagreement among us at Polyconomics. One of the major reasons we can come to terms with the multiple forces hitting the economy at the same time is that we are careful to distinguish between deflation and contraction. At our conference, I drew two large ovals on a display sheet, each one labeled with one term or the other. These are the two separate maladies that are now afflicting the U.S. economy. The contraction theoretically can be fixed with the Bush tax cuts and by the Fed's interest rate cuts, but the deflation can only be fixed by having the government indicate it wishes to end it and also decide to re-balance the interests of dollar debtors and dollar creditors by adding liquidity until the gold price signals an appropriate level.

Robert Mundell, the supply-side Nobel Laureate, spoke at the conference, but did not agree with our conclusions. He said he thought if the Fed slashed interest rates enough, the increase in liquidity that would be required would send the gold price shooting up on its own. Our staff rejected that idea on the grounds that Japan has been caught in a similar deflation and has cut its interest rates on overnight lending to almost zero and the yen/gold signal has not responded. Wayne Angell, chief economist at Bear Stearns, had a similar view, but now has come around to seeing that the Fed must expand its balance sheet sufficiently to drive gold higher, which means putting aside the funds target. I spoke to Angell this morning and told him that I believed he sparked the huge one-day rally on Wall Street a few weeks ago when he noted that the 100 bps cut in the funds rate in January had not budged the gold price. Indeed, gold is now $10 lower and the equity indices have been hammered accordingly.

A real sign that nominal prices are being forced down came with the WalMart announcement of storewide "sales," for the first time in its history. It will not reorder stock at previous prices if it cannot see a turn coming that will allow it the prospect of selling at a profit instead of a loss. This is why monetary deflation is such a slow grinding process. In the next stage, the suppliers to the WalMarts and Home Depots will be forced to cut wages if they are to hold their margins. Employers who have been holding surplus workers because the labor market has been so tight will have to give up on the idea that this is a routine inventory slowdown. Labor will be dumped despite any corrections to the contraction, with workers scrambling to get into new jobs with lower wages and fringes. This is why Japan has been able to hold its society together as it adjusts to the mammoth deflation that brought the yen gold price down by 60% since 1990. If this were instead a 60% contraction, there would be blood on the streets of Tokyo.

We remain absolutely alone in our analysis, which led me to tell our conference-call participants that I felt like the fellow who broke the Japanese code and is having no luck getting the admirals off the golf course at Pearl Harbor. The admirals would rather listen to Abby Joseph Cohen of Goldman, Sachs, who is a great technical analyst and probably believes the "froth" has finally been skimmed from the NASDAQ so it is okay to buy, as the DJIA will end the year at 13,000. Of course it might, but only if the Fed changes its operating mechanism. I suggested to Mundell at the conference that perhaps we could start by having Greenspan take note of the deflation and say he will direct Fed policy to keeping gold above $250 and below $325. Yes, this is a wide, wide band, but it would allow the markets to drive up the gold price to an appropriate level without being hammered back by the Open Market desk and its funds target. Mundell suggested that Angell might be the man to push the idea with Greenspan. If you run into Greenspan, you can give him a push as well.