A Lesson in Deflation Jude Wanniski August 1, 2001

Memo To: Richard Vigilante, American Spectator
From: Jude Wanniski
Re: Deflation & Contraction

I’ve heard, Richard, that you are interested in the distinction I’ve been making between an economic contraction and a monetary deflation. You’ve had a few items on “deflation” in the Spectator since you became editor several months ago, but I’m afraid they were either mostly incorrect or a bit off the mark. You have hit on exactly the right point, though, in wanting to learn about deflation by hearing why it is different from “contraction.” Believe it or not, I actually discussed this topic with Treasury Secretary Paul O’Neill when I met with him and some of his staffers in April, as I only had a half hour with him to make my deflation argument. If you study economics these days, you will not be taught the distinction, but if you want to figure out why the stock market and the economy are in trouble, you must understand the deflation process exactly, for it is a process, not an economic statistic. Let me try:

First of all, in a supply-side model, consumers of goods and services are peripheral, not primary. By that I mean that producers of goods -- those who supply them to the marketplace -- are the primary actors. They produce in order to exchange their surplus output with producers of other goods and services. As I explained it to O’Neill: If he is a producer of bread and I am a producer of wine, and we are planning to exchange our surplus output with each other over a period of time, in a modern economy, this is done through the intermediation of banks and financial markets, not barter. If there is a surprise to the markets in the form of a higher tax on producers of wine and producers of bread, or a higher tariff between domestic producers of one and foreign producers of another, there will be some exchange of goods that will be uneconomic. Instead of being exchanged, they will pile up in inventories. This is a contraction, not a deflation. Prices will fall as the producers discount them in order to get them off the shelves, but this is only a temporary condition. When it is a small event, we write it off as an inventory recession, for as soon as the surpluses are liquidated, the rest of the economy bounces back at the old price structure. The Great Depression was a contraction, not a deflation. It was not caused by the Federal Reserve making dollars scarce relative to gold, the proxy for all commodities. It was caused by tariff and tax shocks that erected barriers between domestic producers and between exporters and importers.

When the Great Depression was over, the general price level gradually returned to higher levels. Because President Franklin Roosevelt had changed the dollar value of gold in 1934, raising it to $35 per ounce from $20.67 per ounce, the price level climbed higher than it had been in the 1920s. Professional economists failed to see this post-World War II inflation had been part of the inflationary process that began with the 1934 FDR devaluation.

Inflations and deflations only can be understood as process phenomena. When Roosevelt raised the dollar/gold price by executive order, the general price level took two decades to catch up with gold. This is because contracts had to unwind in a gradual inflationary spiral between capital and labor. When the debt structure of an economy is mature, it takes a long time for the process to be completed. The same is true of deflation, which is what we are experiencing today. As I explained to Secretary O’Neill, our honest attempts to produce bread and wine and exchange surpluses with each other via financial intermediation will be messed up by either a deflation or an inflation. If our contract is such that I deliver him a loaf of bread every day, with the contract requiring him to deliver the wine all at once at the end of a year, the government must keep the dollar constant against gold in that period, for if it deflates, O’Neill, who is in my debt, will be required to give me much more wine than he anticipated at the outset. If the dollar inflates, as his creditor, I will be forced to steadily increase the amount of bread I give him, and at the end of the year will have to be satisfied with much less wine. In a world where the unit of account is floating against the real world of commodities, gold being the most sensitive proxy to monetary error, inflations and deflations will be the rule, not the exception.

As wise a man as he is, Fed Chairman Alan Greenspan has not been wise enough to realize the problems he caused by ending the dollar inflation, only to preside over the dollar deflation that is now forcing down the general price level. I’ve told friends that it is as if he threw a cigarette butt into the brush back in November 1996, when the process began, and it has been burning its way through commodity producers ever since, but is now reaching up the mountain toward our production of intellectual goods and services. It is nice to be a commodity producer at the beginning of an inflationary process, but the flames finally reach you too. In a deflation, it is nice to be an intellectual producer -- producing goods and services out of your head, not out of the earth. But the flames finally reach you as the general price level adjusts. This is what is happening to our economy today, although Greenspan is doing everything he can to persuade his friends in the Bush administration that it ain’t a deflation, and that with only a little more patience, the tax cuts and his interest-rate cuts will cause the inventories to be liquidated and we will have prosperity in the rebound that follows.

We can not undo the damage that has been done, Richard, but we can prevent the damage that is yet to come as the deflation unfolds. Think of it as a firebreak, devaluing the dollar against gold with a mini-inflation that takes the gold price to $325, the number suggested by Jack Kemp several weeks ago when he wrote about the deflation in The Wall Street Journal. When we get there, we should probably consult with the rest of the world on how to rebuild the international monetary system so that we do not have a floating unit of account any more, but a dollar as good as gold, which does not inflate or deflate.