This is an essay I wrote for clients of Polyconomics in February of this year. The essay was designed to explore the similarities and differences between the 1982 deflation and the current deflation that began in 1997. It is as relevant now as then, as the economy has weakened considerably in the interim. The paper takes readers back to the early 1980s when Paul Volcker was Fed chairman. Volcker, who was trying to stop an inflation by hitting monetarist money- supply targets ended up inadvertently tossing the economy into a sharp deflationary recession as the Reagan tax cuts produced a demand for dollar liquidity that could not be met under the constraints of the monetarist quantity rules. Volcker's successor, Alan Greenspan, has ended up making the same mistake, although this time around the deflation emerged in a strong economy as growth expectations were lifted by a bi-partisan plan to reduce the capital-gains tax in 1997. Today, as in the early 1980s, the CPI is positive, which unfortunately has deluded the financial press and fooled Fed officials into erroneously thinking there is no deflation. This paper clarifies the deflationary process, its effect on financial markets, and how the pain of a full-blown deflationary adjustment can be avoided.
February 22, 2001
THE MONETARY DEFLATION OF 1980-82
(and what it tells us about the monetary deflation of 1997-2001)
The deeper we get into the Monetary Deflation of 1997-2001 and the more painful it gets, the more interest we can get from the political establishment on our ideas on how to end it. It is not as if we have not experienced monetary deflation in the recent past. To get a clear picture of where we are today, it will be helpful to review the deflation of 1980-82, the worst such experience since the return to gold in the 1870s. In Part I, we work through the causes and ultimate resolution of the 1980-82 deflation, with a brief discussion of equity-sector performances during the subsequent recovery. In Part II, we examine the current deflation and how it may be resolved.
Part I: The 1980-82 Deflation
In 1979-80, we experienced a serious burst of monetary inflation, as the Fed tried to offset a decline in the demand for liquidity by adding more of it. The rationale was provided by the monetarists, who observed a statistical decline in the M-1 monetary aggregates from their preferred targets but did not see the rapid jump in the velocity of money until well after the damage was done. The new Fed Chairman, Paul Volcker, had shifted to the monetarist targets from the previous interest-rate targets. This in itself loosed a new round of inflation. The gold price responded to the combination of increased supply and decreased demand for liquidity by jumping from $240 in the spring of 1979 to $850 in February 1980.
These inflationary impulses ended as the Fed slowed down its liquidity additions in September 1980 and as the Reagan victory in November spurred an increase in the demand for liquidity, foreshadowing the bigger economy produced by the promised 1981 tax cuts. Still fighting the inflation, though, the Fed starved the system of liquidity and the gold price tumbled by leaps and bounds. In September 1981, Bob Mundell recommended a stabilization of the gold price at $425, but the Monetarists were in control of the monetary policy levers in the Reagan Treasury and insisted on squeezing the monetary aggregates. As the tax cuts phased in, the gold price dropped faster as liquidity demands were not supplied. With Mundell, a Canadian citizen, reluctant to inject himself into the debate in Washington, we took the initiative at Polyconomics in trying to get the White House and Treasury to understand the process that was crippling the economy. I wrote to President Reagan in the fall of 1981 and wrote a column in BusinessWeek urging monetary ease. Reagan wrote me that he was getting divided counsel. Milton Friedman, he said, was warning against ease and had assured him interest rates soon would fall.
On St. Patrick’s Day of 1982, I was lecturing on supply-side economics at Campbell College in North Carolina. In my guest room on campus, I heard on the radio that gold had dropped to $310 from $320. I called the Fed and asked to speak to Chairman Paul Volcker, whom I had first met at the Nixon Treasury when we left gold in 1971. After exchanging pleasantries, I told him he had to stop the decline in the gold price. He said the Fed did not have anything to do with the gold price. I said he could stop the decline by buying bonds from the banks. “You want me to inflate?” he said. “No, but you must stop deflating,” I said, explaining that if the gold price were not arrested, the recession we were already into would deepen and dollar debtors would be forced into bankruptcies all over the world. I remember mentioning that Poland, which had borrowed heavily in dollars, would be among those countries unable to meet their dollar debt obligations. I do not remember anything of the rest of the conversation, but in the months ahead we spoke frequently about the problem until it was resolved. Here, though, is what I advised Polyconomics’ clients on March 23, 1982, six days later. I expect you might be surprised at how closely the report fits today’s situation, even including the $300 price of gold:
In the last few days I have communicated directly with Paul Volcker, various members of Congress and the Administration that the price of gold should not be permitted to fall below $300. The argument is that the gold price decline is accompanied by increasing bankruptcies, this being a classic deflation (with a decline in the value of gold relative to paper, creditors benefit at the expense of debtors, but debtors can’t pay). The high interest rates no longer reflect “inflationary expectations” entirely or even largely, but rather “deflationary expectations.” Against the threat of escalating bankruptcies, interest rates must rise to all borrowers in order to expand the reserves of the system to cover potential loan losses. If I am right, I explained to these officials, a Volcker signal to the market that he will buy bonds at $300 to keep gold from falling will remove the “deflation premium” to a large degree and bring a sharp decline in interest rates. A BULL MARKET in stocks and bonds will be underway. Volcker would not have to buy gold at $300; he has no authority to do so anyway. He can, though, buy bonds, to prevent the continued deflation, and send the gold price fluttering upward. If it can be built into the political wisdom that gold below $300 signals escalating bankruptcies, Volcker’s report card will switch from M-1 targets to the gold floor. A formal signal would be best, of course, and would have positive effects on “inflationary expectations” as well. Volcker could sell bonds at $310 to prevent inflation, or signal the wider band that Jelle Zijlstra, former chairman of the Bank for International Settlements proposed last September at the IMF. I advised Volcker that the markets now have no idea how many bankruptcies it will take to satisfy him, that the rule he is following could take gold to near zero or to infinity, and that even a $50 stabilization band ($300 to $350) would bring great relief to the markets. He could not do this silently, because the stabilization process would interfere with the monetary targets he is saddled with. Stabilizing gold would send M-l above the permissible target levels because of the increase in the demand for M-1 liquidity in the now expanding economy. Monetarists would complain even as the markets boomed.
At the time I wrote this, it was not yet obvious to me or to Mundell on how Volcker could extricate himself from the official monetary targets. In 1982, there were no supply-siders in the Reagan administration who were at all interested in monetary policy. Treasury had two “supply-side fiscalists,” the late Norman Ture and Paul Craig Roberts, but they believed the Reagan tax cuts would cause the economy to expand, just as the Kennedy tax cuts had invited an economic boom. At the time of the Kennedy tax cuts, though, monetary policy was still driven by the dollar’s link to gold, under the terms of the 1944 Bretton Woods Agreement. As the demand for liquidity increased, the Fed supplied all that was demanded, automatically. In 1982, there was no such automaticity in the floating regime. Still another burden for the supply-side position was at the Office of Management and Budget, where two erstwhile supply-siders, David Stockman as director and Larry Kudlow as chief economist, took the position that budget cuts and the closing of tax loopholes such as the oil-depletion allowance would narrow the emerging budget deficit and inspire a decline in long-term interest rates. This was the Old Time Religion, applauded by Alan Greenspan, who at the time was back on Wall Street. The Monetarists inside the Reagan administration controlled the key posts at Treasury and the Council of Economic Advisors. They were disinterested in either tax cuts or spending cuts, believing everything would be fine if only Volcker would hit their monetary targets.
With no intellectual support inside the Reagan administration for an end to the monetary deflation, it took a crisis to end it. Mexico supplied the crisis. In August 1982, Mexico advised its creditors at the U.S. banks that it could not pay interest or principal on the $60 billion of public debt it assumed in the inflationary phase of the floating regime. It needed $20 billion immediately to pay the banks, but after two IMF-advised peso devaluations that spring and summer, Mexico had run out of hard-currency reserves. As the price of gold had fallen, the price of Mexico’s oil -- which the U.S. banks had collateralized at $36 a barrel -- in the conventional expectation that it would soon top $40 -- dropped to $31. The U.S. recession, the direct result of the monetary deflation, also had dried up the market for Mexico’s farm goods.
In mid-August, Paul Volcker had no choice. If Mexico could not pay the banks, the banks would become illiquid. Their capital soon would disappear and bankruptcies would occur. Volcker of course could not permit this to happen, so he advised the Treasury Secretary that he could no longer worry about the monetarist targets. He had cut the discount rate several times trying to ease as the stock market plumbed new lows, but gold only dipped further. He would have to monetize $3 billion in Mexican peso bonds so its government would have the dollars to pay the banks. The injection of that much liquidity into the bloodstream of the U.S. banking system ended the crisis. The price of gold leaped up. The prices of stocks and bonds on Wall Street instantly followed -- although the monetarists had warned of a bond market collapse if all that “M” was put into the system. The DJIA went from 790 to almost 1100 by year’s end; the NASDAQ rocketed to 250 from 150 in that same brief period. Here is how I explained “The Market Surge” to our clients, on August 23, 1982:
The NYTimes of 8/22 terms it a “Fed-led recovery,” and of course we agree that last week’s boom on Wall Street reflected a re-direction of Fed policy, not passage of the tax bill. The tax bill was seen on Capitol Hill as a way of triggering an “understanding” between Volcker and the White House to lower interest rates. (WH lobbyists were explicit in guaranteeing a drop in rates if the tax bill passed.) But easing can be said to have begun July 1 with the arresting of the fall in industrial commodity prices. The $56 jump in gold last week represented a flooding of money into the system, easing the terrific strains on dollar debtors brought on by the last year of deflation. This relief swamped the negative liquidity effects of the tax bill, which at this point are still anticipatory. The flood came not through domestic open-market purchases but via the foreign-exchange window, interventions that began August 10 to prop European currencies and intensified last week in the Fed bailout of Mexico. These moves have the same effects as open-market purchases of securities. But having monetary policy determined by crises is hardly encouraging. Intervention to stabilize gold was strengthening the dollar even as interest rates declined. But last week’s intervention saw gold climb against a weakening dollar, reflecting the exposure of U.S. banks in Mexico. The prospect for bonds is less encouraging than a week ago, with the Fed’s guiding philosophy even less defined. If the price relief invites recovery, will the Fed try to work down the resulting bulge in M1? Or will it let itself and gold get carried away, which would mean all the painful squeezing of the last year will have been for nothing? I’ll become very concerned if gold goes above $400 and stays there.
In the sudden euphoria, gold actually shot above $500 in the several weeks that followed, as the markets were given no guidance on how monetary policy would adjust in the future. When it became clear the fresh liquidity was not going to be followed by another burst from the Fed, gold subsided, settling closer to $400 for the next year to 18 months. If anything was clear, though, it was that the monetarists were through as a guiding force for monetary policy. Senate and House Democrats immediately announced plans to require the Fed to return to interest-rate targeting, which in any case was the de facto result of the disastrous experiment with monetarism.
From mid-August 1982 when the deflation ended to August 1983, the top performers leading the NASDAQ rally were:
1. Industrial index +105%
2. Telecom index +85%
3. Transportation index +83%
4. Financial index +78%
5. Insurance index +57%
6. Banks index +49%
The worst performing sectors in the NASDAQ from January 2000 through the present are almost a mirror image of the 1982 boom:
1. Telecom index -58.44 %
2. Computer index -50.71%
3. Industrial index -34.78%
4. Other Financial -27.47%
The gold price lines up like a glove with the NASDAQ bust and boom during 1982 and the NASDAQ bear market of 2000-01.
Part II – The Situation Today
The most significant difference between the deflation of 1980-82 and the deflation of 1997-2001 is in the sharpness and severity of the earlier deflation, which took place alongside high marginal tax rates that were being phased out slowly to a still prohibitive level. When the deflation of 1997-01 began, it emerged in an already expanding economy as growth expectations rose on the hope of a 1997 budget compromise on capital gains relief. Beginning as early as November 1996, the market began to discount the passage of the new, lower statutory capital gains tax (to 20% from 28%) and new Roth IRA accounts that increased the demand for liquidity as economic actors geared up for a larger, more productive dollar economy. When the Greenspan Fed did not supply the new liquidity, gold began its retreat from its longstanding $350-$400 trading level. Greenspan, who never believed in monetarist targets, was being guided by the Keynesian concept of the Phillips Curve, which posits a trade-off between unemployment and inflation. He is, in effect, “targeting the unemployment rate.”
The NASDAQ boom of 1997-99 was inspired by lower tax rates on capital, falling nominal interest rates, and reverse bracket creep. Because the dollar was deflating, effective tax rates on capital came down even faster than the statutory rates, which increased the market-wide appetite for risk. As the deflation pushed down the prices of energy and industrial commodities, the service and technology economy benefited from the lower cost structure and a more capital-rich environment spurred by pro-growth tax policy.
From mid-1999 to the present, there has been a dramatic surge in real interest rates and the cost of energy, two sides of the same deflationary coin. Because the energy industry stopped investing in new capacity and exploration after oil fell to $10/bbl in 1998 (following gold down), energy prices began their upward march in 1999 on the heels of the global economic recovery and a smaller base of energy production. With marginal oil producers out of business and new investors reluctant to get back into action, OPEC has been afforded market power it would not have if the dollar/gold price were fixed and the market could trust the price signals flowing from the energy industry. At the same time, in June 1999, the Fed began a crusade to fight inflation that only existed in the imagination of the most ardent Phillips Curve adherents. The result was a Treasury yield curve being pushed into inversion for more than a year.
The current compression in tech stocks -- along with the weakness in the old economy -- is a direct result of this slow deflationary process going unchecked. The feedback effects of more intense dollar deflation have, at the margin, offset the positive effects of reverse bracket creep and lower effective tax rates on capital. The poor earnings reports pushing down tech stocks today are part and parcel of this process, as are the problems with high and rising consumer debt, increasing bankruptcies, high crude and gas prices, and the weak euro.
The way out of the current mess exists in very simple policy changes that Alan Greenspan could implement almost by himself, overnight, although he would have to explain to the market his reasoning for doing so. If the Federal Reserve were instructed to buy bonds until gold rose to at least $300/oz., the economy would regain its footing and the tech slump would give way to a Wall Street boom. It is of course encouraging to see more supply-siders warming to our arguments of two months ago that the Fed would find itself on a monetary “treadmill” by trying to combat the need for dollar liquidity with a lower funds target.
Perhaps the promise of tax cuts alongside rate cuts was too much to resist crowing about, but we knew that it would be unlikely to offset the negative forces bearing down from gold below $260/oz. The fact that gold has fallen from roughly $270 when the Fed began to ease in January to $256 this week, while the DJIA and NASDAQ are both in negative territory for the year, validates our argument. The Fed will have to find a way to meet the demand for liquidity that its interest-rate target is not permitting today.
The longer gold remains at current levels -- or falls -- the worse the pain associated with deflation will be. Perhaps that will allow our warnings and suggestions to be noticed by those who have ignored us and written off our policy prescriptions previously. The tax cuts likely to pass this year may further increase the demand for liquidity and send gold down below $250 when the rest of the price structure has probably not yet adjusted to the $300 level. As we have pointed out many times over the last four years, the first effects of deflation is to benefit producers of intellectual value-added production at the expense of commodity producers. Because all dollar prices must eventually adjust to the commodity price level for which gold remains the monetary proxy, in the last stages of a deflation the production that is primarily intellectual is forced to adjust to the lower numeraire. In an economic contraction that causes a fall in prices of goods and services because of higher tax rates or tariffs -- fiscal shocks to the exchange economy -- prices will jump back once the economy adjusts to the new tax structure and surplus inventories are cleared away. In a monetary deflation of the kind we experienced in 1981-82 and are in the midst of today, the decline in the price level is permanent unless offset by a reflation that pushes commodity prices to the appropriate level suggested by the gold proxy. Importantly, this time around, we are unlikely to have another exogenous crisis force the Federal Reserve to monetize debt and bring about the required reflation:
- U.S. banks have learned not to risk large amounts in specific emerging markets;
Very few countries are suffering deflation outside the U.S.;
- None of the world’s big, weak countries (Indonesia, Philippines, Argentina, Russia) feature the combination of a tight link to the U.S. economy and major indebtedness to U.S. banks that would necessitate a bailout by the Fed. Any crises in these countries could be patched together with IMF, World Bank, and private loans
Therefore, for the Fed to be forced to override its funds target, there would need to be an internal credit crisis of some magnitude threatening the domestic banking system. Unfortunately, this also is unlikely in the near-to-medium term:
- The most severely hit firms at this point in the deflationary cycle (tech) were financed with equity, not debt;
- The reigning view at the Fed is that the 1999-2000 NASDAQ bull market was a “bubble” generated by irrational exuberance;
- As a result, the NASDAQ implosion is being viewed as “healthy” by the Fed, and not as any kind of crisis.
Ultimately, market declines may gather such force that a break occurs somewhere in the financial system, forcing a response by Greenspan. Even without a clear systemic crisis, Greenspan at some point may come to see the pernicious effects of deflation in the economy and recognize the necessity of reviving the reference to the gold signal in Fed policy and seeing the necessity of reflating until gold is at a more appropriate level.
(with Michael Churchill, Michael Darda and Nathan Lewis)