Forecasting the Market
Jude Wanniski
July 18, 2003


Memo To: SSU Students
From: Jude Wanniski
Re: Forecasting the Deflation

Polyconomics is 25 years this month, and while there will be no official celebrations, I do like to think of the forecasts we have made over that period that kept our clients sticking with us. Our clients for the most part are managers of asset portfolios in excess of $500 million, and they would not be happily pay our fees if we could not assure them the market was going in the direction our analysis indicated. We have had many great calls and a very few bummers, but clearly the best of the 25 years was our monetary deflation forecast at the very beginning of the Bush administration. I say that because it is the only one of all our forecasts where Polyconomics was totally alone in seeing it, of all the economists in the competition. None of the other supply-siders joined me in the forecast.

In his testimony before the Senate Banking Committee this past week, Fed Chairman Alan Greenspan had a rough time explaining why his 14 interest-rate cuts and the two big tax cuts since early 2001 have not juiced up the economy. That’s because Greenspan rejected my deflation arguments at the time and is not about to admit his monumental error. Here is the text of the client letter I sent at the end of 2000 that explains the theory of the deflation. At the conclusion of the letter you can link to the client letter that made the specific reasons why the Bear Market was clearly underway:

December 27, 2000

A Berkeley economist named Roy Jastram, who had spent much of his later years studying price indices over the history of the United Kingdom and United States, in 1977 published a potent little book, The Golden Constant. It had a major influence on those of us at the WSJournal editorial page at a time when we still were grappling with the fallout of President Richard Nixon’s decision to cut the dollar/gold link in 1971. The charts in Jastram’s book -- covering the years 1560 to 1976 in the U.K. and 1800 to 1976 in the U.S. -- persuaded me that gold must be thought of as the closest commodity we have to a “constant” in the galaxy of prices. The charts demonstrate that while prices may change in dollars or pounds, the galaxy of prices always returns to a fixed relationship with gold. It is impossible to blink away the fact that the index of wholesale commodity prices in England was the same in 1717 as in 1930; the same in 1800 as in 1930 in the United States. How come? Except for brief wartime periods when convertibility was suspended, the gold weight of the pound sterling and of the U.S. dollar did not change.

There is nothing mysterious or magical about what Jastram called “the Retrieval Phenomenon.” Once you accept his findings and conclusions, the market logic falls into place, as gold is palpably the most monetary of all commodities, the “commodity money, par excellence,” as Karl Marx wrote in Capital. The implications of the dollar/gold price at a clearly deflationary $275 for the financial markets and the economy are critical to anyone hoping to understand the world of 2000 and the year ahead. No matter what else happens in 2001, unless the dollar loses value against gold, the dollar value of profits and wages will have to be squeezed into a smaller space. To those who have difficulty with the concept, I use an exaggeration short of the absurd. Imagine a new Mercedes that now sells for $100,000. The only way it could be sold for $100 is if the factors of production were priced down proportionately. An auto worker making $50/hour in wages and fringe benefits would have to settle for five cents an hour. This kind of adjustment is outside our experience, but it happens routinely in other countries where the paper currency has lost most of its purchasing power. A few years ago, Russia knocked three zeroes off the ruble, going to 6/US$ from 6,000. Workers did not mind working for the equivalent of a nickel an hour because the price galaxy surrounding them adjusted accordingly. And of critical importance, all ruble debts and tax liabilities were reduced a thousandfold. Otherwise, indebted workers and enterprises would have been crushed by the money reform.

Geoffrey Gardiner, a British banker, had this useful observation in his 1996 book, Toward True Monetarism: “Although deflation can cause great distress to borrowers it also makes money go further; a given nominal value of money can finance a greater physical volume of transactions. This is a very important phenomenon. It means that the money supply, though nominally constant, can finance a higher level of economic activity. Consequently the banks do not have to increase their capital bases or their reserve assets, as would be necessary if the nominal as well as the real money supply had to be increased. It is not necessary for the banks to be highly profitable in a period of deflation since they do not face the same need to attract additional capital as a base for increased nominal lendings.”

It is always preferable to be a borrower at the end of a monetary deflation or at the beginning of an inflation. Yet even if we could now say the dollar deflation has come to an end -- and gold will not slide back toward $260 -- it still would not be clear that the squeeze on earnings and wages could end in 2001. If there is economic weakness ahead, with layoffs and unemployment climbing, there still would not be a decline in the demand for liquidity to spur an increase in gold and commodity prices. The current price, after all, is the result of past errors by the Federal Reserve in denying legitimate liquidity demands. As Gardiner points out, the current level can do more work because money goes further. Robert Mundell says essentially the same when he notes that in order to move money prices higher there must be more new money pushed into the economy than it wants. Debtor relief comes only through inflation or Chapter 11.

To be sure, there are other forms of relief. When workers are forced to squeeze into deflationary wages, they do not do so proportionately. A small percentage take most of the hit by going to zero wages, unemployed. Relief for these “debtors” can result from job creation in new areas that are not burdened by debt and are starting fresh. This can occur through changes in the tax system, which we do expect to see in 2001. The Republican President and GOP Congress will come up with some positive tax cuts that especially will help nourish the battered New Economy. The existing liquidity in the system will not be able to stretch that far, though, so we could see more downward pressure on the price of gold. These uncertainties are part of the risk structure facing the entire capitalist system here and around the world. How does the energy industry place its capital bets going forward? When I saw Fed Chairman Alan Greenspan meeting with California Gov. Gray Davis yesterday to discuss the power shortages in that state, it was another reminder that as long as the dollar is not linked to gold, there will be energy problems.

The other side of that coin, of course, is that if the dollar were linked to gold, the energy problems that have bedeviled the world since the dollar/gold link was broken in 1971 would soon go away. I’m sure it never occurs to younger Americans that prior to 1971 there never was an energy problem in the United States. That’s because there always has been an abundance of petroleum and natural gas in the world -- as there is today. The NYTimes still thinks we have to ration petroleum with high taxes because a growing China soon is going to be sucking the rest of the world dry of existing oil. China, though, is unexplored, and almost certainly contains more undiscovered oil within its borders than has been found to date throughout the world. It was Mundell who told us in January 1972, after gold had doubled to $70 an ounce, that we soon would see a dramatic rise in the price of oil and other commodities. Without a constant price signal to guide the flow of capital, we will be stuck with one energy crisis after another, with Alan Greenspan showing up with advice on how to deal with problems he has created.

There seems no way around a deflationary 2001, given the state of conventional wisdom. This doesn’t mean it will be an awful year. We still think high tech can make a comeback in the market and in the real economy. In the old economy – where deflation's impact was first felt – the stronger firms stand to benefit from declining interest rates and tax cuts. With bipartisan support evident, fiscal expansion should be offsetting the slow, steady drag of monetary deflation. In that sense, the Jastram charts are encouraging; they do show that in economies with mature debt structures, the “Retrieval Phenomenon” takes its time. There may even be enough time for President Bush’s Treasury Secretary, Paul O’Neill, to learn on the job and make a positive contribution to the new administration. We still don't see a way around a deflationary 2001, given the prevailing currents.

[SSU Students should register at link in the upper left of this page. The summer sessions will often be the same as the weekend memo on the margin, but when they fall session begins, they will be directed at students alone.]