Two Kinds of Deflation (or Inflation) Jude Wanniski November 14, 1997

Supply-Side University Economics Lesson #10

Memo: To Website Students
From: Jude Wanniski
Re: Two Kinds of Deflation (or Inflation)

I had planned to spend this lesson time on several questions that came in to Reuven Brenner on his "Monetary Anchor" lesson last week, and we will attach a few of them at the end of the material I'm presenting below. Earlier this week, I learned that Fed Chairman Alan Greenspan was going to testify before the House Banking Committee on November 13. I called The Wall Street Journal editorial page and told an editor I would write an op-ed that would address a confusion that has appeared in the financial press and in Greenspan's own comments about the concept of "deflation." It would have had to run on the morning of his testimony. As long as the confusion exists in the minds of the politicians, the press, and Greenspan, it becomes much more difficult to end the deflation. The Journal rejected the op-ed, without explanation, choosing instead to run a nonsensical piece about a "longitudinal flat tax." I did fax my deflation essay to Rep. Barney Frank, the Massachusetts Democrat who is on House Banking and is also concerned about deflation. I'd talked to Barney several times this year about the significance of the dollar/gold price. In a covering memo, which follows, I suggested the line of inquiry. To complete the exercise, I have included the single question Barney Frank asked Greenspan about gold and money, with no follow-up, as Frank believed he had to ask other questions from other directions. This may help you understand how difficult it is to pin down Greenspan. Still, Greenspan's answer was worth something.

November 12, 1997
Memo To: Rep. Barney Frank
From: Jude Wanniski
Re: Greenspan

Tomorrow's hearings concern Asia, which continues its collapse, and to Brazil and Latin America, where the stock market fell 10% today. Japan is hanging together by chewing gum. With the Nikkei below 16000, probably every bank in Japan is technically under water, as equities are so much a part of their capital base.

All this is the fault of the United States, the only superpower, and Alan Greenspan, the chairman of the world central bank, because the dollar is the world's key currency. When you inflate the currency, it is like saying your yardstick will now be 24 inches long. It is easier for people to live with inflation, because the only people who get hurt are creditors, who are paid back 24 inches when they loaned 36. In deflation, the yardstick becomes 48 inches long, which means debtors who borrowed 36 must pay back 48.

All you have to know about gold is that from the dawn of civilization, it has been used by ordinary people to measure other goods and services. It has been the numeraire. And it still is. Greenspan has to face the fact that when he took office 10 years ago, he said the commodity most important in signaling an incipient inflation or an incipient deflation, is gold. You can say you really don't understand all that, yet you don't know a lot of things. But Mr. Chairman, if it is something you believe, and I don't doubt you do, how can you say the problem facing the country is inflation, "when the gold price is now 20% below where it was a year ago, and 12% below where it was when you took office a decade ago?

Please understand, Barney, that we are now on a "Greenspan Standard." The financial markets go up or down depending on where they think Greenspan's head is at, because he has the power to persuade his colleagues to raise or lower interest rates. You want him to lower interest rates. That's really not what I want him to do. I want him to get the price of gold up to $350, which he can only do by lowering interest rates given the operating mechanisms he is following. If we were targeting gold instead of interest rates, he would raise the gold price by adding dollar liquidity to the banking system. The increase in the supply of dollars would cause the gold price to rise in dollars. When gold got to $350, the Fed would stop supplying fresh dollars. If gold were to go to $351, the Fed would drain liquidity until gold gets to $350. This is how Alexander Hamilton explained it to Congress in 1790, and is a good way for me to explain it to you. In other words, if an extra dollar of liquidity shows up somewhere in the U.S., it will show up as an increase in the gold price, by some infinitesimal amount. By adding and subtracting on a daily basis, the Fed then takes all the risk out of money gaining value or losing value. When that risk is removed, interest rates fall to "gold-standard rates," which are typically below 3% for a 30-year bond.

Remember, the Fed has to have some means of determining when to add liquidity and when to subtract it. That is really the only meaningful job it has. When it decides to use unemployment as a target, it will add liquidity when there is unemployment and subtract liquidity when there is a fall in unemployment. Because they cannot keep the price of gold constant if they are on an unemployment standard, it will rise when unemployment rises and they add liquidity (inflation) and it will fall when unemployment falls and they subtract  liquidity (deflation).

As Hamilton indicated, gold is only a signal. A light that goes on when the dollar gold price is going up or down from an equilibrium level. Greenspan has it in his head that $350 is the equilibrium price, and if you ask him and he refuses to tell you, then ask him how he can use it as a signal if he doesn't know when it is green or red. You are completely in charge of this interrogation, because you have him on the record. If I asked you when you tend to cross the street, and you say you would wait if it is red and cross if it is green, I would have you at a disadvantage if I caught you crossing on the red and staying on the green. Greenspan is staying on the green. He should be easing, which is a word that in this case covers both mechanisms — lowering interest rates or adding liquidity.

When the price of gold fell from $385 at the beginning of the year to $310 today, the dollar deflation crippled the rest of the world, whether their currencies were pegged to the dollar or not. Thailand was pegged and it got hit directly. Its neighbors then felt the financial distress of their trading partner, and speculators correctly hit them by shorting their currencies. The problems in Asia did not "infect" Latin America, because the problem was the dollar deflation against gold. Brazil and Argentina are both pegged to the dollar. Brazil this week made the terrible mistake of raising taxes to defend its currency peg — which is the reason for the market collapse.

If you do not understand much of this, you really must make a serious effort, because the track we are on will lead to a general collapse of the world economy. You can't be afraid of Greenspan. Just push him on these issues and you will force him to say the right things. I'm sure he is scared to death as he watches the news around the world every day, and hopes it will not bring us down. Unless he ends the deflation, though, that will surely occur. We can survive better than most because of the cut in the capital gains tax, while they are raising taxes elsewhere. But we are at the top of a mountain that is slowly sinking into the quicksand. It will catch us, too.

Following is an op-ed I wrote for the WSJournal, which they won't run. It might help you tomorrow...

When Federal Reserve Chairman Alan Greenspan testifies this morning before House Banking on the deflation in Southeast Asia, the first thing he should do is give us a definition of "deflation." In recent weeks, the term has been tossed around in the financial press as if there were general agreement that it means the sudden realization of "bad investments" or market discounting of "excess capacity" in a country or in a region. These in turn produce "falling prices" and banking problems as loans turn sour and the value of collateral shrinks.

The confusion exists because almost all discussion on Wall Street about inflation or deflation occurs in a demand-side model. Demand-side monetarists (Friedmanites) insist that inflation (or deflation) is a monetary phenomenon. Demand-side fiscalists (Keynesians) usually argue that inflation (or deflation) is a problem of the real economy, not the money economy. Supply-siders (classical economists) agree with both. Inflations and deflations can be monetary or real or both at the same time.

Think of a balloon as it inflates or deflates. In the monetarist model, the economy first expands as the Federal Reserve adds money to the banking system. If it adds too much, the banks will make bad loans that inflate the balloon past its productive capacity. The balloon will deflate when the Fed takes too much money out of the banking system in order to fight the inflation. This is why monetarists focus on a slow, steady increase in the money supply.

Keynesians argue that the balloon inflates when government tax and spending policies cause aggregate demand to increase. To expand the balloon, the government should lower interest rates or lower taxes or increase spending. If too much is done, and prices and wages appear to be rising at a faster clip, the balloon should be deflated by raising interest rates and taxes or cutting spending, in some combination.

In the supply model, there are two types of inflations and deflations. Monetary inflation is a decline in the monetary standard characterized first by a rise in the price of gold and thence all commodities. Monetary deflation is the opposite. Fiscal inflation occurs either when the government throws greater burdens on the economy than it can easily meet, as in wartime, or when it manages a shift from wartime to peacetime. In either case nominal prices of goods may rise relative to the price of gold until the adjustment is complete.

Fiscal deflation occurs when a war ends suddenly, as World War I did, and the goods and services being produced suddenly came into surplus. The government can only avoid a price deflation by buying up the goods and giving them to people who would otherwise not be able to afford them. Or, the government can deflate by making an error in tax or tariff rates, which is what the our government did in 1929 when it sharply increased the tariff wall in the Smoot-Hawley Tariff Act.

In that case the monetary standard remained constant at a gold price of $20.67 per ounce, so there was no monetary deflation. But goods and services our economy planned to export suddenly found no buyers, as foreigners could not get their goods and services over our tariff wall. The Wall Street Crash occurred because the market knew this would be the inevitable result of a high tariff wall. Unwanted goods and productive capacity piled up on both sides of the wall. The Great Depression occurred as countries tried to offset this fiscal deflation with monetary inflations, which only made matters worse. To this day, monetarists insist the depression need not have occurred if the Federal Reserve had printed less money before the Crash and more money after the Crash. To have done this would have required abandonment of the gold standard, which would have meant a deflation before the Crash and an inflation after the Crash!

In his testimony today, Mr. Greenspan may be asked if he considers the decline in the gold price this year, from $385 to $310, to be inflationary or deflationary. Because he has repeatedly told congressional committees that he considers gold the most sensitive monetary commodity, to inflations and deflations, it would be hard for him now to reverse himself.

It might be more likely that he would argue the cut in the capital gains tax this year, along with the decline in the burden of government borrowing, has produced a fiscal inflation. Prices are being pulled down by the monetary deflation. Wages and asset prices are being pushed up by the fiscal inflation. One offsets the other, for the time being, although supply-siders contend that the dollar monetary deflation will continue to erode the U.S. and world economy unless the gold price rises closer to $350, which would put the monetary standard in equilibrium.

The problem in Asia, which has now surfaced in Brazil and perhaps the rest of Latin America, is that the Asian currencies were forced into a monetary deflation in order to keep up with the falling dollar/gold price. It began with Thailand and spread through the broader currency area.

Where countries compounded the problem, by adding a fiscal deflation to the monetary deflation, as in Thailand, Malaysia and Indonesia, the economic problems deepened. Hong Kong and greater China are feeling the monetary distress through their dollar ties, but at least have not raised taxes to compound the deflation. Earlier this week, Brazil made the stupendous error of raising income tax rates and imposing other surprise austerity measures, which compounded the deflation stress it has felt by its dollar peg.

Members of the Banking Committee who question the Fed chairman need not be fans of the gold signal in order to query Greenspan. He, after all, has made it clear in the past that it is a signal he values highly. In a recent editorial, The Wall Street Journal has urged him not to allow gold to fall below $300. He should also be asked if he agrees with that advice, and if so, would he recommend a price that would make him feel less uncomfortable about deflation.

REP. FRANK (D-Massachusetts): You and others have historically said that the price of gold is an inflationary indicator, and gold is at a very low rate. How do you reconcile a consistent view over time to regard the gold price as an indicator of inflation. Now gold is at a very, very low rate. Does that mean that inflation is not much of a problem? Or has the gold price somehow become an irrelevancy when it comes to indicating inflation?

GREENSPAN: It's a meaningful tool to evaluate the expectations of inflation, which if you're talking about the gold price denominated in dollars, it's one of the major indicators we would employ to make judgments about the expectation for inflation.

At current prices, we're still more than nine times what we were a generation ago ...

That is an important question and I don't think we fully know the answer to that, but there is no doubt that the decline in the gold price in the recent past parallels the decline in inflation expectations which we see elsewhere. I don't think there's any question the Asian crisis has imparted a degree of disinflation to the rest of the world. I think that's evident and I don't think we see the full impact as of yet. You have to remember that a goodly part of that has come in the form of goods, tradeable goods. And tradeable goods, while important to our economy, reflect a not very large part of the overall business structure that we've got. If you take non-farm business, goods production is a third of it. The big part is services.

Alas, Barney Frank had him on a hook, but let him off. Greenspan agreed that gold is a major indicator of inflation expectations, but went on to say that the gold price is nine times what it was a generation ago. This allows him to argue that gold could still be signaling inflation — being up nine times — without having to answer the fact that it has fallen 20% in the last year. Greenspan also dodges behind the word "disinflation" to blame the Asians for "imparting a degree of disinflation to the rest of the world." Is "disinflation" another word for "deflation"? At the end of the exercise, all we know is that Greenspan has avoided any scintilla of blame for what is going on in the world, when in fact his conduct is central to the worldwide deflation.

* * * * *

QUESTION to Professor Brenner from Steven Piraino

The dollar having deflated against gold, from $385/oz. to $3257 oz., one would expect to see negative readings in the CPI soon. What determines the size of the time lag between movements in the price of gold and movements in the inflation indexes Like the CPI? And when do you expect to see actual deflation in the U.S. currency if the gold price remains at $315-325/oz.?

ANSWER: During the last weeks, commodity prices on the mercantile exchange tumbled, as you will see if you check the financial papers. When will deflationary pressures be reflected in the CPI? I have no idea. The reason is the CPI is an arbitrary measure, and many quantities may be adjusted before you will see adjustments in prices. Example: the deflationary pressures lead to bankruptcies. Governments have less tax revenues. They cut spending on schools, medicare, bridges, highways etc. All these being offered (as a first approximation) at a price of zero, do not appear today in any price index. The government will diminish die quantity of quality services. But nothing will show up in the price index.

If you followed discussions on price indices over the last two years, in Greenspan's speeches and those of president appointed committees, you might have seen that they all acknowledge that they do not have a clue of what they are (mis)measuring (though they came up with that 1% a year overestimation - that I do not buy). If you are interested in all the price index debate, you may look at chapter 4 in my book, Labyrinths of Prosperity).

Remember that the whole idea of changes in price indices reflecting anything of interest is based on the view that most goods and services are priced through trial and error by suppliers. It is not clear what changes in CPI or other price indices reflect when governments do the pricing. (Think as an extreme example about once communist countries: Did it matter if steaks were priced at a ruble, when no ordinary citizen ever saw even a memory of it?) So when do deflationary pressures show up in an index that has no good foundations? I do not know. The best guide to detect such pressures are futures markets. One of the points raised in that brief to which you reacted was exactly that: Once you do have a recognized price rule to anchor monetary policy, you do not have to calculate price indices. Today you have to use a lot of ingenuity, looking at futures, at lengths of already existing financial contracts, at how exactly official bureaus of statistics miscalculate price indices, etc., to try to figure out when deflationary pressures may show up in today's statistical mish-mashes.

QUESTION from Mike Barkey

Dear Prof Brenner: I enjoyed reading your lesson at Jude Wanniski's Supply Side University, and appreciate your participation as a guest lecturer. I concur with much of the reasoning in your lecture. Specifically, the importance you place on accurate pricing in the business process and the role of gold as a numeraire to guarantee a constant yard stick for their measure. I do have a question, however.

Since there is a lapse in time between action taken through monetary policy and its effects, would pegging the dollar to gold require a new means for carrying out monetary policy beyond the obvious gold rule? In other words, since monetary policy would now constitute a "look-see" policy — requiring one to look at the price of gold to see whether its price is declining and we need more dollars or increasing and we need fewer dollars — how does it guarantee that the FRB does not act too often (or too infrequently, for that matter) in an effort to stabilize the dollar supply in relation to gold? If your answer is that policy would occur quarterly, for example, how are the governors of the FRB able to accurately look to a "gold Polaris" without first having to know the future impact of prior monetary actions on the value of the dollar in relation to gold that have yet to take effect? Why does this not leave the folks who make monetary policy in the same boat (or perhaps one with smaller holes in its hull) than they are currently?

ANSWER: I think you can distinguish between two times periods: the first while central banks would learn to adapt, and second once - through initial trials and errors - the system will settle down. In the latter case central banks would have learned by then to identify deviations out of the ordinary. It is only to them that they will have to react. The issue is not time, but deviations.

I think in your letter you meant reacting to changes in quantities of gold demanded at the window (once a narrow gold price range is officially defined): when will central banks react? The answer is same as above: deviations from the normal pattern. The difference between this and today is clear: As Greenspan has repeatedly pointed out in his speeches, he is looking at thousands of variables, trying to figure out what is happening. In the gold-standard case, the role of the central banks becomes easier: they only have to look at non-standard demands at the gold window. The investors, when they showed up there, did their thinking and interpretation.

In one sentence: Today you have the wisdom of one decision-maker trying to guess the wisdom of many. With the alternative, you have the central bank reacting to the wisdom and information gathered by many.
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