Memo To: Fans, Browsers, Clients
From: Jude Wanniski
Re: An Unhappy Halloween
Attorney General John Ashcroft is warning us to be on the look for another terrorist attack within the week. That's pretty scary. But just take a look at the stock market this week and you will get a good fright right away. Instead of hitting bottom and bouncing back to signal an economic rebound on the way sometime in 2002, it is in a new slide, as Polyconomics has been warning anyone who would listen.
This is the inevitable result of the market being stomped by "The Deflation Monster," which is the title of a comprehensive article I've written that appears in the September/October issue of The American Spectator magazine. I'm not going to post all 6,000 words here, but George Gilder, the new proprietor of the magazine, has made it available to the Internet audience on his personal website, http://www.gilder.com. The reason it is so long is that George, an old friend, thought that I should have all the space I needed to present the whole story in a persuasive way. It is a scary story, especially when you realize I have been warning of the terrible things the Monster would do to the U.S. stock market and the economy once it arrived on our shores in earnest -- and that almost no one has paid attention. You might imagine The Wall Street Journal would have noticed the fearful hulk tromping toward us. It hasn't, even though I have been warning the editors about it since it began taking shape in the gold market almost five years ago.
There have been some recent articles mentioning "deflation" by various financial commentators, but none of them seem to understand the nature of the beast. I'll run the beginning of the piece here, but recommend you go to the complete article, print it out, and give yourself a good scare when you have the time to read it all. While you are at it, you might also subscribe to the magazine, which George Gilder plans to develop into a Big Foot of a different kind.
* * * * *
In 1995, I predicted that inflation's days were numbered. A year later I warned of a new, more exotic enemy – deflation
Throughout the boom and bust of the late 1990s and the new millennium, I detailed this foe's attacks as it stomped its way through Asia, Russia, Brazil and the U.S. farm and energy economies, and later as it crashed into Wall Street and Silicon Valley. Now it ravages global telecommunications companies and capsizes every Third World economy that counts its debt in dollars, from Argentina to Zimbabwe.
On January 7, I met with Dick Cheney in his transition office near the White House, to warn him that the Bush administration had inherited an economy with a rare disease curable neither by Federal Reserve interest rate cuts nor by the timorous and dilatory series of tax-rate reductions then being proposed by his administration. Indeed, although cuts in tax rates are entirely positive for the economy, they contribute to deflation by spurring the demand for money.
The problem, I told him, was a pure monetary disorder that would cause serious damage unless corrected. There was nothing he could do until the political establishment realized that conventional medicine would not work. In April, I gave the same warning to Treasury Secretary Paul O'Neill, and to Senator Trent Lott, who was then majority leader.
In late February, I advised my Wall Street clients that, until the problem was corrected, there would be no reason to buy equities. The adjustment to a monetary deflation takes time, but it is inexorable, forcing all nominal prices to fall – including the price of wages, assets, and all goods and services, even the price of haircuts. One hundred percent wage reductions, also known as layoffs, are frequent.
Japan is in the twelfth year of a deflation, the yen having doubled in value over the last decade. Equities there hit a 17-year low in mid-August, and only now are its political and economic leaders beginning to understand why interest rates cut close to zero percent have had no effect.
Money, in its simplest form, is non-interest bearing debt of the government. To acquire more money, economic actors give up "goods" or "assets," which is why gold and sensitive commodity prices react first to changes in the demand for dollar liquidity.
Deflation – a significant undersupply of money relative to demand – is first signaled by a fall in sensitive commodity prices, which can change rapidly in highly liquid "spot" markets. Like inflation, it occurs when a central bank – in our case, the Fed – fails to match the supply and demand of money in the marketplace. In the absence of a reference point by which to gauge an under- or over-supply of money, the Fed has to guess.
The current deflationary process in the U.S. began in late 1996 when the dollar price of gold and all other commodities began to fall. In 1997-98, the pivotal price of oil plummeted from $25 to $10 per barrel. Over the next two years, petroleum exploration and investment in production and infrastructure ground to a halt. In one of many misleading signals whereby monetary ease and monetary tightness mimic each other, the sudden deflation-induced scarcity pushed the price to $35 per barrel in 2000. This, after the global economy had emerged from the Asian crisis against a backdrop of diminished crude supplies.
Deflation is especially destructive to debtors, who are committed to paying down their debt with more valuable dollars out of incomes that shrink because of declines in the prices of things they produce.