Cross-Currents in Stocks and Bonds Jude Wanniski September 10, 1998

Memo To: Gretchen Morgenson, NYTimes Columnist
From: Jude Wanniski
Re: Bonds Up, Stocks Down

Your Sunday "Market Watch" column was most interesting in reviewing another unusual period of our history where a bear market in stocks coincided with a fall in interest rates. In the period between 1872 and 1877, equity prices declined by 34% even as corporate bonds — railroad issues, for example — declined to 4% from 5%. You write that "There was no Federal debt yet — imagine!" But you were misled on that point, as a considerable debt accumulated before and during the Civil War. It is correct that stock prices had risen in the 1860s until 1872, but you fail to point out that the government had suspended the gold standard in 1862, in effect "floating" the dollar as an inconvertible greenback. This explains most of the stock market rise, as the dollar gold price climbed to $40 per oz. from $20.67 per oz. and the stock market rose with it. In other words, most of the rise was pure inflation. The fact that stocks climbed a bit higher than the doubling of gold by 1865 in terms of greenbacks reflected the market's discounting of the Union victory. The value of Confederate bonds of course vanished.

The decision to return to gold at $20.67 from roughly $40 also explains the phenomenon you described Sunday, Gretchen. The stock market in 1872 turned south as it became increasingly clear the federal government would return to the gold standard — at some price closer to $20.67 than $40. In the 1873 act that did so, the holders of federal bonds successfully argued that they should not be penalized for having bought the bonds prior to the war. The decision was made to phase in the $20.67 price over a six-year period, and to make the dollar fully convertible on January 2, 1879.

This was an extremely painful period of true monetary deflation for Americans who had acquired debts while the gold price was high. Farmers who had borrowed against their land when wheat was $1 a bushel were squeezed unmercifully as wheat dropped to 50 cents, where it had been prior to the war. Workers who had borrowed when wages were $2 a day were also crushed as businessmen had no choice but to cut their wages back to $1 a day, the wage prior to the greenback era. The bond market enjoyed the steady increase in the purchasing power of dollar bonds. The bear market in stocks reflected the painful adjustment to the monetary deflation, although it must be noted that share prices also increased in purchasing power as the gold price halved. The market rise that began in 1877 anticipated the boom that followed resumption in 1879.

The current bear market on Wall Street, even as interest rates decline, reflects the decline in the dollar price of gold over the past 18 months, to $285 from $385. The commodity deflation struck other parts of the world first, because the United States has become primarily a service economy and because the 1997 tax cuts fueled capital formation in the service sector. Because all prices eventually have to adjust to the low gold price, an increase in dollar liquidity by the Fed is about the only way to avoid further declines in equity prices even as bond prices rise with falling interest rates. A capital gains tax cut also would lift equities, but could not end the deflation. Both Steve Forbes and Jack Kemp have urged this course of action until gold reaches at least a $325 level, which would pull up commodity prices around the world, enabling debtors to pay their creditors.

The mistake almost all economists make is confusing a deflation with a contraction. Because gold is the truest signal of a shortage or surplus of dollar liquidity — the former deflationary as gold falls in price, the latter inflationary as gold rises in price — the Great Depression cannot be considered a deflationary era. Because the gold price was held constant until President Roosevelt devalued the dollar in 1934 to $35 an oz., the era must be properly characterized as a contraction.

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