Forecasting the Deflation Jude Wanniski February 23, 1999

Memo To: Trent Lott
From: Jude Wanniski
Re: Two Years Ago

If you heard teeth gnashing on Sunday morning, they were mine, reading the lead editorial in the NYTimes. The editors patted themselves on the back for publishing last week a four-part series about the global economic crisis, which never mentioned the role played by U.S. monetary policy. Then they praised Treasury Secretary Bob Rubin and his deputy Larry Summers, plus Alan Greenspan, for having prevented the crisis from being worse than it turned out to be! And it also said "no one forecast the start of the new contagion in Asia two years ago." Now I will admit that when I first began warning you and Jack Kemp and my clients and the WSJournal about the deflation, I did not say it would strike first in Thailand. But we did say it would hit Thailand just before it did, and why it did, and why the root cause was Greeenspan's monetary policy. I'll send you anything you need to back that up, Trent, because it is important that we know why the world hit this iceberg and not kid ourselves that we had nothing to do with it. I've dug back as far as I can and found the following memo to you which I wrote more than two years ago, hoping you could find someone to ask Greenspan some questions about his monetary policy. Questions three and four relate to the earliest stages of the deflation which was beginning to concern me:

January 17, 1997
Memo To: Trent Lott
From: Jude Wanniski
Re: Greenspan Senate Budget testimony on Tuesday

Is there someone on the Budget Committee other than Domenici we could get these questions to for Greenspan? Pete really is not interested in this stuff and his staff is generally hostile. You can see from the questions how important it is that they be asked of Alan, who I think would appreciate the opportunity to have them posed. I append to this a memo I wrote the other day about Fed Governor Laurence Meyer, who has been making just awful statements lately about the Fed's responsibility to keep the unemployment rate high!

Questions for Fed Chairman Alan Greenspan
Senate Budget Committee Hearing
January 21, 1997

1. In a speech last week, Fed governor Laurence Meyer suggested that the economy is now operating at what he regards as full employment. According to Gov. Meyer, any further reduction in joblessness could be inflationary because it would push the unemployment rate below its so-called natural rate. In fact, Gov. Meyer strongly implied that unemployment moving below its current 5.3% rate would in itself be sufficient cause for the Fed to raise interest rates. Do you agree that monetary policy should be so closely tied to an arbitrary unemployment rate? Do too many people working really cause inflation?

1A: Follow-up, as Greenspan will waffle: Isn't it obvious that over the past 30 years it has become harder for a family to make ends meet on one income? For many Americans it takes two to break even? If so, that means wages have to rise relative to prices if this situation is ever going to be straightened out. Governor Meyer's statement suggests he believes the role of government is to prevent wages from rising, by keeping the economy growing slowly enough to maintain a high rate of unemployment. Would you respond to my observation, Chairman Greenspan?

2. Here's another way of putting it: There has been some concern expressed in the financial markets recently that wage gains have become excessive, which could be setting the stage for an uptick in inflation. It appears, however, that the wage increases have been accompanied to a considerable extent by rising productivity. Doesn't that mean the gains have largely reflected an increase in real wages, not inflation? Isn't that what we want to have happen?

3. On other occasions before Congress you have discussed the indicators of inflation expectations that you consider the most reliable, including the price of gold and the dollar's exchange value relative to other major currencies. In the past couple of months the gold price has declined from more than $380 per ounce to less than $360, and the dollar's foreign exchange value has strengthened considerably, particularly against the Japanese yen and German Deutschemark. Judging by these market indicators, it would appear that confidence in the dollar's purchasing power has actually been rising significantly. Would you please comment briefly on the recent behavior of these market signals, particularly with regard to what they might mean about the inflation outlook.

4. This is an extremely important follow-up: As the dollar price of gold continues to decline, is there a point at which you might worry that a deflation is at hand? As gold falls, is there not a point at which you would argue among your fellow governors that the gold price is signaling the need to lower short-term interest rates, or at least to provide dollar liquidity to the banking system faster, in order to prevent the slide in gold? [If Greenspan answers this question honestly and clearly, it will give the markets a reason to discuss lower interest rates instead of Laurence Meyer's concerns about too many people working. ]

5. In the last 30 years, by a rough rule of thumb, the price of gold has gone up tenfold, the price of crude oil has gone up tenfold, the price of housing has gone up tenfold, the price of prescription drugs have gone up tenfold, the price of transportation has gone up tenfold, the price of tuition has gone up tenfold, and the Consumer Price Index has gone up fourfold. How is it that there is such assurance among economists that the CPI overstates inflation, when ordinary people know that it probably understates inflation?

5A. If the CPI is adjusted downward, not only will government outlays be reduced for Social Security recipients, but also marginal income-tax rates will be increased, by the amount of the adjustment. Do you have any sense of what this perpetual tax increase will do to the economy, if in fact the CPI does not overstate inflation and we legislate one anyway? [Greenspan will squirm on this question. It forces him to lean toward the budget balancers or the supply-side growth advocates. It represents the essence of our opposition to CPI adjustment.]

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You may recall getting the questions to Spencer Abraham, and those he asked produced terrific responses from Greenspan and a rally in the bond market. Alas, the questions about gold were not posed, and Greenspan did not have a chance to answer them. The dollar price of gold continued its downward trek, and the Bank of Thailand unwittingly tightened its own monetary policy in order to maintain the baht's peg to the dollar. I'd become so concerned about the deflation that in May I asked Bob Torricelli to help me get a meeting with the President. Instead, Erskine Bowles set me up with Larry Summers. Again, I did not mention Thailand, but we spent a half hour discussing the falling gold price and its implications for commodity deflation. So the administration did have that much warning from me. I sent many memos subsequent to the meeting with Summers, by e-mail to him, and he was put on my client list. It galls me to see how they can get away with taking credit for solving a problem they created -- just as they did in the Mexico peso devaluation of December 1994. You need to be reminded of all this, Trent, when the day comes that Rubin steps down and Summers is nominated to take his place.