Q&A Jude Wanniski December 5, 2003

Memo To: Students of SSU
From: Jude Wanniski
Re: Q&A

This Q&A session originally ran in April 2002, a year after the dollar deflation hit bottom when gold traded close to $250 an ounce. When this Q&A ran, gold was back at $300, mostly because of the geopolitical risks that followed the 9-11 terrorist acts. With gold now above $400, we are clearly out of the deflationary period and in the early stages of a new inflation, unless the Fed arrests further increases in gold by tightening monetary policy. The questions were very sharp and it does help you to get into the analytical framework by pushing yourself back in time. I've added some fresh comments in boldface.

Jim Bradley: The argument that Gold is a good indicator because it leads commodity prices, and commodity prices are a good indicator of inflation / deflation (being fungible) might not always be valid because commodities are also an indicator of investment money flows. Gold, being monetary, should not lead just commodities, but ALL transactions (consumption flows included). Two questions: (1) If Gold is a good indicator, why doesn't Gold protect against consumer price inflation? (2) How else (besides the commodity argument) can the investment community be assured that the Gold signals can be trusted?

Answer: 1) Gold does protect against consumer price inflation. If you had bought gold at $35 before the big inflation, your gold would now be worth $300 an ounce. 2) The Gold "signal" in the last 30 years has been flawless in seeing the coming inflation followed by the coming deflation. Those in the investment community who have trusted gold's signals have been very successful. Polyconomics was the new kid on the block in 1978 and now is the most successful firm in the world in calling both sides of the inflation and deflation moves. In February 2001, we warned our Wall Street clients that a bear market in stocks was a certainty because at $265 gold, the dollar value of all prices, including equities, were being forced down. The current bull market did not begin until March of this year when gold was moving up for a variety of negative reasons and the cuts in capital taxation began to appear on the congressional horizon.

Bradley: How do you reconcile the Supply Side assertion of deflation with the fact that residential real estate, health care, and education have been screaming upward in price and are not offset by other falling prices, thus indicating large inflation, not deflation.

Answer: Monetary deflation exists side-by-side with fiscal episodes, by which I mean some prices can rise for reasons unrelated to monetary policy, or fall twice as fast because of a conjunction of deflationary monetary policy and contractionary fiscal policy. Real estate prices in some sections of the country are climbing because the government two years ago eliminated the capital gains tax of the first $500,000 on the sale of a primary home. This transferred at least $2 trillion in wealth to homeowners, in the dollar value of their homes. Polyconomics has been pointing this out to its clients for more than a year. Health care and education costs are rising because of government entitlement programs, which do not recognize monetary pressures – at least in the short run. Analysts who continue to predict a "bubble" in real estate simply do not understand the dynamics of the decision to exempt the first $500K from capgains on a primary home.

Art Patten: You quote Mundell as saying that the market has a limited appetite for dollars, and that lenders will prefer to hold surplus assets in the form of interest bearing government debt. There is an increasingly common argument being made that the past several years have witnessed a 'Fed induced credit inflation', based upon the idea that expansion of the monetary base has induced lending and credit extension at a level in excess of the real assets necessary to support it.

Is it possible that --

a) the market can have an unhealthy appetite for credit and risk?
b) lenders could max out reserve ratios, preferring the higher comparable yield of speculative loans (or investments) to Treasury debt?
c) the Fed can seriously manipulate the demand for money and credit?

Answer: When the Fed is forced to maintain a gold price rule, or face unwanted losses or gains of gold reserves at Treasury, it is neither starving nor stuffing credit on the system. It is simply maintaining the value of the monetary standard, the unit of account. The risks to the health of the economy immediately increase if the unit of account is floating, and the Fed is ignoring those changes by allowing reserves to increase or decrease, stuffing or starving, the needs of the economy. It is not the market that has an unhealthy appetite for credit and risk. It is the government that serves meals up at odd hours. On b) Lenders have no choice between speculative loans and Treasury debt. The Treasury decides the mix of interest-bearing debt and non-interest reserves. If lenders have more reserves than they need to meet legitimate demand, they cannot buy Treasury bonds without the Fed offsetting the purchase in order to hit its monetary target. As to c) Of course the Fed can seriously manipulate the demand for money and credit when it has the power to do so in a floating regime. When anchored to gold, it cannot.

Bill More: Can we have a Lesson that defines "Bank Reserves" in some detail? In particular;

(1)Do they derive from a bank withholding 8% of funds placed on deposit, with the rest loaned-out? Or are they purely a reflection of Fed bond-buying/selling?

Answer: It all depends on a variety of factors. If there is an inflation underway, with reserves losing purchasing power by the minute or day, the banks will lend out more surplus reserves in hopes of beating the inflation rate. In a deflation, with reserves not earning interest, but gaining in purchasing power by the minute or day, the banks will be happy to sit on reserves rather than lend to borrowers who will be hard-pressed to pay back loans with dollars increasingly hard to earn.

Q(2)Can I monitor aggregate bank reserves and if so how? I recall Mundell pointing to soaring bank reserves in the 1970's as a precursor to inflation --was this due to the Fed buying too many bonds?

Answer: You can on the Internet, but we only do so to answer questions from clients about movements in the monetary base. Mundell did not need to look at bank reserves in the 1970's to predict an inflation. He could see the gold price rising and know that money supply was outpacing money demand. It is a much clearer signal, as bank reserves are hard to get your arms around on a spot basis.

Q(3) Is the Monetary Base the sum of currency and bank reserves as you define them? If so does it move in tandem with Gold and thus explain why, eg, Gold rises? If so why is it not the centerpiece of all inflation-related commentary?

Answer: In a greenback world of floating currencies, there are no precise mathematical guides, as each central bank in the universe has a different philosophy of money management. A different "operating mechanism." The measured monetary base can increase because of inflation or because of deflation, given the market psychology as dictated by the central bank. The dollar/gold price sifts through all that and gives us a precise signal of monetary mistakes up or down. It is crucial to understand that gold price movements in all currencies do not CAUSE anything to happen directly. It is a SIGNAL, the same way a traffic light can turn from green to red, but the driver must hit the brakes to get the car to stop. The driver can ignore the signal, at his own peril, which is what the Fed does not in ignoring gold's move above $400.

Q(4) Finally, if individuals move funds from non-interest-bearing checking accounts into interest-bearing ones, has liquidity-demand been reduced and would Gold rise (other things being equal)?

Answer: No. Individuals cannot defeat the bank's operating mechanism. It has a monopoly that can offset any movements, however violent, in the private markets. This is how the Fed could maintain the dollar gold price at $20.67 per ounce during the Market Crash of 1929 and the convulsions that followed.

Bruno Distefano: Jude points to the 1997 tax cuts. Specifically, the Cap Gains cut to 20%, Estate Tax Cuts and the Roth IRA's as having a very positive Supply Side effects on the economy. Much like inflation made taxes worst in the 1970's, forcing people into higher brackets because of inflation, didn't the monetary deflation since 1996 make those 1997 tax cuts more effective?

Answer: The supply-side tax cuts CAUSED the deflation, in the sense that they increased the rewards to risk-taking in the economy and thus invited an increase in the demand for liquidity. When the Fed did not supply the liquidity, the gold price declined, and the pricing mechanism was put on a deflationary track. You are correct, Bruno, that we now have backward bracket-creep, a positive development. But the convulsions to the unit of account that we have to swallow along with the lower real tax rates are a heavy price to pay. The entire economy and the entire work force has to readjust, which can be very painful to debtors who cannot pay and their creditors who are not paid.

Bruno: Was the bubble in stock valuation a bubble or just a realization that values should be higher because of the deflation increased value of those assets and their income streams?

Answer: If the government had taken correct actions prior to the market declines, there would not have been a market decline. "Bubbles" burst when the market gives up on the government doing the right thing.

Terje Peterson: Prelude to my QUESTION:-

I have read your comments on capital gains taxes and I have no reason to disagree that the rate should in general be set at zero. However prior to the introduction of capital gains tax in Australia, periods of high inflation actually allowed the top 50% of income earners to achieve a significant tax reduction. This was due to a couple of factors. Firstly the tax rates and wage rates were periodically adjusted for inflation. Secondly losses incurred on investments could be claimed as tax deductible expenses. A person could borrow money, invest in real estate, use the loss due to interest payments to reduce income tax and at the end of the year sell the real estate at an inflated price and make a nominal tax free capital gain. It was so popular that the name for it (NEGATIVE GEARING) became a part of the Australian vernacular. Many books on how to become rich through negative gearing were published and seminars on negative gearing were as common as house flies. "Pitt Street farmers" (high rolling financial types who owned loss making farms for tax purposes) were a common point of working class discontent. It would appear that inflation was providing some Laffer curve relief to the top 50% of income earners. The real estate and accounting industries thrived.

My QUESTION: Is inflation ever a good thing, given the limitations in other areas of political thinking?

Answer: Australia's "negative gearing" was a creative response to the global inflation that followed the breakup of Bretton Woods and the floating of the US dollar. It is a second-best solution, which never holds up over time in a floating universe. Inflation is a good thing when you are experiencing a deflation, as we are now. The dollar pricing mechanism is slipping bit by bit to equilibrate with gold at $300, forcing all kinds of painful adjustments to society. A bit of inflation to $350 gold would neutralize the need for adjustment. Similarly, when gold was at $850 an ounce in early 1981, the correct solution was a deflation that eventually brought gold down to $350. It is like asking if there are times when a yardstick should measure less than 36 inches. Yes, if the last yardstick you used measured 37 inches, the next measuring 35 would bring you out just right. But it would be better if you used a fixed yardstick at 36 inches and did not have to be creative with "negative gearings," and such.

* * * * *

The deflationary experience that lasted from November 1996 to early 2003 was tracked throughout by Polyconomics and as far as I know by no other firm in the world. Other supply-siders refused to acknowledge a monetary deflation on the grounds that the consumer and producer price indices were still positive. My reasoning has always been that inflation occurs when the price of gold rises from an equilibrium level and deflation occurs when the price of gold declines from any level. If gold remains constant in currency terms, there can still be a sharp fall in prices through a "contraction," which is different than a "deflation." A contraction occurs in the exchange economy when producers expect to sell a certain volume of goods -- and there is then a "shock" to the system that is not monetary in nature. If fresh taxes or tariffs or obtrusive regulations suddenly appear, the total volume of goods produced and sitting in inventory cannot be exchanged. The high-cost producers find they cannot sell and must declare bankruptcy. Their inventories are thrown on the market at fire-sale prices. This is not a monetary deflation. It is a contraction that is self-correcting. As soon as the inventories are liquidated, the surviving producers can sell at a market-clearing profit.