Memo To: Supply-Side Students on Summer Break
From: Jude Wanniski
Re: Deflation Essay, April 2, 1982
In February 1982,1 called Paul Volcker, then chairman of the Federal Reserve, and told him he had to stop the price of gold from falling, or there would be bankruptcies all over the world. On the day I called him, gold had fallen to $310 from $320, down from $625 when Ronald Reagan was elected 15 months earlier. Volcker said he didn't have authority to buy gold, and I told him he had to buy bonds, to inject liquidity into the banking system. Oh, he said, you want me to inflate. No, I said, I want you to stop the deflation. Otherwise, dollar debtors all over the world will be unable to pay interest or principal on their dollar liabilities, and their creditors, the banks, will not get paid and go bankrupt. I'd known Volcker since he'd worked in the Nixon Treasury in 1970, and knew he at least was not hostile to gold. The recession caused by the deflation was the worst since the 1930s, yet Volcker did not know he was causing it.
Milton Friedman's followers were insisting that if he injected liquidity, "increasing the money supply," the bond market would collapse. I told Volcker the bond market would boom, because debtors would then be able to pay and their creditors would rejoice. By July, Volcker had no choice. Mexico said it could not pay its dollar debt to U.S. banks because the price of oil had collapsed. Its government oil company had borrowed when oil was $35 a barrel and now it was below $20. Volcker had to buy $3 billion in Mexico peso bonds, which Mexico used to pay the banks. With all this liquidity flooding the banking system, the bond market boomed, so did stocks, and the monetarists rent off scratching their heads, wondering what happened. Here is the essay I wrote for our clients — and for Volcker — on April 2, 1982. The analysis applies to the current monetary deflation.
By Jude Wanniski, April 4, 1982
Executive Summary: What the press and policymakers are calling "disinflation" is simply deflation, the deterioration of the monetary standard characterized by falling prices. There is a confusion because commodity prices are falling even as the cost of living continues to rise. The price of gold, the "commodity money par excellence" is the surest proxy for all prices, goods and bonds. Its decline from $425, reflecting the deflation since last fall, affects more and more debtors in global dollar contracts. The recession that threatens to become depression could also swiftly turn into a major bull market if the Fed arrests the gold-price decline at $300, signaling an end to continued deflation and the monetarist policies that have guided the open-market desk. With Reagan's economic team hopelessly lost in the deficit squabbles with Capitol Hill, Volcker is now the best hope and while he's getting warmer, he still needs room to experiment.
The popular press is calling it "disinflation," as in Business Week's April 5 lead article on the economy, "Learning to Live With Disinflation." And so are the policymakers. Paul Volcker and Donald Regan and David Stockman casually refer to the current "disinflation," and by their use of this new word we take it that they are happy with the condition. If inflation is bad, then disinflation must be good. And if some disinflation is good, then more must be better.
Unfortunately, the policymakers (and just about everyone else) are trapped in the demand model and are blinded to what is really going on in the economy. Inflation can not be defined as "rising prices" and "disinflation" as "falling prices." Inflation is a deterioration of the monetary standard characterized by a rise in the general price level; deflation is a deterioration of the monetary standard characterized by a fall in the general price level. Inflation and deflation are equally damaging to commerce, everything else being equal. (In a system of progressive taxation, inflation raises real tax rates while deflation lowers them, so there can be structural side effects that can have positive or negative effects on commerce.) Ludwig von Mises, the most important economist of the "Austrian school," in 1949 described the deflation that followed Britain's return to the gold standard after both the Napoleonic wars and World War I at pre-war parities. The description, in his magnum opus, Human Action, fits the United States and the dollar area today. We are experiencing a classic deflation:
People labored under the delusion that the evils caused by inflation could be cured by a subsequent deflation. Yet the return to the prewar parity could not indemnify the creditors for the damage they had suffered as far as the debtors had repaid their old debts during the period of money depreciation. Moreover, it was a boon to all those who had lent during this period and a blow to all those who had borrowed. But the statesmen who were responsible for the deflationary policy were not aware of the import of their action. They failed to see consequences which were, even in their eyes, undesirable, and if they had recognized them in time, they would not have known how to avoid them. Their conduct of affairs really favored the creditors at the expense of the debtors, especially the holders of the government bonds at the expense of the taxpayers. In the 'twenties of the nineteenth century it aggravated seriously the distress of British agriculture and a hundred years later the plight of British export trade. Nonetheless, it would be a mistake to call these two British monetary reforms the consummation of an interventionism intentionally aiming at debt aggravation. Debt aggravation was merely the unintentional outcome of a policy aiming at other ends. (p.784, 1966 Regnery edition)
The deflation we are now experiencing is not obvious at first glance because the general price level is still rising as measured by the conventional indices. The best index to use as a guide to the value of the dollar, and whether it is inflating or deflating, is the dollar price of gold. It is the best index because it is, in Marx's description, the "commodity money par excellence." It is the proxy for all goods and services, present and future, whereas the wholesale and consumer price indices track only current prices. Gold, in other words, embraces the dollar valuations of goods and "bonds," i.e., financial assets. In this sense, the world is now and has been on a gold "standard," by which the markets assess the shifting relationships of paper currencies against the premiere monetary commodity. Milton Friedman and others would insist that as long as the government does not define gold as money it is only another commodity, no different from "pork bellies." But he's wrong, which is why every radio and TV news program reports the price of gold on the hour while remaining silent on pork bellies. News audiences look to the price of gold as a guide to the value of their dollars and dollar assets just as they look to the Dow Jones Industrial Average as a guide to their equity portfolios. News managers who do not report the gold price find they lose market share to other programs that do.
The price of gold, in other words, is the most sensitive indicator of the dollar as a measure of value. If the monetary authority causes the money supply to exceed the money demand for any reason, it is the price of gold that reacts first by rising, and unless the authority takes immediate offsetting action that causes the gold price to return near to or reach its previous dollar level, all other prices would eventually rise to equilibrate with the higher gold price. And at the higher gold price, before it is returned to the lower level, the market will always provide some one or more individuals who will gamble that other prices will rise in gold's train. That is, they will do so unless they have assurances from the monetary authority that the downward correction of the gold price is inevitable. If the price of gold rises in the absence of such assurances by the authorities, those who speculated on a rise in other prices would lose their gamble if the gold price did fall. Of course, the opposite occurs if the monetary authority for any reason causes the demand for money to exceed its supply, the price of gold then falls.
When the price of gold climbed to $850 an ounce in January 1980 the conventional wisdom held that it was the Russian invasion of Afghanistan that caused the dollar price of gold to be bid up from $500 in a few weeks. All we have to know is that in a very brief period paper money lost its attractiveness relative to the commodity money by a great degree and then regained its loss by returning to the $500 level.
At the moment gold was at $850, half the world believed it would go higher than that amount and half the world believed it would go lower. At the margin, where the price is made, we might hypothecate a single individual who believed the price would remain at $850, in which case all other prices would eventually have to climb by the same degree in order to equilibrate with gold. At that moment, all dollar contracts consummated between creditors and debtors — involving any commodity — reflected this expectation of inflation. In the next moment, new information coming to the market caused the demand for dollars to increase relative to the demand for gold, and the gold price fell. Those who borrowed all other goods in the expectation that their price would rise to equilibrate with $850 gold would now have to pay back more than had been assumed at the time the loan was made. The number of such dollar contracts in relation to the whole of dollar contracts was extremely small, however. But there was, no doubt, enough in the wild swing to contribute to the 1980 recession.
If we think of dollar contracts, in a floating world, as gambles by debtors and creditors that the swing can go against either, we can begin to see that inflationary and deflationary effects can be playing themselves out simultaneously. With gold at $320 an ounce, those whose portfolios are weighted with debt incurred prior to the summer of 1979 are still enjoying the effects of inflation while their creditors are suffering its losses. Those whose portfolios are weighted with debts contracted since the summer of 1979, when gold began its rise from $320, are now to one degree or another burdened with the effects of deflation while their creditors are enjoying windfall gains.
Given the fact that there are many constellations of debtor-creditor relationships built on the slopes of gold's decade-long ups and downs it is not possible to stabilize at a price that benefits everyone. At $320, there will still be inflation and deflation, depending on the particular constellation. But stabilization in and of itself brings such great gains to the entire economy that the minor question of who wins and who loses on past contracts is swamped by the future's promise, discounted to present values in a great bull market.
Why has the price of gold been falling from its early 1980 peak? Simply put, the policies of the Federal Reserve turned from inflationary to deflationary. After the price tumbled from its peak to $500 in a matter of weeks, the Fed marched it back up to the $625 range, coincident with President Carter's re-election bid. The deflation really began in earnest on the day of Reagan's election, the price of gold falling more than $300 in the 17 months since. Had the President been unsuccessful in getting his tax program through Congress, the effects of the deflation would have been far worse — monetary and fiscal policy would have worked together to snowball family and business bankruptcies. As it is, the serious gathering of deflationary momentum began coincidentally when the tax program passed in August. Thereafter the Fed's squeeze swamped all other market considerations.
It must be said that the price of gold could not have remained at its $625 range, when Reagan was elected, without continued major upward movement of the general price level. But by driving the gold price down by brute force in a kind of trench warfare, instead of with a long-term strategy, Paul Volcker maximized interest rates and the deflationary pain. Interest rates remain at stratospheric levels at the moment because the markets still do not have any idea of Volcker's intent — how far down he will carry the disinflation as reflected in the price of gold, and with it an accelerating bankruptcy rate. And when he gets where he's going, will he or his successors march back up the slope to new peaks? It has always been the argument of the supply-siders — whether Robert Mundell, Arthur Laffer or Lewis Lehrman — that the markets be advised of a gold stabilization process.
Although Mundell, Laffer and Lehrman have differed on their guesses of where the gold price would ultimately be stabilized, their uniform belief was that the price would fall from the $625 range to $500 (Lehrman), $400 (Mundell), $200 (Laffer) if the markets were advised that it was the government's intent to restore convertibility at the conclusion of the process. The program would have been accompanied by tumbling interest rates in the long-term markets as the demand for long T-bonds surged, on the prospect that the government would indeed stabilize gold and rebuild the credit system around its convertibility.
Both Mundell and Jelle Zijlstra, chairman of the Bank for International Settlements, last September urged a central bank effort to stabilize gold — with its price then at $425. Mundell explicitly proposed a $400 to $450 range. The Treasury would buy gold at the $400 level and sell at the $450 level, and the net effect would be to force Volcker off his M1 policy track. The Fed would have to adjust its open-market purchases and sales of government securities to prevent the Treasury's accumulation of gold at $400 or its loss at $450. Volcker would thus be unable to hit his monetary aggregate targets — M1 would rise in the ensuing economic expansion — and he would be able to justifiably argue that M1 would stabilize over the longer run if the gold stabilization process took precedence.
In the absence of this effort, monetary policy took the gold price down by $100 and the deflationary impact was severe. Dollar contracts as far back as July 1979 are now in the deflationary net and the level of insolvencies and bankruptcies has the word "Depression" in circulation again. "U.S. Farmers Said to Face Worst Year Since 1930's," headlined The New York Times on its March 28 front page. Farmers, who of course borrow over a harvest cycle, are always hit very hard in a monetary deflation. We also hear that petroleum wildcatters are being crunched, for they borrowed heavily for exploration when the price of oil was several dollars higher per barrel. The business failure rate is at 2,000 a month in the United States, a 55 percent increase over the 1981 rate, and curiously enough it is the newer enterprises that are having the most trouble (those that took root prior to 1979 are still not in a net negative position as a result of the gold-price decline, although everyone is indirectly affected by the deflation). The most unambiguous example of the deflationary effect of the gold-price decline is the Soviet Unions scramble for dollar liquidity through gold sales. Its dollar loans and those of Poland and Eastern Europe are heavy within the years of dollar inflation; as the price of gold falls, it takes more gold (or gold equivalents) to pay down the dollar debts. The Soviets have not been driving down the price of gold; it is the Fed that has been driving up the price of the dollar.
I have personally urged Volcker to prevent the gold price from falling further, below $300. The only way the price could go much below $300 without catastrophic effects would be via the method Laffer envisions, with a decline in interest rates cushioning the negative effects of deflation. But Laffer's method is no closer to being considered now than when he first proposed it in 1974. In any event, Volcker is now at least beginning to understand the model. This now seems the only hope left for stabilization, since Treasury Secretary Regan has given himself over to the monetarists and the entire Reagan economic team has become hopelessly embroiled in the dithering over deficit projections.
Supporting gold at $300 can thus not involve Regan and gold purchases as a way around Volcker, but must draw monetary policy directly to the task, buying unlimited quantities of government bonds while gold is at $300 until the price of gold rises to $301 — and selling government bonds when gold is at the ceiling price of $325 or $350 until the price drops below that point. Gold thus would be used as a guide, a standard, at the Fed's open-market desk in New York, as a replacement for the M1 guide that retains almost nobody's confidence.
This puts the central bank on a "gold standard" although gold itself is neither purchased nor sold by the central bank. This is hardly a novel idea. It was described by David Riccardo in his "Principles of Political Economy" in 1821:
..... it will be seen that it is not necessary that paper money should be payable in specie to secure its value; it is only necessary that its quantity should be regulated according to the value of the metal which is declared to be the standard. If the standard were gold of a given weight and fineness, paper might be increased with every fall in the value of gold, or, which is the same thing in its effects, with every rise in the price of goods ..... A currency is in its most perfect state when it consists wholly of paper money, but of paper money of an equal value with the gold which it professes to represent, (pp. 238-44, Everyman's Library edition)
Volcker, who has told friends recently that he is not "allergic" to fixed exchange rates with "some convertibility" but not "pure gold," is at last beginning to see that this is all the supply-siders have ever talked about. Legally defining the official dollar/gold price and backing it with convertibility is only the means by which the Riccardian principles are institutionalized, so the markets can be assured that Volcker's successors would not be tempted to try another monetarist experiment. Even if convertibility is assured, monetary policy could and should be directed at keeping the gold price from hitting the convertibility points. That is, if the government pledged to buy gold at $300 and sell gold at $310, it could instruct the open-market desk in New York to buy securities at $301 and sell securities at $309, which would of course keep all gold purchases and sales within the private market.
Interest rates, which continue to crush the world economy, can not come down unless there is a change in monetary policy that removes inflationary and deflationary expectations. An interest rate contains a "risk premium," which in a gold-standard world is composed mostly of default risk. In the floating regime, where the markets have no guide to how low the gold price might fall, there is a high risk of default in the system. Households and corporations and entire nations that are on the brink of financial collapse are staying afloat only because they can borrow resources at high rates of interest. Because the federal government has to compete in this market for resources, it has to pay market rates. If the government were to sell "gold-backed bonds" in this market in an attempt to economize on interest rates, it would not gain very much because bondholders would have no guarantee against deflation, a fall in the price of gold. But if the government said it would not let the price fall below $300, it would not have to guarantee its bonds in gold to lower the interest premium for deflation. Interest rates would come down for all borrowers.
We are on the verge of either economic collapse or the Bull Market we've all been waiting for. As long as President Reagan hangs on to the tax program for awhile, giving us a chance to watch the Fed approach the $300 price of gold, we can be conditional optimists. It's not enough for it to stay above $300 because the markets have no assurance that a $315 or $320 level isn't coincidentally consistent with the M1 target and that next week well see another nosedive or takeoff. Either the Fed (or the President) has to announce the $300 floor as a policy guide or we have to observe the Fed in action at the point, preventing its decline. At least we could surmise that Volcker is then working up his confidence on the way to a formal statement. It could be just as the U.S. Gold Commission announces that we should absolutely, positively not go to a gold standard that we will sneak one in the back door.