What a Fine Mess
Jude Wanniski
September 7, 2001


There are by now very few if any of our clients who have doubts about our deflation story. Clearly the theory behind our analysis has been difficult to grasp, but as the deflationary process has unfolded in ugly ways exactly as we had predicted, skeptics have been becoming believers. It is important that this process of intellectual evolution development extend into the Bush administration if we are going to soon get to the “inflection point” that triggers a sustained market rally. We have been assuming for several months that it would take fear in the hearts of the political establishment in general to get us to the point where it will swallow the only medicine for a cure: Change in the Fed’s operating mechanism where it targets a higher gold price instead of a lower fed funds rate.

In April, I suggested to Paul O’Neill’s Treasury team that when the new auto models came out in September and did not sell, he could be sure there would be no economic rebound, because the weakness would be demonstrated to be something other than an inventory problem. That evidence is beginning to come in already, with the Big Three getting whacked far worse than they had anticipated. Rebates have begun already for 2002 and industry analysts are quickly raising their estimates of how big those rebates ultimately will be. Chrysler has cut its sticker prices. Retailers are finding that leasing is drying up, while those buying cars are shifting to monthly payments, a sure sign of belt-tightening. The same deflation in Japan, that has driven the Nikkei to long-time lows and has Moody’s lowering Japan’s credit rating, also is driving the GM, Ford and Chrysler folks crazy. The foreign car makers in general and Japan in particular are undercutting U.S. sales with lower capital costs and determination to gain market share. All this doom-and-gloom will translate into housing “for-sale” signs, which now are beginning to appear in greater numbers, especially in the upscale markets. This of course will extend to mid-scale housing as layoffs continue and consumer confidence ebbs.

We have yet to see the political establishment speak up, which it must do to effect the cure. The Wall Street Journal could get the ball rolling if it ran a lead editorial making the case for the gold cure, but having pooh-poohed the deflation story for years, the best it can do is argue for another tax cut. A capital-gains tax cut to 15%, which Senate Minority Leader Trent Lott is pushing, would be nice to have, but it is not the cure for the deflation and would actually add to deflationary pressures unless Fed Chairman Alan Greenspan were warned in advance that he would have to accommodate the increased demand for liquidity it would generate. Empower America’s Jack Kemp already is making that argument to the White House and really should be making it directly to Greenspan. What worries us now is that Washington’s attention will shift to capgains completely, with that fight chewing up the balance of the year, thus letting the Fed off the hook.The most important issue in the entire world is the dollar deflation, which is why even a cut in the capital gains tax must take a back seat if necessary. Because the world in general keys off the dollar, its problems directly impact the global economy, while lower capgains would for the most part only benefit the U.S. Argentina, for example, is being strangled by its constitutional link to the deflated US$. A cut in our capgains tax would increase the demand for liquidity here, driving the gold price down, and tighten the noose around Argentina. A capgains cut also has smaller growth effects when the economy is in a deflation because it is harder to get a nominal gain in capital. The capgains cut in RR’s 1981 tax-cut package did not prevent the most serious recession since the 1930s, as the gold price fell to $310 from $620.

Of course, Washington is far less interested in the global economy than it is in the U.S. economy, and Congress knows how to cut taxes but has little practical influence on monetary policy. Wall Street showed some real spark on Tuesday when Congress came back from recess with stories about Lott pushing capgains. When Bloomberg ran a headline at 2:14 that President Bush seemed favorably disposed to a capgains cut in his one-on-one meeting with Lott, the DJIA was then up 250 points and went higher in the next 30 minutes. A second Bloomberg report at 2:42 “clarified” the story, saying Bush wanted to “look see” at how well the rebates were working before he signed off on a capgains cut. As this would put the issue into next year, the DJIA gave back 200 points in the last hour. The press corps, including the WSJ, completely ignored the connection. But what’s new? The New York Times has not had a single word on the deflation since I began writing about it in 1997, rejecting the two op-eds I submitted without saying why. George Gilder’s American Spectator will run my 6000-word cover story on “The Deflation Monster,” which I hope Vice President Dick Cheney will circulate to the Cabinet. That might spring the Jack-in-a-Box and get some conversation going.

The other bit of good news is that Senator Lott mentioned the deflation idea to the President at their meeting, although there was no press report of the mini-discussion. Lott simply mentioned that he thought the Fed had really not “eased.” This puzzled the President, who mentioned the seven interest-rate cuts and asked Lott what Greenspan should be doing. Lott suggested the Fed “buy bonds,” which is a piece of the answer. I am told Bush asked Lott to get him some paper on the topic, as time had run out. Those wheels are now in motion, as the President will read the paper and pass it on to O’Neill, who breakfasts with Greenspan weekly. We continue to believe Greenspan will retire by year’s end if Wall Street continues to swoon and he refuses to budge on deflation.

If you recall, we reported last month that Sen. Phil Gramm [R-TX] might be interested in the Fed chairmanship, which would mean he would have to announce soon that he will not seek re-election next year. He has not only done that this week, but we have the story that he is being urged to leave now, so the Texas GOP governor can fill his seat with someone who would then have a leg up next year. Gramm, coincidentally, is the only member of the 535 in House or Senate who really understands deflation. As an economics professor at Texas A&M in the early 1970s, he wrote an academic paper on the deflation of the 1870s and the return to a gold standard in 1879, which he concluded was a good thing for the country to do. Is something in the works? Don’t know, except that Texas A&M is offering Gramm its presidency. Gramm is a “pit bull,” not cut out for the presidency, but perfect for the Fed chair if he wants to get us back on a gold standard. I’ve not talked to him about any of this, but will keep you informed. The further the DJIA falls, the more interesting scenarios we will be able to imagine. (NASDAQ will hold up better with better prospects for capital gains.) Don’t worry too much. Bad news is what will get us where we want to go. When we get there, hold on to your hats. Global markets will go into orbit.