Is This Holiday Rally for Real?
Jude Wanniski
December 18, 2001


Probably not. We are most likely seeing just another in a long series of nice little rallies on Wall Street this year, each one pulled apart by the ongoing deflation process. But there are a few encouraging signs, enough to suggest a policy breakthrough perhaps early in 2002 that will give us back a genuine Bull Market. By far the most important was the trip to Japan last week of Deputy Treasury Secretary Ken Dam. He understands the gold issue as well as anyone in the Bush administration, and told the Japanese that if they wish to see the yen weaken against the dollar to deal with their deflation, the U.S. Treasury would not complain on behalf of our manufacturing industries. Presumably the National Association of Manufacturers understands the problems of our automakers and steelmakers have nothing to do with the forex market and will sit still for a slightly weaker yen. The yen immediately softened against the dollar even as the dollar weakened against gold. There are positive signs for equities in both countries, although not yet enough to bank on. We are trying to be of good cheer.

On the dark side, gold at $280 could mean increased risk of a war with Iraq. While we think it will not come to that, the drumbeat from the GOP's War Party is enough to be discounted a bit in the gold market. Remember gold briefly surged above $300 after September 11; in 1990, gold shot up to $425 from $350 when Iraq invaded Kuwait. But with oil behaving itself at the moment, gold's upward drift also could mean a policy drift toward a higher gold price. Gold, after all, has not moved up as much in other currencies, beyond the 2.5% in dollars and the 3.7% in yen. Our thinking is that if Fed Chairman Alan Greenspan today said his Christmas wish were to have gold at $325, it would head there lickety-split. He's not going to do that. But if Ken Dam is encouraging Japan to end its yen deflation, can Treasury encouragement to the Fed be far behind? We do know that our deflation story is being taken very seriously in the administration where it had been considered only an oddity earlier in the year.

In my two trips to Washington early this year, as I warned the deflation would slowly overcome interest-rate cuts and tax cuts, my purpose was to put my reputation on the line. I learned long ago that a political establishment is not persuaded by logic or reason, but by accurate predictions of what will happen if they do X or do not do Y. It was greatly encouraging that one of the people I warned in March, syndicated columnist Tony Blankley, on NBC's "McLaughlin Group" Sunday disputed Larry Kudlow's optimism about a first-quarter recovery by noting Jude Wanniski's correct deflation-related forecasts. Blankley, who had been Newt Gingrich's press secretary, is not associated with me, so his comment may have had the effect of breaking the ice. Somewhere along the line there must be an open discussion of monetary policy. At the moment there is probably not a single member of Congress who is not asking: The Fed has cut interest rates 11 times this year; what more can it do? That is, it can shift its target from the overnight rate to an explicit dollar devaluation against gold/commodities, or even a policy aimed at keeping the yen from moving much above 130 or 135.

The housing market continues to do well, cutting against the deflation not necessarily because mortgage rates are low. Even after the Fed's 11 cuts in the funds rate, the mortgage rate at 7% is higher than it was at the start of the year. More likely is the fact that a house is much more than a "consumer good," for many people a preferable way of using cash that is otherwise paying almost no interest in a money-market account. You do pay tax on what little interest you earn. And you now not only can deduct your interest and tax charges from gross incomes for tax purposes, but also have been exempted from the first half-million dollars of capital gains, if there are any. It's hard to track down numbers on wage costs of home construction in so many parts of the country, but we would be surprised if they have not fallen in nominal terms in non-union areas.

The statistics that hold back serious consideration of dealing with the deflation -- such as the 0.4% rise in the "core" Consumer Price Index for November -- are not being taken seriously by the top administration economists, which is all to the good. Car prices are part of the jump when everyone knows the sticker price is meaningless with discounts that incorporate zero financing. The book chains are complaining about the high sticker prices of both hardcovers and paperbacks, as publishers try to hold up revenues while sales decline. My wife says she paid $20 at Costco for the new John Adams biography, which theoretically retails for $40. We went to see the Harry Potter movie last Monday evening, at $8.50 a ticket. The theater could seat 300 but there were only four of us there. I recalled that in China last year, where the yuan is pegged to the dollar, movie theaters were empty until the chains decided to cut ticket prices by more than half, at which point they filled to the brim. The Laffer Curve works in a deflationary direction too. If all but five major league baseball teams lost money last year, what happens in 2002?

The problem for all our competitors who are predicting a bigger and better Bull Market next year is this absence of pricing power. If you can't raise prices with volume in decline, you can't pay your debts or your wages and certainly cannot handle your pension liabilities. With investment houses and mutual funds desperately trying to coax cash out of hoards, we see daily forecasts of the Dow Jones Industrials reaching 12,000 or 13,000 a year from now. Those numbers are possible, of course, but only with gold close to $350. Even at $300 there would be a deflation drag. For bedtime reading last night, I dipped into the 1934 classic Prices, by Warren & Pearson, the fellows who devised the first price indices. In the deflation chapter I found:

In order to function, an economic society that is based on the private ownership of property must have a reliable medium of exchange. When the medium of exchange rises in value, the chaos that results leads persons to challenge this economic order. The thing that has broken down is not “capitalism,” which is another name for private enterprise, but merely the medium of exchange. Capitalism is no more to blame for this that it is to blame for the failure of a bridge to carry a certain load. One of the necessary tools of society has failed. The remedy is to supply a tool that will work. The only tool that will work is a measure of value that will keep the average price of commodities stable.

Not understanding the fiscal causes of the Crash of 1929 and the Great Depression, Warren & Pearson thought gold was the culprit, which is why they decided to construct "scientific" price indices to guide policymakers. They were correct about the absolute need for a capitalist system to have a reliable money, but we have today a system that interprets their price indices as being inflationary when they should be looking at gold. Unless we make more progress in doing so in 2002 than we have in 2001, this holiday rally will be another in a long line of disappointments.