PAUL O’NEILL does not understand deflation. In the Treasury Secretary’s speech to the National Press Club Tuesday after his return from Japan, he said he told the Japanese that a) they should end their deflation because it`s bad for their economy; b) weakening their exchange rate is a bad idea, one that has been proven to fail as a means to improve an economy. O’Neill needs a better economist to explain to him that he is essentially saying Japan must get out of the basement but under no circumstances should it climb the stairs. A devaluation does not help if you are NOT in a deflation, but if you are, it is the ONLY thing that works. Oddly enough, in Tokyo the markets and the financial press interpreted O’Neill’s remarks as “opening the way for a weaker yen” because he did not specifically say it should stop falling. It went to Y134 from Y133 as traders saw it that way. There may be room for confusion at Y134, but as the yen heads toward Y140 -- where it must go if there is to be any chance for the Japanese banks to see some of their non-performing loans perform -- these confusions must be cleared up.
NAM CAMPAIGN: The National Association of Manufacturers is behind the tough talk from Treasury on the dollar/yen rate. With Congress back in session, the NAM has invited member companies from across the country to hit Congress with a barrage of demands for a weaker dollar. NAM President Jerry Jasinowski was getting an earful from members last summer before September 11, but was discouraged from bringing pressure on the government while it was focused on Afghanistan. The deflation is still poorly understood, which is why there is so much confusion at Treasury, focusing on the dollar/yen rate instead of the dollar/gold exchange rate. The latter can be changed to bring relief to the Japanese and U.S. economy at the same time, with a joint devaluation, but the former might bring an end to the Treasury “strong dollar policy” in an unfortunate way. There is enough dollar liquidity in the system to end the deflation with a simple announcement of the government that it is “re”valuing the dollar’s value of its gold monetary reserves, at $325 to $350. The market would move to that point as long as the Fed did not try to stop it by draining reserves. If there is no such managed effort, there is also enough liquidity to take the dollar/gold rate to $400 or $500 per ounce, and the deflation would give way to a new inflation.
ENERGY: As the U.S. economy weakens in a relatively warm winter, the price of natural gas has fallen to a point that makes it unprofitable to develop new sources. The going rate is $2.40 per mcf and really has to be above $3 to keep the industry profitable. Above $4 discourages consumption, so the optimum would be $3.50. The rig count is down to the lowest levels in a decade. All this means another energy shortage two years from now, as the industry cannot find and develop new fields in a spot market. This is what did in Enron, trying to outguess the energy markets in a deflation that created wild swings in the world energy markets. And yet, the Conference Board “index of leading indicators” is positive partly because energy prices are so low. When I met with O’Neill in March, practically the first thing I told him was that the experience with inflation and deflation should persuade us that we cannot run a global capitalist system with a floating unit of account. Its biggest drawback is the misdirection of capital.
WAR WITH IRAQ: The lineup of global political forces still favors U.S. growling about Iraq, but no U.S. military intervention. Bush political counselor Karl Rove’s speech last week that seemed to position the President as a warrior going into the November congressional elections was not a hopeful sign. The polls say the electorate by a 7-to-3 margin would support action against Saddam Hussein, and Richard Perle, the GOP War Party ringleader, promises that the campaign would be as easy as pie, another Afghanistan. But Secretary of State Colin Powell had lined up the entire world in the coalition against the Taliban and it is doubtful that he could even bring the Brits into a confrontation with Iraq. In 1990, as an advisor to the government in Turkey, Perle talked it into joining the coalition against Iraq. Without a threat from Baghdad, Turkey will not go along this time. With its economy suffering under the poundings of IMF advice, Turkey would rather see the sanctions against Iraq lifted so it could resume open trading with its neighbor. The danger is always the possibility that a sudden “crisis” will develop, perhaps instigated by the Pentagon. The NYPost which takes its cues from Perle, this week reported a secret Pentagon plan to take on Iraq in about six months. It is of course Perle’s easy-as-pie war, which I think would lead to losses to the GOP in both the House and Senate. Remember “triangulation”? The Democrats would push the GOP further and further to the right -- as they did with Newt Gingrich, who, by the way, sits next to Perle on the Pentagon’s Defense Policy Board.
CHINA’S DEFLATION: China and Hong Kong are the last two of the world’s political subdivisions that maintain dollar pegs, and they are now suffering more and more with the imported deflation. The NYT this week reported on textile workers engaging in sit-down strikes in protest against 20% pay cuts. The government would be better off devaluing against gold by 20%, but is not going to give in with the Bush/Jiang summit meeting approaching in Beijing. Devaluation may be the correct thing to do, but China would think it a sign of weakness. Instead, they are joining the complaints about the Japanese weakening of the yen.
GOLD: As we had advised, gold’s advance to $290 per ounce earlier this month was unrelated to monetary policy, but probably had to do with unexpected purchases of bullion, which would mean the price would retreat to the $270s as the gold market adjusted. That is exactly what is happening as gold today moved to $278. Our expectation is that it will settle again at $275, with an upward bias as state and local governments raise taxes to cover budget deficits. To move below $275, there would have to be a new “stimulus” package containing supply-side tax cuts.
UPSIDE: There is at least more and more discussion about monetary issues, as confused as they may be, and that has always been the prerequisite to a solution. In last weekend’s Barron’s, out of the blue, one of the Roundtable participants even tossed out the idea that maybe we should have a gold standard after all. Nobody laughed.