Inflation + Deflation = Reflation
Jude Wanniski
June 6, 2002


After we left the gold standard in 1971, the terms "inflation" and "deflation" were no longer enough to describe general price movements. In the years that followed, as some prices climbed and others fell, the price indices often did not match up with the conventional terms, so new terms were invented. "Disinflation" came to mean a decline in the rate of inflation while the price indices were still rising and "reflation" came to mean a rise in the rate of inflation while the price indices were not yet rising. The idea of separating out "core" inflation B grains and energy B was the bright idea of some government economist who noticed they often moved differently than the rest of the price galaxy. As far as I know, Polyconomics was the first to unscramble the mess and tie movements in the general price level to the unwinding of contract maturities. Gold would move first, then other commodities traded in the spot market, then all other prices tied to contracts that covered years or decades: Wages, business contracts covering future deliveries, mortgages, and government and corporate bonds.

Sometime in the early 1980's, I gave a lesson in all this to Paul Volcker, when he was Chairman of the Federal Reserve, explaining why the low Consumer Price Index was misleading. It was then averaging the falling oil price that followed the decline in gold from $600 per ounce to $300 an ounce with other prices that still had not caught up with the rise in gold to $300 from $35. It probably made his head hurt, because there are so many variables to follow, especially when you add in the differences between "deflation" and "contraction." This is why it is so difficult for many supply-siders to grasp the mess that has been made in the pricing mechanisms by the ups and downs in the gold price since 1993 B with the 10% "inflation" of gold to $385 from $350 followed by the "deflation" of gold to $254 from $385, now to the "reflation" of gold to $325 from $254. We have a bowl of spaghetti.

What our financial clients are most interested in is what does all this mean for stocks and bonds. The government is reporting good news about the end of the recession and brisk economic growth ahead, but the value of capital assets -- which have real and nominal components -- are different than Gross Domestic Product, which can balloon because of an injection of government spending on war, or health care, or public works, etc. The equity markets are still under a deflation pressure that has been relieved to a degree, but has not yet played out. The Dow Jones Industrials may yet dive below 9500 for reasons having little to do with the deflationary forces that are still at work at $350 gold. For the most part, that particular drag on the markets ends at that point. Remember, though, the 30 corporations that comprise the DJIA have different debt structures, which means there will be variations in price adjustments within the DJIA. All we can do here is say with a fair degree of certainty that we are in the ballpark. Because the financial markets do discount the future of real economic activities, though, the bottom of the DJIA will not mean a bottom to the economy itself.

.The gold price did flirt with $330 this week, but that could have been because of reported tradings in the bullion market, where effects can only be temporary in our analytical framework. Or it could have been the slight easing of tensions between India and Pakistan. At least part of the "reflation" of gold in recent weeks has been the increase in the potential for major loss of life on the subcontinent. There is much less chance, though, of serious disturbances in the Middle East. Note the big rally Wednesday on Wall Street even with the news of more suicide bombings in Israel. The threat of intervention in Iraq this year is also receding rapidly, as reasons for ousting Saddam Hussein are dissolved one by one and the costs of ousting him rise. President Bush may have thought it would be easy enough to put together an Islamic coalition against Iraq, as his father did in 1990. But back then, one Muslim state was invading another Muslim state, and to boot, Iraq is a secular state, where most are religious. Now, Bush is proposing that a Judeo-Christian state invade a Muslim state, when it is clear enough to all the other Muslim states that the objective is to eliminate Baghdad's threat to
Israel, which continues to resist the idea of a Palestinian state.

The Joint Chiefs of Staff are opposed to a military action in Iraq, as they don't see the casus belli, but of course they will salute smartly and do what they are told if the Commander-in-Chief tells them it must be done. They will then present the Commander-in-Chief with the costs of the venture, as the only conceivable staging area will be Turkey, if Turkey's secular government is willing to tell its Muslim population that it is going to support Uncle Sam's invasion of Iraq. As the troops required to subdue the Iraqi army would have to come through the mountains to get to Iraq, it will be an extremely expensive operation. Probably $100 billion for starters, with no other country interested in chipping in. I'm not sure of any of this, I must acknowledge, but I think it is probably the reason the President is becoming less bellicose on the subject. If the DJIA were now flying above 11,000 and the Treasury was being engulfed with a tidal wave of capital gains taxes, he might say, "What the heck, let's do it for humanity." But far more likely is the option I have been mentioning here in past missives, that Iraq agrees to an inspections regime that will provide the fig leaf the White House needs to cover its detumescence.

What this leaves us with, though, is a flat market, the kind that really good stock pickers can get rich on, because the macro variables are not so noisy. Before we left the gold standard, this is how the best of the best analysts on Wall Street got rich by making their customers rich, spotting the diamonds in the rough and the dogs that could be cut short. When we do get to that point again, it may not be as exciting, but there is virtue in bedrock stability. We will be on a gold standard sooner or later, which will provide that bedrock and tend to flatten out the market indices. What we see in the months ahead will give us a taste of what it is like to invest in a flat market, with 9500 at bottom, 10,500 at top, depending on the hits, runs and errors of the political class in this period of "reflation." Which reminds me of the late Herbert Stein's remark when he was the chief economic advisor to Nixon in 1973, before the fall. At a press conference, he advised that the administration "did not want inflation and it did not want deflation. It wanted flation."