Back to the Deflation Market
Jude Wanniski
November 11, 2002


Many years ago my intellectual patron, Irving Kristol, told me why his favorite people in the world were asset managers. The reason, he said, was their sole interest was making money for their clients, which meant they would listen to any crazy idea where others would not. Long before supply-siders found support for their ideas in the political market, they found supporters on Wall Street who saw that “Voodoo economics” really did work. I’ve been thinking about this foundation of support lately while connecting the movements of financial assets to the potential for war with Iraq. We don’t have a single client, I suppose, who would not love to see Saddam Hussein take a hike, one way or another, but the way he goes has profound implications for the value of financial assets and the real economy. This is why I breathed easier when Secretary of State Colin Powell on October 9 persuaded President Bush to try one more round of “diplomacy.” 

The market hit bottom at 7,200 when Mr. Bush spoke that word after a Powell briefing. It climbed back above 8500 last week after Powell made 150 phone calls to negotiate UN Security Council Resolution 1441, which gets the weapons inspectors back into Baghdad, with no provision authorizing the automatic use of force. Of the17 Iraq resolutions passed by the U.N. in the last dozen years, the only one that authorizes force is 644, which limits force to kicking Iraq out of Kuwait. There are of course still small risks of war, but those are related to findings by the Hans Blix UNMOVIC team that Iraq really does have ongoing nuke or chem/bio weapons programs that it is hiding from view. The kind of military action that would spring from that kind of finding would have the support of the Security Council, the Congress, and the Arab/Islamic world.  The risks to the domestic and global economy would be small enough to support a “regime change” in Baghdad. 

A unilateral U.S. intervention without evidence of non-compliance with #1441 would of course be successful militarily, as Iraq could not withstand U.S. military might. It might even be the equivalent of the invasions of Grenada, Panama or Nicaragua. One mighty nation state conquering a little, enfeebled nation state would have no detectable effects on Wall Street, one way or the other. The Gulf War, for example, had a relatively small and temporary impact on Wall Street relating to the price of oil. The primary reason was that one Arab nation was invading another Arab nation, and whatever the rationale Baghdad thought it had, there was no side effect. It has been the events since that produced the kind of political terrorism which led to 9-11, with no nation state involved. It is that kind of vigilante “war” that can quickly cut the Dow Jones Industrial Average in half. You may recall how closely Polyconomics watched the debate between State and Defense in the days after 9-11. Recovery on Wall Street tracked Colin Powell’s success in bringing Pakistan and the rest of the world aboard for intervention against the Taliban. 

Although I’m personally persuaded that Iraq has no WMD and presents no threat to the region, that consideration is set aside in my analysis of how things will play out for stocks, bonds and commodity prices. The UNSCOM inspection mechanism of the past was clearly flawed by the loopholes, which permitted members of the team to misbehave, looking not for WMD, but for conventional targets that could be destroyed in the bombing raids that followed. The reorganized 1999 UNMOVIC mechanism, under Hans Blix, has closed those loopholes, which is why even Syria joined in the unanimous vote of the Security Council. The mechanism makes it almost impossible for a provocation of Iraq to not be seen as such and addressed by UNMOVIC. One way or another, the risks of heightened terrorism – of the kind that could shut down transportation in the United States – have been dramatically reduced. In the next few weeks, the acceptance by Baghdad of #1441 should firm up the stock market, still troubled by the possibility there will be more difficulties in getting the inspectors back. Once they are on their way, though, we can return to the other forces bearing upon the economy and the financial markets – especially to the Deflation Monster that continues to cast its shadow over the U.S. and world economy.

With the dollar/gold price at $320, the deflation is not great enough to cause further miseries in the economy itself. As far as forward-looking equities are concerned, gold is still too low, by roughly 10%. We’ve said a hundred times in the last six years when the deflation began that this is not a matter of economics, where there is room for judgment. It is practically physics, where the universe of prices must adjust in a downward direction from a previous equilibrium level. If President Bush woke up tomorrow morning and decided to sign an executive order to fix gold at $320, a great many good things would happen here and around the world. The stock market would rise, as the monetary risks associated with investment, production and exchange would be eliminated. Markets would rise around the world as other economies could link into the fixed gold/dollar. Short-term interest rates would rise as the Federal Reserve could no longer target the fed funds rate, but the longer bonds would rally as the risk of losing value through inflation would evaporate. But there would still have to be a downward adjustment in the general price level, a deflationary drag.

I’m not bringing up the arguments for why this should be done because I believe it soon will be done. There is simply no support for a fixed-rate monetary regime in the Bush administration at the moment. The fact that Larry Lindsey says he is not leaving the President’s side at the National Economic Council reduces monetary reform to near zero. Glen Hubbard, chairman of the President’s Council of Economic Advisors is sympathetic, but he is also having a hard time understanding the differences between deflation and contraction. In a CNBC appearance on Friday, he was fine until he said that prices will rise when the economy expands. Wrong. Wages can and should go up with economic expansion, as capital forms, but prices remain steady. The only time prices go up in an expansion is when they have been depressed in a contraction, bringing about a temporary overhang of inventories that must be sold off before the market is cleared of surplus. That kind of “V-shaped” problem is not what is bothering Wall Street these days.

I’m coming to the conclusion that monetary reform may have to come from the Democrats, whose theorists are not as hung up on a floating dollar as the GOP remains. This is because of the continuing influence of the monetarists at the conservative think tanks. Remember it was a Republican President who floated the dollar in 1971-73 on the advice of Milton Friedman. The neo-Keynesian Democrats really expected to refix the gold price after it devalued to suit their tastes on where it should be. It has always struck me that because a gold/dollar benefits ordinary Americans the most, it would be most likely that the political leadership required to bring about such reform would come from a Democratic leader. There are now none in sight, but as the Democrats lick their wounds from last week’s elections, there may be a Jack Kennedy in the field willing to kick the idea around. (JFK was the last Democrat who backed the gold standard with enthusiasm.) Gold is certainly back in the national conversation – see Gene Epstein’s column in Barron’s this week, for example. It may sound crazy to you, but if you were born to be an asset manager, you will consider all the crazy ideas that abound among the conventional. That’s how big money is made.