After tossing and turning all night thinking about the stress in the bond market, we have decided that it fears deflation, not inflation. The parallel is with the 1984-85 period, when Paul Volcker fought an inflation that had already been built into the calculations of American enterprise. The price of gold fell, from about $425 to $300, and the bond market sank as well. At the time, we'd warned Volcker that to let gold fall below $400 after the economy had factored the general price level above that point would do nothing but harm. We cited Ludwig von Mises, who made the compelling argument in 1948 that a deflationary error does not offset an inflationary error. It compounds it. The bond market now worries that the Fed has allowed a 10% inflation to creep back into the economy's calculus, the gold price rising to a $385 level from $350 and the Fed permitting it to remain at about that level for most of the past year. To drain liquidity from the banking system at this point, to drive down the gold price, would weaken the economy, by causing producers to receive lower prices than they had reckoned upon for their products and by discouraging the markets that finance the production process. This would not be welcomed by the bond market, which does not like a weak economy, as no creditor likes his debtor to be weak. The signals that are now indicating higher prices are throwing fear of deflation into the financial markets. In our report Monday, we suggested that Greenspan somehow signal the market that he would not tighten unless the gold price climbed above $390.
Former Fed Governor Wayne Angell has been arguing that in order to satisfy bond buyers that inflation will not be permitted, the Fed must act decisively to drive gold down, sharply pushing up both the fed funds rate and the discount rate to show it means business. The bond market and the stock market would crater, I'm now sure, if this advice were followed. The fact that the economy is already burdened with the Clinton tax increases of 1993 implies a double-barreled blast. Angell was, of course, absolutely correct last year in arguing for a snugging up of short-term rates when the gold price began its climb above $350 -- that is, before it became entrenched in the calculations of the financial markets. It is, though, too late to do anything about it now unless Greenspan could find a way to do it without raising rates. As Greenspan pointed out in his House Banking testimony last week, inflation has to be caught at its inception. His quarter-point tightening of fed funds was an error, but where we originally thought it not enough, it was too much, especially without an adequate explanation of the Fed's future guideposts. If Greenspan were to now announce a gold ceiling of $390 or $400, he could actually ease back to a 3% fed funds rate and the bond and stock markets would breathe a great sigh of relief. Statistical inflation would show up later this year and next, reflecting the higher price level implied by gold at this price. Greenspan need only explain that it has to be borne, but that it is a mistake that will not be made again. The only other alternative I could suggest to Greenspan is the same advice I gave Volcker a decade ago: If the President would ask Treasury to stabilize the dollar value of our gold reserves at $350, the deflationary stress would be offset by the elimination of further monetary risk. That is, long and short term interest rates would fall and distressed enterprises could refinance.
Von Mises explained this in 1948, but John Maynard Keynes in a 1923 essay had the clearest explanation we've ever seen, when he anticipated the wicked deflation imposed by Winston Churchill in 1925. We faxed a copy to the Fed this morning:
With the development of international trade, involving great distances between the place of original production and the place of final consumption, with the increased complication of the technical processes of manufacture, and with the seasons governing the date of supply of farm products, there must be a considerable interval of time between the dates when effort is expended and the date when the commodity finally yields up its usefulness. During this interval the business world is entering into liabilities in terms of money -- borrowing money and paying out in money for wages and other expenses of production -- in the expectation of recouping this outlay by disposing of the product for money at a later date. That is to say, the business world as a whole must always be in a position where it stands to gain by a rise of price and to lose by a fall of price. Whether it likes it or not, the technique of production under a regime of money-contract forces the business world always to carry a speculative position; and if they are reluctant to carry this position, the productive process must be brought to a standstill. The argument is not affected by the fact that there is some degree of specialisation of function within the business world, the professional speculator coming to the assistance of the producer proper by taking over from him a part of his risk.
Now it follows from this, not merely that price changes profit some people and injure others, but that a general speculation of falling prices may inhibit the production process altogether. For if prices are expected to fall, not enough people can be found who are willing to carry a speculative `bull' position, and this means that lengthy productive processes involving a money outlay cannot be undertaken, -- whence unemployment...
A deliberate policy of deflation, however, greatly aggravates the situation. In so far as the business world believes that those responsible for currency policy really intend to carry out a declared policy of deflation, they are bound to feel some lack of confidence in the existing price level, in which case they will naturally draw in their horns to a certain extent with the result of diminishing employment. For this reason a modern industrial community organised on lines of individualistic capitalism cannot stand a declared policy of deflation.
Keynes was hardly an inflationist, though. He was responsible for building the Bretton Woods monetary system around a dollar defined as a fixed weight of gold. In the same 1923 essay, he makes this following argument in support of a return to gold that Greenspan could easily cite today:
Modern individualistic society, organised on lines of capitalist industry, cannot support a violently fluctuating standard of value, whether the movement is upwards or downwards. Its arrangements presume and absolutely require a reasonably stable standard. Unless we give it such a standard, this society will be stricken with a mortal disease and will not survive. I have dwelt in this paper on the evils of deflation because they are with us now. But the evils of inflation, which were visited upon us three years ago, although they are different in kind, are not less in degree. We can do with neither.
I've not yet spoken to anyone at the Fed about my overnight change of heart. But this mea culpa is on its way. If there was a time for a snugging up, it was last summer or fall. By this February, it was already too late to correct one error with another. The markets have gone through some anguish, but at least Greenspan finally has gold out of the closet and into the intellectual arena.