With gold now trading below $300 (below $293 today), it is at its lowest level since March 1985, when Treasury Secretary James Baker III stopped the slide with the Plaza Accord -- ending the period of “benign neglect” of the dollar’s strength against foreign exchange. The “benign neglect” of the dollar’s strength against gold now is the clear deflationary problem, but in public discussion it instead is fashionable to dismiss the gold signal. The supposition seems to be that while gold is a useful price-level signal when its price is rising, indicating the presence of an incipient monetary inflation, a 24% decline in the gold price in 13 months is not viewed as the signal of an incipient deflation. The widespread comment is that this simply reflects rising confidence in paper money and a consequent lack of demand for gold in a “disinflationary” environment.
We have been alone in warning of a dollar deflation all year, primarily based on the judgment that the gold price would fall as an indirect result of a budget deal between the White House and Congress, one that would include a cut in the capital gains tax. The tax cut would cause an increase in the demand for dollar liquidity and when the Fed would not meet that demand, gold would decline. When gold got to $320 in July, we warned July 9 that unless Fed Chairman Alan Greenspan found a way to talk the Fed into cutting interest rates, to supply the demanded liquidity, there would be financial distress throughout the world: “One of the worst effects of gold at $320 is that the Fed’s monetary error on the deflation side is being transmitted to all countries of the world, to one degree or another...The other countries of Asia that are pegged to the dollar are also being hammered by the deflation, with the Philippines now at the edge of devaluation (which they should do explicitly on the grounds that the Fed has pulled it into a deflation.) Unless Greenspan can soon get out of the corner into which he has painted himself, he will do more damage to Hong Kong than Beijing could do if it tried.” In the same letter we wrote: “Pity the Japanese, who are tightening at the Bank of Japan even though the yen gold price has been plummeting faster than the dollar’s, to ¥37,000 from ¥44,000 since April, a 16% fall. The Japanese government has been trying to appreciate the yen for political purposes, to satisfy the U.S. Treasury, at exactly the time the dollar has been appreciating because of unheeded demands for liquidity.”
Here we are five months later and the world economy continues to feel the consequences of gold’s deflation, with Japan’s Nikkei down 4,000 points since our July 9 observations and the rest of Asia being stomped as well. When will it end, and what will be its continuing consequences? Clearly we can expect no relief given Alan Greenspan’s continuing posture that there is no dollar deflation and that he and the Fed bear no responsibility for the turmoil in Asia. In a speech last night before the New York Economic Club, Greenspan laid all the blame for Asia’s troubles on Asians, and received rousing applause. There is no criticism coming at the Fed from any significant quarter. All of our attempts to rouse The Wall Street Journal editorial page have failed. Tuesday it had a silly lead editorial urging tax cuts in Japan because its “easy money” policy has failed -- when the Bank of Japan’s balance sheet shows not a single yen of added liquidity in the past 18 months. Today, the Journal denounces the Korean bankers for causing the collapse of the won and the Korean stock market and insists that they take the IMF medicine like good little boys.
For the first time since we began sounding these alarms, Jack Kemp yesterday issued a carefully worded statement expressing “concern” that “with the price of gold falling below $300, our monetary policy may be exacerbating the economic turmoil in Asia and parts of Latin America.” As long as it appears the most serious aspects of the dollar deflation are going to be borne by the “submerging market” economies, there is no interest among politicians in locating these difficulties in the Fed’s determination to stamp out inflation with deflation. We can see these signs of a global scarcity of dollar liquidity in the plunge of the Federal Reserve’s custody holdings of Treasury securities for foreign central banks. These custody holdings, which comprise the dollar reserves of many central banks, are down from a record high of $653 billion in mid-April to $618 billion as of last week, which was itself a drop of more than $7 billion from the previous week.
Domestically, while the aggregate data do not yet bear the markings of a monetary squeeze, the forward-looking indicators we watch most closely suggest significantly lower growth expectations in the markets. A summer-long rally in higher-risk stocks tied to congressional enactment of the capital gains tax cut fueled an 18% gain in the NASDAQ/DJIA ratio through early October. In the past several weeks, though, as the lower-risk DJIA first plunged to the 7,100 level and then sporadically worked its way back to recover nearly all of its losses, the NASDAQ has continued to lag. The NASDAQ/DJIA ratio, which we use as a barometer of the market’s risk preference and thus its growth expectations, is now down by 7% since the smaller-cap rally snapped in early October. As we pointed out last month (“Sliding Sideways,” November 10, 1997), the end of the NASDAQ rally appeared closely connected to Greenspan’s October 8 warnings of possible tightening action and subsequent gold price retreat. Though the market’s expectations of a Fed rate hike have been washed out for the foreseeable future, as it becomes more and more evident that the current stance of monetary policy is too tight, we can expect the laggard performance of higher-risk stocks to continue.
Indeed, the market’s recent behavior, with the low-risk DJIA clearly outperforming all other major indexes, suggests that the market is taking a defensive posture which does not bode well for growth going forward. In the first stages of deflation, it is our trading partners who are crushed, forced to sell their goods at distress prices in order to avoid bankruptcy. Gold under $300 or even $320 will continue to cause the underpinnings of the world economy to snap, one day at a time, until the general price level finds a new equilibrium. In his magnum opus, Human Action, which we are re-reading these days, Ludwig von Mises does note that monetary deflations of the kind we are having are less destructive than monetary inflations, because investment is not being squandered on suboptimal projects: “The temporary restriction in business activities that it engenders may by and large be offset by the drop in consumption on the part of the discharged wage earners and the owners of the material factors of production the sales of which drop. No protracted scars are left. When the process comes to an end, the process of readjustment does not need to make good for losses caused by capital consumption.”
Well, yes, but we still don’t know when the process will end. This, because so many policy errors are being made as countries try to cope with their distress by taking IMF medicine or, as in Japan, deflating in an attempt to keep the yen from devaluing against the dollar. Only when enough of this foreign misery comes back to weaken our economy is it likely the Fed will be in a mood to arrest the deflation by adding the dollar liquidity it has been withholding from the world.