Thinking about Deflation III
Jude Wanniski
December 18, 1997


The action we’ve seen in Tokyo these past few days definitely confirms that some percentage of the dollar deflation is bound up in temporary dollar hoards in Asia. That is, under normal conditions, an increase in the demand for dollars in Asia would involve genuine desires for dollars as a circulating medium. These demands would show up very quickly at the Fed and would be met dollar-for-dollar with base money, thus having no effect on the price of gold. The crisis atmosphere has produced the kind of phenomenon we associate with anyone building up cash balances in banks or under their mattresses, in anticipation that dollars will be harder to get at some future point when dollar liabilities have to be met. These are temporary demands on supply and will inevitably unwind either as the crisis atmosphere reverses or when the immediate dollar liabilities are met. This is the reverse of the run-up in gold in August of 1990, when the Iraqi invasion of Kuwait led the market to assume an easing by the Fed. Gold quickly went from $350 to $400. Market participants ran down cash balances expecting they would be more plentiful in the future. When the Fed spurned the arguments for monetary ease, the market reversed, gold returning to $350.

When Japan made its surprise announcement of a tax cut on Tuesday, the most interesting action was not that the Nikkei ran up 500 points on the day, but that it ran up 1000 points during interday trading, after being down early by 200. After the 1000-point run-up, the Bank of Japan threw cold water on the party by draining yen from the banking system and 300 points came off the top. At the same time, in Asian trading, the dollar gold price jumped $5. The fact that the Japanese “stimulus package” is feeble and the BoJ is still bent on keeping the dollar/yen rate under 130 is discouraging, but it may be that policymaking in Japan has turned ever-so-slightly away from further contraction. At least the play of the markets was a tiny victory for those in Tokyo who are favoring growth over austerity, as it is plain as day that the Nikkei loves the idea of a tax cut over a tax increase and that it does not like the BoJ intervening to spoil the party. 

Because so much of Japan’s economic problem is tied to the economic and political policies of the United States, the other very positive development of the week is that Milton Friedman, now 85 years old, has spoken up in both Forbes (December 22 interview with Peter Brimelow) and in a signed piece about Japan in Wednesday’s Wall Street Journal. Friedman correctly identifies Japan’s problem as a monetary deflation and says it can easily be ended by having the Bank of Japan inject liquidity until interest rates rise. Two weeks ago, we criticized the Journal for editorializing that Japan could not solve its problem with monetary ease, because it had lowered interest rates to very low levels and it had not worked. Friedman argues that we should not confuse low interest rates with easy money and high interest rates with tight money. As we have been arguing for the last two years, the extremely low interest rates in Japan are telling us the deflation is discouraging the kind of borrowing that must occur in a healthy economy.

Friedman uses his favorite monetary aggregates to argue Japan is starved for yen liquidity while we use gold, but because supply-siders and monetarists at least agree that interest rates are not reliable indicators, we are now in policy confluence. If the Journal now shifts its position on Japan to argue for monetary ease in Japan, Greenspan will be able join in, and those in the U.S. Treasury who are not uptight about the dollar/yen rate going above 130 will have allies across the partisan aisle. By having Treasury signal Japan that it need not squeeze the yen under 130, the BoJ could solve an important part of Japan’s economic and financial problems by liquifying the economy. Asia would breathe a sigh of relief, and that percentage of the gold price that we identify with the hoarding of dollars would evaporate. Gold, now $287, should rise to $310 or so. 

The next leg to ending the dollar deflation, with gold back to $350, requires the Fed to lower the funds rate from 5.5%. (Note that if gold goes to $350 and the dollar/yen rate is at 130, the deflation would end in Japan. It was on exactly this reasoning last January 2 that we forecast the dollar/yen rate would be at 130 at year’s end.) Here, the supply-siders and monetarists part company, because Milton Friedman’s favorite “M” aggregates are showing sufficient liquidity in the banking system. This is why gold is superior to the “Ms” as a signal of the demand and supply for liquidity, as gold incorporates both supply and demand, and “M” is only a supply function. Monetarism assumes a constant “velocity” of money, which is a key ingredient to the demand for money. Friedman does not take into account the increased demand for liquidity that occurred this year because of the change in the tax laws, particularly capital gains. The falling gold price tells us that the velocity of the dollar has declined and turned negative. In this realm, cash becomes an investment asset. Anyone who sold gold to increase cash balances 13 months ago has done well. If it went into short-term notes instead of cash balances, the investment was an excellent one.

In 1982, the situation was roughly similar to where we are now. The “Ms” looked just fine, but gold had fallen to $300 from $600 in 18 months and we were screaming at Fed Chairman Paul Volcker to buy bonds to liquify the banking system. The monetarists, most particularly Friedman’s protégé at the Reagan Treasury, Beryl Sprinkel, insisted that monetary ease would send the “Ms” soaring and produce an inflation that would wreck the bond market. When the Fed was forced to ease in the summer of 1982, or face a wave of serious bankruptcies, the bond market boomed with stocks. Asked later how come the bond market did not collapse as he had predicted, Sprinkel said he had misjudged the velocity of money -- a number difficult to calculate even months after the fact. 

At this stage of the dollar deflation, the biggest losers continue to be those enterprises that have been keyed to Asia and the NASDAQ stocks that would be hurt worst by a weakening domestic economy. A turnaround in Japan would bring relief, but the best we can see is a straw in the wind and my political conjectures. We should not forget the deflation did not begin in Asia, but here at the Greenspan Fed. In The Wall Street Journal on Monday, Wayne Angell pooh-poohs the idea of a deflation, arguing he will not be concerned until real-estate prices decline. Like velocity, the price of property in the nation is a number that can perhaps be estimated in a deflation after all the bankruptcies have occurred at the new general price level. In an e-mail exchange this week, I asked Angell to identify some square foot of property anywhere on earth, which, when it declines in price, will cause him to write an op-ed recommending the Fed lower interest rates. We might say Angell is now on a Real-Estate Standard. 

There is very little to be cheerful about, as hard as we try. The Fed’s November minutes out this afternoon indicate it is still biased toward tightening, with one Fed president actually dissenting because he wants to raise interest rates! We are in anxious days indeed when the only good news we can celebrate is our rare agreement with Milton Friedman and the monetarists.