Thinking about Deflation IV
Jude Wanniski
January 16, 1998


There is a general sense that Asian markets have discounted the worst of the economic recession the region will feel in the years ahead, but we still see room for deeper declines. When the Nikkei rose 900 points last night, to close above 16000 for the first time in a month, pressure came off the price of gold and it jumped above $290 for the first time since December 30. The yen strengthened against the dollar, but because of the updraft in gold, it didn’t really provide relief to Japan’s deflated banking system. When we work out all the variables, the yen/gold price at ¥37,300 per ounce is only a whisker above ¥37,000 at the beginning of the week. The Treasury long bond is getting whacked today because all this means the Fed is under slightly less pressure to lower the fed funds rate anytime soon. The markets have been trying to tell the Fed that it wants a lower funds rate and will provide a lower yield on the long end if it gets one. Turmoil in Asia, particularly in Japan, helps drive down gold and the dollar up, the bond market up and stocks down. Relief works in the opposite direction.

The Nikkei ran up on the news that the government will permit banks to mark to market the value of their real-estate holdings, which puts more capital on their balance sheets. This has the effect of a small cut in the capital-gains tax, which is very high on real property held less than ten years. That is, if banks want to capitalize the land on their books, prior to the new rule, they would have had to sell it and pay the tax on the capital gains. Real estate has lost 70% of the gains it had developed up until 1990, when the government burst the Nikkei bubble by increasing to ten years from five the time necessary to hold land to get a tax break on capgains. Now, the government expects the new rule will enable them to make fresh loans, but at the margin very little has changed that will bring relief to the actual economy. We see this in the tiny movement of the gold price, where real relief will not be felt at banks until the yen/gold price gets back over ¥40,000, where debtor/creditor balance swings to the debtor and potential debtor.

When an economy is going through a monetary deflation, as Japan’s is and as we are, the risks to the borrower are high if the deflation does not end, so there is a preference to keep inventories at rock bottom. Creditors would like to lend in a deflation, because they will get paid over the maturity of the debt in an atmosphere of falling prices. But they don’t want to lend against collateral that also will fall in price, in an atmosphere where the goods the borrowers are selling may not bring enough in the deflated market for them to meet their payments. Because the decline of the dollar/gold price only forecasts future deflation, if it stays at this level it will take another few years for the thorough adjustment of all other prices and wages. The irritation to debtors increases incrementally every day, which is why we saw the heckling of Greenspan earlier this week as a straw in the wind. During the 1982-83 deflation, Paul Volcker was probably the most cursed man in America, until he relaxed his grip around the necks of debtors.

This was another dreadful week in Asia, with the IMF’s Michel Camdessus trying to strangle everything in sight. The incompetence of the man and his sidekick, Stanley Fischer, is simply breathtaking. The day after he arrived in Jakarta with the announcement that he was there to “calm the markets,” its stock market fell 9% and its currency fell another 2%, which is an 11% decline in dollar terms. We should do whatever it takes to prevent Camdessus from visiting Wall Street. Eleven percent on the DJIA would mean a selloff of 850 points! The only positive news was that Treasury Secretary Larry Summers was in Beijing urging China not to devalue. He should really be telling Greenspan to ease, which is the only way to take this pressure off the world.