Thinking about Deflation V
Jude Wanniski
March 3, 1998


When I wrote the first of this series on December 4, I began with the observation that: “It now appears we have to learn to live with deflation. Fed Chairman Alan Greenspan makes it perfectly clear he is determined to stamp out a non-existent inflation with whatever monetary deflation he deems necessary. His speech to the New York Economic Club Tuesday night was his latest word on the subject, a total whitewash of his responsibility for the wreckage in the emerging markets of Asia and Latin America.” I re-read the letter this morning and nothing really has changed in the three months since, as I hypothesized a $300 gold price and there it remains. If you still have the letter, it is worth re-reading yourself. I’m finding clients asking again why the deflation has not hurt the way the 1981-82 gold deflation hurt, or even why the 1984-85 decline in the gold price was soon felt in the financial markets.

At the Polyconomics annual client conference this past weekend at The Breakers in Palm Beach, the question came up again. Where is the deflation? And of course the financial press is now blaming the weakness in the bond market on the failure of the Asian distress to weaken the U.S. economy. As Greenspan indicated last week, he is fighting off wage inflation that he believes arises from too many people working. We hope that you believe with us that our dollar deflation caused the initial Asian economic decline, which spiraled as the International Monetary Fund stomped around the region spreading its poison. Our analysis then was that the economic decline in southeast Asia would have some small effects on our economy, that we had to be more concerned with the continuing deflation in Japan, and that the Asian governments would probably begin discussions about a monetary bloc that might insulate it from the swings in the dollar. The 15% decline in gold from its equilibrium of $350, we said, would not hurt us as much as the earlier monetary deflations of this floating era because it would be cushioned by the changes in tax policy in the 1997 budget act. We can find no other evidence in this century of a monetary deflation being accompanied by “fiscal expansion,” if we might call it that. But unless the gold price moves up, there would have to be a 15% decline in the general price level over time measured in years, not months.

The dollar deflation has been easily seen in commodity prices, which are the first to follow a gold decline. Since early November 1996, when gold began its decline as dollar demand increased with expectations of the tax cuts that later arrived, the Journal of Commerce index is down 8.5%, a four-year low; the Goldman Sachs index is down 16.6%, a two-year low; and the index of the Commodity Research Bureau is down 7%, near a 40-month low. The declines are much steeper from last summer, when gold’s tumble accelerated. Yesterday’s January personal income report, which includes the personal consumption expenditures deflator, is widely considered the most accurate price index available from the federal statistical bureaucracy. It was up 2% in January from the fourth quarter of 1996, but if you cut out the services component, which Greenspan knows overstates inflation as it understates productivity, the general price level is in decline.

By itself, the monetary deflation would be pulling the economic train down the hill, but the fiscal engine at the other end is pulling the train up. We have previously stressed the importance of the capital gains tax cut, to 20% from 28%, as the primary motive force. It bears mentioning that the other big changes in the tax code that have powerful supply-side effects are also pulling the stock market and the real economy up the hill. These are the increase in the estate-tax deductibility, to $1 million from $600,000 and the Roth IRA. There has not been any supply-side analysis on how big an effect these have on capital formation over time, because their effects accumulate over time, but together they may be as powerful as the lower capital gains tax.

Households will at least mentally capitalize the relief on estate taxation. By that I mean they will step up their risk-taking with liquid assets, on the assurance that future tax liabilities involved in estate planning have been significantly reduced. The new Roth IRA is turning into a major cause for celebration, as households are rapidly figuring out that it is much more advantageous to backload the tax breaks, instead of as with the old IRA that front-loaded the tax breaks. The growth in Roth IRAs is practically exponential, as news of the benefits spread among ordinary workers by word of mouth. If the tax system and gold price were frozen for the next 30 years, there would be no benefit to backloading -- paying the taxes on income up front and none at retirement. The benefits of being able to avoid any taxation that might occur through legislation or inflation are perceived to be so great that many individuals are willing to convert from the old IRA to the new even if they must pay a penalty for the change. We did not take this behavioral advantage into account when we first looked at the Roth IRA, which proves that the masses in aggregate are still smarter than any economists.

At our Florida conference, we did learn that there would almost certainly be a cut in the capital gains holding period, to 12 months from 18, because of the storm of complaints reaching Congress on both sides of the aisle. There will certainly be some sort of tax bill that includes at least small changes in marginal rates, on the “marriage penalty,” for example. These will tend to pull the engine up the hill faster, but remember Greenspan does not want the train to move faster, because he fears wage inflation. Any increase in the demand for liquidity that arises from positive changes in the tax code will be offset by further resistance at the Fed to lowering the fed funds rate. This is what causes the hang-up in the long bond, as the markets see a Catch-22 in the Fed’s embrace of this Phillips Curve philosophy. The effects of the monetary deflation can only be offset with market benefits before they have run their course. Once they have, and the Fed sees fresh signals of market weakness, a lowering of rates and additions to liquidity only would have inflationary effects. Gold would go back up to $350, while we would argue it should stay at $300. The bond market has to build this risk into the long bond. In Japan, where the central bank is not on a Phillips Curve, the deflated gold price is accompanied by a low bond yield.

The idea that the economy is BOOMING is hardly accurate. There is more demand for workers because of the relative increase in capital. But the monetary deflation is holding back the process by which the entire economy can move to higher levels of real income. Workers at the bottom who had one job now find a second one easier. At our conference, Mayor Ed Rendell of Philadelphia told us we would be kidding ourselves on Wall Street if we really believed the expansion was uniform. The upper tiers of the city’s economy are happily doing better, he said, but the bottom tiers are still mired in low wages and an inability to transport themselves to where higher paid jobs are on offer. Greenspan and his colleagues see the aggregates and congratulate themselves on a job well done. “If this is as good as it gets in an expansion,” says Rendell, one of the stars of the conference, “what happens when we hit a little recession?” Rendell, a Democrat in the municipal trenches, was encouraged to call up top to his party’s boss, who thinks everything is swell out there.