Thinking about Deflation X
Jude Wanniski
August 17, 1998


Russia’s ruble “devaluation” may actually take some pressure off its own fledgling domestic financial system, if it can be called that, although it will not solve any of the problems caused by the Federal Reserve’s monetary deflation. Like the People’s Bank of China, the Russian central bank has been trying its best to keep the ruble in line with the dollar for the past 19 months of dollar deflation. China has hung in there, but Russia did see the ruble decline from 5.5 to the dollar to 6.35 currently. There really hasn’t been a ruble devaluation yet, as the central bank merely announced that between now and the end of the year, it might allow the currency to fall to 9.5, but there is obviously someone at the bank who has his eye on gold as well as the dollar. In this 19-month period, the ruble actually appreciated against gold by 10%, from R2000 per ounce to R1800. In our simple model, the economy would do its best -- everything else being equal -- in a range of 6.5 to 7, as long as the Greenspan Fed refuses to end the dollar deflation that has brought gold to $285 from $385. The Fed’s open-market committee, which meets tomorrow to take up these matters, got a nice shove in the right direction this morning from Jack Kemp, whose open letter to Greenspan in The Wall Street Journal has the answers to Russia’s immediate problem. Kemp says the Fed should add liquidity until gold hits $325, which would rescue everyone in the world whose livelihoods are tied to commodity prices.

The dollar gold decline forces a decline in the general price level by the same percentage amount, which means everyone who is trying to meet his debt obligations by selling things that come out of the ground suddenly is unable to sell enough to pay. Russia is a prime example of a nation living off its commodity exports of oil and gas, suddenly put to the wall by the decline in the oil price. It will not be able to pull itself out of the ditch with a loan from the IMF or Treasury’s Exchange Stabilization Fund. All that does is give it hard cash to pay its external bank debt, which is all Treasury Secretary Bob Rubin is interested in. Only a Fed easing this week really solves Moscow’s problem and Rubin’s. If gold goes to $325, oil and gas prices soon will follow enough to permit Moscow to pay its dollar debt and to avoid further disruption to its infant financial structure.

Greenspan does not want to do this because he thinks there is sufficient credit in the banking system and that to add more would be inflationary. I’ve come to think that while Greenspan understands money and banking better than most theorists, he still fails to understand it enough to avoid making such mistakes. The Fed doesn’t really supply credit to the banking system and the economy. And while it technically supplies Federal Reserve notes to banks on demand, it really doesn’t have anything to do with “the money supply.” It can’t supply more currency than the private market desires. All it can do is add or contract bank reserves, doing so by buying or selling government bonds from its portfolio. In this way it changes the mixture of government debt held by the banks. By taking interest-bearing debt from banks in exchange for non-interest bearing debt, the Fed causes banks to become easier in their lending practices, because they want to earn interest and not sit on idle liquidity. 

The Fed thus really has nothing to do with “money creation” or with “credit creation.” All it can do is avoid as much as possible making a mistake in the amount of reserves it supplies the banks. If it supplies more reserves than the banks can profitably use, the surplus in the first instance will show up in a rise in the price of gold. This is because at the margin -- in the first instance of an inflation -- it is better to hold gold than a surplus dollar. If it supplies fewer reserves than the banks can profitably use, at the margin a dollar is more in demand than gold -- and we are in the first instance of a monetary deflation. Milton Friedman’s error, and that of his students who are voting members of the Fed, is in the belief there is a long lag between a surplus or deficit in the system’s liquidity and a rise or fall in the gold price. Because he can’t tell us what price moves with a shorter lag than gold and makes no attempt to do so, I take his argument as mere conjecture. When there are a zillion items that can be priced in dollars, I assume gold is the most likely to change first, whatever the lag. It is a working hypothesis I have used for 20 years and it has never failed. I first learned of the concept from our first Treasury Secretary, Alexander Hamilton.

The next concept I learned from Art Laffer in 1972, when he taught me the classical theorem that you cannot change the terms of trade by changing the unit of account. If a dollar buys 300 apples as well as an ounce of gold, then if the dollar is devalued against gold it is also devalued against apples by the same percentage. If it will only buy half an ounce of gold, it will only buy 150 apples. If it buys two ounces, it will also buy 600 apples. This is why commodity producers around the world and in the United States are suffering, unable to pay their debts, and why their creditors are suffering, their loans now non-performing. We can’t say their problems are over until the prices of commodities begin to rise, and that cannot happen with gold where it is. Yes, the prices of some things will rise because of unusual commercial demand, but only temporarily. For the worldwide commodity deflation to end, the Fed has to add sufficient liquidity to push gold up where it can pull up oil and others in train. There is no point in expecting commodity-producing regions or nations to pull out of their difficulties as long as Greenspan’s vision remains befogged by good news here at the top.

We have to be concerned that demand for dollars will continue to expand and will not be met, which would send gold lower. If we see a tax bill signed by the President this fall, we may also see gold below $270 -- if the Fed refuses to supply the fresh demands for liquidity. This would continue the process of pulling wealth out of commodity producers to intellectual producers, not a pretty picture. The only way to turn about, of course, is if the hypothesis presented here can overtake the conventional wisdom that any problems we see are emanating from somewhere else in the world. Kemp’s letter is a critically important step, as it not only forces the Fed’s deflationists to confront the arguments of a political leader, it also provides support for those Fed governors and regional presidents who will be arguing for ease at tomorrow’s meeting.

It’s not enough for the Fed to “ease” by lowering the fed funds rate by a smidgeon, which we don’t think we could possibly see this week, but may in the next round of FOMC deliberations. There really has to be an intellectual breakthrough by Greenspan, to see the damage already done by his monetary deflation, in order to make the right kind of repairs. That means the Fed and its staff have to be explicitly brought around to recognizing the power of the gold signal. It also means Greenspan has to stop thinking the Fed has anything to do with supplying bank credit that can be the source of inflation. In that sense, he has more respect for gold than Friedman, who really does relegate it to a position as low as pork bellies on the scale of useful information about money demand. 

What would happen if the Fed supplied enough liquidity to get gold up to at least $325 and keep it there? Of course, that would mean the general price level would be a bit higher at the end of the day. But it would mean enormous relief to dollar debtors at home and abroad. It would rescue Russia, China, Asia, Mexico, and give breathing space to Japan to work out a separate set of problems associated with taxes. At home, a Fed easing would rescue people at the bottom who have run out of their cushion of reserves and are being forced into bankruptcy. The Russell 2000, a good measure of the bottom of the equity market, could then catch up with the rest of the market and the blue chip guys at the top of the heap would be pushed higher by those coming up from below.