Thinking about Deflation XI
Jude Wanniski
October 7, 1998


After several days of timid additions to bank reserves, the Fed's open-market desk Tuesday finally dumped in enough to hit the new fed funds target of 5.25%. Its interventions today have even knocked the rate below 5.2%, but we are not going to bother you with frequent commentaries on how these wiggles might be of significance. It is enough to say the Fed is still not committed to ending the commodity deflation and as a result the gold price remains below $300, at a level which requires further price adjustments here and anywhere in the world where governments are keying off the dollar. In a speech to the National Association of Business Economists today, Fed Chairman Alan Greenspan essentially said he did not know what is happening in the world, except he didn't do it. If there are problems beginning to arrive at our doorstep, he will deal with them when they arrive. As Reuters reported: "[Greenspan] said the U.S. central bank had to be especially alert to risks from unknown forces shaking global markets..."

Okay, let's give up on the idea that Greenspan will admit error arid that the deflation will end with sufficient liquidity to get gold and commodities up. After several weeks of sleepless nights and migraine headaches trying to figure out how to get $350 gold, I've decided to think positively of what happens if he doesn't and we are stuck at this level. What will happen? Because nothing escapes adjustment to a true monetary deflation, prices of all goods and sendees have to decline and real property and wages also must come down. We note that while still high, new housing sales are down for the second month in a row, even though interest rates have declined. The financing costs of a new house may not be sufficient to overcome the downward pressure on the price of the new home itself. Prices of raw materials have declined, but the cost of processing, selling, conveying and then fashioning them into a house require reductions in wages of all those people in the production chain. Either everyone agrees to take a pay cut to get wages back in line, or some people will be pushed off the production chain and fewer houses built. People with older houses will try and peddle them as fast as they can to get what little equity may be left in them. The oversupply eventually forces all carpenters and plumbers to accept lower wages and hope they can pay their personal loans, mortgages and taxes.

Imagine the deflation would continue until gold reached $35 per oz., a number that last had relevance in 1967, when President Johnson closed the London gold pool. A carpenter in New York City the top of the line in pay scale for the building trades made roughly $5 an hour in wages and benefits. The carpenter now costs a contractor more than $40 an hour. Can you imagine the amount of blood that would have to be spilled to get wages in line with $35 gold? It will be painful enough to complete the adjustments to $300. As we pointed out last December, when we began these reflections on deflation, the process has some positive aspects. The biggest is that as all prices adjust downward, at equilibrium everyone will have a cut in marginal income tax rates as a result of creeping down the progressive brackets. The same is true of capital gains. Everyone who now holds property that otherwise would sell at an inflated gain would be able to sell at an equivalent purchasing power, but have less nominal gains to tax.

After all, if the value of financial assets were now in decline because of a fiscal contraction, we could not be as cheerful. In other words, when high tax rates or tariffs are the cause of a contraction, the economy adjusts downward to a lower level of productivity. This was the Great Depression. The only way relief could have come was with a government that recognizes the error and cuts the tax rates or tariffs. In the monetary deflation with which we seem to be stuck, when there is adjustment to the new gold plateau, there is nothing to prevent the economy from rising to higher levels of productivity. Quite the opposite, some of the barriers have been removed by the deflation process. Ludwig Von Mises, who taught us what little we know about monetary deflation, also made the point that unlike inflation, it produces little or no inefficient additions to the capital stock, few inherently bad investments. There are no decks to clear in order to get the economy up and running again.

In the first stage of deflation, remember, the producers of commodities take the hit. In the second, the consumers of commodities take the hit. In other words, first the farms, then the cities. When the deflation is complete, everyone is back on an even footing. The adjustment process can get untidy, especially when wage adjustments are involved. It was the Keynesians who pointed out that wages are "sticky" in a downward direction, because workers have to pay their debts with nominal dollars. They are less sticky in a monetary deflation than in a contraction, because the real value of the wages has risen, i.e., an hour's work can buy more gold. In a fiscal contraction, with gold constant, a lower wage really is a lower wage.

The investment implications of continued deflation? Well, if it is good to sell farms and buy cities in the first part of a deflation, it must be good to buy farms and sell cities in the second half. People, companies and countries that produce commodities have taken their hit. Those countries that reacted to the hit by raising tax rates and devaluing currencies are not going to come back without repairing their fiscal architecture. Those who avoided adding barriers will do better, quicker. Because none of us have gone through a real, sustained monetary deflation, we only can imagine it. The deflation of the 1870s is a good one to study because it was sufficiently serious in breadth and length. The mini-deflation we had in 1981-82 was too narrow and short, although both demonstrated how quickly the economy can shoot forward once the adjustment is made. The stock market decline of 1872-77 had to be painful, but if you convert to gold, the valve of the nation's capital stock did not decline in that period.

The only problem with these cheerier observations on what we are going through is that they are sterile. A defender of Greenspan the other day actually insisted that going back on gold in 1873 at the pre-war parity was the correct thing to do because it restored the value of the government's pre-war bonds. That's the difference between an economist and a political economist, I told him. A few bondholders who thought they'd lost half the value of their bonds were made whole, but at the bloody expense of the adjustment process. It would be much nicer all around if the Fed would simply reflate enough to minimize the adjustment costs. A Fed economist who agrees with me e-mailed me a quiz when I asked what he thought of the move last week: "When do firemen put water on a burning building? a) Before the alarm has been sounded, b) After arriving at the fire but as soon thereafter as possible, c) After watching the building burn for half an hour, d) Once all the marshmallows have been toasted, e) After the building has burned to the ground." Please respond no later than the next triple-witching hour. Enjoy the toasted marshmallows.