On Greenspan's Mind
Jude Wanniski
November 19, 1998


The third quarter-point cut in fed funds was welcomed by the financial markets here and around the world, but it did nothing to budge the gold price, which remains the central problem to the world economy. Because the gold price has not responded to three quarter-point cuts, it is now obvious  Fed Chairman Alan Greenspan assumes that gold is no more important a signal of inflation or deflation than other commodities. In last Sunday’s New York Times Business Section, the lead article by Fed reporter Rick Stevenson explored all the possible facets of Greenspan’s thinking that might go into a policy decision. There was no mention of gold. If Fed reporters and Fed watchers now have concluded that Greenspan doesn’t watch gold, we can assume Greenspan prefers to have it that way. He also may have concluded that even if gold in this $295 range has had a deflationary effect on parts of the world economy, it probably has been fully absorbed. Former Fed Governor Wayne Angell, now chief economist at Bear Stearns, looks at the world much as Greenspan does, and Angell thinks the deflation adjustment is behind us because almost all of the decline in the gold price occurred in 1997, and for the last year has more or less stabilized.

The error he -- and I think Greenspan -- makes is in not understanding that for all prices that are tied to contracts -- especially labor contracts -- the adjustment process occurs in CYCLES. When the gold price doubles, all other prices must eventually double (minus tax considerations), but in a country where the average maturity of debt is fairly long, like ours, it takes a fairly long time for all prices in the system to adjust. They do it a little at a time.

In a country where people don't trust the government, because of previous devaluations, the maturity of its debt structure will be short. If it is very short, as it was in Mexico prior to 1989 when Carlos Salinas came in, a doubling of the gold price was followed by a doubling of other prices in a calendar year. Labor unions demanded immediate adjustments. When the peso devaluation occurred four years ago, going from 3.5 to the dollar to 7, the general price level only rose part way in the next year, because the peso stability of the previous six years had lengthened the maturity of the debt structure. Mexico’s central banker Miguel Mancera proudly told me the average maturity of government debt had lengthened to five years. This is why Mexican economists are going batty now, trying to figure out why the CPI inflation is 50% higher than they thought it would be. The peso now is about 10 to the dollar, a 300% depreciation in four years. Adjust it for the dollar deflation and it still is down about 250%. The early rise in the gold price still is feeding the new rise, as wages and leases and industrial contracts continue to adjust in their own time cycles. This is why the 67% devaluation against gold in 1934 still was feeding CPI inflation in the early 1950s.

Greenspan may have expected that with the decline in the gold price, the deflation problem would appear soon, and when it did not here at home, he was led to believe demonetized gold no longer has much significance as a signal. In the past, Lew Lehrman has also discounted gold when it didn't fit his theories because of statistics involving the marginal cost of mining gold in South Africa -- which is all beside the point. Angell made the same error in saying gold now is cheaper because there is better technology to get it out of the ground -- when better technology has been able to get it out of the ground in every generation for six thousand years.

In other words, if I'm right and gold has not lost its powers, the dollar price deflation will continue through many cycles until the adjustment is made to $300 gold. Only two years have gone by and there should be at least another ten or twelve before the process has been completed. Better to get the price up to $325, at least, to avoid all the wrenching adjustment that has to take place. The financial structure will continue to discourage borrowing, as borrowers in aggregate know they will have to pay back their debts with dollars that have more and more purchasing power as the decade ahead unfolds. Japan is in even worse shape, as their deflation runs much deeper. Why would anyone borrow yen for a ten-year investment, say -- even at minuscule interest rates -- if they know that for ten years the purchasing power of the yen will increase in cycles until equilibrium returns. This is why we see such close correlations between the yen gold price and the Nikkei over the past year.

My guess is that Greenspan has to see this before he is willing to discuss the problem and begin letting the market know again that gold at $325 or $350 (still my choice) is optimum, and that if we can't get there by lowering interest rates -- which don't increase liquidity -- we have to target gold directly. He has to see that at any given moment, the price of gold represents an equilibrium in the supply of liquidity and the demand for it. Changing the interest rate does not alter that relationship. The supply continues to be driven by the new demand, which leaves gold and commodity prices unchanged. To end the deflation, more liquidity has to be added than is being demanded, and at the moment no thought is being given to that imperative.

GOP LEADERSHIP: We won’t know much about the policy implications of the new Republican team in the House until we see what kind of staffs they assemble. Bob Livingston, the new Speaker, and J.C. Watts, Jr., the new GOP conference chairman, now can start looking around for staff. Cultural conservatives, the religious right, budget balancers and old Cold Warriors all will be urging their most loyal folk onto these staffs. Livingston badly needs a supply-sider on his team, which Newt Gingrich never had, in order to mesh policy with House Ways&Means chairman Bill Archer and Rules chairman David Dreier, who is devoted to returning to dynamic scoring on tax legislation. The biggest struggle will be over the new director of the Congressional Budget Office as June O’Neill, who proved a flop in her four-years, doesn’t want another term. J.C. Watts, who was the only candidate for any leadership post actively supported by Jack Kemp and is the only black Republican in Congress, may have more real policy power than any of the Democrats in the Congressional Black Caucus. The move may signal a real shift in the GOP approach to black voters nationally and lead to a necessary realignment of the two major parties. I’ll get back to this analysis after I’ve had a chance to see how this personnel situation shakes down behind the scenes and probably have a report after Thanksgiving.

CLIENT DINNER: We’re having our autumn client dinner on December 7 at the Yale Club in NYC. Our guest will be Iraq’s Representative to the United Nations, Ambassador Nizar Hamdoon, a fine fellow who will not bring any weapons of mass destruction, but plenty of experience in dealing with our government, others in the Middle East and the world in general. You will be getting special letters of invitation, but you can mark the calendar now.