Thinking about Deflation XIV
Jude Wanniski
July 8, 1999


The reports everywhere about gold sales by the British government of course were said to be the reason for the yellow metal's decline to $256 on Monday, from $260 or so. Gold now is down 10% for the year, from the $288 plateau it had reached -- after a two-year decline of $100 per ounce from the $385 plateau that held during the three years 1994-96. Conventional wisdom remains that gold steadily is losing its importance as a monetary commodity, which is why the UK as well as the International Monetary Fund are discussing openly the sale of more of their gold reserves into a declining market. The UK actually sold 25 metric tons and said it plans to sell 415 tons in all from its reserves. The amount is not terribly large, against total world gold of 125,000 metric tons in public and private hands, but the trumpeted news of the sales makes it appear there is a direct connection. Our view remains that the gold price in the primary currencies of the world is the purest measure of the excess or dearth of monetary liquidity in that currency's trading area -- and that its continuing decline in dollar terms represents a deepening of a deflation caused entirely by the Federal Reserve's failure to supply sufficient liquidity to prevent it.

Our evidence is overwhelming -- both in the currency markets and in the commodity markets. In the currency realm, if the declining dollar/gold price were simply a sign of the species passing from one owner to another, why is the price of gold in euros almost exactly what it was at the beginning of the year, even a bit higher? The fact is, the European monetary authority has been stabilizing its new unit of account against gold, not the dollar, and this is the reason the euro has been "weakening" against the dollar for these several months, to $1.02 from $1.17, almost 15%. (In the same period, sterling has "weakened" against the dollar by about 5%.) We do not have the slightest idea if the euro managers are targeting gold purposely, but if they are, we applaud them for breaking away from the dollar as a guide and using gold. By doing so, the new Europe is refusing to import the monetary deflation Greenspan has fashioned here.

The happy result will be to provide a solid foundation for the new monetary system, avoiding almost all the problems we have worried about as we have watched the new financial architecture go up without a clear sign on how it will manage the system liquidity needs. The old European currency "snake," which attempted to stabilize the old system without a common accounting unit, was a perpetual cause of tension because it only could target against the dollar. Each central bank in the snake had to worry about the political pressures resulting from trade flows inside their own system and with the United States. No one country by itself could break away and target gold. There is sufficient memory of Switzerland in 1973 trying to go it alone with a gold peg, with the Swiss franc so strong relative to the rest of the world that it was crushing its export industries. If Europe becomes comfortable with a gold target and the markets view euro stability against gold as purposeful, not happy coincidence, at the margin banking would begin to shift away from the New York/London banking establishment to Europe. This would force rethinking here of a floating dollar. At the moment, the market clearly believes the stable euro/gold price is coincidental, as the 10-year bond in Germany in the last few weeks has lost a bit of ground to the U.S. Treasury equivalent. The spread has gone from 170 basis points to 110.

If the dollar/gold price simply were reflecting news of U.K./IMF gold sales, not the continuing liquidity squeeze by the Fed, other dollar/commodity prices would not be acting in tandem. From the November 1996 days when gold began its 33% decline from $385, the Commodity Research Bureau Index also has come down by 25%, with farm prices taking bigger hits. Corn is down 32%, almost exactly matching gold's decline. Soybeans and wheat are down 42%. Those of you who are not part of the agricultural community may not be aware that 40% of the hog farmers have been bankrupted during this period and where farmers are surviving, it is by living off their reserves. The expectation in the farm community has been that prices will rise, as they always seem to do when there is a serious downdraft, but doubts now are setting in as prices continue to decline. The CRB index is down 3% since the Greenspan Fed boosted the Fed funds rate, with corn down 11.3%, soybeans down 7.6% and wheat 4.8%, just since July 1.

Just as the gold price decline began after the 1996 elections, when the demand for dollar liquidity expanded in anticipation of the 1997 tax cuts (as in 1996 we warned would happen), there is again market anticipation of supply-side tax cuts. The stock market we think now has begun discounting a tax cut this year, but there are no signs the Fed will supply the increased liquidity the exchange economy must have. The bounce back in the oil price probably will show up in the Consumer Price Index by August, stoking arguments for another rate hike. At the same time, we must continue to factor in the Y2K dilemma. The world in general and U.S. in particular will build inventories at an increased pace as Y2K approaches, which puts upward pressure on the wages that scare the Fed into fantasizing inflation. With OPEC vowing to keep oil production tight, it has the short-term ability to get prices up even in a monetary deflation. The demand for crude and refined product climbs as Asia rebounds and Y2K defenses are built.

Why is the Japanese 10-year bond at 1.6% and the US Treasury at 5.85%? The markets have been taught that the Fed is targeting the unemployment line, which means it will ease when the line gets longer. It almost certainly will at Y2K, if only to run down inventory build-ups. While we are becoming more optimistic on several aspects of Y2K, there still are concerns about global problems feeding into our financial system. The tendency will be for gold to decline this year, but rise next year as pressures build on the Fed to shorten the unemployment line. Japan does not have a similar problem, as the Bank of Japan has been trying to shorten the unemployment line by lowering interest rates, to no effect. Neo-Keynesians such as MIT's Paul Krugman have pronounced Japan's problem a "liquidity trap," a time-honored Keynesian way of saying he does not know why his prescriptions have failed to excite aggregate demand.

As monetary deflation continues, so too will pressures from our deflated industries for tariff relief and non-tariff barriers from the federal government. Stop the beef, stop the steel. Jack Kemp, who wrote President Clinton three weeks ago urging a dollar/gold peg above $300 to get us through Y2K, has not heard back from the White House. Check my website today for a report to Kemp on a wholly different topic -- A dynamite report that explodes the idea China has been getting nuclear secrets from our national laboratories. It's really very good news, although it will be denounced by all those who have a vested interest in China bashing.