Thinking About Prices Jude Wanniski November 10, 2000

Last week’s Lesson #8, about the interaction of money and taxes, took us only part way into this most important topic. I promised to continue it this week, but in the interim decided to devote this week’s lesson to the critical importance of accurate prices as signals to the capital markets. The core of the lesson will be a letter I wrote to the clients of Polyconomics on July 6, 2000. If it sounds too elementary for men and women who are in senior positions of asset management on Wall Street, this should demonstrate that the most brilliant minds easily can forget basic rules of economics when the entire investment community and the press corps that serves it has come to accept a different paradigm.

The fact that Polyconomics is almost entirely alone in arguing that global capitalism always will be less efficient than it should be when the dollar is floating -- not anchored to gold -- does not mean we must be wrong. One of the chief reasons we are sure of our ground is that we learned our basic lessons from Robert Mundell, the 1999 Nobel Prizewinner in economics, who was able to predict the behavior of capital markets as he observed the divergence in the dollar as an accounting unit and gold as an accounting unit. When they were tied together, the markets had one price by which to guide capital flows. When they separated -- the dollar being conceptual and thus nominal, gold being palpable and real -- the markets were forced to focus on the nominal unit because it is legal tender. The only way to understand the “energy crisis” of the 1970's was to see that the unhinged nominal dollar would throw off inaccurate signals to the capital markets. After several years [1985-1993] of stability between nominal and real accounting units, as the dollar/gold price hovered around $350, the disturbances resumed. That is, the nominal price of gold climbed to $383 and now has dropped below $270.

How can the capital markets function efficiently when there is so much volatility in the real and nominal accounting units? When the price of gold moved up by 10%, it meant to us that the price of oil would soon follow, thus inviting the capital markets to direct more capital to the world energy industry. When the price of oil fell sharply from the $383 plateau, it meant that oil prices would also fall sharply, thereby bankrupting those sources of capital which had aimed at $383. As the price of gold fell by more than half, for two years the markets directed almost no fresh capital to the world energy industry. When the world economy began to recover, it called for more energy and there was none. The nominal oil price then tripled, even as gold remained in the deflationary grip of the Federal Reserve. Normally, a tripling of a price would cause markets to send waves of fresh capital into the commodity involved, but the markets no longer trust the price they see. If they make new investments at this level, only to see the nominal price crash again, they will suffer losses as great or greater than they did in 1998-99. If there is a cold winter in the big oil consuming regions of America and Europe, there will be even more disturbances in the nominal prices of energy. When seen in this light, it becomes obvious that the world economy will continue to be fraught with risks, with the poorest people suffering the most because of the malfunctioning of global capitalism. It is not difficult to fix. The President of the United States, whomever that might be come January, could do so with the stroke of his pen by executive order instructing the Federal Reserve to relink the dollar and gold. Alas, Polyconomics still remains alone in making the observation, which means it is not likely to happen. Here is my July 6, 2000, client letter, “Thinking About Prices.”

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As I watch the unusual changes taking place in the prices of equities, debt instruments, and commodities, I keep coming back to the idea that among the most important functions of a price is to allocate scarce resources. That is, when the price of apples goes up relative to the supply of oranges, at the margin more capital will be directed toward growing apples compared with the amount allocated to oranges. The apple price will then fall relative to the orange price. Notice there is no “inflation” involved, even though the example begins with a rise in the price of apples. Either eating apples has become more fashionable or a blight has caused a shortage of supply, pushing up the price.

In the 1992 (14th edition) of Economics by Samuelson and Nordhaus, for example, there is a brief section on Rationing by Prices that reads: “High oil prices stimulate oil production, whereas low corn prices drive resources out of agriculture. Those who have the most dollar votes have the greatest influence on what goods are produced. For whom are goods delivered? The power of the purse dictates the distribution of income and consumption. Those with higher incomes end up with larger houses, more clothing, and longer vacations. When backed up by cash, the most urgently felt needs get fulfilled through the demand curve. Even the how question is decided by supply and demand. When corn prices are low, farmers cannot afford expensive tractors and fertilizers, and only the best land is cultivated. When oil prices are high, oil companies drill in deep offshore waters and employ novel seismic techniques to find oil.”

When thinking about today’s market prices, there are a host of interesting questions that are not addressed in the textbooks. Why did the market price of Amazon.com rise so high last year and fall so far this year, and will it ever get back to where it was? What about DrKoop.com? What made it soar and crash so quickly? Why have market prices of Old economy assets fluctuated so dramatically against the Internet corporations? Why has the price of oil risen so high relative to its traditional relationship with the price of gold and why is the market hesitating to increase the price of oil assets even as the oil industry hesitates in directing new capital flows to the search for new sources? The price of corn and other farm commodities fell sharply in recent years, but instead of bouncing back when investment shied from that sector, farmers are planting more and, with the aid of good weather, are preventing prices from recovering to where there can be a positive return on investment.

At the heart of the confusion coming from Wall Street analysts and government policymakers -- particularly at the Fed -- is the floating unit of account. If the dollar price of a thing rises, is it because it has become scarce relative to other things, or is it because the Federal Reserve has made a monetary error? If it is the latter, it is not the kind of textbook signal described above and does not mean the market should automatically allocate a greater capital flow to that thing. When President Nixon broke the dollar/gold link in 1971, the dollar price of gold doubled to $70 from $35 in a matter of months. Gold mines began producing more at the margin because of the profit opportunities. But there was no great capital expansion toward the gold fields as Nixon simultaneously announced wage-and-price controls and it was uncertain if the gold price would hold or retreat. Many economists who advocated the delinking of the dollar and gold had predicted the dollar gold price would fall once gold was demonetized. The oil producers of the Middle East had been selling their output for $3 a barrel and found a steady increase in demand at that price. By 1973, Aramco’s oil output had doubled to 6 million bbl a day, but the Arab partners in the company began to realize the dollar prices of everything they were buying with their oil revenues had climbed. The terms of trade had turned against them. With gold at $140 in 1973, the OPEC producers announced a quadrupling of the oil price, to $12 from $3.

It is useful to recall that almost all economists at the time concluded that the world was running out of oil and OPEC was in the driver’s seat in rationing scarce resources. In 1976, all the Democratic candidates for President, except Jimmy Carter, blamed Big Oil and promised to break up those firms and even nationalize them. Notice Al Gore flailing around, blaming Big Oil and George W. Bush for the relatively teeny increase in the oil price this year. Of all the economists in the world when Nixon went off gold and its price doubled, Robert Mundell was the only one to see that the most important unit of account in the world, the U.S. dollar, had changed in real terms, which led to his prediction in January 1972 that there would soon be a dramatic rise in the price of oil and other commodities.

In the same way, it really is impossible to think about today’s marketplace without understanding the difficult job the market has in rationing capital with a deflationary dollar. There are no Nobel Prizewinners in the commodity trading pits or in the commercial banks or on Wall Street. The mechanisms that have evolved to deal with capital allocation are all necessarily automatic and built around the market prices of the things being evaluated. Yet if a price goes up, or down, is it a signal for more capital or simply an inflationary or deflationary impulse?

The point of this review is that if the dollar were now to be legally defined in terms of something real, like gold, there could no longer be monetary errors, up or down. All price movements of commodities would be real, which would mean even small increases or decreases would enable the market to automatically ration capital to one thing or another. There would be no oil “crises” in the future as we have experienced them under a floating accounting unit, because at the margin the market could plan for more or less capital infrastructure to lift and bring to market oil and gas from the stupendous proven reserves that are on the books. We would not have to depend on the generosity of the Saudis to get through a cold winter -- just as we never had to worry about the flow of energy in all the years the dollar did have definition in terms of something real. He has his Nobel Prize, but Mundell is still a lonely voice. He wrote recently on the editorial page of the WSJournal that there is no world monetary system and there will not be unless the dollar, the euro and the yen are tied together and anchored by gold. In other words, the world’s capital markets must somehow operate without clear price signals. This can only mean myriad booms and busts, gluts here and shortages there.

What about Amazon.com and Dr. Koop, e-commerce and the New economy? These are all babies born into this odd globalized marketplace that must somehow function with fuzzy prices.