The Deflation Spiral
Jude Wanniski
November 16, 2001


To: SSU Students
From: Jude Wanniski
Re: The Deflation Spiral

Today's supply-side university lesson is a client letter I wrote ten days ago entitled, "The Deflation Spiral." Questions posted in Talkshop and a flood of e-emails have convinced me to use this piece to clear up some confusion about the process of deflation and the markets' reaction to it. It is important to understand that deflation is a process, not an event. There are reasons the deflation process is long, slow, grinding, and doesn't get discounted all at once by the market. The deflation process will be inexorable, though, if it is not dealt with by Federal Reserve Chairman Alan Greenspan or the political leadership that gives the Fed its powers.



If the financial markets are as efficient as we say they are -- and we also say the DJIA may have to fall another 1500 points before the index equilibrates with gold at $275 -- why then doesn't the market simply fall 1500 points? The answer is that we are in a deflationary spiral and the market only discounts what it sees of the spiral as it receives fresh information about it from day to day. If President Bush were to awaken tomorrow and say, "By gosh, Polyconomics is right, and I'm going to do what Wanniski says and sign an executive order getting gold to $325," there would be 1000 points on the immediate upside as the deflation risks priced into the markets dissolve at roughly 10,400, a bit more if the markets believe there would be a formal gold fix. The market only discounts bad news or good news as it seems likely to happen, assessing those risks accordingly.

If the U.S. economy were not mature, and did not have many contracts extending out 30 years, there would be no need for a spiral. Countries that hyper-inflate have no contracts to unwind. When we were into the early stages of great inflation in the 1970s, after decades of price stability, some economists used the term "wage-push inflation" to describe the process. The carpenter's contract expired and his union won a big increase because commodity prices had gone up. Then the plumber's union saw the increase in commodity prices plus the cost of a carpenter's work and demanded the same wage PLUS. Then to the painters and butchers and bakers and candlestick makers. Only those few economists who understood that the inflation was rooted in the dollar's devaluation against gold could see that the workers were not causing the inflation. When Nixon broke the dollar-gold link in 1971, he also instituted wage-and-price controls, trying to hold back the inevitable adjustment process. Inevitable is the correct word to apply to the current deflationary spiral, unless that lightbulb goes on over the President's head or some other circumstance causes gold to rise. Why inevitable?

In classical theory, there is a saying that you cannot change the terms of trade by changing the unit of account. If an apple trades for an orange when the unit of account is 1, the apple will still trade for the orange if the unit of account is 2. If a carpenter's hour trades for a plumber's hour at 5, they will trade on those same terms if the unit is 50. The same is true in reverse, when the unit of account is deflating. There is a big difference, though, between an apple and a carpenter's wage, as the apple is priced in the spot market and the carpenter's wage is tied to a contract. In an inflation or a deflation, the first response to a monetary error comes in commodities, going up in an inflation or down in a deflation, with gold leading the way. If gold had fallen for the last five years without being followed by other commodities, we could posit that for some external reason there was simply a glut on the market. We could say it was no longer playing its traditional role as the best proxy for all commodities, the commodity money par excellence, as Karl Marx put it best.

We then consider that if a carpenter's wage buys 10 apples when the unit of account is 5, the terms of trade will not change if the unit is 50. The only difference would be that because of the wage contract, the period of adjustment would be longer before the terms of trade corrected to proper balance. If you add in leases that last for years, sometimes decades following a long period of gold-dollar stability, the adjustment spiral will take a very long time. Classical theorists also spoke of the "veil of money" that obscures the adjustment process going on around us, as apples, oranges, butchers and landlords inch their way back to equilibrium.

We now see a small breakthrough at the NYTimes -- where Chief Financial Correspondent Floyd Norris for the first time has sniffed "a whiff of deflation." So has Morgan Stanley's Stephen Roach, who Monday sent clients warnings of "Rising Deflationary Risks." Both Norris and Roach, though, remain in a demand model and do not understand the origins of the deflationary process that has wrecked American commodity producers from 1997 onward. They now are sniffing it because it is moving under their noses to the bulk of the contract economy. Stephen Roach says "recessions are deflationary events," which is true ONLY when they begin with a fall in the gold price. Most recessions here and elsewhere have been "contraction" events, usually caused by fiscal shocks to the system. It is possible to have a contraction and a deflation simultaneously, which is what is happening in Argentina. If the dollar were tied to gold at an optimal rate of exchange between the two, where the contract problem is minimized, there could not be an inflation or a deflation. If other countries large or small then were to tie their currencies to the dollar, they would not experience inflation or deflation either. Depending upon their circumstance, they might have an adjustment period of more or less expansion. To escape from the boom, countries would have to do bad fiscal or regulatory things to their systems. The stable money would be working for them.

There are some clients wondering if the end of the stock market adjustment may be just around the corner, and if it might be time to buy. There are some supply-siders who differ with my analysis who are saying just that. Those who do still are making the mistake of thinking that if the price of gold/commodities stays at the same level for three or four years, almost all the adjustment will only take that long. They will then translate that hypothesis into a recovery on Wall Street sometime soon, as the gold price is now at its average level for the last three years. The nominal value of equities still has a long way to fall in this spiral, though, because markets are discounting not the end result of the deflation, but the ever-changing process of adjustment. It is always an efficient market in that sense. It will not fall further or faster than it needs to on any day of the week or month, because there is always the chance someone in charge will see the light and halt the "deflation monster" as it tromps toward us. Most of the deflation process in the non-commodity sectors is still ahead of us, not behind us.

Instead of reducing prices for finished goods and services, a company's first move is to increase the size of the candy bars or tissue paper or cereal box or the size of the steak dinner in the restaurant. Autos and furniture are given away for the first year, no interest. The hard part comes with wage adjustments, either with layoffs of folks and bankruptcies of firms that reorganize with a lower wage/pension structure, or with "give-backs" on union contracts or non-union pay schedules, as workers realize their paychecks are worth more with each passing day. Cash in a mattress gains in purchasing power along the length of the spiral, which is why Milton Friedman is so wrong in praising Alan Greenspan for stuffing so many "M's" into the banking system, as he did on the Reuters wire today. This can only mean a boom next year, says the Nobel Laureate!! Wrong again, Milton. The Fed can cut the funds rate to zero and the Congress can spend itself silly and cut taxes too, and the price level will still have to spiral... downward.