When Does it End?
Jude Wanniski
June 28, 2002


Memo To: SSU students
From: Jude Wanniski
Re: January letter to clients

This is a letter we sent to Polyconomics clients on January 17. We're not always right, but we have almost always gotten the direction of the markets and economy right in 24 years of using a supply model for guidance. The collapse of Worldcom this past week is a perfect example of a company sweeping its problems under the rug, hoping the economy would recover in time to save it from anyone noticing. Enron and Worldcom are both victims of the deflation, but they don't know they are because the government and the press corps persuaded the business world the economy would recover.

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This is the big question we get every day. When will the Bush administration realize it has to deal with the deflation instead of waiting for the mythical recovery on which it has been counting? One would think with the market’s sharp slide these past several days that someone in a relatively high position would get nervous enough to publicly propose a policy change in the right direction. But that is not always the way the world works. I recall that the 1936 Republican platform condemned President Franklin Roosevelt for not enforcing the Smoot-Hawley Tariff Act as aggressively as they thought he should!! Bad ideas die hard.

The carnage and fallout from the collapse of the Argentina economy is a grim reminder that when things go from bad to worse they can go even further. Christopher Ecclestone, who lived in Argentina for ten years prior to joining Polyconomics in 2001, says things are so bad in Buenos Aires -- with the financial system totally frozen -- that the military does not want a takeover because it would not know what to do. With the best minds in the world supposedly working on the problem, including the top economists of the Bush administration and the IMF and the top bankers of the United States and Spain, they have collectively driven a modern economy with a highly-educated work force into the Stone Age. The IMF/World Bank agents did the same for Yugoslavia, hammering it with Ivy League advice a dozen years ago until the economy was destroyed, scattering its bits and pieces back into the 15th century where ancient tribal forces killed each other for what was left.

The Wall Street Journal, which supported the IMF “shock therapy” policies in Yugoslavia and in Russia as well, finally decided yesterday that Turkey should “stay away from the IMF” or its crumbling economy will also re-enter the Middle Ages. The Journal urges Turkey to follow Russia’s lead in slamming the door on the IMF and adopting supply-side policies! We note the Journal years ago adopted Turkey as a house pet, because it is a rare Islamic democracy, but thus far has been turning a blind eye to the IMF’s wrecking crew in Istanbul. It is nice to finally see some outrage! It is also encouraging to see Paul O’Neill muttering about the IMF, the first Treasury Secretary in memory to carp openly about IMF policies toward the developing world. To date there is only huffing and puffing, but they are at least hopeful signs.

Hopeful, but they have nothing to do with the deflation. The inexorable drag of the deflated dollar has been passing directly under the noses of the Journal and our Treasury Secretary. But they not only do nothing about it, they say nothing about it. And the reason for that is because it is not now inside their box, as the saying goes. I have been advising the Journal editors for five years about the path of the deflation, but once they rejected the argument, it was almost totally ignored. I have been advising the Bush administration for a year that this process was underway and that it would become more painful as it unfolded. Yet, I have also known that nothing would be done until the President became aware that it was his problem. When Enron’s Ken Lay called various Bush Cabinet officers last fall, warning of trouble, they did not tell the President because the warnings were not taken all that seriously. That is the way things work. If the President’s Cabinet is not fearful and the press corps is unconcerned, the Leader of the Free World does not realize there is a Deflation Monster gnawing away at the economy until he stares it in the face.

In this instance, the problem continues to be the most powerful economic player in the administration, the chairman of the National Economic Council, Larry Lindsey, who is at Mr. Bush’s elbow in the West Wing of the White House, practically cheek by jowl. Lindsey was on CNN’s Novak, Hunt and Shields show last weekend, where Bob Novak noted that both Jack Kemp and Jude Wanniski had been warning that the economy is suffering from a monetary deflation and that neither tax cuts nor interest rate cuts would end the recession. “Quite the contrary,” said Lindsey, “I think textbook economics has worked....Hey, textbook economics work the first time. Let’s use textbook economics a second time.” This is of course no textbook recession and Lindsey’s Harvard textbook is hopeless in confronting one of the rarest of economic maladies.

If and when the President loses confidence in Lindsey, there would be an opportunity for policy change. The nature of the problem, though, would require a paradigm shift by Fed Chairman Alan Greenspan. Remember that while it is an easy problem to solve once the decision is made to solve it, it does take political will to make the shift. Paul O’Neill and Greenspan go back a long way and presumably are on the telephone several times a week in addition to their weekly lunch. O’Neill’s comment yesterday that things are looking up and that he hopes Greenspan soon will have to think of raising interest rates to slow an expanding economy shows us how little hope there is at Treasury, at the moment. Greenspan himself must have nagging internal doubts about the prospects for recovery. His recent speeches and comments clearly advised the markets not to expect a recovery, which is why the bond market has rallied so sharply in recent days, no longer pricing in 200 bps of interest rate increases hammered bond prices in November/December.

We do know Glenn Hubbard, the chairman of the President’s council of economic advisors, understands there is a deflation process underway here, as well as in Japan. He has less clout than O'Neill, though, when it comes to advising the President. His office is only a few hundred steps from the Oval Office, but might as well be in Baltimore, as Hubbard has to get past Lindsey to counsel the boss. Hubbard has been successful in helping convey to the Japanese the administration’s interest in having it end its deflation with a cheaper yen. That might be a promising avenue to influence an end to the deflation here, but the Tokyo government faces angry trading partners in Beijing and Seoul, who believe the cheaper yen is allowing Japan to steal market share from them in Asia. The yen has eased to Y132 and we expect it to sit there for awhile, as the respective governments get used to that level before the yen can move toward the implied target of Y140.

Given these glacial variables, you can see the climate for policy change in the near future does not appear likely. The Enron scandal does not help move things along, even though we believe Enron would not have happened if the deflation that began five years ago did not confound their speculations in the energy markets. We need a gold standard, and so does the world, to prevent these kinds of excesses, which always lead to corruption, as with the S&L scandals. In his remarks yesterday in New York at a Fed numismatic exhibition, Greenspan was hardly encouraging, boasting that he has been able to successfully manage the dollar as a fiat money because it remains the most important international reserve currency! We come to expect the electorate itself to force change when it feels the pain, but the polls indicate it thinks things will soon improve. There may be more discontent by the November elections if, as we believe, things will go from bad to worse. Will the deflation then end? Maybe, but maybe not. Someone at the top will have to break out of the box before change can occur, and that might take months, or longer.