A Review of Our Deflation Analysis Jude Wanniski September 25, 1998

For 20 years we have been watching the dollar gold price as a pure signal of the economy's demand for dollar liquidity — currency and bank reserves. From 1978, when Polyconomics was founded, until 1982, we wrote about the need to expand the demand for liquidity through tax cuts as preferable to reducing the supply of liquidity by the Federal Reserve in order to combat inflation. In early 1982, we published our first treatment on the problem of deflation, which we believed only could be satisfactorily resolved by increasing the supply of liquidity.1 This was in a client letter in which I argued: "The deflation we are now experiencing is not obvious at first glance because the general price level is still rising as measured by the conventional indices. The best index to use as a guide to the dollar, and whether it is inflating or deflating, is the dollar price of gold...It is the proxy for all goods and services, present and future, whereas the wholesale and consumer price indices track only current prices. Gold, in other words, embraces the dollar valuations of goods and 'bonds,' i.e., financial assets. In this sense, the world is now and has been on a gold 'standard' by which the markets assess the shifting relationships of paper currencies against the premiere monetary commodity."

It is this hypothesis — that the world never left the gold standard, only the governments of the world -that led us to warn Fed Chairman Paul Volcker in February 1982 of the dire consequences of a deflation that everyone else was viewing as a positive "disinflation." I told him in a telephone call to his office that with gold at $310 he had to add liquidity to the banks in order to prevent bankruptcies of people and Institutions around the world whose debts were in dollars. Only two years earlier, in 1980, the gold price had averaged $600. The rise to that high level was the result of the Volcker Fed supplying bank reserves at a time the demand for reserves was in steep decline because of the contractionary effects of President Jimmy Carter's credit controls. The Fed in late 1979 continued to add reserves while "the money supply" as defined by the monetarists remained sluggish. As it did so, gold continued to climb and briefly got to $850/oz. on February 1,1980. In a client letter I wrote December 20, 1979, "Volcker Dinner," I reported on a small dinner party in Manhattan at the Lehrman Institute the night before. At the time, gold was trading above $490:

Volcker opened with a 15-minute rambling discussion about how he really is serious about controlling the monetary aggregates, and that the new numbers are even a bit more restrained than the targets. Interest rates will come down when the inflation psychology is broken; he won't bring them down. He worries about the rising price of gold, but says it doesn't dominate his concerns, and he thinks it mostly has to do with [the outbreak of war between Iraq and Iran]. He talks about eventually having a "well-constructed tax cut," but the time isn't right. First have to bring down inflationary expectations.2

The price of gold hovered above $625 through August. It wasn't Volcker who caused the tightening as much as the prospect of Reagan's victory over Carter. The demand for reserves began to expand in September of 1980 as the market began to price in the likelihood of a victory by Ronald Reagan, who campaigned on a platform of income-tax rate reduction based on the legislative proposal of Rep. Jack Kemp of New York and Sen. Bill Roth of Delaware. As the demand for liquidity was not met by a fresh supply by the Volcker Fed even after the tax cuts had passed into law, the price of gold continued its decline and hit $425 by Labor Day 1981. Observing the expansionary effects of fiscal policy and the contractionary effects of monetary policy, Yale's James Tobin said it was like a train in New Haven, with an engine on one side pointed to New York and another at the other end, pointed toward Boston.3 In the next 12 months, the power of the deflation overwhelmed the phased-in tax cuts. Gold continued its decline to the point where I felt compelled to call Volcker and warn of global depression unless he acted, that he was presiding over a monetary deflation — not "disinflation." The monetarists, who dominated monetary policy in the Reagan administration, insisted that the monetary aggregates pointed toward continued inflation, and that monetary ease would cause a collapse of the bond market. The government of Mexico forced Volcker to act when it informed its dollar creditors — the big banks in New York and San Francisco — that they could not make their interest payments. The price of oil had fallen to below $20 a barrel although they had expected it to remain well above the $30 a barrel when they borrowed heavily in 1980. When the Fed was forced to buy $3 billion in Mexico peso bonds so the banks could be paid, the gold price surged above $400 and both the stock market AND the bond market boomed. Finally, the twin engines of monetary and fiscal policy were pulling together in the right direction.

In 1984, President Reagan sought re-election on a platform of tax reform around the proposal of Kemp and Sen. Bob Kasten of Wisconsin. The demand for liquidity picked up again and the dollar price of gold went into a new decline, to below $300, as the Fed would not supply the demanded bank reserves. The Plaza Agreement of 1985 (at New York's Plaza Hotel) ended the U.S. Treasury's "benign neglect" of the dollar, which was so strong against foreign exchange that the U.S. Congress was threatening protectionist measures against Japan. The monetary deflation ended with gold settling at $350, where it centered during the period 1985 to 1993. This was because of the influence first of Fed Governor Wayne Angell, who was sworn in February 1986 when gold was exactly at $350, then Alan Greenspan, who became chairman in July 1987. At the swearing-in ceremony, Volcker told Greenspan he wished he had listened more carefully to Angell's advice. A few months later, the gold price climbed above $350 — almost certainly because a higher capital gains tax had taken effect in 1987 as a result of the Tax Act of 1986 and dampened liquidity demands. Greenspan told Fortune magazine that the dollar would probably have to devalue by 2% a year for a period of years. As this comment was reaching the market, Treasury Secretary James Baker III essentially dissolved the Louvre Accord that promised currency policy coordination with Germany and Japan. The stock market crashed as this double-barreled blast ended expectations that inflation could be ended and thereby remove the tax risk of inflated capital gains. On the Friday before the Monday Crash, Angell told me by telephone that Secretary Baker was "playing with fire."4 Neither Angell nor I knew that Fortune was already circulating with the Greenspan interview. Here is the relevant section:

The biggest inflation threat comes from the dollar. At his confirmation hearing last July, Greenspan made it clear he thought the dollar had stabilized and was not in much danger of falling soon to the 120- to 130-yen-to-the-dollar range. (Lately the yen has been trading at around 145 to the dollar.) There is no evidence he has changed his mind since.

But Greenspan does believe that the dollar is likely to creep down slowly over the longer run. Its value is largely determined by investors the world over who decide what proportion of their portfolios they wish to hold in U.S. securities. The difference between interest rates on, say, ten-year government bonds in Japan and the U.S. tells something about what all these investors expect the future worth of the dollar will be. U.S. interest rates are now around three percentage points higher than Japanese rates. This implies that investors expect the dollar to drift down relative to the yen by that amount each year for the next ten years.5

In the period that followed, Greenspan gave no more interviews, never again suggested a dollar devaluation, and worked closely with Angell to keep the dollar stable — always with an eye on $350 gold. In 1990, when Iraq invaded Kuwait, the gold price shot up to $415 in anticipation of an easier monetary policy by the Fed to offset the contractionary effects of higher oil prices in the Middle East. When the Fed refused to ease, either because of oil or to accommodate the 1990 Bush tax increase that broke his campaign promise, gold again came down to $350. In a recent television interview, former President George Bush offered the view that it was Greenspan who caused his defeat, by keeping money so tight that he, Greenspan, caused the recession that ended the President's re-election chances. It was our opinion that long-term interest rates in the last Bush years were a point higher than would have been necessary if Treasury Secretary Nick Brady had not been incessantly calling for the Fed to ease.

For this reason, even before President Bill Clinton was elected, we forecast a stronger bond market on the assumption that Clinton would win and that he would end White House criticism of the Greenspan Fed. He and his advisors were not going to repeat the soft-money mistakes of the Carter Administration. The new President in 1993 announced that he would not, as promised, propose a middle-class tax cut, but instead would ask for an increase in tax rates on the rich. When Wall Street nose-dived on this announcement, Clinton was momentarily taken aback, but soon was all smiles as he noted the strength of the bond market.

Gold held at $350 for several months of President Clinton's first year, as the long bond entered a long rally that took the yield down to 5.78%. Gold's rise, along with the bond yield, began after the Clinton budget and tax increase passed by one vote in the Senate, with no Republicans joining in. There had been confusion during the budget debate when Greenspan was under pressure by Democrats to promise to "accommodate" the tax increase with easy money. He told the Senate Banking Committee the bond market would not let him, but he was so fuzzy in his answer that the NYTimes reported on page one the next day, a Saturday, that he said he would accommodate the tax increase. We were alone in noting the major discrepancy and urged Greenspan to clear it up. A fuzzy statement was issued by the Fed, not clear enough to embarrass the Times. It was already too late; the Times' story was taken as gospel by the electronic media.

When the price of gold began rising from its $350 level to roughly $385 when the decreased demand for liquidity was not drained by the Fed, Angell urged a monetary tightening. These were his last days at the Fed, though, as he resigned in January 1994 to become chief economist at Bear Stearns. Greenspan watched gold sit at $385 for three months before he decided that an inflation was coming and the Fed would have to strike pre-emptively. He raised interest rates six times in small increments, and the gold price scarcely budged. We advised him that unless he told the market that he wished the gold price to fall, a higher interest rate would not do the job, as the market would think he would raise rates again and that in itself would cause a decline in the demand for liquidity. Only withdrawing liquidity directly would cause the gold price to fall. At Bear Stearns, Angell disagreed with us and with Greenspan, arguing that the Fed should raise interest rates sharply in order to discourage the market from thinking more would be on the way, which presumably would cause an increase in the demand for liquidity and a drop in the gold price. It was in this period that Greenspan began to suggest to us that perhaps gold was no longer the inflation indicator it had been in the past. Otherwise, he seemed to be saying, higher interest rates and slower economic growth would cause a decline in inflation expectations and a lower gold price.

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As 1996 opened, we postulated on January 4 that the budget gridlock between the Republican Congress elected in November 1994 and the Democratic President would somehow find a muddled resolution prior to the presidential election that fall. As the stock market fell and the gold price flirted with $400 on January 5, we surmised that if there were a cut in the capital gains tax as part of a budget deal, "Increased demands for dollar liquidity would generate downward pressure on the gold price, requiring the Fed to steadily bring down the funds rate in order to offset the deflationary bias." The funds rate had been cut to 5.5% in December 1995, which of course helped nudge gold up as liquidity was added to hit the new target. It was cut again in January and gold continued to drift up during the budget crisis until it hit $420 in April and the long bond went to 6.75% and eventually above 7%.

There was no budget deal in 1996, but our January 2 letter of that year forecast the Dow Jones Industrial Average would rise to 6000 from 4800 as the presidential contest shifted to a debate over economic growth instead of budget balance. We based this forecast on the entry of Steve Forbes, who was already forcing Bob Dole in that direction by demonstrating the political appeal of a flat tax, but later in the year we also credited Clinton with signing the Telecommunications bill and reappointing Greenspan. (We said a Forbes victory in November would mean a DJIA of 7000.6 When Forbes dropped out, we predicted on March 15, 1996, that Jack Kemp would be Dole's running mate, having re-established himself as "the active leader of the Reaganauts, a man once again willing to throw the long ball even if it doesn't result in a score." He did this by endorsing Forbes the day after Dole had swept the Southern primaries and seemed invincible: "A week ago, Jack may have been wondering if he might be offered an ambassadorship to Palookaville in a Dole administration. Today, he is vice-presidential material, whether Dole likes that or not.")

There were hawks at the Fed during that season who argued for a rate increase. Although gold was at $383, we said it would be a deflationary move to drive it down to $350 by draining liquidity. It would be preferable to have gold come down to the $350 level through a rise in the demand for liquidity, via a tax cut. Kemp's presence on the GOP ticket could not overcome the electorate's aversion to putting Dole in the White House with Newt Gingrich in charge of Congress. The day after the election, we wrote "The Best Man Wins," November 6, 1996, noting a willingness among Democrats to talk budget compromise in 1997. Two days later, in "Bonds: Moving Toward 6%," we again noted the increased likelihood of a successful growth agenda led by Senate Majority Leader Trent Lott and the impact it would have on bonds: "The bias is for an increased demand for liquidity...which makes it easier to conduct monetary policy."7 By November 11, we noted in "The Clinton/Lott Government," signals that the White House would be prepared to accept a capital gains tax cut for the right kind of trade. On November 15, in "Clinton/Lott Government II," we observed that "Fed Chairman Alan Greenspan has to be as happy as a clam, with gold nudging below $380."

Not happy enough, as it turned out. With all the bipartisan happy talk, the DJIA climbed to 6547 on November 27, paving the way for Greenspan's speech a week later, December 5, in which he warned about "irrational exuberance" on Wall Street. The following day, we noted that Greenspan now has "no maneuverability...to push through a rate cut [even] in the face of the gold price collapse." The Fed was now embarked on fighting the inflation engendered by the 1993 rise in the gold price that followed the Clinton tax increase. We warned: 'The abrupt decline of gold from its long-standing range above $380 indicates that the demand for dollar liquidity is now outstripping supply at the current 5.25% funds rate. In other words, gold trading below $375 for an extended period for the first time in more than three years indicates that the Fed's policy stance is in fact slightly biased toward deflation."8

On December 17, 1996, with gold at $368, we wondered if Greenspan really wanted an excuse "to keep the economy at a weakened level to prevent a rise in the level of real wages."9 Netting out the pluses and minuses, we were bullish: "As long as Senate Majority Leader Trent Lott keeps the GOP unified in Congress and the congressional Democrats in line, there should be a positive tide that pulls the markets up well into the year."

As 1997 opened, our sense was that if there were a budget deal that produced a cut in the capital gains tax, the Dow could hit 7800. As the dollar/gold price would continue to fall to $350, we assumed, the dollar/yen rate would climb to 130, where the consensus of Blue Chip economists did not see it higher than 112 or so. Our forecast was on the money, with only Ed Yardeni of Deutsche Morgen Grenfell close at 128. With a lower capital gains tax increasing the demand for liquidity, "the long bond should weave its way below 6% as Greenspan could get the gold price closer to $350 without deflationary consequences."10 Four days later, we explicitly noted the long bond "looks cheap" at 6.75% with gold trading at a 39-month low, below $360. The mistake was made only in noting that "the $350 level is where [Greenspan] would like to see it stabilize." As it moved toward $350 with no signs of a Fed willingness to ease, the long bond ran up over 6.85% We became fidgety in February as gold dipped slightly below $340, "A Whiff of Deflation" was the headline on our February 12 letter.

The problem we ran into was similar to the Tobin locomotives. The budget deal was moving along in Congress, increasing the demand for dollar liquidity as the real economy began gearing up for a more capital-rich environment. The DJIA hit 7000 on February 18 and our letter the next day, "The Dow at 7000: No Big Deal," pointed out that adjusted for the gold price, the Dow would have to be at 10,000 to equate with its position in early 1966 when gold was $35 and the Dow briefly touched 1000. On February 21, 1997, we agreed with Abby Cohen of Goldman Sachs that the DJIA would remain in a trading range for awhile. "The skittishness in the markets should be with us for the next three or four months, as the White House and the Republican Congress get beyond general statements into the details of budget making." On February 26, the DJIA fell 100 points and the long bond fell 1 1/4 points as we found "Greenspan at His Scariest," telling the Senate Banking Committee that he was now worried that workers would soon start asking for bigger paychecks that would be inflationary.

Gold went back to $350 by March 12 after popping as high as $360. Suddenly, Greenspan took note of gold as it inched upward, even though he apparently was unconcerned on its way down. In the first week of March, when asked what he looks at to detect inflation, he told the National Association of Business Economists that "in order to evaluate where the pressures are on the price level, you have to look at the whole structure of the system." According to Reuters: "Among the data he looks at, Greenspan said, are money supply — 'even with its deficiencies' — gold prices — 'the only truly monetary metal out there which captures changes in price expectations as well as anything we've got' — and the Treasury's new index-linked debt."11 Largely based on careful analysis of these three components, we surmised that the Fed would not raise the 5.25% funds rate at the next meeting of the FOMC. We were wrong. On March 26, we commented on the Fed's decision to raise the rate to 5.5% (where it remains to this day): "Under the Fed's now formalized fine-tuning approach, judgments about incipient inflation will be made based on the policymakers' readings of 'demand' relative to 'growth potential.' In other words, additional rate hikes are a strong possibility until growth slows enough to satisfy Greenspan that the threat has passed. "12

Growth didn't slow. As it became increasingly likely that there would be a budget compromise, the economy continued its expansion. So did the demand for liquidity, which sent gold falling further. In our Global 2000 reports, we began to worry about the dollar deflation being transmitted to other countries that were keyed to the dollar, and thus deflating along with us. Thailand had been trying valiantly to keep the baht tied to the dollar, but we saw they had no choice but devaluation with gold at this level. It was the first of the Asian countries to be hit by the dollar deflation, as we noted in our Global 2000 reports of June 18 and June 26.13 On July 9,1997, we expressed these anxieties as gold hit $320 and wondered if Greenspan were buying the argument of Wayne Angell, now at Bear Stearns, that gold could go as low as $300 without causing harm:

[Greenspan] should resist all such temptations, which simply allow him to rationalize away the fact that the Fed should be supplying more liquidity and isn't. One of the worst effects of gold at $320 is that the Fed's error on the deflation side is being transmitted to all countries of the world, to one degree or another. Small countries that have been tying their currencies to the dollar are dragged into a deflationary squeeze with far greater rapidity than the U.S. itself.14

On July 22, Greenspan testified before the House Banking Committee and triggered a rally in stocks by saying he saw no inflationary threat at the moment. We were troubled by Greenspan's response to a question from Rep. Frank Lucas [R-OK] about $320 gold. It told us that Greenspan knew we were in a deflationary mode, that it did not bother him, and that he reserved the freedom to raise interest rates to fight inflation no matter what the price of gold:

[Commodity prices] become early signals of the process when you begin to see shortages begin to emerge, and you begin to see people starting to trade on those shortages which, if fueled by excess credit, engenders inflation. And the extraordinary decline in the gold price -- which incidentally only is in small part, the result of sales by central banks — what we are seeing now is the obverse, namely an increasing sense of the purchasing power of money, of currency, or for want of a better term, is fiat money. And the implications of that is that inflation expectations generally are falling. In the various surveys which have shown very exceptional increases in consumer confidence in the last year or two, we're now beginning also to see a fairly marked decline in long-term inflation expectations in those surveys.15

At the same time, Greenspan theoretically remained willing to discuss the weaknesses inherent in the Fed's conduct of monetary policy. At a speech at Stanford on September 5, with Milton Friedman in the audience, he said the current regime "is far from ideal," and "we continuously examine alternatives that might better anchor policy, so that it becomes less subject to the abilities of the Federal Open Market Committee to analyze developments and make predictions. Gold was such an anchor or rule, prior to World War I, but it was first compromised and eventually abandoned because it restrained the type of discretionary monetary and fiscal policies that modern democracies appear to value."16

There was no indication from Greenspan that the financial problems spreading throughout Asia had anything to do with Fed policy. Malaysia experienced a 25% devaluation of the ringgit between mid-August and mid-October and its prime minister, Mahathir Muhammad, blamed Jewish speculators on Wall Street. In an October 14 letter to his deputy, Finance Minister Anwar Ibrahim, I explained why Thailand was the first country hit by the dollar deflation:

The other Southeast Asian economies were not chosen by the speculators as the primary target because they were stronger than Thailand at the outset. Thailand's special problem was that it took seriously the advice of Paul Krugman, a prominent American economist, who two years ago toured Southeast Asia warning your countries against "hot money" flows. You wisely ignored Krugman's advice and continued to welcome equity capital, which is what he considers "hot." Bangkok fell for his advice and tightened up on capital inflows, which stalled the country's growth. It became the weak link when the dollar deflation appeared this year. When the baht's devaluation weakened the whole region, because of the interlacing of trade among your countries, the speculative pressures shifted to Kuala Lumpur, Jakarta and Manila.

On October 23,1997, we were the first to label the problem "The Asian Flu," noting that "What began as the sniffles in Bangkok has turned into a widespread influenza," with "no doctor anywhere in sight...who seems to know how to arrest its spread...Our weakest link is the Japanese economy, where old-fashioned Keynesians at the Finance Ministry and Bank of Japan are combating recession with an insanely deflationary monetary policy of close to zero interest rates and tax increases designed to balance the budget. Meanwhile, the witch doctors of the IMF are running amok in the region, demanding tax increases and 'free floats' in exchange for cash."17

In the week of October 20, the commodity deflation picked up steam around the world as gold fell to $309 from $325, we said "almost certainly directly related to the dollar liquidity squeeze in Hong Kong."18 Wall Street experts blamed the Swiss for saying they were thinking of selling gold from their reserves, but why did copper fall 1.7%, aluminum 2.1%, lead 3.6%, with zinc, tin and nickel also in decline? The declines took place on one day, October 27, as the DJIA lost 550 points in a general scare over the Asian crisis.

Two days later, stocks having recovered, Greenspan seemed unfazed, and our October 29 client letter stated flatly: "Alan Greenspan, Deflationist." He testified before the Joint Economic Committee and when Rep. Maurice Hinchey [D-NY] complained the Fed was too tight and the slow growth would be bad for the workingman, Greenspan cheerfully acknowledged Hinchey made a reasonable argument, and in 18 months we would know if he or Hinchey were right. The Fed chairman seemed to be dug in for the long haul, "because he does not see the economic declines getting started around the world. Now we have to wait for the weakness to show up in government statistics before Greenspan will consider an end to his deflation."

In this light, we issued a series of reports judging the bond market would outpace stocks until it was clear Greenspan is prepared to end the deflation. In the 11 months since, the total return on a 30-year bond has been 20%, and we signaled the moves of the trading ranges with fair precision. On October 31, with the long bond at 6.15%, we saw the yield falling even as conventional commentary turned bearish: "With real long-term bond yields still high by historic standards, a substantial further curve-flattening against the 5.5% funds rate appears achievable. Certainly, breaking through the 6% barrier at this point seems within reach."19 On November 21, with the yield at 6.05%, we argued "Bond Yields Still Have Room," and not due to a "flight to quality" because of Asia: "No flight to quality has ever produced the sharp yield curve flattening that the Treasury market has experienced recently, as the whole point of such trades is to embrace the relatively low risk found at shorter maturities."

Our December 3 client letter, "Gold Below $300," expressed growing frustration that our deflation analysis still was being ignored. Five months after our July 9, 1997 warning that the deflation which began in Thailand would spread throughout the world, with Japan the weakest link, the Nikkei was down 4000 points: "In a speech last night before the New York Economic Club, Greenspan laid all the blame for Asia's troubles on Asians and received rousing applause. There is no criticism coming at the Fed from any significant quarter." The Wall Street Journal lead editorial of December 2 urged tax cuts in Japan because its "easy money" policy had failed; we had to point out that the Bank of Japan's balance sheet showed not a single yen of added liquidity in the previous 18 months.20

By December 16, gold was at $285 and the long bond yield was at 5.92%. We suggested in "What's Next for Bonds?" that under prevailing conditions, it could go down another 10-to-15 basis points, but no lower without clear expectations of an easing move. For the next six months we were insistent that bonds would remain in a trading range between 5.8% and 6%, and so they did.

As 1998 opened, we continued to agonize over the monetary deflation, but our annual forecast on January 2 remained upbeat, primarily because Kemp had broken with his other economic advisors and decided to go on the offensive with Fed policy. In our analytical model, there are rarely economic policy changes without a political leader taking a lead. We noted that Ed Yardeni had that day forecast a 5% long bond by the end of the year, "a number...I would have picked if I still had the confidence in Greenspan that I had a year ago." Yardeni's forecasts, though, were heavily weighted by his assumption that the Y2K computer problem would begin affecting the financial markets late in the year. Our forecast was 5.5%. On the DJIA, I was confident it would climb above 9000, but "end somewhat lower, say 8800." Yardeni saw the CPI up 1.4% year-over-year, the lowest number of the 50 economists whose forecasts were published in The Wall Street Journal of January 2.1 could see the CPI under 1 % for the year if gold stayed at $300, but the CPI has become such a poor statistic we rarely pay attention to it anyway.

For the first time on January 3, in Chicago, Greenspan mentioned the word "deflation," but the financial press so mangled the reports on what he said that the relevant sentences were not reported in The Wall Street Journal: "For most purposes, biases of a few tenths in annual inflation rates do not matter when inflation is high. They do matter when, as now, inflation has become so low that policymakers need to consider at what point effective price stability has been reached. Indeed, some observers have begun to question whether deflation is now a possibility, and to assess the potential such a development might pose for the economy"21

As far as bonds were concerned, we never varied from our bullish outlook, while counseling patience in the trading ranges from one step to the next. In "Rangebound," January 26, we said it might take six to eight months before Greenspan would realize he had to ease. By May 22, we saw bond yields itching to get to a lower trading range: "We're now five months into the trading range for the 30-year bond that we anticipated in December, with bears taking over in the vicinity of 5.9% and bulls in the vicinity of 6%... In the near to medium term, at least through July, we'll continue to swing through the current trading range although tending toward more, not less, strength in bonds. As we move further out, current yields are likely to prove a bargain."22

Bonds yields did inch down to a lower trading range, from 5.7% to 5.85% as there seemed more confidence there would be no Fed tightening. On July 20, when the long bond closed at 5.71%, we made another bullish bet and suggested a new range from 5.6% to 5.75%. That call held up until August 13, when with the long bond at 5.65%, we said "significant additional gains for bonds could well be in store. Indeed, we could soon witness the rare sight of the entire bond yield curve inverting relative to the 5.5% funds rate, an event that has previously occurred only as a consequence of prolonged and extensive monetary tightening."

In that same missive, we noted a Jack Kemp letter to Greenspan that was subsequently published as an open letter in The Wall Street Journal. Eight months after his first careful criticism of Greenspan's role in the Asian crisis, his patience was wearing thin: "It is now abundantly clear to me — as it is to a growing number of Americans — that the Fed's tight-money policy is causing some serious financial problems in the domestic and world economy by fighting nonexistent inflation to the point of causing a liquidity shortage. I am growing increasingly concerned that the Fed seems unmindful of the steep decline in commodity prices that is the direct result of the world economy demanding more dollar liquidity than the Fed is willing to supply."23

The rally in bonds of course was assisted greatly by the selloff in equities that began in earnest in late July. The crumbling on Wall Street had already been felt in the lower cap stocks, with the Russell 2000 in negative terrain for the year before the blue chips hit their peak on July 17. On July 28, we noted that Barton Biggs of Morgan Stanley had been predicting a bear market for three years, but his latest call of a cyclical bear downturn now might be correct. "Maybe it will take a few quarters of downtime on Wall Street," we said, "before enough people complain about the domestic costs of deflation to turn Greenspan around. He clearly wants to see the unemployment lines lengthen before he adds dollar liquidity to a world dying of thirst."24
Three days later, July 31, the DJIA fell 143 points or 1.59%, the decline instantly following Senate Majority Leader Trent Lott's statement on the Senate floor that there would be no big tax cut in 1998 and maybe no cut in the capital gains tax at all. NASDAQ stocks were down 2.46% for the day and we noted in our August 3 letter that "NASDAQ stocks of course are more sensitive to capital gains taxation...because they rely more on rewards to equity than the blue chips, which are more sensitive to debt, having the reserves to withstand economic weakness." On August 11, we asked: "How Far Down?" as the stock market decline continued: "Will a DJIA of 7500 forecast a long enough unemployment line to cheer the FOMC, which meets next week to ponder the inflation only it sees? Or will there have to be enough blood spilled to make absolutely sure? How about 7000?"

We finally got what we were waiting for on August 31, when the DJIA went down with a sickening thud, falling 513 points or 6.4%, NASDAQ down 8.6%. We celebrated the event with a September 1, 1998  report entitled "A Kick in the Pants," — to Greenspan of course, saying we believed this was a big enough kick that "the market may have hit bottom." Which it had, exactly. And yet we were careful to say that while the bull market would resume, it would be sluggish, "with the pace of the advance to be determined by the actual scenario that will play out."

Our January 26 estimate that it would take six to eight months before Greenspan would see he had to ease proved accurate, but just barely. Eight months minus three days later, on September 23, Greenspan appeared before the Senate Budget Committee and for all practical purposes announced to the world that the FOMC would vote to ease when it met on September 29th. The stock market greeted the news with a 257-point run-up of the DJIA and a bigger percentage increase on NASDAQ. What prompted Greenspan's request to come before the committee on short notice was the kind of crisis Paul Volcker faced in the monetary deflation of 1982. Long-Term Capital Management L.P., a hedge fund with $80 billion in assets, had become illiquid because of the complexity of its trades and the equity selloff s impact on its highly-leveraged balance sheet. On the verge of collapse, it would have threatened its creditors, some of the biggest trading firms and banks on Wall Street. The New York Fed gathered the creditors at its offices near Wall Street the night of Greenspan's testimony and a $3.5 billion "lifeline" was arranged, with an implicit guarantee from the Fed that it would somehow stand behind the deal. With the big boys meeting atop the huge move that welcomed Greenspan's announcement of ease, the rescue of Long-Term Capital was lubricated.25

We are as yet by no means out of the woods, but it will have to stay a bit scary to keep the Fed on its toes. The problem remains a deflation that will not end unless enough liquidity is added to get the gold price up beyond $325 but not beyond $350, where inflation kicks in again. Little by little, the financial establishment is learning about true monetary deflation — and that it doesn't like it.

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 1 Jude Wanniski, "Deflation," Polyconomics, April 2, 1982. 'The price of gold...is the most sensitive indicator of the dollar as a measure of value. If the monetary authority causes the money supply to exceed the money demand for any reason, it is the price of gold that reacts first by rising, and unless the authority takes immediate offsetting action that causes gold to return near to or reach its previous dollar level, all other prices will eventually rise to equilibrate with the higher gold price."
2 Jude Wanniski, "FYI: Volcker Dinner," Polyconomics, December 20, 1979.1 also advised my clients in the letter that Volcker did not seem to understand the role of gold and would need help if he were to succeed as Fed chairman.
3 Jude Wanniski, "A Monetary/Fiscal Stalemate," Polyconomics, February 3, 1981. The Tobin quote appeared in his Jan. 20 letter to The Wall Street Journal: "If a Volcker monetary locomotive pulls the economy one way while a Kemp-Stockman fiscal engine pulls it the other, will the train reach both destinations, disinflation and expansion?...It's best to be realistic about stagflation. It can't be solved by assigning disinflation to the Fed while tax cuts and defense spending "get the economy moving again.' The train may creep in one direction or the other, but the main result will be higher interest rates, nominal and real."
4 Jude Wanniski, "The Monetarists are Back," Polyconomics, October 29, 1987. "The stock market crash has brought the monetarists out of the woodwork, working to dynamite everything James Baker III has done since the September 1985 Plaza meeting on international monetary coordination. Milton Friedman says recession is on the way and we must sink the dollar and pump up the money supply. His student, Michael Darby, Asst. Secretary of Treasury for Economic Policy, has been telling JBIII for months that 'money is too tight,' which is one of the spurs behind JBIII's threat to the Bundesbank October 15, that triggered the global stock market crash. Fed Chairman Alan Greenspan, who helped set the set this stage by telling Fortune magazine earlier in the week that he saw no floor to the dollar, is also under monetarist influence."
5 Sylvia Nasar, "Why Greenspan is Bullish," Fortune, October 26,1987, p. 30. The interview clearly indicated Greenspan felt no obligation to the Louvre Accord along with a willingness to see the dollar devalue against the yen. Otherwise, the interview offers an excellent view of the wheels and gears of Greenspan* s basic thinking that remains evident today. The most striking feature is his belief that the economy could grow at much faster rates than conventional thinking at the time without pushing up the consumer inflation rate, then coming in at a steady 6% annual rate.
6 Jude Wanniski, "Thinking About 1996," Polyconomics, December 26, 1995. "[T]he DJIA can approach 6000 in 1996. If Steve Forbes is the GOP nominee (and everything else being equal), his clearer commitment to the supply-side agenda could overtake not only Bill Clinton, but a DJIA of 7000." The DJIA hit 6000 on interday trading on October 11.
7 David Gitlitz, "Bonds: Moving Toward 6%," Polyconomics, November 8, 1996. On November 20, in "Gold Below $380," Gitlitz added: "As it becomes increasingly apparent that current market conditions offer little opportunity for gains on long positions in gold, selling pressure could intensify, setting the stage for another break below $375 per ounce."
8 David Gitlitz, "Fedwatch: Greenspan at AEI," Polyconomics, December 6, 1996. Gitlitz added: 'The failure of the open-market desk thus far to conduct its normal seasonal injection of permanent reserves — a "coupon pass" in market parlance — in defiance of expectations, also appears to be adding to the scarcity of liquidity. It bears noting that the DJIA reached its peak of 6547 on November 25, which is also the last day gold traded above $375."
9 Jude Wanniski, "Wall Street: Themes and Variations," Polyconomics, December 17, 1996. We noted that Barton Biggs of Morgan Stanley was worried enough to pull his model portfolio down to 56% stocks from 74%, increasing his cash position to 15%: "If we are right, he will be sorry he did when the new calendar year arrives with its positive realities for equities."
10 Jude Wanniski, "A Springboard into 1997," Polyconomics, January 2, 1997.
11 David Gitlitz, "Fedwatch: Greenspan's Pre-Emption Signals," Polyconomics, March 12, 1997.
12 David Gitlitz, "Greenspan's Rate Hike: One Shot, or First of Several?" Polyconomics, March 26, 1997.
13 Liz Carver, 'Time Runs Out on Baht," Polyconomics, June 26, 1997.
14 Jude Wanniski, "Gold at $320," Polyconomics, July 9, 1997. In the same client letter, we noted that Japan was being squeezed unmercifully by the dollar deflation: "Pity the Japanese, who are tightening at the Bank of Japan even though the yen gold price has been plummeting faster than the dollar's, to ¥37000 from ¥44000 since April, a 16% fall. The Japanese government has been trying to appreciate the yen for political purposes, to satisfy the U.S. Treasury, at exactly the time the dollar has been appreciating because of unmet legitimate demands for liquidity. The pain in the Tokyo financial structure must be excruciating. Gold would have to go at least above ¥40000 or [T]he alternative is a steady decline in the Nikkei."
15 Jude Wanniski, "Greenspan's Missed Opportunities," Polyconomics, July 24, 1997.1 expressed frustration that members of both House and Senate Banking Committees failed to ask him why, by his own personal gold rule, he was not calling for monetary ease: "Sen. Connie Mack [R-FL] began to ask, but like Rep. Lukas a day earlier, let him off the hook.*'
16 Jude Wanniski, "Greenspan's Stanford Speech," Polyconomics, September 9, 1997. In another passage, Greenspan hinted at the need for gold as an accounting unit even in a modern world of rapid technological change: "No matter how complex individual products become, there will always be some general sense of the purchasing power of money both across time and across goods and services. Hence, we must assume that embodied in all products is some unit of output and hence of price, that is recognizable to producers and consumers and upon which they will base their decisions."
17 Jude Wanniski, "The Asian Flu," Polyconomics, October 23, 1997.
18 Jude Wanniski, "Discounting a Serious Deflation," Polyconomics, October 27,1997. "We are sure Fed Chairman Alan Greenspan knows he should be increasing dollar liquidity, to prevent the slow implosion of the world economy, but the fed funds rate of 5.5% does not permit him to add liquidity...If the stock market falls another 500 points, he will be begged to open the spigots...The problem with that is he should not be easing to help the stock market, but to correct the deflation, the opposite of the '87 problem he faced."
19 David Gitlitz, "Stocks & Bonds: Two for the Seesaw," Polyconomics, October 31, 1997.
20 Jude Wanniski and David Gitlitz, "Gold Below $300," Polyconomics, December 3,1997. We note that for the first time Jack Kemp joined in our criticism, having issued "a carefully worded statement expressing 'concern' that with the price of gold falling below $300, our monetary policy may be exacerbating the economic turmoil in Asia and parts of Latin America." On FoxNews Sunday of December 28, a more confident Kemp told interviewer Tony Snow that the Asian crisis might not have occurred if Greenspan had used the $350 gold price to argue for additions to dollar liquidity.
21 Jude Wanniski and David Gitlitz, "2'/4 Cheers for Greenspan," Polyconomics, January 5, 1998. "Here Greenspan reminds his audience that while the Fed can target price indices when inflation rates are high, the flaws outweigh the benefits when rates are low. Because we know Greenspan has publicly stated his belief that the Consumer Price Index overstates the annual inflation rate by more than a percentage point, he is telling us that deflation may already be upon us...The bond market had no trouble reading the speech. For the first time since May 1995...the yield on the two-year note — at about 5.45% — has dropped below the funds rate."
22 David Gitlitz, "Adventures in the Trading Range," Polyconomics, May 22, 1998.
23 David Gitlitz, "Fedwatch: Foreshadowing a Turn," Polyconomics, August 13,1998. The Kemp letter to Greenspan was published in its entirety in The Wail Street Journal of August 17.
24 Jude Wanniski, "Cyclical Bear Market?" Polyconomics, July 28, 1998.
25 Jude Wanniski. "At Last, Greenspan," Polyconomics, September 24, 1998. We noted that the first straw in the wind came from London, where New York Fed President William McDonough came over the Bloomberg wire at 9:54 a.m., Sept. 22, saying that while a week earlier he was not worried about the economy, he now was concerned about its possible illiquidity. The Wall Street Journal of Sept. 24, reporting on the extraordinary rescue of the hedge fund, noted that McDonough had flown that night from London to New York for the meeting.