Taxes and Deflation
Jude Wanniski
August 28, 2001


Memo To: Bob Novak, Chicago Sun-Times
From: Jude Wanniski
Re: 10 Runs, 10 Hits, 1 Error

Nice column on “Dr. Greenspan’s Medicine,” except for one error. Cutting the capital gains tax will not increase the supply of liquidity in the system. It will increase the DEMAND for liquidity.... and when it is not supplied by the Fed, the price of gold will fall and the deflation will be worse!! You should be careful in following the logic. If state and local taxes are reducing the demand for liquidity, there will be more of it in supply, and the price of gold will rise. A big tax increase would end the deflation, but replace it with a contraction. See? The only way to solve the problem is to devalue the dollar against gold.

Your column also makes it appear that in 1996 I forecast the deflation that is "coming," when in fact I forecast the deflation that began in 1997, first hitting commodity producers, now catching up to the rest of the economy. Real property has already taken a hit in commodity producing areas. Angell does not understand deflation if he says there is only a 15% chance of a decline in real property prices in the other sectors. There is a 100% chance. Note Larry Lindsey saying laid-off workers are being rehired at slightly lower wages. When they run out of home equity to borrow against, they will have to walk away from their mortgages. The adjustment process to a monetary deflation is automatic.

I talked to my Mercedes dealer this morning when I dropped the car off for service. He tells me they are having to discount to move cars and their profit margin has shrunk to 6% from a normal 18%. He agrees that other carmakers have had to give their cars away to make room for the new models, and the result has been a collapse of the used car market.

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Robert Novak August 27, 2001

Doctor Greenspan's medicine

WASHINGTON -- The Dow-Jones Industrial Average, which had been gingerly climbing upward last Tuesday afternoon, plunged the moment the Federal Reserve reduced short-term interest rates another one-quarter of a percentage point. That anomalous occurrence prompted worried financiers and economists to repeat the question they have asked all summer: Why has Chairman Alan Greenspan's monetary strategy failed? Tuesday's drop in the Dow reflected the market's lack of confidence in Doctor Greenspan's medicine. The seventh reduction in the federal funds rate voted this summer by the Federal Open Market Committee (FOMC) might have pleased investors more had it been for 50 basis points instead of 25. Shortcomings by the central bank, however, are coming to be seen as qualitative rather than quantitative.

Erstwhile Greenspan champions are now admitting the hard truth. The FOMC's tactics are no more effective than were the Bank of Japan's repeated interest rate cuts a decade ago. To avoid an economic disaster, there is increasing belief that the Fed should start fighting deflation by targeting commodities. Gold? That is not a fashionable target, but a basket of commodities including gold might be.

Wayne Angell, chief economist at Bear Stearns and a former Federal Reserve governor, is a friend and admirer of Greenspan who believes that the American economy depends upon the longtime Fed chairman. Nevertheless, he is blunt about Greenspan. "I think he needs to be more
forceful," Angell told me.

Angell explains how seven interest rate cuts totaling 300 basis points can have so little impact. With an anemic equities market, funds are being stuffed into the 21st century version of the mattress: interest-bearing, risk-free accounts. So, the heavy M-2 money supply figures that delight monetarists are no help in reviving the economy. In Angell's opinion, Greenspan is still running a tight money policy despite all the interest rate cuts.

That opinion is growing. Robert L. Bartley, editor of The Wall Street Journal, startled the financial community with what he wrote in his influential column last Monday. Bartley had not joined the chorus criticizing Greenspan and still hasn't. Nevertheless, he suggested that "perhaps something has gone awry." He perceives what Greenspan and Bush administration policymakers stubbornly refuse to recognize: the specter of deflation.

Bartley sees hope in recent easing of the dollar ("Perhaps (it) ... is the first sign that Chairman Greenspan is one step ahead of the deflationary demon.").

Supply-side consultant Jude Wanniski, Bartley's former colleague, disagrees. Wanniski forecast the coming deflation in late 1996, and now he sees the slightly lower dollar against gold as a false dawn -- caused by increased state and local taxes resulting from reduced surpluses.

Indeed, if Democrats in Congress have their way in rolling back President Bush's tax cuts, the price of gold will be boosted the wrong way. A national tax increase would, Wanniski recently told his clients, produce "a decline in the demand for liquidity and a concomitant increase in the gold price. The deflation would be replaced by a contraction."

In April, Wanniski advised Treasury officials to watch deflation's impact on automobile sales. Thus, when the Ford Motor Co. announced Aug. 17 that it plans to curtail auto production this autumn, that sounded like the major prop of the American economy starting to collapse.

Angell long has feared an even more frightening prospect: deflation spreading to still-healthy real estate. A high-ranking administration official recently asked him what the chances are for that catastrophe. The reply: 15 percent.

That is much too probable. A real estate collapse would signal deep recession while the Republican administration and Democratic Senate engage in scholastic debate over federal bookkeeping practices and Bush makes unsubstantiated predictions of 3.2 percent growth next year. If the president would drop his resistance to Senate Republican Leader Trent Lott's proposed capital gains tax cut, the resulting liquidity would strike a major blow against deflation.

Without requiring congressional action, however, Greenspan could instantly cut through the gloom. To fulfill the hopes of his admirers Wayne Angell and Bob Bartley, he must shrug off the suffocating, secretive Federal Reserve apparatus (where seven out of 12 regional bank presidents apparently still see the inflationary bogey man around the corner). Alan Greenspan could still redeem his glittering reputation after two very bad years.

©2001 Creators Syndicate, Inc.