It’s
been six months since the once invincible US economy has plunged
into significant weakness. A recession has yet to take place,
nor is one inevitable or even likely, although it remains a
significant possibility. What is especially alarming is the size
of the downturn: the economy has gone from 5% real growth to
almost 0% very, very quickly.
The ongoing downturn should be kept in
perspective: the economy has leveled off for the time being, and
most of its fundamentals remain strong.
Unfortunately, the most alarming aspect of our current
woes is the fact that few analysts attribute our economic
problems to its true source. Bob Novak recently wrote that Alan
Greenspan was flummoxed by the weakness in consumer confidence
in spite of respectable spending levels. What could explain this
discrepancy? What’s going on?
In
a word: deflation.
The
term deflation at its most basic level means the opposite of
inflation, which is what worries economic watchers most of the
time. Inflation can be described as a situation in which too
much money chases too few goods. Conversely, deflation is when
not enough money chases too many goods. During a deflation, the
money in circulation is insufficient in satisfying all the
exchanges that are occurring in the economy at any given time.
It is not unlike a runner that cannot go faster or farther
because he does not have enough oxygen to breathe.
Inflation
tends to occur with far greater frequency because of the
temptation for central bankers to print more money in an effort
to cure a recession, or fund a war, or bail out a politically
connected investment group that loaned out far too much dough.
Deflations often occur by accident, or when the central bank is
so overzealous in avoiding inflation that they end up causing
the opposite problem. During inflation, the dollar in your
wallet loses its value as a unit of account, so people who work
and save and do the right thing see their efforts vanish before
their eyes. During
a deflation, the dollar in your wallet actually increases in
value, and just holding onto the dollar actually reaps a small
return on investment.
We
have been in a global deflation for a few years, as a
consequence of the policies of Fed Chairman Alan Greenspan. Put
simply, he has not provided sufficient liquidity (currency and
bank reserves) into the US economy, and by default the world
economy, which uses the US dollar as the monetary standard time.
This had some positive repercussions for the US economy for a
while, as ours is a service economy that likes lower prices.
However, the lower prices have been devastating to food and
commodity producers. Furthermore, the deflation contributed to,
and may have even caused, the Asian crisis in 1998, as
overextended banks saw many of their investments default, which
in turn caused an economic meltdown. (A deflation favors
creditors over debtors, but creditors cannot benefit if they
can’t get their loans repaid.)
What
about higher energy prices? Well, if you recall, the price of
oil hit $10 a barrel in 1998, and gas was less than $1.00 a
gallon in some places. But this caused oil and gas companies to
cut back in exploration and production, and the stuff does not
come out of the ground without a lot of investment.
Consequently, there was an insufficient supply of the stuff to
meet growing demand, which is why prices are so high.
The
incontrovertible evidence that proves a deflation is occurring
is the gold price. Remember, gold is the incipient indicator
which determines whether there is too much or too little
liquidity in the US and world economy. Gold always has and
always will tell us the overall state of our monetary system,
because gold is the commodity that has served the world since
the dawn of civilization as measuring the value of every other
good and service on the planet.
Gold
stands at $260 an ounce at the present time, when the optimal
price should be between $300-$350, based on calculations of what
the price level would be in equilibrium, without inflation or
deflation. Until Greenspan and company put more liquidity into
the system, however, the price of gold will remain lower than
its optimal level, and the deflation will remain. This means the
Federal Reserve must supply the necessary liquidity by
intervening in the market without focusing on the interest rate
alone.
Cutting
interest rates have not helped matters so far. Although cutting
the federal funds rate, which is the primary instrument at the
Fed’s disposal, can reduce the cost of credit, it has an
indirect and sometimes unintended effect on the liquidity in
circulation. Indeed, in the past months the Federal Reserve has
actually had to take money out of the system in order to meet
the lower federal funds target. The interest rate cuts have
increased the demand for liquidity more than they have increased
the supply of liquidity, and so the interest rate cuts have
actually been tightening monetary policy, the exact opposite
of what the interest rate cuts were intended to do!
This
is a lot to chew on, I know. However, understanding monetary
policy is not impossible. Once you understand monetary policy,
you will be able to understand not only what is happening around
the world, but how to create the conditions to improve the world
as well. I assert that there is no way to underestimate the good
that will come to the world when the dollar links itself to gold
once again.
I
highly recommend that everyone read the following:
Jude Wanniski: A
Gold Polaris
Bob Novak: Snap
Out of It, Bush
Jude Wanniski: No
Reason to Hold Equities
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Deflation; Why It's Coming,
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