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16 August 2001

Memo To: Jude Wanniski
From: Ed Bugos, The Goldenbar Report
Re: Hot Air and Voodoo Economics

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Below is a reprint of our recent email communication, which resulted from my memo to you yesterday, on Monetary Deflation.

You replied that:

Wanniski - Deflation is when fiat money becomes scarce relative to gold, the best proxy for real goods. When the dollar began its deflation in 11/96 from the $385 level to the current $275 level, I warned that the price of oil and other commodities would follow. They did. If they had not, you would have been correct and I would have been wrong. Your commentary is in a monetarist framework whereby you simply measure some M quantity of money and conclude that because M has risen, we are inflating, not deflating. This is not helpful to policymakers or to investors. If you would like to make your comments in TalkShop, please proceed, but I do not think they have much utility.

This riposte offended me a little, the sensitive guy I am, and provoked the following reply to you:

Bugos - But fiat money is not scarce relative to gold. And that is a FACT. Thus, the utility of your comment is as wrong as your use of the term deflation. The price of oil collapsed in 1998 because in the 4 years prior, OPEC did a lot of cheating, and then by 1997, the strong dollar collapsed the Asian currency regime and killed global demand. All the commodities fell in dollar terms between mid 1997 and mid 1999. But the continued monetary stimulus continued to stoke prices while the strong dollar policy eventually turned the supply glut into a shortage... the same thing it is doing in the gold market, which is why gold actually is scarce relative to fiat money.

Then after I told you how disappointed I was in your reply, you replied by saying:

Wanniski - how can the dollar be strong, sir, and fiat money not be scarce relative to gold? The whole point of a gold standard turns on gold's acceptance as the closest thing to being money in the commodity universe. If there is one too many dollars (which pay no interest), at the margin someone will prefer gold (which pays no interest), which becomes relatively scarce given the surplus of dollars. That's inflation. If the bank is stingy with supplying dollars, they become relatively scarce relative to gold, and the gold price declines. This is what enabled me to predict the decline in oil and commodity prices. I did not mean to offend you when I said your framework has no utility, only that it is not internally consistent. I'm happy that you have a good forecasting record nevertheless. It may be that you at least follow gold and have an instinctive feel for the market. Intellectually and logically it is not acceptable, with so many loose ends that you must ascribe the decline in the oil price to $10 from $25 to OPEC cheating. That's a new one on me.

My friend at SafeHaven, Bruce Stratton, was right. It certainly is time to get braver. What ever happened to the real world?

I am flabbergasted that you insist on telling me that fiat money has got to be scarce relative to gold simply because I agree that the dollar is strong. That is wrong on so many accounts that I don't know where to begin. First, relative to gold, it is not as strong as all that. You are using one convenient time period to make your case against the strong dollar.

Relative to gold, the dollar continues to depreciate, in the long term. In the short term, while the dollar index (a trade weighted average of fiat exchange rates) has soared 21% since January 1999, gold prices have lost only 3% against the dollar. It is no accident we choose this period. January 1999 is when the CRB bottomed out, which incidentally is still up about 5% against the dollar, even with gold included.

We have made the case that dollar policy is the mechanism by which the Fed is able to export its inflation to the nations with the weakest currencies, and a good look at the inflation rates in these countries supports our hypothesis. The point being that a discussion of the strong dollar needs to be "understood" in a broader perspective than just in terms of gold. Your dependence on this one relationship is far too simple minded for the real world, despite the fact that you are (one of) the author(s) of The Way the World Works.

Second, we are pretty careful to follow the strong dollar with the word policy, as is intended by the nation-state you live in. There is less ambiguity that way, which is why the only thing that a Treasury secretary ever says is that the strong dollar policy hasn't changed.

Moreover, as you must know, investment demand does not conform to the classical shape of the demand curve. It has been shown that it is indeed possible to have a rising quantity of a particular asset, paper or hard, accompanied with a rising nominal value for it.

I am hoping, for the sake of your own credibility, that you do not need examples of this?

The strong dollar, as we discuss it, is in relation to other fiat currencies, and it is the policy that we normally discuss when we say strong. By itself, the statement "strong dollar" is meaningless and inaccurate.

Nonetheless, the value of the dollar in relation to other fiat paper is subjective, and so it has been strong rather subjectively. As far as objective value, the dollar's recent record has also been poor, except again in this period of time you like to focus on where the inflation that the Fed produced showed up in asset prices and, in those nations that subsist on competitive devaluations, goods prices as well.

We have made the case that the Federal Reserve System, which is in charge of the global capital base, had maximized the dollar's marginal utility in regard to inflating assets, by the first quarter of 1999, roughly when the CRB bottomed. Since then, the ability of policymakers to contain the inflationary byproduct of their policies has been compromised by the sheer over-inflation of the money stock… yes this does happen.

The last six months are moot because the indexes are higher than their 1999 lows, and because the retracement is only corrective in nature. My prediction for you now is that gold will rise over the next three to five years, money supply will continue to grow, and so will interest rates continue to rise.

A break down in the Machiavellian dollar policy will be responsible for a breakout in inflation, not an aggressive Fed because the Fed has already been aggressive, for the past 14 years.

Please sir; let's establish a few facts… so that we can anchor this discussion:

  1. A discussion of the concept of scarcity involves a relationship of quantities, not just prices. Prices are only signals, if they can be trusted, which they cannot if there exists almost any kind of market intervention
  2. The credibility of your analysis, "in" a hypothetically free gold market, proves that there exists the motive for the Treasury to target gold prices in developing dollar policy
  3. To compare the value of the dollar, and measure inflation, in terms of only gold is a pretty good example of linear thinking
  4. Inflation is a loss in the purchasing power of the currency. Gold, while imperfect, is perhaps the best measure of that, as well as other things. You missed a step there when you said that inflation "is" a rising gold price
  5. Oil production soared from 1993 to 1997 (see article), before collapsing in 1998.

As I read your comments I couldn't help but notice how you mentioned your correct prediction of the decline in the price of oil, just before you poked at me for bragging about my forecasts. Perhaps, you too have a good feel for that market. But to be honest, I doubt it because you have never heard of this practice, which OPEC is often blamed for: cheating.

The fact is that oil production soared from 1993 to 1997, according to the Energy Information Administration.

Source: EIA

The EIA calls this demand, but according to Say's Law, supply creates (is) demand.

When oil prices were at $11 a barrel (nearest contract) back in early 1999, we saw that as the result of two things, before we predicted that they would turn around: OPEC countries did cheat in the prior cycle, which did in turn ruin the organization's credibility. Second, in late 1994, or early 1995, the makeup of dollar policy changed.

We can argue about the variables, but not the change in behaviors on foreign exchange markets. One of the key policy maneuvers at the time was a small change that the Federal Reserve made, and which allowed the banks to avoid marking to market their bond portfolios, for Wall Street. It may have even been you who had pointed it out at the time.

This was very bullish for stocks, and the dollar. And with that, the foundations of the new economy were born with an increasingly imperialistic currency policy at the helm. We do not need to confirm this judgment with an academic review; its history is already printed in my charts, and you write about it every other day yourself. The result was a global recession in demand. The dollar easily soaked up excess global purchasing power and the price of oil in dollar terms collapsed.

The supply glut caused by OPEC between 1993 and 1997 helped a little. But I am amazed that you have not heard the (old) OPEC cheating angle before. Larry Kudlow (CNBC) made it a point of building viewers expectations that they will cheat any day, nearly every day while oil prices were rising in 1999 and 2000. I know you may not have ever heard of him, but that is a shame because your ideas on deflation are similar.

At any rate, I strongly advise that the next time you make a prediction on oil prices, that you take into account the actions of, and perceptions about, OPEC. For they are as important to the oil market as the Treasury or Fed are to the currency market, or to the gold market.

You heard it here first, apparently. Now, back to the dollar, briefly:

I can't help it, but I don't see the inconsistency in my analysis that you allude to. On the other hand - and I promise that I will reflect on this - I can't for the life of me figure out how you can discuss the idea that dollars are scarce, relative to gold, without considering their relative quantities. Yes, you are correct that under a true gold standard, perhaps we could make these conclusions without consideration for evidence of other interaction between relative quantities.

But if price is all that you choose to rely on, despite the modus operandi of the "evil" dollar (policy) replacing the truth of a gold standard, then that to me is inconsistent, internally.

Let me clear up my position for you. It is not only due to the fact the money supply expands that we say that we are inflating. I noticed that in discussing inflation, you kept to the term "goods," deliberately excluding services, I presume, and essentially assigning credibility to Mr. Greenspan's model of "conceptual" GDP.

Rumor has it that the crime of inflation is not solely in the rise in prices, but more specifically, it is in the distortions it causes to the economy, and the corruption it gives rise to, and which ultimately plays a role in the transfer of your wealth.

When you started Polyconomics you combined politics with economics. Well, we've done one better. We've added the way that the markets work, to that.

Accordingly, we've noticed that most prices, as I mentioned in my first memo to you, were not deflating - according to your use of the term, which may just be another intellectual inconsistency - and that more and more so, they have been inflating.

We may be persuaded to exclude services from our analysis, if you really twist our arms, but we will certainly include asset prices in any analysis of inflation. Anything less than that would be investment suicide, wouldn't it sir?

It's funny that writing this letter makes me feel sort of like a student that disagrees with the teacher about his grade. My teachers never liked that, but they too were often wrong.

In any case, we would be happy to update you on real world market developments regularly, through a subscription to The Goldenbar Report. After all, having just learnt about the nature of Arab corruption, you must already be ready to one up your colleagues at breakfast next week.

Ed Bugos

Home of The Goldenbar Report

The Goldenbar Report: is an online investment resource for the individual or institutional money manager whose business it is to understand the economic debates which drive the macroeconomic / reflexive trends in an inherently unstable global capital marketplace. It is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you toconfirm the facts on your own before making important investment commitments.

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