Members of the G20 have announced they will, as necessary, reflate their economies to create liquidity, unfreeze credit and restore global economic growth. But can reflation, whether through fiscal expansion, money printing or “quantitative easing,” be introduced without accompanying inflation? John Katz, analyst, writer and blogger for www.thegoldwatcher.com addresses this question in the following article and asks, “will this all end with a house of cards collapse?”
'Over the past 35 years it has seemed as if everyone in finance has wanted to be someone else. Hedge funds and private equity wanted to be as cool as a dotcom. Goldman Sachs wanted to be as smart as a hedge fund. The other investment banks wanted to be as profitable as Goldman Sachs. America's retail banks wanted to be as cutting-edge as investment banks. And European banks wanted to be as aggressive as American banks. They all ended up wishing they could be back precisely where they started.' - The Economist
Supply of newly mined gold is likely to continue the slow decline seen over the last few years. Prospects are less clear for demand. It's affected by geopolitical, economic and macroeconomic conditions, and it's anybody's guess which will have the greater influence. This article addresses only macroeconomic issues. Essentially demand for gold in inflationary, deflationary and changing economic conditions.
A July 2007 Fortune Magazine feature The Greatest Boom Ever starts with this upbeat comment from US Treasury Secretary Henry Paulson: “This is far and away the strongest global economy I've seen in my business lifetime.” Presented under the caption As the World Prospers associated charts illustrate soaring GDP per capita in advanced and developing economies, soaring commodity prices, world GDP and trade. For a picture of what has followed since the article was published we will have to view the charts upside down. Presented under another caption If America Falters Uh – Oh more charts illustrate the risks associated with the U.S. living beyond its means: a growing current account deficit, soaring household debt and soaring leveraged buyout loans.
By the time the Fortune article was featured Ray Dalio, the ever prescient CEO of Bridgewater Associates, was already warning clients on the imminent dangers of excessive financial leverage. Dalio now suggests we all seek a better understanding of deflationary consequences starting with the Great Depression. In a recent Barron’s interview headlined Recession? No, It's a D-process, and It Will Be Long, Dalio predicts a long and painful depression. He calls it a D Process. A disease that's going to run its course. After a period when people financed their spending by borrowing and debts rose relative to incomes 'a time comes when incomes aren't sufficient to service the debt. The reversal process follows and the country needs a debt restructuring. There are two alternatives. Either raise incomes or print a lot of money. For a country that has a lot of foreign debt denominated in its own currency, Dalio notes, “it's preferable to print money and devalue...”
Notwithstanding current rhetoric on global co-operation surely that's exactly what's going to happen. It's also fairly obvious now the write downs required from creditors and other stakeholders to keep General Motors alive will only be secured if demands are accompanied by threats of bankruptcy or actual bankruptcy. Probably the latter. Dalio sees General Motors as a metaphor for the United States with enforced restructuring as the mechanism to relieve debt.
Gold and The Dollar
I remember I was taught many years ago as a young law student 'The law can do anything except make a man a woman.' As solvency issues loom for banks, enterprises and even nations we can take it as read that General Motors won't be the only case where bankruptcy laws are used to restore nominal solvency to otherwise insolvent enterprises, organizations and even nations. The formidable powers of the law have relevance for all economic conditions, currencies and for gold.
Let’s start with economic conditions. The communiqué presented after the April 2nd G20 Summit of world leaders is both upbeat and vague. What exactly does the promise to do whatever is necessary to revive national economies mean? Print money? Even vaguer is the boundary between avoiding all protectionist activities and securing level playing field competitive conditions.
Fiduciary currencies are of course only creations of the law. The value only exists while the Government issuing the currency acts responsibly. Typically the fiduciary element of the Zimbabwe dollar and its value were lost when the Mugabe government destroyed the economy.
Gold is also no stranger to legislative action. In the days of the gold standard Governments enacted laws making gold the measure by which all other values were set, made gold coins legal tender and then, when it suited them, prohibited private gold ownership and even confiscated privately owned gold. The International Monetary Fund (IMF) was constituted in 1945 as the organization mandated to implement the Bretton Woods global monetary system. In its founding articles gold was established as the core unit of value. Since then the IMF has written gold out of its articles and even banned currencies backed by gold.
The Current Financial Crisis and The Great Depression
Opinions differ on whether current conditions are best compared to various post World War II recessions, Japan's brush with deflation over recent decades or the conditions that led to the Great Depression in the 1930s. In The Goldwatcher I make the case for comparing conditions to 1933 when newly elected President Franklin D. Roosevelt faced the ravages of deflation, a depression, a banking crisis and a loss of faith in the dollar. To stop public runs on banks followed by private hoarding of gold Roosevelt criminalized private gold ownership and obliged private owners of gold to deliver their holdings to the US Treasury in exchange for paper certificates.
Roosevelt also recognized the need for a general restructuring of values to counter the effects of deflation and restore nominal solvency. In one of his fireside chats shortly after taking office he outlined the causes of the crisis and the solutions proposed. This sentence from the speech, highlighted in The Goldwatcher, has a vital message: “The Administration has the definite objective of raising commodity prices to such an extent that those who have borrowed money will, on average, be able to repay that money in the same kind of dollar as they were borrowed.” To put it bluntly the United States was going to inflate its way out of the deflationary crisis. Roosevelt was true to his word. In 1934 he raised the dollar price of gold from $20.67 to $35 per ounce - a devaluation of the dollar to gold of over 50%. It was unfair on savers and those who had delivered their gold to the Treasury were reimbursed at the lower $20.67 price. But the devaluation restored nominal solvency to the Treasury, banks and commerce.
The $35 per ounce price for gold lasted till 1971 when President Richard Nixon reneged on the Bretton Woods commitment to settle dollar debts in gold if required to by foreign treasuries. Since then we have been in a world of fiduciary money without any standard measure such as gold, silver, oil or other asset with intrinsic and commercial value to value currencies. Theoretically currencies are now valued against each with exchange rates set by supply and demand in open markets without official intervention. But theory and practice aren't always on the same tracks - as we have seen again recently with Switzerland's open intervention to reduce the value of its currency by 5%.
The key mover in the recent G20 initiative British Prime Minister Gordon Brown has spoken about the 2nd April 2009 London Summit outcome as a new Bretton Woods. But there is no meaningful comparison. In 1944 when the Breton Woods accords were made the United States was the world's dominant military power, principal creditor, owner of 70% of all monetary gold and an oil exporter to boot. It ruled the roost, set the agenda and had the resources to secure effective implementation. Breton Woods even crowned the dollar linked to gold at $35 an ounce as the world's de facto global currency. Though links between the dollar and gold have been severed the dollar remains the world's dominant reserve currency. The reserve currency status of the dollar is what has made it possible for the U.S. to borrow using its own currency. If that relationship changes severe and unwelcome consequences will follow.
But can the dollar retain its privileged position? Though still the global superpower the U.S. is no longer the world's principal creditor. Instead it's the world's largest debtor and borrower with Zombie flagship domestic banks on life support. It also depends on oil imports for over half its requirements. And even its formidable military supremacy lacks potency in unconventional wars against terrorism and religious extremists. In a nutshell after World War II the United States was in a position to bankroll and enable post war global economic recovery backed by the strength of the dollar. Now the U.S. is itself dependent on a global economic revival and is in no position either to underpin a global economic recovery or dictate terms to others.
The Great Disconnect
Members of the G20 have announced they will, as necessary, reflate their economies to create liquidity, unfreeze credit and restore global economic growth. But can reflation, whether through fiscal expansion, money printing or, if you prefer, the awkward phrase quantitative easing, be introduced without accompanying inflation? It would be reasonable to debate that question if the current crisis had not been the result of a U.S.-centric casino capitalism spree that developed over the last few decades, moved into overdrive in the years following the turn of the century and ended with a house of cards collapse.
Headlining recent turning points gives some insight into the casino capitalism spree. By the time President George W. Bush took office in January 2001 the dot.com bubble had burst, equity markets had collapsed and the United States and world economies were teetering on the brink of recession. Even had 9/11 not occurred, monetary reflation was on the agenda to fend off deflation. After 9/11, Washington responded with vigorous monetary and fiscal initiatives. The Fed rapidly cut its target rate from 6.5% to 1% and kept it there for a full year to reinforce the stimulus. Federal tax rebates and tax cuts added impetus.
Washington also tapped in enthusiastically to the vendor finance opportunity of Asia lending and America spending. As Americans spent with renewed gusto, Asia obliged with abundant cheap money- even funding the Iraq and Afghanistan wars and domestic budget deficits. Cheap money from vendor finance also funded the mortgages that kept the housing bubble soaring. The 1990s dot.com casino capitalism morphed from stock exchanges to shadow banking, hedge funds, commodities, all kinds of derivative bets and eventually imploded with the housing bubble. The well known commentator Gary Shilling has described the phenomena as the Great Disconnect between the real world of goods and services and the speculative world of financial assets. The result was the financial house of cards that collapsed when the housing boom turned to bust.
The House of Cards
House of Cards, a CNBC documentary on the rise and fall of the US housing bubble, reveals rampant excesses of financial leverage, mortgage rackets and official myopia associated with the housing bubble. The program starts with a review of the economic reflation initiated to head off recession in the wake of 9/11. The blatant frauds and regulatory failures that followed are so extreme that in a fictional presentation they would be dismissed as too farfetched to be credible. In the closing sequence CNBC anchor David Farber interviews former Fed Chairman Alan Greenspan and asks whether he saw the housing bubble inflating and if he should have taken steps to prevent it. Sticking to his committed laissez faire dogma Greenspan defended his position on the grounds that the CDO 'instruments' used to market dubious mortgage securities to banks and other investors worldwide were too complex. Here are his exact and extraordinary words:
“Some of the complexities of some of the instruments that are going into CDS's bewilders me. I don't understand what they are doing. And if I didn't understand it -and I had access to several hundred PhDs - how will the rest of the world understand it.”' This is the same Greenspan who promoted financial derivatives as by far the most significant event of finance during the past decade, predicting that market participants would increase their reliance on derivatives to unbundle risks and thereby enhance the process of wealth creation.
The derivatives plague that hit Wall Street and world markets from early 2007 supports the compelling case that casino capitalism created fantasy wealth on flawed premises. The first was that American consumers would always be in a position to absorb production from ever expanding productive resources in China and other developing economies. The second was that continuously rising asset prices would always enable them to access more debt to fund their spending habit. The third was that China, and other creditors, would always be willing to provide the funding. The reality is different. Deflation looms in the wake of the collapse of the house of cards. Too much manufacturing capacity, too much production, and not enough buyers.
Motivation, Timing and Strategy
Like any other investment gold makes sense only in the context of motivation, strategy and timing. The surge in the gold price from an average price of $270 in 2001 to over $850 at the time of writing follows the general lack of trust in fiduciary money that gathered pace after 9/11. But it's a common misconception, especially when gold is the flavor of the month, that it will always be a safe haven. Gold only makes investing sense when it is bought at a reasonable price. It's useful that every year the London Bullion Marketing Association publish a survey with current forecasts from leading analysts supported by reasons for the forecast. The average high, low and overall average prices for 2009 are: Average High: $1073: Average Low $721: Overall Average $880. The gap between the highest individual highs and lowest individual low is even greater. The wide range of expectations reflects current uncertainties.
Inflation & Deflation
Linked with the question 'Do Trees Go to Heaven' the Chapter in The Goldwatcher on price prospects was completed in March 2008. The analysis followed the line that policy makers would find themselves walking a tightrope between inflation and deflation and were bound to find inflation the lesser of two evils. As candidates for the forthcoming American Presidential election had not yet been selected it was necessary to note 'without reassurance on future policy commitments the chances of a systemic solvency crisis, resembling in some ways the crisis experienced in the 1930s can't be ignored (but) we still don't know who the new US President will be, who will be in the administration and what mandate they will have from the electorate...' The conclusion was 'The case for gold price rises is strong. But so are prospects for a recession and tight money. Loose money fuelled the boom in asset prices. Tight money would deflate price excesses...Gold bulls had the right message in 2007 (as) seismic economic developments spurred gold price rises that were predictable, dramatic and probably sustainable. Gold bugs are now urging investors to bet the ranch on gold. On my analysis that would be foolhardy. (Co-author) Frank Holmes also advocates moderation in the following Chapters.'
Key developments in 2008 and 2009 include losses of hundreds of billion pounds, dollars, euros etc by leading investment and other banks in the United States and throughout the world. Government funded state bail outs followed with trillions of dollars created to expand central bank balance sheets and keep banking systems alive in a near zero interest rate environment intended to fend off deflation. President Obama has now secured a fiscal stimulus package that will result in U.S. Federal Budget Deficits exceeding $1 trillion for at least the next three years. Yet any official talk of encouraging inflation would be frowned on. But let's consider whether solving the current crisis will be helped by some inflation.
The conservative and highly regarded Harvard Economics Professor Kenneth Rogoff, a former Chief Economic Advisor to the IMF, is now surprisingly in the camp proposing inflation as part of the solution to current debt problems. In an article Inflation is now the lesser evil he makes the case that “it's time for the world's major central banks to acknowledge that moderate inflation would be helpful. All central banks need to do is to keep printing money to buy up government debt. The main risk is that inflation could overshoot, landing at 20% or 30% instead of 5-6%. Indeed, fear of overshooting paralyzed the Bank of Japan for a decade. But this problem is easily negotiated. With good communication policy, inflation expectations can be contained, and inflation can be brought down as quickly as necessary. It will take every tool in the box to fix today's once-in-a-century financial crisis. Fear of inflation, when viewed in the context of a possible global depression, is like worrying about getting the measles when one is in danger of getting the plague.” A recent op ed in the Financial Times makes the case that coordinated inflation could help bail us all out by inflating away 10% of government debt
Writing in Vox on No Ordinary Recession Trento University Professor Axel Leijonhufvud goes further and warns on the danger of inflation flowing in the US from successfully turning the recession round:
“If government programs end up not being large enough to turn the recession around, we have to look forward to a deflationary period of indeterminate length. If they do succeed, however, severe inflationary pressures may surface quite quickly.
The US ratio of federal debt to GNP is not particularly high at this time. But it does not take into account the very large off-balance liabilities of entitlement programs. Since the present crisis began, moreover, the Federal Reserve System and other federal agencies have made bail-out, loan and credit guarantee commitments totaling many trillions of dollars with uncertain eventual implications for the consolidated federal balance sheet. Much will depend on the willingness of the nation's foreign creditors to continue to accumulate or at least to hold dollars at low rates of interest. Should this willingness falter, inflation will be hard to contain.”
Chris Wood, the Hong Kong based equity strategist with a formidable reputation for prescient macro calls is now so convinced the global paper money system will continue to inflate he forecasts gold will more than triple and reach $3500 by 2010.
In the next article in this series I will review the G20 April 2nd Summit outcome and examine:
1) Whether affording the IMF increased funding coupled with IMF plans to issue further Special Drawing Rights represents a structural change in the global monetary system; and
2) The outlook for gold, the dollar and other currencies in the light of developments.
The views expressed in this Newsletter are those of the author(s). They are offered to readers for information and general guidance only. Nothing in this Newsletter is intended, and should not be taken, to constitute economic or investment advice.
John Katz is an analyst, strategist and financial writer based in London, U.K. To gain experience and qualifications in the Financial Services Industry he first completed the necessary exams to qualify as an approved Securities Dealer and Trader. While working for a London based hedge fund he was accredited by the United Kingdom Regulatory Authorities. He has contributed articles to the financial press, commentated for business television, and is the author of Portfolio 2001 - How to Invest in the World's Best Companies, Random House Business Books, 1999. John was co-author with Frank Holmes of The Goldwatcher: Demystifying Gold Investing, John Wiley & Sons, 2008. Readers can find his independent and objective posts on The Goldwatcher Blog at www.thegoldwatcher.com.
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