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This article, Part Three in a series on key economic developments since publication of The Goldwatcher. addresses Gold Price Prospects, Red Ink and Animal Spirits.
The articles were commissioned and published by The Stock Research Portal Review.
Part One and Part Two address the sequence of events that led to the collapse of the Casino Capitalism House of Cards and almost led to global financial meltdown in September 2008.
THE GOLD PRICE, RED INK AND ANIMAL SPIRITS
‘Conventional Wisdom’ on gold prices:
Gold was again on course to breaching the magical $1000 threshold at the end of May when Goldman Sachs published a Research Note ‘The US Dollar – As Good as Gold.’ The report set out why they were not recommending gold at current prices .
Unsurprisingly the gold price retreated within days of the research being published falling from $975 on May 29th to $919 on 22nd June. I say ‘unsurprisingly’ not because Goldman’s Wall Street consensus analysis was specially insightful or revealing. Rather, because when they scent blood in the air packs of speculators, all too often with eager investors following in their tracks, get carried away and when they hear a warning shot they panic.
The ‘Dollar As Good As Gold Report’ concluded: ‘With the average cost of production estimated at $500 per ounce, the marginal cost of demand at $700 per ounce and no shortage of gold for real long term use, a price of $950 seems enough to provide mining companies with very attractive returns on their capital.’ The analysts added ‘if worries about the debasement of paper currencies persist, or any signs of inflation appear, the demand for additional gold could push prices above $1,250. Between March 1973 and August 1975, the moving 3-year average of year-on-year inflation was 10% and gold rallied 27%. Between May 1978 and November 1981, when inflation measured 12% per annum, gold rallied 47%. So clearly, unanticipated inflation is favourable for gold prices.’
As they were not expecting either inflation shocks or that the dollar would will be debased by lax monetary policy when global economies recovered Goldman were not recommending gold. They noted, however, ‘just like crude oil in mid-2008, if enough people worry about the dollar and inflation, momentum can carry gold to much higher levels beyond any measure of fair value.’
Though not everyone will agree average gold production cost is as low as $500 an ounce Goldman’s arguments were in line with a general Wall Street consensus on gold and with ‘conventional wisdom.’ We all generally expect gold to perform well when inflationary pressures build up. The statistics they quote confirm this view. However contrarians and out of the box thinkers won’t be impressed by analysis that doesn’t address deflation. Many among them, including the writer of this article, see both deflation and global overcapacity as menaces to the global economy.
Though we all have a pretty good understanding of the effects of inflation most of us know literally nothing about deflation. And that’s only to be expected. It’s three quarters of a century since the deflation associated with the Great Depression. We know that since property and stock exchange bubbles popped two decades ago Japan has experienced deflation. But we aren’t familiar with the causes and effects of deflation, don’t know when there is a real danger of deflation or understand why gold is ultra important when there is a danger of deflation
Leading economists, including Nobel Laureate Dr Paul Krugman are also questioning old views on Japan. He warns ‘we may or may not be about to face our own lost decade, but the sheer misery millions of Americans will face in the near future probably exceeds anything that happened in Japan during the 90s.’
Gold, deflation and capital preservation:
The comments on gold and deflation that follow are from an exceptionally thorough, well informed and insightful article written in 1986 by Dr. Sam Hewitt, founder of Sun Valley Gold Company. His analysis challenges the flawed ‘conventional wisdom’ that because gold performed badly during recent decades in a period of disinflation (the 1980s and 1990s) it will do even worse during deflation. The lesson from history is that currency hoarding is a common feature in deflationary episodes and ‘the interaction between declining credit quality and currency hoarding is key to understanding the role of gold as an alternative currency. Each historical episode of deflation confirms that whenever confidence has declined in the issuer of paper currency gold was favoured over paper currency as a capital preservation asset.’
In the Sun Valley report deflation is defined as : ‘falling levels in economic activity and falling price levels on an absolute basis. Contraction of economic activity is generally preceded by an unsustainable boom period and usually kicked off by an event which causes economic confidence to be lost. Characteristic of most deflationary periods are deteriorating credit quality and the shift by investors from capital growth to capital preservation. Deflations typically end after crisis conditions force policymakers to enact large-scale inflationary policies designed to counteract deflationary conditions.’
Reading this definition of deflation it is tempting to say the current financial crisis must be a poster child for the unsustainable boom, loss of confidence and the associated poor credit quality that follows. But that’s only half what needs to said. The current crisis is also a crisis of solvency at all levels from State to household. Further, policymakers have made a global commitment to do whatever is necessary to restore economic growth. In attempts to reflate economies trillions of dollars have already been committed to supporting liquidity, bailing out banks and industries. Yet the world is still faced with overcapacity and solvency crises. Trillions more will be needed. The State of California’s inability to meet its commitments reflects the solvency crisis at state level. The General Motors and Chrysler bailouts reflect major industrial examples. Further, after the second anniversary of the global financial crisis we have to question why the reflating formula hasn’t worked. The answer appears to be excessive credit fed the unsustainable boom. Lax regulation made it possible. Financial leverage is now amplifying the consequences.
Putting Humpty Dumpty together again:
Commentators have used the analogy of Humpty Dumpty’s fall to describe the global financial collapse and question whether Humpty can be put together again. A Goldwatcher blog “Has Bernanke whizzed the Humpty Dumpty economy into a Hunky-Dory economy? dates back to March 2008.
How little we knew about Humpty then! In their recently published book ‘Animal Spirits’ the celebrated economists Nobel Laureate Dr. George Akerlof and Dr. Robert Shiller inform us Humpty’s misfortune hails from a time before children’s story books were illustrated. This explains why over the years we have forgotten Humpty was an egg. So, the authors conclude, ‘all the King’s horses and all the King’s men could not put him back together again.’ And, they add (emphasis mine) ‘that tale well describes the current financial crisis.’ Out of the box analysis in their book ‘Animal Spirits,’ discussed later in this article, contributes to a better understanding of the crisis and suggests innovative solutions.
Also discussed in The Goldwatcher is Nobel prize winner Paul Krugman’s comment on prospects for a dollar plunge resembling the bad tempered road runner cartoon character Wile E Coyote at the moment he stepped over the edge of a cliff with his legs flailing in thin air and realized, alas too late, he was about to plunge into a chasm.
Dr. Krugman concluded if creditors find they have been myopic there may yet be a Wile E Coyote moment for the dollar. Ironically, it wasn’t the dollar that faced a Wile E Coyote moment when the financial crisis hit. It was the global economy. And, as the crisis developed, the dollar has remained in demand as a perceived safe haven.
Debtor creditor imbalances between the US, China and other dollar surplus countries are often cited as the root cause for global financial instability. In whitewashing President George W. Bush’s borrowing binge Fed Chairman Ben Bernanke made the case that a global savings glut had literally foisted trillions of dollars of cheap money on US consumers. Indeed, as cheerleader for the global savings glut theory, Bernanke may have been the most myopic of all concerned parties. Commenting on his whitewash The Goldwatcher quoted the well respected investment banker and economist Donald Coxe’s acerbic comment that it was really a case of a global savings glutton gobbling up the savings of the rest of the world. In any event the global savings glut story is now history. Harvard Professor Jeffrey Frankel, authoritative on currency issues, sees the global saving glut issue as stone dead. In a recent paper on Global Currencies prepared for Central Banks Frankel writes ‘Regardless who is right about the last 8 years over the next 8 years national saving will fall globally. In the short run, governments are responding to the most severe recession in 70 years by increasing their budget deficits. In the long run, the spending needs created by the increased retired population and rising medical costs will continue to reduce saving, both public and private. In response, long-term real interest rates should rise, from the recent low levels.’
Contrarian and out of the box thinking:
While Bernanke and others were hyping the global savings glut and other patently flawed theories contrarians and other out of the box thinkers anticipated and warned of the pending crisis. In his book Debt and Delusion, published in 1999, a British economist Dr Peter Warburton made the case that central bankers were so obsessed with rooting out inflation they only looked at credit statistics relating to banks - ignoring the enormous, burgeoning and largely unregulated credit explosion taking place in what we now call the ‘shadow banking’ system. As a consequence in the boom years linkages between reported expansion of credit in the major Western economies and real world money were grossly understated and misleading. Further the impressive reduction in inflation reported was an illusion ‘obtained largely by substituting one set of serious problems for another.’ The effect was tipping economies into over capacity and deflation.
Warning now of an imminent return to inflation Warburton is again running contrary to the consensus view that a global excess capacity glut and deflationary pressures will keep inflation at bay. He accepts consumers can expect to be the beneficiary of inventory liquidation for an extended period of time. But lean inventories and ‘the fracturing of the supply chain mean that obtaining products will become not only more difficult but also more expensive.’ It’s worth remembering that when Chrysler & G.M. sought bailout taxpayer funds among the most compelling reasons for support were repercussions that would follow for the industry’s component supply chain if they went out of business. Even Ford, still able to survive without government support, informed Congress if G.M. or Chrysler went out of business they would be vulnerable to supply interruptions and would also require government support. Foreign owned auto manufacturers in the US were in the same boat.
Auto component suppliers remain vulnerable as, compounding the dire conditions in the industry, they have been obliged to accept an expanded role in the supply chain requiring additional finance for just in time manufacturing programmes and associated customer support obligations.
The message from Dr Warburton’s analysis is a Keynsian focus on the consumer will not be sufficient for economic revival. The supply chain can’t be ignored. If it’s broken the economics of the industry will be affected and prices are likely to rise.
In spite of a cash for clunkers scheme introduced to support car sales in the U.K. manufacturers put their prices up. Many, including Ford, have already increased prices twice this year It’s unlikely now auto prices will ever be as low as they were over the last few years. So, while there is a strong case to make that deflationary pressures will keep inflation tame, there are also instances where inflationary pressures will prevail.
Animal Spirits, credit and unemployment:
The phrase ‘animal spirits’ was introduced into the economics lexicon by Lord Maynard Keynes who recognised people are not always rational in their financial decisions. They also act following their animal spirits – ‘ a spontaneous urge to action rather than inaction… our innate urge to activity that makes the wheel go round.’ In their book ‘Animal Spirits’ mentioned above Akerlof and Shiller approach macroeconomics from the perspective of human behaviour and find conventional macroeconomists failed to anticipate and prevent the financial crisis because they ignored essential behavioural characteristics. These include confidence, fairness, concerns over corruption, bad faith, and money illusions. I can add with some satisfaction that the chapter in The Goldwatcher addressing gold prices starts with a quote from Lord Keynes on animal spirits followed by the sub heading ‘Introduction : A crisis of Confidence.’ Not only do Akerlof and Shiller make a convincing case for the imperative to restore confidence but they also find confidence and lack of confidence have multiplier effects.
Bantering with the phrase animal spirits in a book addressing economics and behaviour makes for some entertaining reading and also for some confusion. But the key conclusions Akerlof and Shiller reach are substantial contributions to improving monetary policy. They identify the credit crunch as ‘the overwhelming threat to the current economy, and argue ’it will be difficult and perhaps even impossible to achieve the goal of full employment if credit falls considerably below its normal levels.’ To bridge the gap they propose a credit target for policy makers and note ‘achieving the credit target is urgent for several reasons. Most pressing is that firms that count on outside finance will go bankrupt if they can not obtain credit and, if the credit crunch continues and many firms go bankrupt, it would take an impossibly large fiscal and monetary stimulus to achieve full employment.’ Akerlof and Shiller approach issues of credit and unemployment from a different perspective to Dr. Warburton but their conclusions aren’t far apart. Talk of green shoots in the economy isn’t convincing while unemployment is rising and while firms that can’t access credit are going our of business,
Nouriel Roubini’s red alert:
Dr. Nouriel Roubini, the economist who has most consistently identified the causes and evolution of the financial and economic crises, now sees light at the end of the tunnel with the U.S. and global recessions over by late 2009. But he also forecasts an anaemic and vulnerable recovery with a peak unemployment rate of close to 11% in 2010. Such a large unemployment rate, he notes, ’will have negative effects on labour, income, consumption and growth; will postpone the bottoming out of the housing sector; will lead to larger defaults and losses on bank loans (residential and commercial mortgages, credit cards, auto loans, leveraged loans); will increase the size of the budget deficit (even before any additional stimulus is implemented); and will increase protectionist pressures.’
A vulnerable dollar:
In this climate of uncertainty gold has already made a comeback in central bank reserves after years when its retention in their vaults was often seen as pointless. Now in the light of concerns over the stability of fiat currencies it makes sense for central banks to own gold again. David Rosenberg, former Chief Economist for Merrill Lynch and now chief economist and strategist with Gluskin Sheff & Associates, comments the US dollar “.. is the only policy tool that has not budged one iota since the crisis erupted two years ago. But we are sure that as the unemployment rate makes new highs and increasingly poses a political hurdle in a mid-term election year, it would make perfect sense for a country that always operates in its best interest - even if it may not be in everyone’s best interest - to sanction a US dollar devaluation as a means to stimulate the domestic economy.” With downside potential for the dollar he suggests investors protect their portfolios from the consequences of a declining dollar with a range of investments including gold.
David Rosenberg’s analysis is consistent with the committment policy makers have made to take whatever steps are necessary to revive economic growth. Competitive devaluation is not on the agenda. But currency debasement and inflation can also come via fiscal deficits and lax monetary policies initiated by fire fighting policy makers and central banks. Gold attracts again as a quasi currency insulated from policy manipulations eroding the value of fiat currencies.
Reports from national mints and gold dealers in all major centers confirm physical gold is in short supply. It’s obvious why it is. Currencies are vulnerable to debasement and, when confidence declines in the issuers of paper currency, gold is favoured as a capital preservation asset.
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