Red Ink, Animal Spirits and the Price of Gold
Today's Newsletter is authored by John Katz - Co-Author: The Goldwatcher.
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. He is also writes The Goldwatcher blog www.thegoldwatcher.com
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'Conventional Wisdom' on gold prices:
Gold was on course to breaching the magical $1000 threshold again at the end of
May when Goldman Sachs published a Research Note 'The US Dollar - As Good as Gold.'
The report set out why at current prices they were not recommending gold .
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 packs of speculators and all to often
also investors get carried away when they scent blood in the air. Then,
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 didn't expect 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 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 quoted above 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.
We all have a pretty good understanding of the effects of inflation. But 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.
Other than knowing that since the 1980s Japan has endured a multi decade deflation
experience most people 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 chance of deflation.
Leading economists, including Nobel Laureate Dr Paul Krugman are questioning
old views on Japan and warning '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 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. The
essential message from the analysis is the 'conventional wisdom' that because
gold performed badly during recent decades in a period of disinflation it
will do even worse during deflation is flawed. 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.'
Deflation is defined in the Sun Valley report 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 the definition of deflation its tempting to say the current financial crisis
is 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.
The State of California's inability to meet its commitments reflects the solvency
crisis at state level. The General Motors and Chrysler bailouts reflect industry
examples. We are on the second anniversary of the global financial crisis and 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 and financial leverage is amplifying the consequences.
Putting Humpty Dumpty together again:
To describe the global financial collapse commentators have used the analogy of
Humpty Dumpty's fall and have been questioning whether he 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 had 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 U.S., China and other dollar
surplus countries are often cited as a root cause of global economic
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 U.S. 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 were anticipating
and warning of a 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 our 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, apart from dire conditions in the
industry, they have been obliged to accept an expanded role in the supply
chain involving 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 has written
that while he sees light at the end of the tunnel with the U.S. and global
recessions over by late 2009 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:
Against this background of uncertainty and doubt gold has already made a comeback
in central bank reserves. This is after years when its retention in their
vaults was often seen as pointless. The revived interest in gold is, of course,
because of concerns over the stability of fiat currencies.
David Rosenburg, 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 investments including
gold.
David Rosenberg's analysis is consistent with the view that to escape the consequences
of unsustainable booms policy makers are prone to take whatever steps they can
to revive economic growth - even if they devalue their currencies
in the process. Gold attracts again as an investment that retains purchasing power
regardless of manipulations eroding the value of fiat currencies.'
Reports from national mints and gold dealers in all major centers confirm that
physical gold is in short supply and the reasons why are obvious. 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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Copyright 2009, John Katz and Stock Research DD Inc. All rights reserved.
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