Alasdair Macleod – 15 November 2009
It is less than a month since I last wrote about gold in an article that marked its clearance of the $1,000 level. I pointed out that central banks appeared to be changing their approach to gold. China and Russia were net buyers, and since then India has acquired 200 tonnes from the IMF. The suspicion is that the European central banks are withdrawing from the market with diminished stocks in the face of escalating demand.
Mining supply is also drying up. In an interview with the Daily Telegraph on 12th November, Aaron Regent, president of Barrick Gold, which is the largest gold mining company in the world, stated that global output was falling by about a million ounces a year. He described the situation as “peak gold”, and said that Barrick is winding down its hedge book. This has important implications for the market, since production hedging and central bank leasing are required for futures market liquidity. The withdrawal of key producers coupled with central bank caution makes it difficult for the bullion banks to maintain short positions, potentially squeezing the market further. So the short term outlook continues to improve.
For the longer-term, the sceptics point to other factors that may drive the price. An obvious candidate is dollar interest rates, since high or rising interest rates make holding gold costly through loss of interest. Bob Prechter of Elliott Wave International is bearish, since he thinks the forces of deflation are unstoppable, and will be reflected in a flight to the dollar when the dollar sell-off is complete. So two questions are raised: what correlation is there between gold and the dollar, and what correlation is there between gold and interest rates? The chart below plots these three values, and shows the 60 month moving average for each to illustrate trends.
Gold has had two bull markets since 1971, the first ending in 1980 and the current one that started in 2000. These bull markets were separated by a twenty year consolidation, together making three distinct phases.
In Phase 1 gold rose, as did interest rates and the dollar. In Phase 2 gold and interest rates fell, while the dollar continued to rise. And in Phase 3 gold rose while the dollar and interest rates fell. There is therefore no correlation between gold and interest rates or gold and the dollar on a long-term basis, which suggests that so far as gold is concerned, other factors must be more powerful.
Gold and inflation
At least we know from the chart that analysts who claim mechanical relationships exist between gold and the dollar, or gold and interest rates can be discounted. It is perfectly possible for gold to hold its ground or even rise in the face of a rising dollar or rising interest rates. More fundamentally, gold is generally accepted as a back-stop store of value, and therefore a protection against inflation. So to forecast the trend for gold, the analyst has to attempt to forecast the course of economic policy with an eye for inflationary consequences.
This analyst sees the authorities trying to resolve several difficulties at the same time. Principal among these are the dangers of deflation and contracting bank lending to the private sector. The former, in the minds of government officials, requires government to stimulate the economy by maintaining whatever deficits it takes; but this creates a further problem, what Keynesians call the paradox of thrift. Large deficits financed by domestic savings take money away from consumption, and to that extent works against economic growth. At the same time, there are indications that foreign trade partners are reluctant to invest their trade surpluses in dollars and therefore finance government deficits. So where is the money to come from?
The second problem is contracting bank lending, which if left unchecked will risk a descent into an Irving Fisher debt-deflation collapse. This is reflected in the build-up of bank reserves at the Fed.
Bank reserves deposited at the Fed are not money in circulation and as long as they remain there they cannot contribute to inflation. But the money is not the Fed’s, and can be withdrawn at any moment. Under the fractional reserve banking system, when it is withdrawn the withdrawing bank can gear up ten times as much credit on its balance sheet, which will then be highly inflationary. However, this is not the current situation. The Fed is more concerned about deflation and it is obviously having great difficulty persuading banks to increase lending to businesses and individuals. This deflationary stand-off was experienced in the early thirties, and the Fed does not want it to happen again.
The obvious solution would appear to be to encourage banks to lend these reserves and related credit to the government. Putting aside concerns about inflation for a moment, as much as $10 trillion could be made available to cover government deficits from these reserves. One third of this would be adequate to cover budget deficits for the next two years, by which time the economy should be back on a sustainable growth path.
This solution to America’s economic problems is very similar to that proposed by Tim Congdon and Gordon Pepper for the UK in the early stages of the debate about quantitative easing.
The mechanisms for encouraging banks to deploy their deposits at the Fed to finance government debt can be simple and effective. They range from crude quantitative easing to issuing new treasury securities with characteristics attractive to the commercial banks. The neatness of the solution from the government’s point of view is that these funds can be directed into the wider economy, where it is wanted, as recommended by Congdon and Pepper. A solution on these lines is therefore very likely.
The economic consequences of such a policy will be disastrous, but that is not my point: I am trying to estimate how future economic policies will affect the price of gold. We know from analysis of the thirties depression and more recently of Japan’s lost decades, that these policies are not a solution. As is the case for any insolvent spendthrift all that is achieved is bankruptcy is delayed. But unlike individuals, governments have the power to print money to stave off bankruptcy. That is my point.
The problem with printing money is that once embarked on, it gets progressively more difficult to stop. In this context, the performance of gold is fully justified. The short term risk to gold’s bull market is a systemic shock, which given the parlous state of the global financial system is quite possible. In that event, any set-back would be unlikely to be significant.