As an appendix to yesterday’s article, ‘Misunderstanding gold demand‘, I have produced a detailed analysis of The CPM Group’s gold research. Of all of the major research firms, they have the most information available about how they think. While I chose to focus on the CPM Group, as far as I have been able to determine from published reports, GFMS agrees on the basic framework of the quantity model, if not on all of the particulars. The other major research firm, the WGC, uses the numbers compiled by GFMS. From those aspects of the CPM Group’s thinking that are available to the public, I have tried to reverse engineer how they see the gold price from what is available.
In the next section I will explain my interpretation of their thinking. And then, in the following section I will provide my critique of the CPM Group. I have found several problems in their model: the first, that they consider market data on a year-by-year segregated basis; the second, the belief that gold holdings are not part of the market; and third, the premise that net flows drive the gold price. I will discuss each of these points in more detail below.
The CPM Group’s Model
My sources consist of the CPM Gold Yearbook 2012 (cited below as Yearbook) and a 1996 presentation to the Australian Gold Conference by the CPM Group’s founder Jeffrey Christian, Gold: Supply, Demand, Price and Research (below, AGC Presentation) [1]. After reading the sources, I have synthesized what I believe to be the CPM Group’s model of supply, demand, and price into the following propositions:
Gold Supply: The gold supply consists of mine production plus “secondary sales”. The latter consists of melted gold sold in the form of scrap by the jewelry sector and the fabrication sector. See the Yearbook, p. 105: Gold supply, which includes gold output from mines in market economies, gold exports from transitional economies into market economies, and old gold scrap that has been refined, is estimated to have totaled 119.9 million ounces in 2011…. Gold Demand: Gold demand is the sum of the following: industrial use (electronics, dental, medical, other), gold use to make new jewelry, official sector net flow (IMF, US, Canada, other) and investor sector net flow (coins, bullion, bars, Indian). See the Yearbook, pages 6-7. Investment demand is defined by CPM in some places as the net flow of the investor sector and in other places as the net flow of the investor and official sectors combined. My citations in support of this are:
Yearbook, p. 4, labels on the chart titled Gold Supply and Demand shows investor demand as the difference between supply (defined as mine + secondary) and fabrication demand. From the quantity balance equation (3, above), total supply less fabrication demand must equal net investor and official sector flows.
Yearbook, p 11: Net purchases of gold by central banks have complemented healthy gold investment demand…. Ifnet central bank purchases have complemented investor demand, they cannot be the same thing.
See the Yearbook, p. 29, Investment demand (subtitle), followed by: Net additions to private investor gold holdings declined to 34.3 million ounces in 2011
Yearbook, p. 8: (chart) Net Investment Demand is plotted on the left scale of the chart with the gold price on the right scale. The chart’s title is Investment Demand’s Effect [sic] on Gold Prices.
Yearbook, p. 9: Gold investment demand is one of the strongest influences on gold prices.
Yearbook, p. 10: …it is projected that net additions to private investor gold holdings will remain at extremely high levels, which is expected to help keep prices at elevated levels during 2012.
Yearbook, p. 69: “Central banks were net buyers of gold for the fourth consecutive year in 2011”. (i.e. net flow into the central bank sector was a positive number).
Yearbook, p. 233: Strong investment demand for gold, particularly during the first three quarters of the year, pushed prices higher.
AGC Presentation, p. 4: my next slide [not shown in PDF – rb] illustrates the weightings of each supply and demand sector in CPM Group’s amin gold price model. Central bank activity and investment demand trends … exert much more powerful influences in determining the gold price.
AGC Presentation p. 8: SLIDE SEVEN: Investment Demand’s Effect on Prices. My next chart compares levels of investment demand for gold to changes in gold prices. We call it our most important chart. Herein lies the key to accurate gold price forecasts: Investment demand is the most important influence on gold prices. Markets are made at the margin, and in the gold market investors are the marginal market participants.
AGC Presentation, p. 8: Over the past few years, investors have not been buying a great deal of gold. As a consequence, gold prices have languished. Investment demand reached a low of 184 mt (5.9 million ounces) in 1994. Investor demand increased 11.7% in 1995, but the level, at 205 mt (6.6 million ounces), remained low. A further increase, to around 239 mt (7.7 million ounces), is projected for this year. The steady increase is being reflected in the slow upward march in gold prices; the low levels overall are being reflected in the fact that prices are not rising sharply.
Quantity Balance: Demand equals supply. See the Yearbook, pages 6-7. The total supply consists of 31.0Moz mined, 4.5Moz secondary, and 13.2Moz from transitional economies for a total of 50.0Mz. Total demand consists of 43.9Moz fabrication, -8.7Moz official sector reserve sales, and 14.8 net investor portfolio additions, for a total of 50.0Moz. Quantities Drive the Gold Price:Each of the terms in the quantity balance equation is a contributing cause of the gold price, with net investment demand being the most important cause. If the net investor sector flow is a large positive number, this is deemed a cause of a higher gold price, while a small positive or a negative number is deemed a cause of a lower gold price. My reason for thinking this is the following citations: Forecasting the Gold Price: Knowing the cause of an event does not necessarily help to forecast the event. A cause can only be used to forecast an effect if the cause occurs far enough in time before the effect that the cause can be identified and acted on.
Mr. Christian states that net investor flows can be used to forecast the gold price. I am not clear from the following whether Christian is saying that the net investor flows in one year can be used to forecast the following year’s gold price, or whether he means that a correct forecast of next year’s net investor flows is the key to forecasting the next year’s price. Below is a relevant passage:
AGC Presentation p. 8: SLIDE SEVEN: Investment Demand’s Effect on Prices. My next chart compares levels of investment demand for gold to changes in gold prices. We call it our most important chart. Herein lies the key to accurate gold price forecasts: Investment demand is the most important influence on gold prices. Markets are made at the margin, and in the gold market investors are the marginal market participants.
Summary: Based on the above, it appears The CPM Group posits the following logic regarding the gold market, though I cannot say for certain because their quantitative model is proprietary.
Supply is defined as mine plus secondary
Demand is the sum of the various components.
The price on any market is set by supply and demand. If the number that CPM has defined as “demand” increases, the price will be higher.
Critique of CPM Group’s Model
Consumption versus Asset
My first criticism of the CPM Group’s model is that its conceives the price formation process only in the context of annual data. In fact, annual production and consumption quantities are quite unimportant in the overall picture of gold price formation. The error of looking at gold as an annual market is widespread and follows from a failure to understand the difference between a consumption commodity and an asset.
Most commodities are produced primarily for consumption. Consumption permanently destroys the economic value of the commodity (or in some cases, makes the commodity costly to recover back to a form where it has economic value). The market demonstrates that a commodity is produced mainly for consumption by the lack of large above-ground stockpiles. A small stockpile measured in terms of production output would be several days, weeks or a small number of months at most. All commodities other than gold have stockpiles that are small by this definition.
In consumption commodity markets, production and consumption must remain very nearly in balance because on the one hand, reserves will be depleted quickly if consumption exceeds production and, on the other hand, production can only exceed consumption if stockpiles increase. Stockpiles generally will not increase much beyond a few weeks or months of production flow because users and speculators have historically demonstrated that they are not willing to hoard larger supplies. For a consumption type commodity, the supply that is produced during a given year, plus small stockpiles, is the only supply available for consumption during that year.
An asset is a good that people buy in order to hold, rather than consume. Some examples of assets are land, property, money, stocks, bonds, and gold. Nearly all of the gold ever mined still exists either as bars, coins, or jewelry. The total quantity of gold stockpiles grows by about 1-2% per year, implying a ratio of stockpiles to one year production in the 50 to 100 x range. Only a small amount of gold is truly consumed. Even jewelry fabrication is not consumption because its bullion value is retained and can be reclaimed at the relatively low cost of melting. Gold is held in a continuum of products which can be transformed from one to the other, such as bars, coins, and jewelry.
Price formation in an asset market works differently than in a consumption market. Because consumption goods are bought in order to be permanently destroyed, buyers must bid for newly mined product. The reservation demand to and from stockpiles does not play much of a role in the pricing process. All possible supply (regardless of price) is from recent production, and any possible demand (regardless of price) is demand for current consumption. In a consumption good market, the lack of stockpiles ensures that:
quantity supplied = quantity produced
quantity demanded = quantity consumed
In an asset market production and consumption (destruction) do not significantly impact the supply or the demand because they both are small compared to the above-ground supply. In a consumption market, the trade is mostly from producers to consumers, while the majority of gold trading consists of movement of gold from one stockpile to another stockpile. The supply schedules are dominated by the offers of existing stockpiles at a range of prices. The demand schedules are dominated by reservation demand to hold existing stockpiles. Selling by producers and buying by (destructive) consumers is small in comparison.
As I have explained here, the gold market is a single integrated market where all sellers compete against all buyers. It is not an annual market for the current year’s supply. Buyers compete to buy any gold, not only for gold mined in the last year. All sellers compete to find buyers. The reservation demand for existing stocks, because it is so large, is the major player in the price formation process.
While I have argued above that the quantities traded do not drive the price, my point here is a different one. Consider a gold market without producers or (destructive) consumers. The market would clear at a price and quantity where the supply and demand schedules come into balance. Adding a relatively small quantity to either side of the market would not move the price much, even if the buyer (seller) were totally price-insensitive because of the large depth of the supply and demand schedule on either side of it.
Recent Activity Sets the Price
In the AGC Presentation (p. 100), Mr. Christian explains that he does not consider gold holdings to be part of the market if those holdings have not changed hands recently. This is consistent with the view discussed in the previous section, that the market price clears only the current year’s supply against the current year’s demand. If I understand the reasoning behind this, Mr. Christian believes that only transactions participate in price formation. After a particular gold ounce has not been traded for a long enough time, he no longer considers that ounce to be part of the market. At that point, in Mr. Christian’s view, that ounce has no impact on the market price. This view is consistent with the CPM’s mistaken focus on quantities traded as the keys to the gold market:
Gold also has a multiplier. For the Australian dollar, as with the U.S. dollar, I believe the multiplier is around 3 or 4. For gold, our estimate is that the multiplier is around 9 at present. That is, an ounce of gold entering the bullion market, from mine output, scrap recovery, central bank sales, or wherever, will be involved in 9 transactions before it exits the bullion market, either being used in a fabricated product or being dumped into an investor’s inventories somewhere.
Mr. Christian’s view is entirely mistaken. As I have explained, the supply side of the market is formed by all of the owners of existing gold, who offer it at a range of reservation prices. The price is an emergent property of the decisions of all of the owners of gold stockpiles to not to sell below their reservation prices, and the decisions of gold bidders not to offer above their reservation prices. The reservation demand of the sellers of existing gold, no matter how long ago it last traded, is the primary reason for the gold price being where it is.
Net Sector Flows
My second criticism of the CPM Group’s model is over-emphasis on net sector flows. In the preceding section, I discussed Mr. Christian’s incorrect view that gold holdings are not part of the market. Removing holdings (the primary locus of price formation) from consideration leaves only quantities recently traded as a possible object of investigation. The CPM Group goes to the far regions of the earth to measure quantities. The effort expended to get the numbers is impressive. While these numbers contribute to our understanding of what is going on in the market, they are largely irrelevant to an understanding of the price.
As explained above, net sector flows are caused by preference changes, and are not a cause of the gold price. Quantity balance rules require that “total supply” as the CPM Group defines it be equal to the sum of gross fabrication demand and net investment flows (private and official). This identity is logically valid and true at all times, but it contains no information about the cause of the price, for the reasons given above: a net flow into, or out of, one sector of buyers is not the cause of the price being higher, or lower. For every inflow into one market sector, there are equal and opposite outflows from other market sectors.
As discussed above, I believe that the CPM Group’s model attributes causality to net flows based on the mistaken belief that the market’s price equilibration process only balances net flows during a year. As explained, flows are not a cause or driver of the price; they are a reflection of changes in preferences that have occurred since the last trading activity. These changes in preferences determine where the gold flows.
CPM Group: Conclusion
The CPM Group’s approach to the gold market is consistent with common practices in the industry. Their approach is not any more mistaken than that of the other analysts who do things the same way. I have chosen CPM as the subject of this appendix because the clarity and detail of their reports has made it easier for me to follow their thinking. I do not take issue with the entire contents of the yearbook, only with their misuse of quantities.
I cannot rule out the possibility that the CPM Group has found statistical correlations between net flows into or out of one of the sectors, and the gold price and that these correlations are employed in their proprietary model. This could occur if it were generally true over many years that actors in one sector (or country) tended to be more price sensitive, or those in other sectors less price sensitive. If that were the case, then buying by the traditionally price-insensitive buyers would be correlated with a higher gold price and selling by price-sensitive buyers would be coincident with a lower gold price.
I should also give CPM Group credit for their study of macro-economic factors that do impact the gold price. These factors influence the price through their effect on investor preferences. I agree with the 2012 Gold Yearbook Press Release that “a host of economic, financial and political problems” are driving investor interest in gold. The Yearbook covers in detail macro-economic factors such as monetary policy, the business cycle, currency exchange rates, debt, and political uncertainty.
[1] I had hoped to use only free sources but I found that the yearbook, which is priced at $150, contained invaluable information in my understanding of the CPM Group’s model. The CPM Group originally provided me with a free copy of the yearbook, but prior to writing this article, I purchased a copy at the normal retail price.
Robert wishes to thank Mr. James Hickling of GoldMoney.com for assistance in copy editing the final draft.
Most gold market research is based on the premise that the supply side of the market can be characterized by the quantity supplied and demand side by the quantity demanded. The specific cause and effect relationship between these two variables and price is often unstated; and perhaps rightfully so: is it not obvious that a greater quantity demanded is the cause of a higher price, and that a greater quantity supplied is responsible for a lower price?
No.
This article will show that market forecasts based on quantities of gold are meaningless. Widespread statements like “Gold demand was up by 15% in 2012” are true but only if they are understood in a misleading sense. The supply and demand sides of the market consist of supply and demand schedules, not quantities. A price forecast based on quantities is a non sequitur because there is no causal connection from the quantities to the price. This error has side-tracked the majority of analysts into an obsessive focus on quantities while ignoring the actual drivers of the price.
The first part of this article will examine the definitions of supply and demand and discuss their relationship to price. Most analysts define supply and demand as quantities. There are several ways to do this. If used consistently, any of these definitions are valid but none of them are useful for the purpose of price estimation.
After establishing the definitions, I will show that the quantities supplied and demanded must conform to an arithmetic relationship that is logically true but has no causal connection with the gold price. Supply and demand totals can be any numbers that satisfy the arithmetic relationship, while at the same time the price can rise, fall, or stay flat.
The next section will explain the true drivers of the gold price: the supply and demand schedules. These schedules are not scalar quantities and cannot be measured; they can only be observed indirectly through the gold price itself. I will show that the cause and effect relationship between quantity and price runs in the opposite direction from what is widely assumed. The quantities are driven by a temporary disequilibrium between the market price and the supply and demand schedules of investors. This disequilibrium induces market participants to supply, and to demand gold to bring their portfolio in line with their preferences.
An appendix delves into materials from the CPM Group, a prominent and respected gold market research consultancy, showing how their research relies on the same error.
This article does not entirely stand alone; it builds upon other articles that I have written about the gold market, and on the marginal price theory of the Austrian School. Some parts of this article will not make sense unless you are familiar with some of these concepts. I chose to do this partly to avoid repeating ideas that I have already published, and partly to control the length. I have linked to background material that I believe is relevant.
The Usual Explanation
First, let’s look at the examples. Most published analysis of the gold market is concerned with supply and demand numbers.
As the gold price increases, demand for gold and other precious metals has continued to grow. Demand for gold has continued to grow in 2012 and is predicted to increase further next year. Research by Source, a provider of exchange traded products, shows that inflows into European gold ETPs have reached $6.8bn this year to date, constituting a staggering 15.4pc growth
Almost every page of the World Gold Council’s Third Quarter 2012 Gold Demand Trends deals with either the quantity supplied or demanded by a sector of the market. The following sentences are selected at random for illustrative purposes:
Third quarter gold demand was up 10% on the previous quarter but 11% lower than record year-earlier levels (p1)
Investment demand was 16% below the exceptional levels witnessed in Q3 2011. (p2)
Total demand (including OTC investment and stock flows) was 2% weaker year-on-year … (p2)
The most significant contribution to the fall in gold demand came from a drop in bar and coin investment.
The World Gold Council’s web site contains the following:
Since 2003, investment has represented the strongest source of growth in demand. The last five years to the end of 2011 saw an increase in value terms of around 534%. In 2011 alone, investment attracted net inflows of approximately US$82.9bn.
Investment demand, the key driver for gold prices, remained at historically high levels last year. Net additions to private investor gold holdings declined to 34.3 million ounces in 2011, down 5.8% from 2010 levels. Even though net additions to private investor holdings slipped lower in 2011, a year in which prices touched a record high, the decline had followed two years of double-digit growth from already high levels of net additions to investor holdings. (p2)
Gold fabrication demand rose 0.6% to 72.9 million ounces in 2011, slower than the 2.3% growth in 2010 due to higher gold prices. Despite higher prices, many consumers sought to purchase more gold jewelry, specifically in developing countries, as a hedge against inflation and form of savings. Developing countries’ demand for gold in the form of jewelry rose to 50.2 million ounces, up from 49.6 million ounces. (p3)
…Demand for gold has been declining worldwide, but prices haven’t. What does this mean for someone investing in gold?
Gold demand declined 11 percent in the third quarter of 2012 compared to the third quarter of 2011, according to the World Gold Council (www.gold.org). Demand fell in every sector except for purchases by central banks.
Market Sectors and Flows
Most gold analysts divide the market into sectors. This section will discuss how this is done and what the quantities mean in relation to the sectors. A typical sector breakdown is: mines, industry, jewelry, investors, and the official sector (central banks). Some writers break the investment sector down into bars, coins, and ETFs. The choice of sectors is not critical to the points that follow; none of the conclusions would change if, instead of these sectors, flows between countries were used instead. Some reports combine the two approaches, dividing the developed world market into sectors and treating the rest of the world on a country or regional basis. Any of these breakdowns would serve equally well.
Below is a list of the sectors, their buying, and their selling:
Sector
Buying
Selling
Mine
Not a buyer
All production sold to the market, where it is eventually refined into investment, jewelry, or industrial products.
Industry
For electronics, dentistry, and other applications that use up gold.
Recovery from scrap
Jewelry
Raw material for fabrication.
Melt from scrap jewelry sold by people who no longer want it.
Investor
Additions to portfolio holdings.
Reductions from portfolio holdings.
Central banks
Add to gold reserves
Subtract from gold reserves
Inter-sector Flows and Quantity Balance
The quantity balance between sectors is at the core of most market analysis. The quantity balance is an equation relating all of the flows in the market to each other. (A flow is the quantity bought and sold, while a stock is a quantity held by someone over time). Quantity balance is the requirement that every movement of gold must be accounted for on the buy side and the sell side. It is similar to the way that double-entry bookkeeping works. This section will derive the quantity balance equation. The following section will discuss its significance.
Over a one-year period, every trade that takes place between a buyer and a seller is counted in the following way: the quantity of gold bought (and sold) is added to the buying sector’s gross quantity bought and to the selling sector’s gross quantity sold.
At the end of the year, net flows for each sector are calculated. The definition of the net flow for a single sector is:
sector net flow = sector total buying – sector total selling
Sector net flow can be a positive number, meaning that the members of the sector bought more than it sold; or a negative number, indicating that the members of that sector sold, in aggregate, a greater quantity of gold than they bought.
Assuming that mines sell all of their production, which is nearly always true, mine sector net flow is always a negative number.
For every trade, the quantity bought is equal to the quantity sold. This means that the sum of all sector net flows is zero. By the rules of algebra, this arithmetic identity can be rearranged in several ways:
(1) quantity mined + net industry + net jewelry + net investor + net official = 0
(2) net industry + net jewelry + net investor + net official = quantity mined
The CPM Group uses a different sector breakdown than I have used here, so their quantity balance is a little bit different. They use the following market sectors: total supply (mine plus scrap), fabrication demand (industry plus jewelry), official sector and investment. Their quantity balance in their partitioning is summarized in equation (3), below.
(3) quantity mined + industry sold + jewelry sold
= industry bought + jewelry bought + net official + net investor
In this breakdown, official and investor sectors have a net flow on the right side of the equation but the jewelry and industry sectors have gross purchases on the left of the equation and gross sales on the right.
The preceding equations are all saying the same thing: all the gold that comes out of mines ends up as net inflow into one or more market sectors. These identities all follow directly from the laws of arithmetic. They contain no new information. They are only a restatement of the original assumptions, namely, that miners sell all of their production, and that no gold is destroyed during a trade. The mine sector net flow is always negative but the other sector net flows could be positive, negative or zero.
Gold can be destroyed not in the physical sense, but in the economic sense. This means that the industrial process renders some of the metal into a form where it would be too costly to recover. The boundary where recovering gold from industrial use is cost effective depends on many factors, especially the price of gold, which can change over time. Gold destruction occurs only in the industry market sector. The rate of gold production always exceeds gold destruction. Consequently the total of gold held above ground grows over time.
The False Logic of Quantities
I believe that the error of attributing gold price moves to quantities is based on the following invalid thought process on the demand side (with similar thoughts on the supply side not shown here):
The gold price is driven by supply and demand
Supply and demand are quantities
Looking at the demand side, more demand implies a higher price, less demand a lower price.
More supply means a lower price, less supply a higher price.
The key to forecasting the gold price is therefore measurement of gold supply and demand.
Arthur Stein is representative of this type of reasoning. Quoting at length from his bearish forecast,
Gold is unlike other commodities in many respects. For investors, one of the significant differences is that the supply of gold (called “above-ground gold”) never decreases; it only increases. So declining demand should cause a decline in the price of gold, not an increase.
The sources of total demand are another concern. Jewelry demand has been declining since at least 1997. Jewelry demand in 2011 was 40 percent lower than 1997 and demand in the first three quarters of 2012 was 9 percent lower than the same period in 2011. … Industrial and dental demand declined in 2011 and is on track to decline another 6 percent this year. … Investment demand (bars, coins, Exchange Traded Funds, etc.) declined 3% in the first three quarters of 2012 compared to 2011.
The bright spot for gold demand was official sector (central bank) purchases. Central bank activity went from net sales to net purchase in 2010, and net purchases continued to be positive in 2011 and the first three quarters of 2012.
The main problem with this view, as I will show in the next section, is that there is no cause and effect relationship between the quantities and price.
Flows not the Cause of Price
The financial media commonly reports that buying is the cause of the price going up. Stories in the financial media usually report only one side or the other side of the market. For example, an increasing number of small investors buying coins is often cited as the cause of gold price strength. However, the same story could equally well have been written as a bearish report about the increasing number of investors willing to sell their coins. Either story would be true, at least from a quantitative standpoint and both would be wrong in attributing the movement in the gold price to one side of the market only.
If the reporter accurately described a large volume of coin buying and an equal volume of coin selling, then what conclusion about the price should the reporter draw? Exactly none. Buying as such is not the cause of the higher gold price, nor is selling the cause of price declines. If buying could take place without selling or selling without buying, then one or the other could be an independent cause of price moves. But neither can occur without the other. Buying and selling occur always in equal quantities, and, at the same time. For every purchase of gold by a buyer, an equal quantity is sold by the seller. The quantity of buying, which is always the same as the quantity of selling, is not the cause of the gold price.
While everyone agrees that the gold price is driven by supply and demand, not everyone who voices agreement means the same thing. The correct version is: the gold price is driven by supply schedules and demand schedules. Most analysis of the gold market is based on an incorrect interpretation of the statement, namely, the gold price is driven by the quantity supplied and the quantity demanded. An increase in gold demand is the cause of a higher price if an increase in demand, means a change in the preference rankings of coin buyers for more gold/less cash. In that case, all other things equal, transactions would occur at a higher price.
The quantity balance equations are logically valid at all times, but they are accounting identities, not statements of cause and effect [1]. The quantity bought and sold is not an explanation of why the price moved. All inter-sector flows must balance, but flow is not the cause of the price; it is a summary quantity of gold traded, at whatever price. Any combination of positive, negative, or net inflows or outflows into any one or more sectors could occur during a year where the gold price was higher, lower, or unchanged.
Suppose during the last year that net investor inflow is a positive number and net official inflow is negative. This indicates that over one year, investors purchased gold from central banks. But this fact is an arithmetic identity, not a cause of the gold price movements during this year. If, the following year, central banks on net purchased gold from investors, we are still no closer to knowing at what price the gold was purchased, and whether that price is higher or lower than the current price.
The True Cause of the Gold Price: Marginal Preferences
Each investor strives to maintain their desired holdings of all potential assets, including cash (i.e. one or more national currencies such as the US dollar or euro). As their preferences change, and as market prices change, investors adjust their portfolio holdings, at the margin, to bring them in line with their preferences. The price of an asset emerges as investors balance, bid for assets they wish to hold more of and offer assets they prefer to hold less of.
Supply and demand as they contribute to the price must be understood not as quantities but as schedules. Market prices balance the aggregated supply and demand schedules of the entire market. These aggregated schedules are also known as the more widely used supply and demand curves. In the standard micro-economic presentation, the supply and demand curves intersect at a point, marking the price and the quantity.
I have written about the application of supply and demand schedules to the gold market in Does Gold Mining Matter? There I explain that the supply schedule for gold (in dollar terms) is dominated by the owners of the world’s existing stockpile of gold, and that mined gold during any one year period has a relatively small impact on the supply schedule. The price is set primarily by the reservation demand schedules of the owners of the existing gold. In the same piece,I show that the quantity mined, which many analysts incorrectly believe is “the supply”, has little influence on the gold price.
The quantity balance constraint cannot be a cause of the gold price because balance equations contain only quantities. The gold price is the quantity of money exchanged for the quantity of gold. Any explanation of the gold price must contain some reference to the quantity of money involved. Equilibrium price theory provides a complete theory of the cause of the gold price, taking into account the gold and money sides of the market.
If the gold price is higher now than it was at some point in the past, that can only be due to a shift in preference schedules. One of the following must be true: 1) either buyers valued the gold more highly and thus were willing to pay higher price, or 2) sellers valued their gold more highly and were only willing to part with it at a higher price. Historical net flows provide a summary of where in the market were the buyers who valued gold the most highly, and the sellers who valued it the least.
Up to this point I have argued that the quantities supplied and demanded are not the cause of the gold price. The true causal relationship between price and quantity is nearly in the opposite direction. Transactions occur in the market because there are some investors whose mix of cash and gold holdings is not consistent with their preferences. Trading will occur until everyone has adjusted their portfolios, at the margin, to their preferred holdings. If no one changed their preferences after this moment, and no new gold were mined, then no more trading would occur.
Trading continues because people are always changing their minds about what they want to own. Individuals who did not previously consider themselves gold investors enter the market; others no longer consider gold a good investment sell out. The more individual investors that have changed their preference rankings since the last market price, the greater the disequilibrium in the market, and the more change in the ownership of gold and cash is necessary in order for investors to reach their desired holdings. The volume of trading reflects the extent that holdings of some individuals no longer reflect their preferences.
Attributing a higher gold price to an increase in coin buying alone ignores the equal quantity of coin selling that is necessary for more coin buying to occur. More coin buying means more coin selling. The media story about coin buyers driving the gold price higher could be correct, if the buyers are the only ones whose preferences have changed. In that case they are willing to pay up, higher into the supply side of the market. But action in the coin shops could also result from sellers liquidating at lower prices, or a simultaneous set of changes by some buyers and some sellers that cancelled each other out in price action, leaving the price unchanged after a large volume of trading.
Demand Schedules Not Measurable
So far I have argued that the gold price is an outcome of the preference schedules of investors. A preference schedule is not a number. It is a spiky curve representing a range of quantities and prices. Schedules are not directly measurable in the way that quantities are, because they include hypothetical quantities that would be supplied and demanded at prices above and below the market. In order to have the complete supply and demand schedules, the analyst would have to know how much gold would be sold and purchased at every price. When gold trades, we know only the quantity supplied and demanded at one price.
Laura Davidson explains this point in her excellent piece The Causes of Price Inflation and Deflation. In reading the quoted passage, it may help to understand that reservation demand for money is another term that means the same thing as the term that I have been using, cash holding preference, except measured against all goods in general.
When the social reservation demand for money changes, it can neither be measured nor observed directly. Whether market participants hoard money, or dishoard it, the amount of money in their wallets and their bank balances in the aggregate remains exactly the same ceteris paribus. There is no special place from which money flows, or to which it flows, when the demand for cash balances changes.
The same point can be made for any good that is demanded in order to be held in stockpiles. Examples include not only gold but most financial assets such as stocks and bonds. Reservation demand can be inferred, indirectly, by observing the price. Davidson continues,
Nevertheless, it is possible to observe the effects of the change [in reservation demand]. Suppose, for example, prices-in-general are falling, and yet the supply of goods in the market has not changed. From this it can be deduced that the exchange demand for goods must have fallen. But let us also suppose the money stock has not changed. This leaves only the reservation demand for money as the causative factor for the reduction in the demand for goods and the ultimate cause of the price deflation.
While I have spent most of this article discussing demand, the supply side of the market works the same way. Supply schedules and demand schedules together drive the gold price. Supply schedules are immeasurable as are demand schedules.
Conclusion
The main point that I have tried to show is that the demand numbers used in most gold market reports do not measure the demand side of the price formation process. The same could be said about the supply number. These two numbers are connected through the quantity balance constraint but they are not the cause of the gold price.
Gold market analysts have a tougher job than other financial analysts. In Value Investors Hate Gold, I argue that it is more difficult to analyze the yellow metal than equities because quantitative measures such as yield, cash flows, balance sheet leverage, and growth rates provide a fundamental basis for analysis. Gold has none of those things.
The fundamentals of gold are the current purchasing power of money; expectations about the future purchasing power of money; the growth rates of various national money supplies; the volume of bad debts in the system; expected growth rates of bad debts; the attractiveness of other available investments; and the investor’s preference for consumption rather than investment. These factors do not act directly on the gold price. Instead, they are focused through the prism of investor preferences, which are not measurable. The price is the ultimate measurement of how investors view these factors. Gold presents a paradox: that which drives the price cannot be measured, that which can be measured does not drive the price.
Few publications have the capacity to enrage like the Financial Times. On the one hand, it carries thoughtful, well written and engaging commentary from the likes of John Kay, Luke Johnson and Gillian Tett. On the other hand, it regularly publishes Martin Wolf. The latest weekend edition does not disappoint. Tim Harford, hitherto unobjectionable, publishes what can only be an elaborate ironic joke against gold, ‘The Bundesbank takes back its doughnuts’..
For anyone that missed the news, Germany’s central bank is in the process of moving 54,000 gold bars from the US Federal Reserve and the Banque de France back to Frankfurt. What is that all about? Tim Harford:
There is no thinking behind that. This is gold we’re talking about, so we’re entering the asylum.
Strike One.
But gold has been a good investment – if one can call it that – over the past decade. Tim Harford:
It’s been an excellent investment. But there’s no logic behind the gold bubble.
Strike Two.
Perhaps he could be more expansive. Tim Harford:
..gold is a bubble because its investment value isn’t connected to the stream of income it produces. Housing produces rent. Bonds produce interest payments. Shares produce dividends, or at least the prospect. But gold doesn’t produce any income stream.. Therefore it is a bubble. It may remain an excellent investment: any bubble that has persisted for 4,000 years has to be pretty resilient.
Strike Three. You’re out.
It takes either guts or self-delusion to call yourself an economist when you plainly don’t understand money. JP Morgan once said that gold was money, and everything else was just credit. To us, that isn’t a bad definition. And money – in the form of US dollars, British pounds, Euros or Yen – doesn’t produce any income stream either. A dollar bill or a five pound note are, like gold, economically inert. They only produce income when they are transformed into bank deposits – a transformation that in the process exposes the holder to the credit risk of the depositing institution. But at the moment, cash deposits are effectively yieldless, meaning that savers are now exposed to return-free risk. A flight into real assets at this juncture would be grounded on reason.
Tim Harford is, of course, free to insult savers in gold, just as Martin Wolf is free to insult Austrian economists – of a school of thought he recently described as “an American disease” (words which we suspect will come back to haunt him) – who understand that field more profoundly than he does. But the debate is only valid in the first place if the insult contains at least a germ of underlying truth. Implying that people, and central banks, are mad to hold gold also implies that we should hold our savings in the form of conventional, fiat currency instead. How has that worked out as a store of value? Since 1913, when the US Federal Reserve (a private banking cartel as opposed to an arm of the US government) was established, the US dollar has lost 98% of its purchasing power. With state money printing now accelerating to a level never seen before in world history, is the purchasing power of paper money likely to be enhanced, or further degraded relative to hard assets?
The bubble is not in gold, it is in paper. There is admittedly something rather endearing about the concept of a 4,000 year old bubble. But most professional investors would use a more pragmatic definition of the word. A bubble, by definition, pops. Has gold popped? Every paper currency in the history of mankind has burst. Every single one. Which store of value has the better long term claim?
Gold ‘bugs’ are not irrational. It is a fairly unusual bubble that enjoys such little participation from investors: private institutional ownership of gold worldwide is almost non-existent. And it is paper money unbacked by anything of tangible value that we would be mad to use to the exclusion of all else. There is a fundamental illogic to Tim Harford’s criticism of central banks for holding gold and repatriating it, when he simultaneously grants them validity in controlling conventional fiat money. They cannot at the same time be mad in using gold as a store of value and sane for the issuance, management and manipulation of the supply of unbacked fiat, can they?
Detlev Schlichter recently demolished the case for the $1 trillion platinum coin, a proposal that highlights the desperate absurdity at the heart of modern western central banking. It is critically important that investors and savers understand the desperate absurdity driving monetary policy and currency debauchery.
The ghoulish problem that we face is that we know that this system will unravel, but we do not know when. The pragmatic response, then, is simply to hold one’s wealth in those forms of saving and investment that are least likely to depreciate in real terms – and which also hedge against the widest possible range of potential economic and political outcomes – for the duration of this long emergency. That need not mean gold exclusively. But it’s certainly a fine place to start. Tim Harford would disagree – and that would also be an excellent argument in its favour. Sell economic ignorance; buy gold.
Episode 88: GoldMoney’s Andy Duncan talks to Doug Casey, the founder and chairman of Casey Research and the author of a new book called Totally Incorrect. They discuss the current state of global finance and the chances of an upcoming paper money collapse.
Casey points out that the recovery after the 2008 financial crisis is just an illusion created by central bank money printing which will ultimately lead to very high inflation once bank lending starts to pick up again. Both men discuss what will happen when all the US dollars currently held overseas are repatriated as foreigners lose confidence in the greenback. They also speculate about what Keynesians might be thinking at the moment, and analyse how non-western central banks are beginning to behave with regards to gold.
They evaluate the likelihood of western economic collapse in 2013, what this would imply for the global monetary standing of gold, and how GoldMoney subscribers can best protect themselves and their assets. On this note they also talk about how a future world monetary situation might look like once we are through the Keynesian collapse. Casey also speculates about how the theories of Professor Hans Hermann-Hoppe might have applicability to the shape of the world order post-crash, and what readers can look forward to if they purchase a copy of Totally Incorrect.
Finally, they discuss what type of “black swans” we can expect to land in the coming months.
This podcast was recorded on 15 January 2013 and previously published at GoldMoney.com.
Last Wednesday the Bundesbank released a statement to the effect that 300 tonnes of Germany’s gold will be moved from New York and 374 tonnes from Paris. This should be a simple operation: rail or trucks from Paris, and a few military planeloads (or ships) from America – as soon as they have somewhere to store it.
Instead they plan to do it over the next seven years, which is a postponement. This tends to confirm suspicions that the gold does not actually exist. As a side issue, along with the Bundesbank statement is a PDF download with slide number 14 entitled “Storage at the Federal Reserve Bank New York”. It looks like a photomontage rather than real gold, and the come-on is to believe it’s the Bundesbank’s. This gives the game away: the whole exercise is a public relations stunt.
Why hold any gold in New York nowadays? The Soviets are no longer menacing the Fulda Gap. Yes, New York is obviously still a critical trading venue, but not for physical gold – the Bundesbank apparently withdrew 940 tonnes from the Bank of England in 2000, where the physical market is actually located.
The reason this matters is that independent deductive analysis has concluded that the central banks have been supplying the market with physical bullion in order to suppress the price, all of which is either officially denied or goes unanswered. The origin of price suppression actually go back to the 1990s, and was exposed by Frank Veneroso in a paper published in 1998, confirmed by detective work from our own James Turk, and triply confirmed by the evasive responses on this issue given by central banks and the IMF to the Gold Anti-Trust Action Committee (GATA). The public are unaware of this issue because the mainstream media, with the occasional exception, refuses to investigate the subject.
But here is something that joins up a few more dots. We know that Gordon Brown sold half of Britain’s gold at the bottom of the market from 1999-2002. We commonly assume that he was just incompetent. What is not commonly appreciated is that he learned his economics from Ed Balls, the current Shadow Chancellor. As his economics advisor, Balls was the puppet-master and Chancellor Brown the puppet. Ed Balls was also a close friend of Larry Summers, who was US Deputy Secretary of the Treasury from 1995 and then Secretary of the Treasury from 1999 to 2001 – the time of Britain’s gold sales. As Treasury secretary Summers was head of the Exchange Stabilization Fund, the US government’s mechanism for supplying bullion to the markets. In the light of these deeply Keynesian relationships from the mid-1990s, it is unlikely that Brown acted in isolation. More than likely Washington was also supplying the market through swaps and leases that were never recorded as changes of ownership.
The net result is that there is not enough physical gold left in the vault to deliver to Germany, which is why they are stalling for time. What was presented to us last Wednesday was just a desperate attempt to stop the whole issue becoming more public.
This article was previously published at GoldMoney.com.
Episode 86: Professor Patrick Barron is an Austrian School economist who teaches courses in banking and economics at the University of Wisconsin-Madison and the University of Iowa. He also writes regular pieces for Mises.org.
Professor Barron has put forward the idea that the only route out of the ongoing euro crisis for Germany is an initial return to the Deutschmark, followed preferably by a subsequent move to a golden Deutschmark. He discusses this idea with GoldMoney’s Andy Duncan, along with the three major obstacles to his desired outcome, which include a lack of current party-political support in Germany for this idea, along with outside political influences over Germany’s monetary policies, and the growing uncertainty over Germany’s access to its own physical gold supply.
As well as exploring the current financial situation in Europe, Professor Barron also comments upon the recent fiscal cliff event in the United States, and mentions the recent article in The New York Times, by Paul Krugman, on the subject of a special trillion dollar platinum coin. He explains why eventually he believes the US dollar will go back to a link with gold, and why he thinks the price of gold may then reach $38,000 dollars an ounce. Professor Barron runs his own website, which GoldMoney subscribers can find at www.patrickbarron.blogspot.com/.
The book mentioned heavily in the interview, The Tragedy of the Euro, by Professor Philipp Bagus, can be downloaded for free from this link.
This podcast was recorded on 11 January 2013 and previously published at GoldMoney.com.
Not your typical Cobden Centre interview, but hopefully thought-provoking …
John Llewellyn is one of the most highly regarded economists in Europe, having worked in the private sector, academia, and national and supranational policy institutions. He now runs his own consultancy, advising governments, multinational corporations, and institutional and private investors. He was educated in the neo-Keynesian tradition but, on becoming an applied economist, he became what he terms “an evidence-based eclectic”. As such John recognises the potential explanatory limitations of the Keynesian paradigm for a world of excessive debt and unprecedented policy activism. At present, he is concerned about what appears to be an unfolding, synchronised global cyclical downturn amidst what remains a structurally weak growth environment. The consensus is in his view too complacent in believing that recent policy stimulus actions will either lift growth rates or reduce debt burdens meaningfully over the coming 1-2 years.
BY WAY OF BACKGROUND…
Born in England, but raised in New Zealand, John Llewellyn attended The Victoria University of Wellington for his BA (Hons) degree and then Oxford University, where he obtained his DPhil. He then researched and taught at Cambridge University for nearly ten years, and was a Fellow of St John’s College. Thereafter, he moved to Paris to the Organisation for Economic Cooperation and Development (OECD), the supranational economic policy analysis and forecasting organisation, where he rose from Head of Economic Forecasting to Deputy Director for Employment, and finally Chef de Cabinet to the Secretary General. In 1995 he moved to London, where he was Global Chief Economist for Lehman Brothers until 2005, when he became the firm’s Senior Economic Policy Adviser. Following the bankruptcy of Lehman Brothers he set up his own firm in 2009, Llewellyn Consulting, which specialises in thematic macro research (e.g. demographics, technological innovation, climate change) and economic risk assessment.
I came to know John during my time at Lehman Brothers in the mid-2000s, where I was the European Head of Interest Rate Strategy. We worked closely together to link economic forecasts and risks with practical, implementable strategies for the global interest rate and currency markets.
We both became deeply concerned by developments in global housing and credit markets in the mid-2000s, in particular in the US, agreeing that a dangerous bubble was forming in association with global trade and capital flow imbalances. On numerous occasions we presented our counterparts and other colleagues in New York with this view. It was not well received.
When the crisis began to unfold in 2007, and then intensified in 2008, neither of us was particularly
surprised. We did not, however, predict that not only Lehman Brothers but also a number of major financial institutions would fail. The intensity of the crisis and the aftermath of tepid growth, together with lingering structural problems and global imbalances, have caused both of us, each in our own way, to change the way we think about the world, and question some core assumptions. In general, this process has led us to become decidedly less optimistic in how we see the economic future.
John and I continue to speak on a weekly basis, and get together at least once a month to review global economic developments and assess the risks, as we see them. Recently, John identified an associated set of economic risks that could well result in a much sharper downturn in global growth over the coming year than the consensus expects. What follows below is a rough amalgamation of several informal, recent conversations between us about how John came to this view; about the risks associated with excessive debts and so-called ‘financial repression’; the future of the euro and possible alternatives to the current set of national economic policy choices. The conversation then turns to the financial markets.
THE GATHERING STORM
JB: John, in your most recent economic risks publication, you write that, in 2013, economic activity in nearly every part of the world is likely to slow. That is highly unusual. Normally there are at least a few pockets of strength that support demand for weaker economies. If that is not going to be the case, does this raise the risk of a generally sharper downturn across the world?
JL: It does. Conventional, single-economy, economic models assume stable and reasonably large fiscal and monetary multipliers. These are derived from historical observation. But there is little evidence about synchronised global downturns, so most of the data are irrelevant, or at least potentially misleading: policymakers are therefore likely to underestimate the size of the coming slowdown. This analytic point used to be one of the major reasons for, and messages from, the OECD; but the message is heard less these days. Were the US, the EU, or China to get traction with new stimulus in the near-term, then the slowdown would be less likely to be synchronised, and the consensus, as best I can tell, would be more likely to be correct that 2013 growth will be similar to 2012. On the other hand, if there is a further move toward outright tightening of policy, say due to the fiscal cliff in the US, or enhanced austerity in Europe, things could get worse.
JB: Let’s step back for a moment. Neither the fiscal cliff nor austerity would be an issue if debt burdens were lower, or growth higher, or both. Manageable debts are a nonissue. How did the developed world get into this mess? Is it purely a result of the financial crisis, or were there longer-term, structural forces at work, largely unseen by the policy mainstream?
JL: To some extent the answer differs from country to country. Some, like Greece and Portugal, were simply consuming beyond their means, and had to rein in total expenditure. Others, like Spain and Ireland, as well as the UK and the US, let leverage in their financial systems build up to such an extent that, when assets prices collapsed, the authorities had little option but, in effect, to nationalise the resulting private sector debt in order to keep the financial system functioning. But overlaying this in virtually all economies was, and is, a set of promises made by generations of politicians that they will be unable to meet, not least given the ageing of populations.
JB: Doesn’t this bring a central tenet of Keynesian economics into doubt, that you can borrow your way to prosperity? While countercyclical government borrowing and spending seems reasonable on paper, we now have quite a bit of empirical evidence that these debt burdens accumulate over time, that governments embrace deficit spending but eschew the offsetting surpluses required to keep finances in balance. Going forward, should we have faith that policy can be more responsible?
JL: The central tenet of Keynesianism is subtler than the bastardised version that came to be taught later. I was taught what I would term ‘classical Keynesianism’ in New Zealand, and had it reinforced at Cambridge by former colleagues of Keynes, such as Joan Robinson, Austin Robinson, Richard Kahn, Nicholas Kaldor, as well as more recent luminaries, such as Geoff Harcourt and John Eatwell. This central tenet is that borrowing works if it takes GDP back towards full employment, and fairly quickly, and if it kindles, or re-kindles, Keynes’ ‘animal spirits’ – the entrepreneur’s intrinsic faith such that he or she is willing to incur the certain cost of borrowing now in the expectation that he or she will earn a return in an unavoidably uncertain future. In other words, as Robin Matthews pointed out in the 1960s, Keynesianism works only if people believe it will work. Or, as Keynes observed, economies are held up by their own bootstraps.
FINANCIAL REPRESSION PAST, PRESENT AND FUTURE
JB: Returning to the fix we appear to be in, I know you have thought extensively about policies that limit financial freedom in order to subsidise government debt service and reduction, collectively termed in the jargon as ‘financial repression’. Could you elaborate on this and how you see it developing going forward?
JL: Basically in such circumstances, governments do four things: they encourage inflation; they instruct the central bank to keep short rates and bond yields along the curve low; they oblige savers (including pension companies and insurance companies) to hold an increased proportion of their assets in government bonds; and they impose capital controls to prevent savers from taking their capital abroad in search of higher real yields.
JB: But does it work? Recall that Carmen Reinhart made explicit that ‘financial repression’ is historically associated with failing third-world governments desperate for public revenue. What does this imply about the developed world today? Are you troubled by this? Does it not seem, potentially, to be a road to ‘financial tyranny’? A road to Argentina, to name an obvious case in point?
JL: It does work; but of course it is troubling. The West has used these policies before. The UK, the US, and France amongst others did exactly what I have summarised to reduce public debt as a proportion of GDP after WWII. But there was a difference then: As various people of that generation have told me, they were completely aware at the time that the war bonds that they were buying would not be worth much, if anything, after the War. But they bought them nevertheless, because that was the price for having a chance to defeat tyranny. I am not sure that the younger generation will be so tolerant today with politicians and political parties who made promises only to get elected, and which they knew they could not fulfil.
PRESENT AT THE CREATION
JB: You were, to use a colloquial term, present at the creation of the euro. You knew some of the architects. You observed, indeed contributed to, some of the planning, as well as the implementation. And now you have observed the crisis unfolding. You have always held that the euro is a political project, and remains so. You are also on record as having more confidence than most that the euro will not only survive but that it will in time prove its detractors wrong, that it will enhance European economic performance through greater stability and integration.
Given recent developments, this seems a bold view to some. Would you care to elaborate?
JL: All economists involved in the creation of the euro knew that its initial institutional arrangements contained a number of important flaws. But those ‘present at the creation’ also knew that Chancellor Kohl and President Mitterrand knew this too. The Kohl / Mitterrand calculation was that they were the last generation fully able to appreciate the enormity of war in Europe; that they would bind their two economies together by ‘a thousand silken threads’; and that they would hope that when, in the future, the project ran into problems, their successors would choose to fix them rather than allow the union to break up. So far, the gamble has paid off. Of course, the British do not see it that way. They were told by Edward Heath that this was an economic union, and they believed him. And British economists in turn analyse the union purely in economic terms. That is a generalisation: but you get the point.
JB: You also hold, and rightly so I believe, that there is far too much focus on the troubles of the euro-area and not enough on those elsewhere. As a case in point, consider Japan, which has comparatively larger demographic issues with which to deal and which is, following a multi-decade period of sub-par growth, slipping out of trade surplus and into deficit. In my opinion, this is an issue not only for Japan but for the entire world. How do you feel about Japan?
JL: Under US guidance, Japan did a brilliant job after WWII in adapting its manufacturing sector to the Western (initially US) market which the US opened to it, and then widened further by admitting Japan to the OECD. But Japan’s policymakers drew a wrong conclusion: That the only way to grow was to sell goods to foreigners. As a result they never allowed any real competition, nor any structural reform, to take place in the service sector: They did not realise that they could get rich also by selling to themselves. To this day, they have not learned that lesson.
JB: It is so easy to forget that no single economy is a closed system. Especially today, given how globalised the world has become. Even the US, which has a comparatively small external sector, is today far more widely integrated into the global economy that it has ever been. There is also the non-trivial matter of the US providing the world’s reserve currency. Some argue that this ‘exorbitant privilege’, to use a term coined by former French President Valery Giscard d’Estaing, is not at risk. I know you disagree that the US is a ‘safe-haven’ in the way normally portrayed in the financial press. Could you please elaborate?
JL: A country is a safe haven right up until the moment when investors decide that it is not. The US economy produces a vast array of goods and services. If since WWII one had to hold monetary assets denominated in any currency, that currency would be the US dollar. Dollars can be converted into anything that one might conceivably want. But alternatives are emerging: The euro. The renminbi. At the least, investors will want to diversify; and indeed they are so doing. And if the US does not deal with its fiscal problem, the move away from the dollar will likely accelerate.
JB: But that is precisely the point: The US is not a safe haven. A safe haven cannot be a country that is at risk of devaluation, default, or some combination of the two. But that does leave a rather small list of countries, and I would suggest that none of them is realistically the provider of a dominant reserve currency, or the provider of sufficient additional aggregate demand to provide for Keynesian stimulus to bail the world out of its excessive debts. If this is the road we’re on, where does it lead? Can the economics profession continue to act as if the policy tools and actions that got us into this mess can get us out? Or does the solution lie elsewhere?
JL: Just as reflating one’s own economy requires that entrepreneurs and investors have faith in the future, so does reflating the world economy require that entrepreneurs and investors have faith in the currency or currencies that are attempting the reflating. I shudder to think what the world economy will look like of investors’ faith in the dollar declines, rather than revives.
FROM DEBT CRISES TO CURRENCY CRISES
JB: When a debt crisis becomes a currency crisis you have a problem that is an order of magnitude greater, because at that point you are not only distorting macro price signals via ‘financial repression’ but as there is now so little confidence in the stability of the currency, and households and businesses no longer have confidence in their ability to manage their time preferences effectively. Austrian economists would argue that this is so damaging that, if sustained, it will destroy an economy’s capital stock through severe resource misallocation. Do you have some sympathy with this view or is it too pessimistic?
JL: I have some sympathy, but also some humility. When economies are so far away from where they have even been in modern economic history; when the structure of our economies, with their much, much larger government sectors, is so unprecedented; and when we have been told so confidently what will happen by economists who engage in a priori theorising only to be proved wrong later, I am, I confess, rather more humble.
JB: The alternative to printing your way out of a debt burden is to allow for bankruptcy, restructuring and reorganisation of the capital stock to take place instead. Josef Schumpeter called this ‘creative destruction’, and he believed that it was not only helpful but in fact essential for economic progress. Might a severe recession be exactly the bitter medicine required at this point to save the patient, rather than more of the palliative to date that appears not to be working, or perhaps even making the problems worse? Would you argue that Britain’s basket case economy of the 1970s could only have been turned around in this way? Or could there have been a more mainstream, Keynesian way to go about it, such as an even larger currency devaluation?
JL: I have never liked ‘severe recession’ as the cure for anything. The spectre of all that lost output always appalls me. It smacks of the same mentality that advocated bloodletting and leeches. It has always seemed to me that more useful things could be done with potential output than just letting it flow out to sea. The state could build toll roads, harbours, airports, even certain types of housing, and sell them off later to the private sector when confidence returned. Surely that ought to be possible.
JB: Let’s move a bit closer to your current home. What about the UK of today? Does the UK need to undergo another Thatcher-like experience, something beyond timid ‘austerity’, including more meaningful structural reforms to make it more competitive internationally in exports? If so, would that be easier to accomplish were the UK to leave the EU? You have said that there is a distinct possibility of that in the coming few years.
JL: I think that leaving the EU is a distraction from the real issue, which is that UK companies are sitting on a pile of cash and are so uncertain about the future that they will not invest. Meanwhile households are trying to reduce their borrowing; and so is the government. The only thing to be done, in my view, would have been for the government to have undertaken the type of investment that companies otherwise would have done, and sell it on later. But that idea ran straight up against political dogma.
JB: But if the UK economy needs to rebalance, doesn’t the US need to as well? And on the other side of these trade deficits are trade surpluses elsewhere. Can the world continue to grow without first correcting these imbalances to at least some degree? And doesn’t history suggest that imbalances this large are ultimately corrected only in periods of unusually weak growth?
JL: Here you are putting your finger on a problem that Keynes highlighted at the end of WWII, but which Harry Dexter White, the senior US Treasury official at the 1944 Bretton Woods conference, refused to acknowledge. Surpluses and deficits are mirror images of one another. Two sides of the same coin. There cannot be one without the other. Hence being in surplus is just as contributory to imbalances as being in deficit. In a properly run global world, policies would bear down on surplus economies and deficit economies equally. But they never do.
ON FINANCIAL MARKET VALUATIONS AND THE MONETARY FUTURE
JB: Taking into account our discussion so far, I think there are ample reasons why the stock market should appear ‘undervalued’ to many. P/E ratios may not be particularly high, even if profit margins are. The fact is, however, revenues simply cannot grow rapidly in this environment, at least not in real terms. And record profit margins cannot survive a proper global rebalancing as the cheap labour of emerging markets converges on the developed world. In my opinion, given the structural macroeconomic headwinds we have discussed, stock market valuations should, in fact, be at generational lows, perhaps below where they were in the early 1980s or early 1960s. Your thoughts?
JL: I think that that argument is correct as far as it goes. But given that investors are starting to lose confidence in paper assets, and particularly government paper, they want to hold something real: and that includes shares in companies. And it is not as if there is a stock market bubble – so far at least. PEs in the US and the UK are not far from their historical averages.
JB: But if stock market valuations need to adjust even lower from here, perhaps much lower if policymakers don’t embrace more meaningful structural reforms, and if bond markets are overvalued due to the risks of currency devaluations, where, exactly, is an investor to hide? I lean toward a diversified exposure to real assets, including raw commodities. Could you perhaps share your thoughts on that?
JL: Clearly, commodities, industrial, food, and of course gold, are obvious contenders.
JB: Speaking of gold, you are aware that I believe that there has now been so much global economic confidence lost that it will not be properly restored absent a return to some form of gold standard, if only for international rather than domestic commerce. While I know you are sceptical, you don’t disregard the idea entirely. You have mentioned before the possibility of an international pricing convention based on a ‘bancor’, a currency based on a fixed basket price of globally traded commodities. How might that work? And are you confident that there would be sufficient support for such a regime, given that global economic cooperation is endangered by the threat of competitive devaluation, trade wars and the rise of economic nationalism generally?
JL: It would work by governments setting fixed rates for converting currencies into a basket of commodities. I think that it makes logical sense; and it could help in spurring the production of commodities that would later be in demand as activity picked up. Kaldor thought a lot about this, and we discussed it when I worked under him. But equally, I am sure that it is a non-starter. Two decades of life in the OECD has shown me just how hard it is for countries to agree about anything so fundamental.
JB: Some economists simply dismiss the idea of a gold standard as archaic and unworkable. I don’t think you hold that strong an opinion. But what would you see as the primary disadvantages of a gold standard, or relative advantages of the current dollar reserve standard. Does it come down to how much confidence you have in policymakers?
JL: It is possible to have confidence in individual policymakers at the national level, while nevertheless having little confidence about their ability to agree to reforms to the international system as a whole. And that is where I come from. In any international negotiation of this sort, two types of country have disproportionate influence: the biggest; and those in current account surplus. Today, that would mean the US and China: and I doubt that they would agree on any reform that proved to be in the global interest.
IF JOHN WERE IN CHARGE
JB: Now I’m really going to put you on the spot. An economist of your stature must always be considered a potential candidate for a senior policy role, say as a senior advisor to a finance minister, or a member of a central bank policy committee. Were you to be appointed to a role in which you had a broad mandate to design and implement fiscal and monetary policy, say for the euro-area or the UK, what would you do? If hard choices need to be made and if you had the mandate to make them, what would these be?
JL: In the UK, about which I thought particularly as an adviser to the Treasury from 2009 to 2012, I would have “thrown everything at the 2008 crisis, including the kitchen sink” as my friend William Keegan put it and as, in fact, Alistair Darling did. And I would thereafter have set out on much the same course of fiscal consolidation as Darling did, and Osborne continued. I think that Paul Krugman and Ed Balls understate the risk that would attach to the government borrowing substantially more. But, as I indicated above, I would also have embarked on finding ways to support private-sector-like investment. My proposition throughout has been that the government should have been willing to underwrite, or undertake, investment that produces marketable output – ports; airports; toll roads; certain types of housing, etc. These could be valued and entered as an explicit, verifiable, line in the National Accounts, and could later be sold to the private sector. The ratings agencies would, on my understanding, have been open to such a plan being explained to them.
JB: I’m pleased to hear that there are things that might yet be done within the existing policy framework to help, at least if people listen to you a bit more! Thanks so much for your time; I’m certain that Amphora Report readers will appreciate it.
JL: Thank you John.
JB: Perhaps we can do this again in a year or so to see how things are panning out?
JL: It would be my pleasure. Perhaps you will even eventually win our bet that Greece withdraws from the euro-area.
JB: Well as you recall that bet expires on 31 December. It appears I will need to treat you to dinner in the New Year.
JL: Ah yes. Well as you strategists sometimes say, all views are potentially correct; the timing, however, is always uncertain.
JB: Indeed. Well Happy Holidays!
JL: To you too John.
POST-SCRIPT: FROM RISK TO UNCERTAINTY
My many conversations with John, including those recent ones merged into the transcript above, were an important input into my 2012 Amphora Reports. While the primary purpose of these reports is to interpret contemporary economic and financial market developments through the lens of Austrian economics (and occasional, plain common sense), it is essential to continuously check assumptions, however strongly held. As I’m certain is clear from the conversation(s) above, John has provided an invaluable source of such checking.
This is not to say that we agree on most things. Far from it. For example, as alluded to briefly in closing, I am of the opinion that the euro-area cannot survive in its current form. John believes that it is indeed salvageable, although he does doubt the willingness of policymakers to do what is necessary.
This brings us, I believe, to the crux of the risks the lie ahead. Policymaker activism continues to escalate across economies. This is not going to change in the near-term, nor absent another crisis that clearly and plainly discredits economic central planning generally, be it in fiscal or monetary matters. As has increasingly been the case in recent years, future risks are going to originate primarily from policy decisions. They will, in other words, be qualitative rather than quantitative in nature.
This article was previously published in The Amphora Report, Vol 3, 09 January 2013.
Is reserve currency status an economic blessing or a curse? The answer might seem obvious, as reserve currencies have been shown to confer lower borrowing costs on their issuers. But what of the borrower who, enticed by low interest rates, borrows more than they can pay back? Naturally the result will be a default. However, for the issuer of a reserve currency that is unbacked by a marketable commodity, such as gold, in the event that they borrow too much, they can just print more currency. While this avoids default indefinitely, it also hollows out the economy, erodes the capital stock, reduces the potential growth rate and, eventually, leads to a dramatic devaluation of the currency and loss of reserve status. History has not been kind to countries that have followed this path. In my view, the grave investment risks associated with the US dollar’s inevitable and potentially imminent loss of reserve status are not priced into financial markets.
RESERVE CURRENCIES, TRADE IMBALANCES AND THE ‘TRIFFIN DILEMMA’
Having written a book about international monetary regime change past, present and future, I weigh in again in this Amphora Report on what is gradually becoming a more mainstream debate about whether or not the US dollar is at risk of losing reserve currency status; what currencies might replace it; and, should it happen, what general economic and financial market implications this would likely have.[1]
As it happens, I have a rather strong opinion on all of these matters. But first, let’s consider what a reserve currency is and what it is not. Second, let’s distinguish carefully between reserve currencies that are backed by a marketable commodity, such as gold or silver, and those that are not. Third, let’s take a look at shifting global economic power and monetary arrangements. Then we can move into what I think is going to happen in future, what this implies for financial and commodities markets, and what investors can and should do to prepare.
What, exactly, is a reserve currency? It is an international money that is used to pay for imports from abroad and is then subsequently held in ‘reserve’ by the exporting country, as it does not have legal tender status outside of its country of issuance. In the simple case of two countries trading with one another, with one being a net importer and one a net exporter, over time these currency ‘reserves’ will accumulate in the net-exporting country. In practice, as reserves accumulate, they are invested in some way, for example, in bonds issued by the importing country. In this way the currency reserves earn some interest, rather than sit as paper scrip in a vault.
Beyond a certain point, however, accumulated reserves will be perceived as ‘excessive’ by some in the exporting country, in that they would prefer to purchase something with this accumulated savings instead. In this case they have a choice: either they can purchase more imports from the net-importing country, thereby narrowing the trade imbalance, or they can exchange their reserves with another entity at some foreign-exchange rate. For this reason, other factors equal, as reserves accumulate, the reserve currency will depreciate in value.
As trade imbalances and reserve balances grow, so does the natural downward pressure on the value of the reserve currency as described above. This leads to what Belgian economist Robert Triffin called a ‘dilemma’: for unbalanced trade to continue to expand, the supply of reserves must increase. Yet this implies a chronically weak reserve currency, which leads to price inflation. Indeed, under the Bretton Woods system of fixed exchange rates, the supply of dollar reserves grew and grew, price inflation increased and, eventually, as one European central bank after another sought to exchange its ‘excess’ dollar balances for gold, this led to a run on the official US gold stock and the demise of that particular monetary regime.
While hailed as an important insight at the time, Triffin was pointing out something rather intuitive: Printing a reserve currency to pay for net imports is akin to owning an international ‘printing press’, the use (or abuse) of which causes net global monetary inflation and, by association, some degree of eventual, realised price inflation.
‘CANTILLON EFFECTS’ AND THE NON-NEUTRALITY OF INTERNATIONAL RESERVES
Now let’s combine Triffin’s insight with that of Richard Cantillon, a pre-classical 18th century economist, that money is not ‘neutral’: new money enters the economy by being spent. But the first to spend it does so BEFORE it begins to lose purchasing power as it expands the existing money supply. The money then gradually permeates the entire economy, driving up the overall price level. Those last in line for the new money, primarily everyday savers and consumers, eventually find that, by being last in line for the new money, their accumulated savings are being de facto ‘diluted’ and the purchasing power of their wages diminished.
Extropolated to the global level, this non-neutrality of money implies that an issuer of a reserve currency is the primary beneficiary of the ‘Cantillon effect’. First in line for the new international money you have the owners of capital in the reserve issuing countries, who use the new money to accumulate more global assets, and at the end you have workers the world over who receive the new money last, after it has placed general upward pressure on prices. Greater global wealth disparity is the inevitable result.
Another way to think about the benefits of issuing the reserve currency is that it generates global seignorage income. Federal Reserve notes pay no interest. However, they can be used to purchase assets that DO bear interest. No wonder the Fed always turns a profit: it issues dollars at zero interest and collects seignorage income on the assets it accumulates in return.[2] But in a globalised economy, with the US a large net importer and issuer of the dominant reserve currency, this seignorage income is partially if indirectly sourced from abroad, via the external accounts.[3]
This becomes particularly notable in the event that domestic credit growth is weak relative to abroad. The Fed may print and print to stimulate domestic credit growth but if that printing does not get traction at home, it will instead stimulate credit growth abroad and, eventually, contribute to higher asset and consumer price inflation around the world.
Over time, this will impact the relative competitiveness of other economies, where nominal wage growth is likely to accelerate, eventually making US labour relatively more competitive. That may sound like good news, but all that is really happening here is that US wages end up converging on those elsewhere, something that should happen in any case, over time, between trading partners as their economies become more highly integrated. But to the extent that this wage convergence process is driven by reserve currency inflation, rather than natural, non-inflationary economic integration, the Cantillon effects discussed earlier result in wages converging downward rather than upward, implying a global wealth transfer from ‘owners’ of labour—workers—to owners of capital.
So-called anti-globalists disparaging of free trade are thus not necessarily barking mad—well, perhaps some are—but they are barking up the wrong tree. The problem is not free trade; the problem is trade distorted by monetary inflation. If you want workers around the world to get fairer compensation for their labour, shut down the reserve currency printing press. And if you also want them to have access to the largest possible range of consumer goods at the lowest possible cost, remove trade restrictions, don’t raise them.
RESERVE CURRENCIES: GOLD-BACKED, AND UNBACKED
Prior to the First World War, the bulk of the world was on the classical gold standard. Although the British pound sterling was the dominant reserve currency, it was not possible to print an endless amount of pounds to pay for endless imports, as external reserve currency balances were regularly settled in gold. The British pound thus held its value over time, as did other currencies on the gold standard, and there was not a ‘Triffin Dilemma’ resulting in growing, unsustainable trade imbalances. Moreover, absent monetary inflation, there were no insidious Cantillon effects taking place. Industrial wages were generally stable through these decades, which were characterised by mild consumer price deflation. This implied an increase in workers’ purchasing power and standards of living. So while there are certain similarities between sterling’s previous, gold-backed role as a reserve currency and that of the unbacked, fiat dollar today, there are even greater differences.
(For those curious how such a stable international economic order could break down so completely in such a short period of time, please turn to the extensive literature on the causes and consequences of WWI, arguably the greatest tragedy ever to befall western civilisation.)
Returning to the present, countries that have been exporting to the US and accumulating dollars in return are increasingly getting the joke, but they aren’t laughing. Hardly a week goes by without some senior official in an up-and-coming country rich in natural resources or with competitive labour costs criticising US monetary policy while suggesting that gold should play a greater role in international monetary affairs. The BRICS (Brazil, Russia, India, China, now joined by South Africa), individually and together, have already made numerous official, public statements to this effect.[4] One can only imagine what is being discussed in private, behind closed doors.
Recently, quite similar monetary concerns were expressed openly by Turkey, historically a ‘swing-state’ in its global orientation, yet currently a member of NATO and thus at least a nominal US ally. Prime Minister Erdoan, who is far more popular with the electorate in his country than most western leaders are in theirs, had this to say recently, in criticism of the International Monetary Fund (IMF):
The IMF extends aid on a who, where, how and on what conditions basis. For example, if the IMF is under the influence of any single currency then what, are they going rule the world based on the exchange rates of that particular currency?
Why do we not switch then to a monetary unit such as gold, which is at the very least an international constant and indicator which has maintained its honor throughout history. This is something to think about.[5]
Historians will note that once upon a time, France was a full member of NATO, but following President De Gaulle’s decision to challenge the dollar-centric Bretton Woods system in the mid-1960s, there erupted a series of dollar crises that culminated in the collapse of the Bretton Woods regime in the early 1970s. Is history about to repeat?
(Incidentally, history has already nearly repeated once before, in 1979-80. While the mainstream historical economic narrative about this period is that the Fed resorted to punitively high interest rates to fight the high rate of domestic price inflation, one look at the behaviour of the dollar in 1979-80 tells a different story, that the air of crisis at the time had an important international dimension. FOMC meeting transcripts also reinforce this arguably ‘revisionist’ view that the dollar’s reserve status was at risk.)
Clearly there is growing dissatisfaction with the current set of global monetary arrangements, which allow the US to print the global reserve currency to pay for imports, an ‘exorbitant privilege’ as it was termed by another French president, Valery Giscard d’Estaing. Under the Bretton Woods system, France, or any participating country for that matter, could choose to exchange its accumulated dollars for gold. As predicted well in advance by French economist Jacques Rueff, a contemporary of Robert Triffin, the eventual exercise of this choice to exchange dollars for gold by not only France but a handful of other countries led to a run on the US gold stock in 1971 and an end to the dollar’s gold convertibility.
THE RESERVE CURRENCY CURSE IN DISGUISE
Let’s now turn to the question posed at the beginning of this report. Is reserve currency status a blessing, or a curse? The answer may seem obvious. After all, isn’t it nice to hold the power of the global printing press? To enjoy relatively low borrowing costs? To possess the ‘exorbitant privilege’, as it were? On the surface yes, but what lies beneath?
As Lord Acton is purported to have said, power tends to corrupt. By corollary, absolute power corrupts absolutely. And to the extent that an economic power that is held nationally is exercised internationally, then the corruption thereof has a deleterious international economic impact.
In the case of an unbacked reserve currency, the ‘benefits’ of lower borrowing costs accruing to the issuing country appear to result in overborrowing and overconsumption relative to the rest of the world, eroding the domestic manufacturing base over time and widening the rich-poor gap to levels that are socially destabilising. Trade wars, currency wars or other forms of economic conflict are the inevitable result. In some cases, actual wars follow. In others, they don’t. But in all cases, the reserve currency curse is recognised only too late, when an economy begins consuming its own capital in a desperate and counterproductive attempt to maintain its previous standard of living. Austrian economist Ludwig von Mises described capital consumption as akin to “burning the furniture to heat the home.” Sure, it might work for a time, but what comes next? The floorboards? The walls? The roof?
For those who think that a capitalist, free-market economy would never consume its own capital, outside of wartime, you may be right. But what of an economy that merely pretends to be capitalist and free market, but in fact sets the price of money by decree at an artificially low level so that there is little incentive to save? Well, take a look, this is what happens: Negative net investment!
US DOMESTIC INVESTMENT, NET OF DEPRECIATION, % OF GDP
It is highly intuitive to reason that, if an authority mandates a price ceiling below the natural, market-determined price for a given product, less of it will be produced and a shortage will result. Well here you see the empirical evidence: holding the ‘price’ of credit —the interest rate — artificially low over a sustained period of time leads to a shortage of savings, capital consumption and, therefore, a lower standard of living.
Notwithstanding basic economic common sense and clear evidence as presented above, the US Fed may still honestly believe that its neo-Keynesian models are right. Alternatively, like Galileo’s clerical inquisitors, it may be simply unwilling to admit that the models, or the entire theory, are wrong. The International Monetary Fund, for what it is worth, has already determined that its models are flawed, although they also admit they have little idea what to do about it other than to shoot in the dark, something that is not exactly reassuring.[6]
THE TURKEY IN THE GOLD MINE
Today, as the dollar is not convertible into gold, there could not be a run on the official US gold stock. But there is no reason why central banks around the world can not diversify out of dollars and into gold, something that would have much the same result: the dollar would decline versus gold and real assets generally, US imports would become more expensive and economic growth would be highly ‘stagflationary’, just as was the case during the 1970s, in the aftermath of a substantial dollar devaluation.
As it happens, these developments are already underway. According to recent reports, many central banks are accumulating gold, including Russia, China, Brazil, India, Bangladesh, Mexico, South Korea, Kazakhstan, Turkey and Indonesia.[7] While central banks must report their gold reserves to the IMF, the sovereign wealth funds of these countries are under no such obligation and, as sovereign wealth funds occasionally operate in effective if unofficial collaboration with their respective central banks, it is highly likely in my opinion that there is much more official gold accumulation taking place than is officially reported.
As they are not free-market, profit-maximising entities in the same sense as independent private investors, these official gold buyers are not as price sensitive. If they are instructed by their political leadership to diversify their reserves out of dollars in some amount, or at some regular rate, they are going to carry out that mandate, regardless of the price, until that policy changes. This is strategic, not tactical gold buying, as it were.
This is just one of many reasons why the gold price is going up. The most fundamental is simply that the values of currencies such as the dollar are going down as a result of endless quantitative easing (QE) or other forms of monetary expansion. That the agents swapping their dollars for gold happen in some cases to be price-insensitive official institutions is just one mechanism by which a global shift out of paper into hard assets is taking place.
I don’t pretend to know exactly what is going to happen from one day to the next. But when you step back and see the larger picture of one country after another expressing disapproval with the dollar reserve standard, you can’t help but notice that the game is changing. Central bank or other official forms of gold buying is but one aspect. Another is the growing official collaboration on monetary and other economic matters by the BRICS. Then there are the various bilateral currency arrangements between an increasing number of countries that allow them to reduce dependence on the dollar for bilateral trade.
At first glance, Turkey’s recent admission that it is paying for imports of Iranian natural gas with gold in order to avoid US sanctions may seem a small, insignificant development by comparison but within the larger context it could have a disproportionate impact.[8] Indeed, Turkey may be only one of several countries monetising gold for use in importing Iranian gas or other goods. As a canary signals danger in a coal mine, might Turkey be signalling something rather more significant for international monetary relations?
Quite possibly. Game theory is highly instructive as to how international policy regimes, once destabilised by changing conditions or incentives, can suddenly shift to, or collapse into, a new equilibrium, sometimes in response to seemingly insignificant developments. When countries that comprise in aggregate about 1/3 of all global trade flows express dissatisfaction with the dollar and the IMF, the current international monetary regime is clearly unstable. When a medium-sized player such as Turkey moves from one side of the game board to the middle, or to the other side, there is always a chance that this represents the proverbial ‘tipping point’ from one equilibrium to another. In this case, if history is a guide, then as the world moves away from the current, dollar-centric reserve standard system it will move to one based on mulitiple currencies, yet with some degree of explicit gold backing for major currencies.[9]
Why gold? Part I of my book, The Golden Revolution (available here), concludes with a discussion about why gold has by far the strongest claim to use as the future international monetary reserve replacement for the dollar. While historical precedent is important, there are also two important theoretical points to consider. First, there is no existing fiat currency alternative to the dollar at present, in the way that the US dollar provided an obvious alternative to the pound sterling following WWI. Second, given the increasingly obvious breakdown in cooperation in international monetary relations, it is highly unlikely that, as the dollar’s role diminishes, there could be a universal agreement about how to construct or implement a global currency alternative to the dollar. Yes, the IMF has proposed precisely this and (no surprise here) has put itself forward as the bureaucracy that could manage it, but as discussed above, Turkey, the BRICS and a handful of other nations don’t trust the IMF to act in their national interest. They apparently do trust in gold.
As a medium of exchange that cannot be printed or otherwise manipulated by any one country to somehow exploit another, gold holds more than just a historical claim to a future role as international money. It provides a basis for mutually-beneficial international trade when trust in monetary stability is lacking. The answer to the question of what currency or currencies can provide the future international reserve is thus as paradoxical as it is elegant: every currency, if linked to gold, and none, as gold itself provides the trust.
RECENT DEVELOPMENTS IN FINANCIAL AND COMMODITIES MARKETS
At time of writing, global equity markets have corrected modestly lower from the lofty valuations seen in early October. A series of corporate earnings disappointments and profit warnings was initially ignored but finally became so widespread across countries and industries that the selling pressure intensified sufficiently to reverse the big bull market that took place over the summer, in anticipation of yet another round of global monetary stimulus that arrived in September.
I expressed my concern with equity valuations back in October so I’m not exactly surprised by this development.[10] However, I am hardly omniscient and for all I know equity markets will begin to move right back up again for reasons that may have nothing to do with earnings, or profit expectations, or anything else that, in a normal world at least, would be expected to determine prices.
I have written variations on this theme many times but it seems entirely appropriate to revisit it again here: we do not live in a world in which financial asset prices are driven by sensible value judgements but rather speculation enabled and encouraged by policy makers in a growing number of ways. Applying a traditional, value-based investment approach in this environment is fraught with peril.
There are some things about which we can be relatively certain, however. If the dollar continues to gradually lose reserve currency status, or does so abruptly in a future financial crisis, it will reinforce the stagflationary economic conditions already prevailing in the US and in many other countries. Import prices will rise, yet growth will remain subdued given that the capital base is being consumed.
Of course there are things that US politicians could do to encourage savings and investment rather than consumption, but these things are politically unpopular. For example, neither of the two presidential candidates in the recent election advocated even a small reduction in the size of the federal budget, even though the deficit remains near record highs and the so-called ‘fiscal-cliff’ approaches. The ‘debate’ was so narrow relative to the vast scale of US economic problems that it seems a stretch to call it a ‘debate’ at all.
My impression is that the election was fought primarily on social issues. Now I don’t want to belittle those who feel strongly about social issues, but it seems a bit odd that these should determine the election result for the highest political office in a country founded on the principle that the federal government should stay out of social issues. One could be forgiven for thinking that the electorate is by comparision relatively unconcerned about the economy. I suppose Americans are schizophrenic, as many peoples seem to be.
Turning to Europe, I note that the political winds are now shifting decisively against those who would use the current crisis to centralise yet even more power in Brussels or in the ECB. This can be seen at both the regional level (eg Catalonia, Scotland) and the national (eg Greece, the UK, Ireland). At the margin, such sentiments make coordinated bailouts more difficult to implement. Although I am hardly supportive of bailouts for weak euro-area sovereign borrowers (or their lenders, if you prefer), if they are not forthcoming, this will deal a serious blow to European equity markets.
Speaking of political winds, there are also disturbing developments in France, where the government has recently threatened to nationalise corporate assets in the event that their owners seek to reduce capacity and fire workers in response to the economic slowdown well underway. This is not exactly going to attract foreign investment into the country. In any case, European economic growth is going to be unusually weak as long as the deleveraging continues, which might be rather a long time given the starting point.
I would like to remind readers that, during the stagflationary 1970s, major stock markets did not perform well. Yes, I know the conventional wisdom, that stock prices tend to rise with inflation, but then they can also perform rather poorly, in particular in real, inflation-adjusted terms.
Now it is the case that, in a historical comparision, stock market valuations in both the US and Europe are not particularly high. But really, given the context, why aren’t they particularly low instead? Sure in some countries, such as Spain, trailing P/Es and other classic valuation measures are essentially distressed, indicating good value. But today’s Spain is tomorrow’s… well, I don’t know. Pick a country, any country. There are plenty of candidates. So notwithstanding the modest correction of late I believe it is still too early for a general return to the equity markets.
Turning to bond markets, the outlook is inextricably linked to what happens with currencies, including of course the dollar. When a currency devalues for whatever reason, it takes its bond market with it. Yes, in practice it is not quite as simple as that, but when it comes to the most overpriced bond markets of today, such as those for US Treasuries, German Bunds, UK gilts or Japanese government bonds (JGBs), any devaluation in these currencies is likely to have an even greater impact on bond holders than on those sitting in cash instead. (That said, I believe there are pockets of value in distressed corporate debt and would recommend that readers familiarise themselves with some of the instruments available for getting some diversified exposure.[11])
Cash itself, of course, is at constant risk of devaluation, regardless of currency of denomination. Policymakers have made it abundantly clear that the value of cash is a policy tool, perhaps the single most important one there is. I regard it as highly unlikely that this thinking will change absent a future financial crisis that not only results in the death of the neo-Keynesian economic paradigm but also one that shows the current economic policy elite the door.
That leaves commodities. They may not be the stuff that powers Wall Street and credit creation but that is where the excessive leverage in the global financial system resides. Commodities cannot be arbitrarily diluted, devalued or defaulted on. They do not go bankrupt. They cannot be created by policymaker whim, although it is true that misguided regulations or price controls can create artificial scarcity, which is price supportive. That said, there is no certainty that commodity prices are going to rise, but if they don’t, this is unlikely to be the direct result of government action. Indeed, a general decline in commodity prices would be an indication that governments are finally backing away from inflationary policies, something that would, eventually, set the stage for a sustainable economic recovery built on savings, rather than on debt.
Well I’m not holding my breath. I fully expect governments to continue to implement misguided inflationary ‘solutions’ to economic problems themselves caused by inflation. And therefore I am over- rather than underweight commodities in my portfolio. Yes, some of these are likely to do better than others in the current global climate and I take that into account when managing positions. But much of investing remains a guessing game no matter what anyone tells you, including me.
The ultimate response to uncertainty, natural or man-made, is to diversify across a broad range of assets. What holds true for assets generally holds true for commodities specifically. I do have a soft spot for gold, but as all good traders know, emotions are distracting and dangerous. Fortunately, one doesn’t need to feel emotionally about gold to understand, entirely through logic and reason, that if the primary source of uncertainty in the world is the very future of money itself, then gold is likely to outperform in the event that such uncertainty continues to rise.
POST-SCRIPT: A BRIEF COMMENT ON RECENT DEVELOPMENTS IN THE GOLD MARKET
As the topic of gold and gold investing has featured regularly in the Amphora Report, I am sometimes asked to comment on developments in the gold market. This has been unusually common of late, due to Germany’s decision to audit a portion of its gold holdings held abroad and Ecuador’s announcement that it will follow Venezuela’s initiative from last year and repatriate at least some portion of its gold reserves held in New York and London. (As an aside, don’t you ever find it ironic that those who shout the loudest that gold is but a ‘barbarous relic’ are those who live and work atop the bullion vaults under the NY Fed or the Bank of England, for example?)
Well, as it happens, I have long held that the act of physical repatriation of gold held on a custodial basis abroad is of more than just symbolic importance. As I wrote in an Amphora Report back in late summer 2011, following Hugo Chavez’s decision to repatriate Venezuela’s gold reserves:
Venezuela’s decision to take delivery of its gold places additional focus on the unique role that physical gold plays in the global economy. In recent months, the central banks of Mexico, South Korea, Bangladesh and Kazakhstan have bought gold on the open market. Others no doubt continue to accumulate gold less overtly. Why? If there was growing faith in the dollar-centric global financial system, would central banks be accumulataing gold reserves at the fastest pace since the 1970s?
No, on the contrary, this trend is a clear indication that global confidence in the dollar continues to erode. Should more countries line up to take physical delivery of their gold, rather than leave it in US custody, it would be a sign that confidence in the US itself, as a safe and reliable jurisdiction for global commerce, is also beginning to erode.[12]
Are we to interpret recent developments in the gold market as signs that “confidence in the US itself, as a safe and reliable jurisdiction,” is eroding? As with a handful of other things discussed in this report, I leave that to the reader to decide.
[1] I previously discussed at length the causes and consequences of the dollar’s loss of reserve currency status in IT’S THE END OF THE DOLLAR AS WE KNOW IT (DO WE FEEL FINE?), Amphora Report vol. 2 (May 2011), available here.
[2] Prior to the global financial crisis of 2008 the Fed purchased primarily US government bonds. However, it has since purchased a broad range of assets, including those that were part of the deal the Fed made with JP Morgan regarding its takeover of failing investment bank Bear Stearns.
[3] The Fed would be earning seignorage income directly rather than indirectly were it to purchase interest-bearing foreign securities instead of domestic ones. Note that the amount of seignorage income generated rises in proportion to the devaluation of the dollar relative to the currencies of US trading partners. That devaluation increases income is a simple accounting identity, although some Keynesians argue that this income is ‘real’. It is not. It is inflation.
[4] For a thorough discussion of the official BRIC position on these matters please see THE BUCK STOPS HERE: A BRIC WALL, Amphora Report vol. 3 (April 2012) available here.
[5] A recent article in the Turkish press detailing his comments on this topic can be found at the link here.
[6] For a discussion of the IMF’s recent reconsideration of some of their economic forecasting models, please see THE KEYNESIANS’ NEW CLOTHES, Amphora Report vol. 3 (2 November 2012). The link is here.
[7] Please see the most recent statistics from the World Gold Council, available at this link here.
[8] This was reported by Dow Jones Newswires and is available at this link here.
[9] For convenience purposes, smaller countries could always peg their currencies to that of a major trading partner and, in this way, indirectly back their currencies with gold.
[10] Please see A VICIOUS CYCLE, Amphora Report Vol. 3 (October 2012), available here.
[11] For a discussion of distressed investing, please see WHY BANKRUPTCY IS THE NEW BLACK, Amphora Report Vol. 3 (April 2012). The link is here.
[12] THE BUTTERFLIES OF AUGUST, Amphora Report vol. 2 (September 2011). The link is here.
This article was previously published in The Amphora Report, Vol 3, 27 November 2012.
The greatest threat to worldwide prosperity is the collapse of what remains of free-market capitalism. Not depletion of scarce natural resources. Not environmental degradation. Not global warming (or is it “climate change” now?) No, the greatest threat to worldwide prosperity is the complete collapse of what little remains of free-market capitalism. Throughout the world, and not just in totalitarian countries, the state has been advancing at the expense of economic liberty. The indispensible tool that enables the modern state to usurp our liberties is its access to unlimited amounts of fiat money controlled by central banks — i.e., the unholy alliance of the state with the central bank.
Fiat-money expansion has made the advance of statism possible through its ability to thwart the wishes of the people as the final arbiters of state spending. The state can obtain an almost limitless amount of fiat money from its central bank. It need not increase taxes or borrow honestly in the bond market, so it need not fear a tax revolt or high interest rates respectively. All it needs to do is convince the central bank to buy its debt. The state then takes control over more and more resources, squandering them on war and welfare, depriving the free-market economy of its capital base. Once the capital base has been depleted, the economy will go into a steady decline.
The poster child of this phenomenon is the (former) Soviet Union. Yes, total collapse is a real possibility — for us too. The Russian people may have believed that economic decline would reach a plateau, stop, and then reverse. As explained in stark terms by Dr. Yuri Maltsev, former economic advisor to Mikhail Gorbachev, in Requiem for Marx, the Soviet economy deteriorated into one of subsistence. The capital base of Russia had been destroyed, and collapse soon followed.
The monetary printing press is seen as an alternative to saving and investing as the means to grow the capital base. Monetary stimulus attempts to generate economic recovery mainly through exports.
If a nation can increase its exports, so the logic goes, it can increase employment, pay off debts, etc. So, rather than properly reforming the economy, monetary authorities engage in a destructive “race to the bottom” through competitive debasement of their currencies. First one country then another intervenes into its own currency markets to cheapen its currency against all others. But currency devaluation will not work, as explained in “Value in Devaluation?”
What is desperately needed is for one country to break from this failing and ultimately disastrous model of fiat-money expansion and its horrific effects. This one country must be in a special position whereby it is readily apparent that it is being harmed by currency debasement over which it has no control. Fortunately for the world there exists such a country: Germany.
The Intolerable Monetary Position of Germany Creates a Unique Opportunity
Germany is the fourth-largest economy in the world, behind only the United States, China, and Japan. Amazingly, it does not control its own money supply, because it is a member of the European Monetary Union (EMU), composed of 17 nations using a common currency — the euro. Each member, regardless of size, has an equal vote over monetary policy, administered by the European Central Bank (ECB). Increasingly Germany’s is the lone voice for monetary restraint — recently it was outvoted 16 to 1 over an ECB plan to print euros in greater numbers in order to bail out bankrupt members of the EMU. This is a situation that would be intolerable for any other country; however, due to Germany’s history, it is reluctant to be seen as “anti-Europe” and instead has tried to work within the EMU framework to force bankrupt countries to reform their economies. But this is a hopeless exercise, as explained by Dr. Philipp Bagus of King Juan Carlos University, Madrid, in his brilliant book Tragedy of the Euro. All the benefits flow to the irresponsible countries, so there is little incentive and no enforcement mechanism for meaningful reform. Therefore, in a previous article (“A Golden Opportunity “), your authors have called for Germany to leave the EMU, reinstate the deutsche mark, and anchor it to gold.
Most recently there have been calls within Germany to repatriate substantial gold reserves held overseas. The Bundestag — federal Germany’s legislature and, as such, representing all diverse elements and factions in the country — is the impetuous behind this movement. The Bundesbank, Germany’s still-extant central bank, has agreed to repatriate about one-tenth of its vast overseas gold deposits over the next three years.
But this is inadequate for the real task at hand. Germany must repatriateALL of its gold. There is only one reason that a central bank would wish to repatriate its gold: to serve as reserves in a gold backed monetary system. The market must be assured that the gold actually exists, that it is under the total control of its rightful owner, and that it is not leased or part of a swap arrangement. Furthermore, the central bank must be willing to honor demands to deliver gold in the quantity specified in exchange for its paper money certificates and the commercial-bank book-entry deposits.
Delivery of Gold upon Demand Is Crucial
If Germany is to back the deutsche mark with its own gold, markets must be certain that the Bundesbank can and will deliver the gold upon demand. For under a gold-backed system the gold isthe money. The pieces of paper that people carry in their wallets and keep in cookie jars and the book-entry receipts at commercial banks are not money per se; these are money substitutes that can be exchanged for real money — gold. The central bank can meet this requirement only if it has absolute control over its gold.
The Bundesbank has significant portions of its overseas gold deposits at the Federal Reserve Bank in New York and the Bank of England in London. At one time it may have made sense to deposit gold in these countries in order to protect it from the possibility that the Red Army would overrun Germany. Fortunately that threat is no more. But the Federal Reserve Bank has been very circumspect about displaying Germany’s gold to its rightful owners. Now, I ask you, is this not very suspicious behavior? Why would the Fed refuse to show the actual gold to Germany or any other nation with gold deposits? The reason usually given is one of security, but what does the Fed think is going to happen? Does it think that armed robbers will be able to abscond with some bars? This is preposterous! The gold is the property of Germany. Germany should insist on viewing its gold, counting its gold, testing its gold for fineness, and making quick arrangements for moving its gold to its own vaults in Germany.
Let Justice Be Done
Either the gold is all there, and rumors to the contrary are baseless, or some portion of the gold is not there or is encumbered in some way. If the former, all is well. If the latter, then let’s learn about it now, so that we can stop any further theft and so that we can establish a financial-crimes tribunal to try all who had a part in the theft. If that means prosecuting central-bank officials in the United States or the United Kingdom, so be it. If that means that the exchange rates for the dollar or the pound sterling fall in relation to other currencies, so be it.
Let’s learn the truth, whatever that may be, so we can get on with the important work of placing the world’s finances on the solid foundation of sound money and not on promises of confidence men. Let us adopt the Latin legal concept fiat justitia ruat caelum, “Let justice be done though the heavens fall,” and not lose sight of the goal of saving what remains of free-market capitalism and beginning the difficult process of restoring our liberties.
This article was co-authored with Patrick Barron and previously published at Mises.org.
In his recent Mises Daily article ”Fool’s Gold Standards“, John P. Cochran warns his readers against accepting any monetary reform less than that of money created by the free market. Therefore, he felt it necessary to criticize our previous Mises Daily article ”A Golden Opportunity,” in which we advised Germany to leave the European Monetary Union, reinstate the deutsche mark, and tie it to gold.
Although he admits that our “recommendation may be a step in the right direction … it leaves Germany with a central bank and a discretionary monetary policy.” That it does — for now.
In no way was our essay intended to imply that central-bank control of gold-backed money was the point at which we desired monetary reform to cease. As Austrian economists, we fully understand and support the goal of full monetary freedom of the marketplace as that which best advances liberty, prosperity, and peace. The question becomes, how will we achieve it?
We believe that Germany is in a unique position to end the destructive forces of fiat monetary expansion that seem to gain new impetus every day. That is number one. Before we can have the perfect money, we must have a better money, and Germany is in a position to show us the way. All of us who desire liberty, prosperity, and peace should ask Germany to seize this opportunity to stop what surely will destroy free-market capitalism. By reinstating the deutsche mark and tying it to its vast gold holdings, Germany can be the catalyst that creates a cascade of similar virtuous acts that will lead eventually to full monetary freedom and all that that will bring.
Consider the likely consequences of the world’s fourth-largest economy establishing a 100 percent gold-backed currency. This currency would dominate world trade, because all trading nations would desire to denominate their exchanges in the soundest money available. For a while at least, that would be the deutsche mark. Demand would drop for the currencies of all other nations unless and until these countries did the same thing. A virtuous cycle would ensue as first one then another country linked its currency to gold. The country with the most to lose would be the United States, whose dollar currently is preferred for international trade. But as demand increased first for the deutsche mark and later for the currencies of other nations who followed Germany’s example, demand for the dollar would fall and prices would rise precipitously in the United States as countries no longer found it advantageous to hold dollars abroad. At this point, the United States would be forced to return to gold. In our opinion, nothing less will bring the world’s superpower to its senses; i.e., the United States will not voluntarily adopt gold, because it benefits the most from the current inflationary system. However, if the major trading nations of the world adopt gold-backed currencies, even the United States will be forced by the market to do so.
But this is not the end. Once the peoples of the world see the advantages to using gold money, they will begin to understand that central banks are not required to perform the money function at all. Why couldn’t HSBC, Citibank, Barclays, Deutsche Bank, or any of a number of well-respected international private banks do the same? These international banks are more nimble than any ossified government bank to meet the needs of business and finance. Furthermore, these international banks are more trustworthy than national central banks, which tend to operate in great secrecy in order to hide the risk they are taking with our money. Private banks would have to answer to stockholders employing their own independent auditors.
Consider how religious toleration arose in the West, first as an expediency by princes who vied for power with the Catholic Church. Different religions were established and protected by the state. But over time, religious tolerance came to be seen as a good in itself. Today we accept religious tolerance in the West as a universal given, yet it is a relatively recent phenomenon.
It is in this vein that we recommend that Germany end the tyranny of the inflationary euro and adopt a golden deutsche mark. Such a courageous yet self-protective action will lead to a U-turn in monetary policy, away from monetary destruction and toward better and better money everywhere.
This article was previously published at Mises.org.
