gold and deflation

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    Gold and Deflation

    By John H. Makin

    On September 8, 1933, almost four years after the October 1929 stock market
    crash, the new American president, Franklin Roosevelt, raised the domestic
    price of gold by 44 percent from $20.67 an ounce, where it had stood for
    more than a century, to $29.82 per ounce. The objectives of this change
    were to raise commodity prices and weaken the dollar in foreign exchange
    markets. More broadly, the aim was to help end the deflation that was
    crushing American businesses and households, especially those with debts,
    the burden of which was magnified by falling prices.

    So virulent was the deflationary pressure, however, that prices continued
    to fall during the balance of 1933 while the dollar strengthened, thus
    exacerbating the deflation gripping the American and global economies.
    Therefore, on January 15, 1934, President Roosevelt proposed further
    reflationary measures to Congress, which promptly passed the Gold Reserve
    Act on January 30. The result was to fix the price of gold at $35 an ounce
    on February 1, bringing to 69 percent the total increase in the price of
    gold over the space of just five months.

    Gold Hedges Inflation and Deflation

    For those who were trying to preserve, not to mention enhance, wealth in an
    environment of persistently falling stock prices, shaky government
    finances, and governments vying for a weaker currency, to have bought gold
    in 1931, 1932, or early 1933 proved to be a brilliant move. The price of
    gold, which climbs steadily in a world of rising inflation (as it did
    during the 1970s, from $35 to over $800 per ounce), jumped suddenly and
    spectacularly between September 1933 and February 1934 amidst deepening
    global deflation.

    Gold can be a hedge against the risks of both more inflation and more
    deflation because both phenomena entail the prospect of serious trouble for
    financial assets. Rising inflation depresses the value of outstanding bonds
    and riles foreign-exchange markets. Rising inflation also distorts relative
    prices and increases uncertainty about the market value of stocks; remember
    the stock market crash of 1973 and 1974 after the quadrupling of oil
    prices. Gold becomes the asset of refuge in periods of rising inflation.

    During periods of intensifying deflation, stocks suffer as the real value
    of company debts rises and the profit outlook deteriorates. Companies are
    unable to cover the cost of production (especially when excess capacity is
    in place) that was financed with the issuance of debt or equity. Initially,
    deflation makes sovereign (government) bonds more attractive. But advancing
    global deflation raises the possibility that governments will have to
    engage in competitive currency devaluations as each, by means of a weaker
    currency, tries to export deflation. That is what happened in 1933 as
    President Roosevelt joined the rush and pushed down the dollar by sharply
    devaluing against gold. In the middle of a global deflation, that was the
    only convincing way to accomplish a reflationary devaluation. Roosevelt
    wanted to send up a rocket that would explode high up and spell out the
    words "higher prices in America" for all the world and for America's
    debtors to see as a sign of hope.

    Post-Bubble America Today

    In the United States at the outset of 2003, while inflation is very low,
    there is no widespread deflation. Globally, countries are not overtly
    engaging in competitive devaluations, although many are preventing a rise
    in their currency's value by purchasing dollars. President Bush is not
    intoning that the only thing we have to fear is fear itself. Nor is the
    Federal Reserve dragging its feet about easing monetary conditions. The
    federal funds rate has been cut by 525 basis points since the abrupt
    initiation of easing with a 50-basis-point rate cut on January 3, 2001. The
    latest reduction came on November 6, 2002, when another cut of 50 basis
    points exceeded expectations by a wide margin. The November 6 action
    reduced the federal funds rate to 1.25 percent--its lowest level since

    The recent rate cut by the Fed has been followed by extraordinary
    assurances from Fed chairman Alan Greenspan and Fed governor Benjamin
    Bernanke that the central bank is prepared effectively to print money
    should the aggressive interest rate cuts by the Fed prove inadequate to
    stimulate demand sufficiently to produce a sustainable recovery, in which
    the economy grows steadily at about 3.5 percent. That trend level of
    sustainable growth is sufficient to sustain higher employment and the
    growth of profits that is, perhaps unfortunately, already assumed by many
    analysts to be on tap for 2003.

    American policymakers have not relied entirely on stimulative monetary
    policy to revive economic growth. Stimulative fiscal policy, an alternative
    to global devaluation of currencies against gold as a means to spur demand
    growth in a weakening global economy, has also been enacted by the United
    States. The deflationary experience of the 1930s gave birth to the
    Keynesian notion of active fiscal stimulus as a means to boost demand
    growth. This occurred partly as a result of the limited success achieved
    with occasionally disruptive currency devaluations during the 1930s. A
    Republican Bush administration, in the face of persistent hand wringing and
    complaining from Democrats gripped suddenly by a new fervor for fiscal
    rectitude--the Rubin fallacy syndrome--cut taxes to provide fiscal thrust
    worth nearly 2 percentage points of GDP growth in 2002.

    Now, as we enter 2003, the Bush administration is preparing to offer
    another dose of fiscal stimulus in the form of more tax cuts, worth as much
    as 1 percent of GDP. Wisely, no action has been proposed to offset federal
    revenue losses that have accompanied the weaker economy and stock market.
    Still, one wonders whether the Rubinites are just biting their tongues.
    Apparently, voters saw through the silly policy corollary to the Rubin
    fallacy syndrome--do not cut taxes, even during a recession, because lower
    deficits were supposed to have been the key to the boom of the 1990s--and
    voted to increase Republican margins in the House while returning control
    of the Senate to Republicans. Perhaps it is not surprising to find that in
    a recession, as in a tepid recovery with falling stock prices, lower tax
    rates constitute a happy combination of good politics and good economics.

    Stocks Fall While Gold Rises

    After more than two years of proactive, stimulative monetary and fiscal
    policy measures and despite an absence of overt deflation and the return of
    modest growth in America, something is definitely still disturbing
    investors, households, and businesses. The stock market, as it did after
    1929, has gone down for three years in a row and now the price of gold, as
    it did in 1932, also a third down year for the stock market, has started to
    rise. Over the past two years, since January 2001 when the Fed began
    easing, the price of gold has risen from $260 an ounce to more than $345 an
    ounce or by nearly 39 percent. The biggest part of that increase--more than
    20 percentage points--has come over the past year.

    The history of the post-bubble scenarios both in the United States in the
    1930s and in Japan in the 1990s is rich with suggestions to explain a sharp
    rise in the price of a sterile metal--gold--during a period of intensifying
    global disinflation and deflation. The recent weakening of the dollar
    coupled with a two-year period of rising gold prices suggests that
    investors are searching for a safe-haven asset at a time when equities have
    suffered and government finances--especially in Japan and Europe--are
    beginning to come under increasing strain. Until now, and in two episodes
    this year when investors fled riskier assets, including stocks, junk bonds,
    and emerging market securities, they rushed into U.S. Treasuries and U.S.
    dollars. But more recently, over the first three weeks of December 2002, in
    what looks to be the early stages of another flight from risk, investors
    bought more gold, adding $25 an ounce, or nearly 8 percent, to the price in
    that short span.

    Other symptoms of the rising disenchantment of investors with financial
    assets, especially stocks, appeared during the third consecutive year of
    falling stock prices. The search for alternatives to equity assets coupled
    with a change from a focus on wealth enhancement to a focus on wealth
    preservation has resulted in the adoption of two separate strategies by
    many investors. The disinflation and deflationary environment in the global
    economy, together with uncertainty, causes investors to abandon risky
    assets and to acquire claims on reliable sovereign governments such as the
    United States. Rising uncertainty also leads to an increased desire to hold
    cash or other highly liquid assets.

    However, as extensive monetary and fiscal stimulus measures have failed to
    produce a sustainable recovery, investors are beginning to display a
    preference for other assets that would benefit from an aggressive and
    successful--perhaps global--effort at reflation. This behavior follows an
    initial, more benign flight from equities when the opportunity cost of not
    investing in the stock market fell sharply. Then, households shifted to
    consumer durables, especially cars. This shift became pronounced after the
    September 11 tragedy. Aided by sharply falling interest rates, households
    have also been encouraged to substitute larger investments in residential
    housing. Perhaps the most enduring symbol of wealth preservation for
    middle-income American households, especially for those who indulged in a
    brief flirtation with the stock market, is the comforting tangibility of a
    larger house.

    But the rise in the price of gold is different. It serves as a sign that
    many investors perceive that reflation efforts have not been successful and
    will have to be intensified. This is not too surprising. While widely
    discussed, reflation efforts in Japan have neither been sufficiently
    aggressive nor successful. The other major economic area outside of the
    United States--Europe--seems to be stuck in a worsening disinflationary
    recession, and its central bank has been reluctant to ease as aggressively
    as the Fed has eased, while fiscal policy is actually moving in a
    contractionary direction.

    In the United States, substantial monetary and fiscal stimulus has helped
    to produce a recovery of sorts, but a disconcerting underlying reality
    persists. After nearly two years of aggressive monetary stimulus and one
    year after one of the largest fiscal boosts in half a decade,
    year-over-year nominal GDP growth stands at just 4 percent--the lowest
    level in postwar history for this stage of an American economic recovery.
    We also learned in the third quarter that the year-over-year growth of
    corporate profits (after tax), based on the government's NIPA (National
    Income and Product Accounts), is more than a standard deviation below the
    norm for postwar cycles. With real growth in the fourth quarter of 2002
    looking to be below 1 percent while the GDP deflator is below 2 percent,
    nominal GDP growth will fall far short of the 5 or 6 percent level
    necessary to sustain growth of profits at a rate currently forecast by most
    analysts for 2003. Meanwhile, the implicit GDP deflator (base index) for
    nonfinancial businesses is falling at an annual rate of 1.7 percent--also
    the worst performance in the postwar period. No wonder corporate managers
    complain of a lack of pricing power.

    If U.S. GDP growth, with the help of substantial monetary and fiscal
    stimulus, is still insufficient to support the growth of profits and
    employment in 2003, the outlook for U.S. demand growth, the sustaining
    force for the global economy over the past two years, is not bright. While
    the United States is proposing additional fiscal stimulus at the federal
    level worth up to 1 percent of GDP during 2003, the fiscal drag from
    deteriorating state and local finances will erase that positive impact.

    Beware Higher Gold Prices

    Optimists, making comparisons between the current post-bubble period and
    the United States in the 1930s, have been consoled by the notion that
    widespread deflation has not taken hold in the U.S. today. That is a
    dangerously misleading source of comfort. What we have learned over the
    past year is that low nominal GDP growth, the sum of modest real growth and
    tepid price increases confined to the services sector, is insufficient to
    produce widespread profit growth consistent with the forecasts--or perhaps
    the hopes--of most equity analysts. Therefore, the search for alternatives
    to equity assets together with a desire for wealth preservation, which has
    initially led to purchases of government securities and a movement into
    cash, will continue. If investors should conclude, and it would be
    premature to do so at this point, that the only option left to policymakers
    is to print money in quantities sufficient to create rising prices and
    perhaps dollar depreciation, the continued search for wealth preservation
    will lead to further purchases and a higher price of gold.

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