As good as gold again
The Toronto Star
Saturday Ontario Edition
December 21, 2002
HIGHLIGHT: The tarnished precious metal has received a boost from central bankers' wish for inflation They're so determined, the theory goes, that prices will rise and gold will be a hedge.
Unusual things are happening in financial markets - soaring gold, a falling U.S. dollar, deflation.
Deflation talk is buzzing through the economic world, seeping out in speeches of central bankers, turning up in the minutes of their interest-rate meetings. Deflation itself showed up last month in U.S. wholesale prices.
Will it run wild in the economy or be struck down by a determined Federal Reserve Board? And if deflation is afoot, why is gold rising? Gold, as we have come to know it, rises and falls with inflation. In 1980, when inflation peaked, gold hit a record high of $850 (U.S.) an ounce. It may be rising, strange as it may seem, because inflation-fighting central bankers around the world are collaborating to inflate economies.
"We're looking for a very good year for gold and gold shares through most of 2003," Bob Hoye, editor of Institutional Advisors in Vancouver, said in an interview.
Forecasters are of several minds about how things will unfold. Most agree the U.S. dollar must fall but only a few see gold as the main beneficiary. Many concede that falling wholesale prices are worrisome but few think they will lead to a 1930s-style depression.
Still, the economic landscape heaved late last month after a speech by U.S. Federal Reserve governor Ben Bernanke in which he said the United States would stop at nothing to defeat the dread deflation. The government can pre-empt it by cutting taxes and slashing interest rates - to zero if necessary, he said.
And if that doesn't work, or if tax cuts take too long to kick in?
"The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost," the Fed governor continues. Printing money would lower the U.S. dollar in terms of goods and services, which is the same as raising prices.
"We conclude that, under a paper-money system, a determined government can always generate higher spending and positive inflation."
The Fed governor did not stop there. If debasing the dollar doesn't work, why, the Fed could manage long-term interest rates by buying bonds, the way it does short-term rates by buying and selling treasury bills. Or it could offer fixed term loans to banks at zero interest, taking corporate bonds, commercial paper, bank loans and even mortgages as collateral, flooding the banking system with new money.
Nor would that empty its tool bag. The U.S. Treasury could buy up foreign bonds, effectively depreciating the foreign exchange value of the greenback.
There have been times when dollar depreciation has been effective against deflation, Bernanke notes.
"A striking example from U.S. history is Franklin Roosevelt's 40 per cent devaluation of the dollar against gold in 1933-34, enforced by a program of gold purchases and domestic money creation," Bernanke points out. Consumer price inflation went from -10.3 per cent in 1932 to -5.1 per cent in 1933 to 3.4 per cent in 1934.
"The economy grew strongly, and by the way, 1934 was one of the best years of the century for the stock market."
James Grant, esteemed editor of Grant's Interest Rate Observer, was impressed.
"I thought it was a brilliant speech," Grant said in an interview from his Manhattan office. "The government has just said it is prepared to stop at nothing short of aircraft monetary policy (dropping bank notes from low-flying airplanes) to stop deflation," he said.
"The Fed will not settle for no inflation."
Bernanke's speech also impressed economists.
"The Big D is back," Jeff Rubin, chief economist at CIBC World Markets in Toronto, said in a release earlier this month, "and ... it's sending chills down Fed Governors' backs."
Deflationists make some forceful arguments: that the psychology, once it takes hold, is difficult to reverse because people will put off spending if they think prices will be lower a year from now, causing a downward spiral; that the aftershocks of the burst asset price bubbles are still being felt; that mushrooming debt loads are unsustainable; that central bankers will be hard-pressed to find rising asset prices against which to extend credit.
Inflationists make but one: Deflation is too terrible to contemplate in today's debt-laden society so it will be stopped. It's a compelling argument.
Deflation is frightening because prices and wages tumble but debts do not so they become more difficult for people, businesses and governments to repay. Your $300,000 house with the $250,000 mortgage falls to $150,000. You pay 5 per cent interest on your mortgage but consumer prices are falling at a 5 per cent annual rate, so your real cost of borrowing is 10 per cent. Then your partner loses his or her job. When Federal Reserve policy makers slashed short term interest rates by half a point on Nov. 6, deflation was on their minds, minutes of the meeting show.
"A failure to take an action ... would increase the odds of a cumulatively weakening economy and possibly even attendant deflation," however remote, the minutes said.
American manufacturers would welcome a lower dollar. Last week the National Association of Manufacturers said it planned to lobby Treasury Secretary John Snow to bring down its value.
"The dollar is still too high, and a clear message we will present to the new secretary is that before manufacturing can recover, the dollar has to return to more normal levels," Frank Vargo, vice-president of the association, told Bloomberg News. Vargo figured the U.S. dollar was 15 per cent to 20 per cent overvalued against the euro and the yen.
Grant is skeptical. This week the euro, yen, and Swiss franc all gained on the greenback.
"As a store of value we favour none of the above," he writes in his newsletter. Europe's and Japan's problems are even worse than the United States'.
"Our best idea is to hedge one's dollars with gold or the shares of the companies that own and produce it," he concludes.
Gold will gain in importance as paper money depreciates, Grant predicts. The market will change its mind about managed currencies and the stock of central bankers worldwide will enter a bear market, he adds. Gold will enter a reciprocal bull market.
"I believe gold is going to have a monetary role in the upcoming months, quarters and years that it has not had for the past 20 years," Grant said in the interview.
(He does not foresee a return to the gold standard, where paper currency is backed by gold in governments' vaults.)
"I'm bullish because the institutional investing world will rediscover (gold) as central banks make good on their threat to create enough currency, or fiat money, to solve what ails us," Grant says.
His conclusion: Buy gold and gold mining shares with paper money. Gold is, after all, a classic hedge against inflation, and "Nothing is so inflationary as a whiff of deflation."
Copyright 2002 Toronto Star Newspapers, Ltd. |
