Up and Down Wall Street
THURSDAY, NOVEMBER 29, 2012
Is Bad News Still Good News for Gold?
By RANDALL W. FORSYTH
Despite Wednesday's dip and deflationary debt fears, central-bank money printing likely means continued loss of value of paper currencies vs. the metal.
Woody Allen's conundrum aptly describes the effects of the fiscal crises faced by governments all over the globe on the price of gold. History shows bankrupt governments will clip coins or print money to cover their debts, which is why gold has served as a store of value for centuries. But recent crises have been different; gold's value has made it an asset that can readily be sold to meet liquidity needs.
So, while gold prices typically rise in troubled times, they have plunged in recent years whenever market risks mounted, notably plunging 25% during the 2008 financial crisis.
Now, two economists who are both concerned about the fiscal crises on either side of the Atlantic come to diametrically opposite conclusions about what they mean for the price of gold.
Not to keep you in suspense, Leigh Skene of Lombard Street Research thinks the European debt set off a serious chain of defaults, which makes deflation inevitable and will send the dollar soaring and gold plunging. By contrast, John L. Williams, who heads Shadow Government Statistics, thinks that beyond the fiscal cliff lies the U.S. government's insolvency, which will set off a run on the dollar that will result in hyperinflation and launch gold into the stratosphere.
In other words, a choice between despair and utter hopelessness or total extinction.
"The European crisis makes gold's near-term prospects poor," LSR's Skene writes. "It will cause a serious rash of defaults, some of which will be too-big-to-bail-out.
Global bad debt could total 10 times as much as the now swollen central bank balance sheets, so defaults will swamp governments and central banks, so deflation is the only possible outcome. Real interest rates and the dollar's foreign exchange price will soar.
Low-to-negative real interest rates and a weak U.S. dollar caused the explosive rise in the price of gold. Their reversal will weaken it. Silver's price is more volatile than gold's, so [it] will fall further from current levels."
Gold's longer-term prospects, Skene continues, will depend on the public's desire for stable currencies through a return to the gold standard in reaction to central banks' poor performance over the past century. Based on numerous assumptions that the dollar's link to gold would be restored over the next decade, he comes up with a gold price of $2,170 an ounce.
"This is not a forecast," Skene emphasizes. The numerous assumptions that go into his calculation -- the ratio of gold to the U.S. money supply, the rate of deflation, how long it takes to reestablish the gold standard plus the discount rate applied during the period leading up to monetization of gold -- all affect that price. He reckons the return from gold would be about 10% per annum leading up to monetization, but the probability of monetization is the main determinant of future gold prices. All of which are unknowable.
Williams, by contrast, sees the dollar collapsing as international investors abandon the greenback as the global financial system's main reserve currency and transaction medium because of the insolvency of the U.S. government, which he predicts will become apparent by 2014.
Beyond the brouhaha over the fiscal cliff, he asserts the federal government has been running deficits that would total $5 trillion a year if measured by generally accepted accounting principles. The present value of federal-government obligations -- including the promises to pay entitlements such as Social Security and Medicare -- totals some $90 trillion, Williams calculates. That is close to the $87 trillion indebtedness cited by former Securities and Exchange Chairman Christopher Cox and former House Ways & Means Committee Chairman Bill Archer in their recent Wall Street Journal op-ed article calling for Congressional action to address these liabilities that are ignored in the fiscal-cliff discussions.
Williams, for his part, is pessimistic anything can be done after the U.S. government has lived beyond its means for so many years. "No amount of spending cuts, outside of the politically untouchable social programs, and no amount of tax increases, can bring the GAAP-based annual U.S. budget deficit into balance," he writes.
The inevitable result is for debt monetization -- that is, for the Federal Reserve to print money to cover the deficits -- according to Williams. That has been the remedy of kings from ancient times to cover the gap between what they wanted to spend and the taxes they could exact from their subjects; they clipped the coins to expand the supply of money, with hyperinflation the inevitable result.
That, in essence, is what Williams expects. And the Fed so far has financed much of the federal deficit with its so-called quantitative easing -- the purchase of securities to expand the U.S. money supply. That has absorbed the lion's share of the supply of new Treasury securities, although under so-called QE3 the Fed has committed to purchasing $40 billion of agency mortgage-backed securities per month.
The central-bank's net holdings of Treasuries hasn't expanded significantly under its current maturity-extension program, aka Operation Twist, which involves the purchase of longer-term notes and bonds, offset by the sale of shorter-dated securities, which is supposed to wind down by year-end. Wednesday, the Wall Street Journal reported the central bank is likely to approve the continued purchase of Treasuries -- without any offsetting sales -- at its next meeting scheduled for Dec. 11-12. Once again, there was no attribution to any source for the information; such stories don't get into print unless it's the straight dope from the top.
For now, global investors are unconcerned about Washington's fiscal plight. That was evident from Tuesday's auction of two-year notes, in which the Treasury received $4 of bids for every $1 of securities being offered.
Indeed, a plunge over the fiscal cliff would likely set off a market crisis that would spur a flight to quality -- into U.S. Treasury securities and the dollar -- just as after Standard & Poor's stripped Uncle Sam of his triple-A credit rating. Treasury securities yields fell to record lows subsequently and are still substantially lower in the wake of the downgrade.
Williams doubts this can go on forever. At some point -- he says by 2014 -- investors will cease to accept as their primary liquid asset the ever-growing stock of U.S. debt and by extension the dollar. The flight from the greenback will spark hyperinflation, as has been the case through history in banana republics or Weimar Germany.
So, who's right? Does the insolvency of European governments cause deflation, which sends the dollar soaring and gold plunging? Or does the insolvency of the U.S. government cause a collapse in the dollar and hyperinflation?
Probably both and neither. European governments and international institutions are likely to connive in any way possible to avoid the defaults and the resulting deflation from Europe. The most expedient way is for the European Central Bank to buy the bonds of the heavily indebted economies of Spain and Italy. That would both finance their deficits and lower the value of the euro, which would boost the competitiveness of the peripheral economies of the euro zone.
Does this violate every precept of the founding of the single currency? Of course it does and Germany will object vociferously.
But ECB President Mario Draghi has pledged to do whatever it takes to save the euro. Since he made that pledge last July, that in itself has restored confidence. The ECB can only buy bonds when a government accedes to harsh conditions, which none has had to do. So far, Draghi's mere declaration has lowered the funding costs for Italy and Spain, but actions may eventually needed to back up his words.
Meanwhile, the Fed has effectively inaugurated QE infinity, buying securities until unemployment is brought down to some satisfactory level. So, the U.S. central bank will be churning out greenbacks, which will effectively fund the federal budget deficit. In addition, the Bank of Japan is being urged to engage in quantitative easing until deflation turns into inflation by the leader of the opposition Liberal Democratic Party, which is likely to regain power in elections next month.
Bottom line: every major central bank around the globe is likely to continue printing money to stave off any deflationary undertow induced by the massive debt of their governments. Notwithstanding short-term sell-offs such as Wednesday's $25 drop, central-bank policies should keep interest rates near zero and negative in real terms, which in turn ought to keep gold in its long-term uptrend. As long as authorities try to do whatever it takes to hold the system of fiat currencies and indebted governments from flying apart, paper money will continue to lose value relative to the traditional store of value, gold.
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