A Brief Treatise on Gold and Other Currencies
Asset prices were volatile in 2011, especially to the downside. As the sovereign debt and banking crisis in Europe continued, signs of a global economic slowdown mounted, and a variety of other negative factors weighed on securities markets. One of the best performing assets in 2011 was gold, up 10%, although also with plenty of volatility. The S&P by comparison was flat while touching both 1,100 and 1,350 in the course of the year. Balestra has held varying amounts of physical gold and gold derivatives since 2002, during which time it has been our single largest asset and in most years the most volatile. This report will present some background information for gold and explain our case for gold as an important investment asset.
History is replete with politicians and central bankers hijacking sound currency systems. That process is once again well under way on a global basis. Ever more debt and fiat currencies are flooding global markets. We believe the bull market in gold has further to run despite the second half 2011 setback. The post World War II global monetary stability underpinned by the U.S. dollar (and gold until 1971) has come undone.
Conventional wisdom has it that gold is an anachronism, which John Maynard Keynes famously called a “barbarous relic.” For over 60 years since WW II, individual countries and the global economy have functioned quite well as gold’s role as a currency and store of wealth has diminished. Indeed, the final break in 1971 of the technical connection between the U.S. dollar (as the world’s reserve currency) and gold heralded a magnificent period of global growth and prosperity. History shows, however, that eventually any given monetary paradigm breaks down. We believe that this kind of change is now underway.
The long-term case for gold is supported by other strong factors. While gold does not pay interest or a dividend, unlike fiat currencies, it cannot be created in infinite amounts. It is also not subject to ratings downgrades and deteriorating sovereign balance sheets. It is not a liability of a company or a country. The skepticism about gold in the developed world is not shared in the developing world. Gold deposits have become harder to find and far more expensive to mine and process. Central banks have recently been building their gold reserves, instead of selling them. Gold is not substantially held across the worldwide spectrum of investors. Conventionally trained investors are not believers. Nevertheless, if for no other reason than that the global store of gold is limited while paper money is rapidly proliferating, gold’s role as a store of value is expanding, and its investment profit potential is rising.
The Evolution of Money
Over the course of centuries, metals became the currency of choice because they are divisible, portable, and easily stored. Metals can be standardized and made into coins. Eventually, governments entered into the business of money creation by standardizing coins unique to their jurisdictions. The first coins were valued based on the actual weight of the metal in the coin. Many different metals were used, but by the middle ages, silver and gold rose to the top.
Individuals looking to safeguard their gold deposited it with goldsmiths. The goldsmiths issued receipts to be used to redeem the gold at a later time. Eventually, these receipts began to circulate as a medium of exchange. As gold receipts gained widespread acceptance as currency, the goldsmiths/bankers discovered that their gold holdings were quite stable, with few depositors seeking to redeem at any given time. Gradually, the goldsmiths/bankers removed the warehousing fees and started paying interest in return for the right to loan out the gold they held. The nascent bankers further discovered that they could loan out a multiple of the gold on deposit to increase profits. Rather than loan out the physical gold, the goldsmiths simply created new gold receipts. Thus, we had the beginnings of the framework of the modern day system of fractional reserve banking, where a bank depositor and a borrower from the same bank effectively had title to the same ounce of gold (i.e. one ounce of gold but two ounces of gold money). The additional money created through this process is referred to as bank credit, and is the primary means by which new money now enters the global economy.
The final progression in the evolution of money was the complete removal of any commodity backing. Fiat money, as it is called, derives its value from the legal tender status bestowed on it by the issuing government. Critics of fiat money rightly point out the prior failures of fiat money standards. That is, all known fiat money regimes prior to the one operating at the present have ended with debilitating inflation.
The History of Currency Debasement and Fiat Money
Currency debasement is used to describe present date central bank actions such as quantitative easing. However, the classic meaning of the term currency debasement refers to when ruling regimes would systematically lower the metal content in order to increase the amount of coins in circulation. The government could easily introduce the debased currency into circulation by paying its bills with devalued coin. As the previously higher valued coins were used to pay taxes, the government would melt them down to make the new coins. The earliest known example may be the Roman Denarius, which was first issued in 211 B.C. as a relatively pure silver coin. Over centuries, the silver content was gradually reduced by various emperors. By the 4th century A.D., the silver content was less than 1%. Rampant inflation had become evident, and is now considered to be a major precipitating factor in the fall of the Roman Empire.
It is quite easy to see that early currency debasement was simply a precursor to fiat money. In many cases, a commodity standard was merely a pretense that governments adhered to when it was not a hindrance to rulers’ objectives. Historically, when governments found they could not finance themselves under a commodity money standard, they have either debased the currency, or moved to fiat currency.
The first known paper currency, which was dubbed “flying money”, originated in China under the Tang Dynasty around the 9th century A.D. Due to a copper shortage, it was intended to be used as representative currency for the copper coins that normally circulated. The succeeding Song Dynasty began issuing paper money in greater amounts in the 10th century A. D. Although the notes were valued at a fixed rate to gold, silver and silk, redemption was never actually allowed. Over the ensuing centuries, inflation became a problem, and the notes fell out of favor. Succeeding ruling regimes expanded the use of paper currency with virtually no commodity backing. In 1455, amid hyperinflation, the Ming Dynasty suspended the use of paper currency and returned to a copper standard.
Colonial America had several early disasters with fiat money. A shortage of specie (coins used as money) with which to finance trade led to the issuance of fiat currency in the mid 1600’s. Massachusetts is believed to be the first colony to indulge, with the first examples of paper fiat money issued by private merchants. However, in 1690, the need to pay soldiers for the Canada Expedition against New France led to the issuance of fiat bills by the Massachusetts Bay Colony. The soldiers’ salaries quickly lost around a third of their face value. Over the next several decades, the government issued increasing amounts of fiat currency with the promise it would eventually be redeemable for silver or gold. Those individuals with the means hoarded gold and silver specie, which steadily appreciated relative to the colony’s currency. Specie that was not hoarded found its way overseas to pay for imports, leaving the rapidly depreciating fiat currency as the only medium of exchange.
Decades of inflation ensued as the government printed new currency to finance deficit spending at various times. Several schemes were floated to attempt to redeem the inflated currency, but to no avail. In 1749, the British government shipped silver and copper to the Massachusetts colony to pay for the redemption of the notes. By this time the notes had lost roughly 90% of their face value. Other American colonies had similar experiences to Massachusetts throughout the 1700’s, prior to the Revolutionary War.
Due to the lack of gold and silver in the colonies, the Revolutionary War had to be financed by fiat currency. Both the individual colonies and the Continental Congress issued paper money. By the end of the war, all of the existing fiat currencies had become virtually worthless. Following the war, American leaders sought to restore stability to the currency system. The United States Constitution denied individual states the right to coin and print money. With the Coinage Act of 1792, the silver dollar technically became the national American currency. Except during various wartime periods, the U. S. would remain on some form of silver or gold standard (or a combination, called bimetallism) up until 1971.
One of the most notorious fiat money debacles took place in France in the early part of the 18th century. Following the War of the Spanish Succession, France was left with crippling debts, and a shortage of specie. In 1716, a Scottish economist by the name of John Law was named Controller Generale of Finances. Law believed strongly that money was merely a means of exchange, and thus, did not constitute wealth. His theories provided a philosophical basis for paper fiat money (paralleling current central bank policies), which happened to be convenient for a highly indebted French nation. He replaced the gold based currency with paper credit, then increased the available credit through a newly formed national bank (Banque Generale). By 1720, investors became suspicious and fear grew concerning the amount of gold specie backing the currency. A bank run ensued. Law fled France in fear of his life, as the French economy was left in shambles.
The most impactful experience on current European thinking is the Weimar Republic. During World War I, Germany suspended convertibility of its currency to gold, and financed the war entirely through debt. Political upheaval following Germany’s defeat led to the German Revolution, and the establishment of the Weimar Republic in 1919. With its economy devastated, a huge debt overhang, and an enormous amount of reparations owed to allied nations, political turmoil was virtually guaranteed. Reparations were to be paid in gold, or in foreign currency. Germany proceeded to massively print money to buy the foreign currency for reparations and meet all of its other obligations. It worked for a while but then inflation proceeded to reach absurd proportions. One U. S. dollar in April 1919 was worth 12 German marks. By December 1923, one U. S. dollar could buy 4.2 trillion German marks! In November 1923, the Reichsbank (German Central Bank) ceased the printing of new money. The new German reichsmark was introduced in 1924 at a conversion rate of 1 trillion paper marks, and was convertible to gold. While the German economy was still virtually decimated, the new currency provided enough stability for the country to enter a period of relatively substantial and sustained growth.
Whether due to war, corruption, or social welfare spending, governments have a predilection to run up large debt loads. The feasibility of printing money to inflate away the debt makes the temptation irresistible.
Fiat Currencies and Gold in the Global Economy
Gold has been the best asset to own during recurring episodes throughout the history of individual countries running up massive sovereign debt and debasing their currencies. However, we now live in a world that is a full blown global economy with a complex global financial marketplace. Our view on gold and its upward movement over the past decade is not a simple function of the U.S., much less Europe and Japan, running up massive debts and liabilities and debasing their currencies. Indeed, the worst sovereign debt offender over the past decade is Japan and yet its currency has continually strengthened and its sovereign bond market has the lowest rates in the world. Furthermore, gold’s ascent over the past five years has occurred as expectations have oscillated between inflationary and deflationary. Balestra has continued to hold the view that deflationary pressures are pervasive in developed countries.
From A 19th Century Gold Standard to Today
As global trade expanded during the Industrial Revolution in the latter half of the 19th century, a desire to increase global trade led to an increasing level of international cooperation and the creation of an international gold standard. The United States and Great Britain had both established gold standards that called for their currencies to be redeemable into gold at a fixed price. Many countries around the world then pegged their own currencies at a fixed exchange rate. Under these circumstances, participating countries had minimal control over their individual monetary policies. While the system was not perfect and was often steered and adjusted by central banks and governments, most economists believe the Pre-WW I standard performed as was intended. In effect, large and persistent trade imbalances were not allowed to occur.
While the gold exchange standard of the late 19th and early 20th century ran relatively smoothly, the beginning of World War I made it impossible to maintain. Many nations throughout history have found war extremely difficult to finance without the use of highly inflationary monetary policy. Under mild inflation, a gold standard may be maintained, but war has typically put severe strain on economic resources. Most countries suspended convertibility of their currencies to gold during WW I. After the war, it was difficult to determine how to properly fix exchange rates under a gold standard. Large existing imbalances, along with widely varying levels of inflation, made pre-war prices unworkable. In the post World War I period, attempts to return to previous stability offered by the gold standard proved futile.
By 1931, the British were once again forced to abandon the gold standard. Throughout the rest of the 1930’s, countries around the world would follow Britain’s lead. Competitive devaluation became the prevailing policy prescription as nations hoped to spur exports in order to grow their way out of the depression. High tariffs and trade barriers were implemented. The previous combination of gold backed currencies and international cooperation gave way to a period of widespread discord.
The prevailing consensus has it that the Federal Reserve doomed the U. S. to severe debt deflation by raising interest rates in the early 1930’s to defend the gold standard. Studies have shown that the countries that left the gold standard, and depreciated their currencies relative to gold, recovered quicker than those that did not. However, without excessive credit inflation during the 1920’s, the Great Depression would not have occurred. Most analysis surrounding these events focus on what policy makers should have done once the system was in peril. Much less attention has been given to the weaknesses of the system, or policy mistakes leading up to the 1930’s. Developing a system that balances the interests of sovereign nations (whether well-intended, or not) with international stability is exceedingly difficult.
By the end of World War II, the global leaders began to reach a consensus for a need to return to some form of international monetary collaboration and hard currency. The lessons of paper currency and unconstrained debt creation had seemingly been learned. Trade had contracted in the preceding years as countries resorted to tariffs and competitive devaluations. Leaders acknowledged that these policies were detrimental to the world as a whole. The Bretton Woods Conference, named for the town in New Hampshire, was held in July 1944. Delegates from 44 nations gathered and agreed to a plan to construct a global financial system to regulate international monetary transactions. The agreement established the International Monetary Fund (IMF) and the International Bank for Reconstruction and Development (now part of the World Bank). The general scheme required participating countries to maintain fixed exchange rates versus the U. S. dollar, while the dollar was fixed to gold at a price of $35 an ounce. Any short-term balance of payments problems were to be handled by the IMF using capital provided by members based on a quota system.
No nation had the power to challenge the U. S. at the bargaining table. After WWII, most of the major economic powers of the world were in dire shape. The United States, which had been gaining a growing share of world production prior to the war, escaped with its manufacturing base intact. Effectively, this was a positive for freer trade, because the U. S. used its power to open trade channels. However, the use of the U. S. dollar as the world’s reserve currency had both benefits and drawbacks.
An interesting difference in the $35 fixed price of gold in the Bretton Woods System (BWS) versus prior gold standards was that it was only open to foreign governments. That is, the fixed rate was only meant to be used to settle balance of payments flows within official channels. The interesting characteristic of such a structure is that it allowed the U. S. to run inflationary monetary policy as long as foreign governments refrained from exchanging excess dollars for gold at the fixed rate. Initially, this was seen as an admirable quality of the system. The Brettton Woods “pseudo-gold standard”, as some have called it, allowed the U. S. to transmit monetary stimulus to the war-torn nations of Europe. The belief at the time of the agreement was that a true gold standard would not allow enough free credit flow for the reconstruction that was necessary. So participants were willing to accept the dollar as the new primary reserve asset. Yet, by the early 1960’s, attitudes were changing. U. S. dollars were beginning to pile up in foreign government coffers, and cracks started to show in the system.
In 1960, an economist by the name of Robert Triffin noted that as the producer of the world’s reserve currency, the United States was required to run a current account deficit in order to supply the world with the excess reserves it demanded. This would be true of any country whose currency was used as the primary reserve asset. In effect, the U. S. was the de facto central banker to the world. Of course, endless current account deficits would eventually prove unsustainable as markets lost confidence in the reserve currency. By 1959, there already appeared to be too many dollars in circulation to maintain the $35 peg. On this basis, Bretton Woods was on borrowed time, but the participant nations sought to maintain the system as long as possible. In 1961, eight major nations joined to create the London Gold Pool. These countries pooled their gold reserves in order to help maintain the fixed price of $35 an ounce. In effect, they would sell gold on the market when necessary to cap the price, and buy it back if it fell below $35.
Efforts to maintain Bretton Woods persisted until 1968, when it became obvious the system was untenable. The large budget deficits created by U. S. President Lyndon Johnson’s Great Society programs, as well as the Vietnam War, put even more pressure on the $35 peg. The free market price rose well above $35 as the London Gold Pool dissolved, and U. S. gold reserves began to be depleted. The President of France, Charles de Gaulle, began advocating a return to a “pure” international gold standard, while aggressively accumulating gold reserves. Various legislative measures were taken in the U. S. to stem the outflow of gold, and to spur U. S. exports, but to no avail. Foreign exchange rates started to float, because nations no longer had the means to intervene. The system began to come apart at the seams.
In 1971, U. S. President Richard Nixon took the unilateral measure of withdrawing convertibility of the U. S. dollar to gold. It had become quite evident by then that the U. S. would likely lose all of its gold reserves if it attempted to maintain the $35 an ounce peg. There were simply too many dollars floating around the world. Gold priced in U. S. dollars began a spectacular bull run, culminating in a spike to $850 an ounce in January 1980. With the “Nixon Shock”, as it came to be known, there was no longer any limit on money creation by the Federal Reserve. The world had entered a new era in monetary history that was unprecedented. For the first time outside of global warfare, the entire world was on a fiat money standard.
The advent of a global fiat money standard completely removed all restraints on central banks and governments interested in trying to manage the business cycle. In the decades leading up to the millennium, while central bankers were congratulating themselves for longer economic expansions, and shorter recessions, debt was reaching epic proportions. Monetary easing could be pursued with no regard to the convertability of dollars for gold. The U.S. Fed became ever more aggressive at every economic downturn to try to shorten recessions and threats to growth, which laid the groundwork for the crisis of 2008.
Gold Supply and Demand
There are approximately 166,000 tons of physical gold above ground in the world right now. Secret stashes aside, this is all the gold that is available to the world presently. It is quite dense (almost twice the density of lead), and all known gold could be comprised in a cube of just 67 feet cubed. Based on recent average prices, all of this gold is valued at almost $8 trillion.
Roughly half of above ground supply exists as jewelry. Though jewelry is the use most associated with it, gold has historically had various uses. It is a highly malleable metal that can be drawn into wires, or extremely thin sheets. It is a great conductor of electricity, and does not tarnish. These qualities make gold a valued component in solid state electronic devices, as well as standard computers. While gold’s use in industry is smaller than other metals, it is not insignificant at 11%. Central banks and governments (i.e. the public sector) hold around 17% of outstanding stocks, with private investors holding slightly less than 19%. Existing known allocations leave a little more than 2% as unaccounted for.
While the allocation for gold has been quite stable over the years, at the margin, incremental demand is changing in a substantial way. From 1999 through 2010, the public sector had been a net seller of gold, because legacy Eurozone central banks saw little need for gold reserves. That net selling has swung dramatically. From a high point of around 650 tons of sales in 2005, the public sector has become a net buyer of around 200 tons. Over the last decade, the average annual sales amounted to roughly 5% of annual demand. Now, the public sector is estimated to be adding 5% in annual gold demand. That is a significant swing. Major, developed nations hold an average of around 58% of their international reserves as gold. Those nations most rapidly accumulating international reserves, namely Asian developing countries, hold less than 3% of reserves in gold. There is considerable scope for further accumulation of gold as an international reserve asset.
Private incremental demand for gold is somewhat in line with historical allocations. Annual jewelry demand has averaged 56% of total demand for the last five years (represents 50.5% of existing stocks). Technology demand has run at around 12% of total demand, against 11% of outstanding stocks. Up until 2010, private investment made up the balance of annual demand. But as we noted, central banks are now taking up around 5%.
Another important element in the demand equation is the role of China and India. These two countries make up roughly 36% of the global population, but only around 12.5% of global GDP. Nevertheless, China and India comprise over half of the global annual private demand (jewelry plus investor demand) for gold. The implications of this are more meaningful in light of the high real GDP growth rates, and the high inflation both countries have experienced. High economic growth, compounded with high inflation, provides robust demand for gold. China and India place more cultural significance on ownership of gold than we do in the west.
The extraordinary capital investment China has undertaken in the last decade has been a persistent driver of the bullish trend in all commodities. While precious metals are usually included in the bullish mix, the primary focus is usually on industrial commodities. Many have proposed Malthusian themes such as, peak oil, or even peak copper. We remain rather agnostic toward these more extreme theories. However, bottlenecks in the production of many commodities are apparent. Costs are rising as the feasibility of finding and harvesting minerals and energy sources diminishes. Some who propose that gold is in a bubble readily admit the supply issues in other commodities. Their more skeptical view on gold is probably owed to the fact that gold has outperformed other commodities. We believe the outperformance is primarily due to gold’s historical use as a monetary metal and a store of value. However, it should be noted that there have been severe production constraints on gold as well.
According to the U. S. Geological Survey, global gold mine production has been trending down for the last decade. Production peaked in 2001 at 2600 metric tons. There was a 7% increase from 2008 to 2009 (the latest available data), which may hold out some hope for expanded supply. But the lack of a stronger supply side response is telling given the extraordinary price increase in gold. Like many other commodities, gold is becoming increasingly tougher to find. Chart 1 below shows that cash costs of production have risen to a record level in recent years. Combined with the powerful demand drivers we have already outlined, the supply situation presents a very bullish technical setup.
Gold Price Movement
There is, and has been, plenty of skepticism of investment in gold, and that skepticism has limited gold holdings among investors. Standard investment analysis involves discounting future cash flows back to the present in order to determine the value. Since gold produces no cash flows, its value is considered indeterminate. Therefore, it is a speculative asset, not an investment. Our thinking is that there is always uncertainty in estimates of future cash flows plus the uncertainty as to the real value (adjusted for inflation) of prospective flows.
The crisis in 2008 and the ongoing Eurozone contagion have created uncertainty which is systemic in nature. Initially, the international banking and financial system were the focus of investor fears. Bank bailouts and subsequent fiscal stimulus created large budget deficits among developed countries. High deficits are severely aggravating already unsustainable debt levels, and investors are now concerned about sovereign debt. For countries
with their own currency, the consensus sees default as inconceivable. The central bank can print whatever money is necessary to pay the government debts and expenditures.
The erosion of confidence in previously “riskless” sovereign debt creates a very bullish case for gold. If sovereign debt investors believe they will be paid coupons, but that the payments will be in depreciated currency, they will seek to hedge that risk. Gold has historically been considered a hedge for inflation (typically consumer price inflation).
Many have been perplexed with the simultaneous rise in the gold price combined with falling yields of U. S. Treasuries and deflation. One way to reconcile this paradox is to understand that gold is more than simply a hedge against present inflation; it is also a hedge against loss of confidence in central banks. The analysts at GaveKal, an investment research group, have noted that the price of gold has a higher correlation with the volatility of consumer prices than with price inflation itself. The implication is that gold is reacting to central banks’ loss of control over prices. An example of this loss of control is the rapid transition in 2008-09 from inflation to deflation. Deflation presents investors with an increased potential for nonpayment of coupons/dividends. Inflation means fixed income investors will see cash flows devalued. Gold is considered a hedge against both of these contingencies.
We acknowledge the difficulty in determining an objective valuation for gold. However, much of the value in financial markets is open to subjective determination. A comparison of gold to other commodities or assets shows that talk of a gold bubble may be premature. The ratio of the U. S. dollar gold price to both crude oil and the S & P 500 Equity Index show there is considerable upside on a relative value basis. The current Gold to Brent Crude price ratio (chart 2) of approximately 15 implies that with the Brent Crude price stable, gold would have to double in price to reach the relative value high of the late 1980’s. The ratio of gold to the S & P 500 (chart 3) is presently 1.3. It reached a high of 7.5 in 1980.
Given gold’s history as a reserve asset and monetary standard, it makes sense to also compare it on that basis as well. One way we can do this is to compare the value of all gold held by the U. S. government to the value of the monetary base. The monetary base is the only part of the money supply directly affected by the central bank. It consists of currency in circulation, bank vault cash, and commercial bank reserves held with the Federal Reserve. If we value gold held by the U. S. government at market prices, approximately 17% of the monetary base is now “backed” by gold (chart 4). At the gold price peak in 1980, this ratio was 130%. For U. S. gold reserves to fully back the monetary base, gold would have to be priced around $10,000! Granted, some may see this comparison as arbitrary. However, after a multi-decade hiatus, gold may be reclaiming its historical status as a primary reserve asset. Both investors and central banks are now buying it on that basis.
Recent price action in the gold market has been extremely volatile. Gold skeptics have been highlighting this volatility as an indication that gold is a dangerous bubble. However, the volatility we have seen in gold is less than what we have experienced in equities! Gold is simply reacting to the same economic uncertainty as equities. Given the relentless rise in gold over the last several years, there will continue to be periods when speculative momentum traders create extreme moves. Caution is warranted during these periods. However, such short-term volatility has little relation to the long-term bullish case. Globally, long-term investors are seeking ways to store value in assets other than cash and sovereign debt. Beyond currency price volatility, and sovereign credit downgrades, what happens to bond investors if the collapse in interest rates reverses? Despite the attention gold has been receiving lately in the media, indications are that average investors do not have a high exposure.
Historically speaking, relative valuations for gold are not stretched. Some analysts have forecasted seemingly fantastic target prices ($5000, $7500, etc.). We see no point in engaging in this practice. However, based on the relative valuations we have provided, such targets are not implausible over the long-run.
Modern Currency Debasement
Since the “Keynesian Revolution” that began in the 1930’s, there has been increasing action on the part of governments to manage economic outcomes. Policy makers and academics rarely question the efficacy of such intervention, and most individuals assume the “experts” know what they are doing. While the crisis of 2008-09 raised doubts in many minds, the subsequent recovery returned everything to business as usual. The herculean policy measures enacted may have saved the world from imminent depression, but the actual underlying problems have not been dealt with, and they continue to fester. At some point in the future, there will have to be acknowledgment of the systemic weaknesses in the global financial system. Until that time, central bankers will pursue the time worn path of currency debasement.
Enormous debt accumulation is a pervasive element in modern developed economies. As shown in the chart below (chart 5), the average gross debt to GDP ratio for the G-7 has exploded since 2008 to surpass 100%.
However, despite large deficit spending, and unprecedented monetary stimulus, economic growth has been subpar. The ongoing debt deleveraging in the private sector threatens to overwhelm the tenuous cyclical growth we have seen since 2008. Economic prognosticators outside of the mainstream abound at both ends of the inflation versus deflation debate. Many confidently predict future hyperinflation while others paint a picture of Japanese style deflation, or rather, a replay of the 1930’s debt-deflation. Neither outcome can be predicted with any certainty. The future will be driven by a process that is as much political as it is economic in nature. We now have the convergence of a broad array of secular economic forces, such as: demographic shifts; excessive debt in developed nations; unorthodox monetary policy; structural long-term unemployment in developed nations; and rising global trade tensions. Modern day central bankers believe they have learned how to control inflation. However, they are less certain of their power over deflation. We believe this presents a clear bias toward policy makers creating excess inflation in the coming years.
A chart of the U. S. Monetary Base (Chart 6) illustrates the worry of those predicting hyperinflation. It shows the drastic change in the Federal Reserve’s balance sheet from implementation of QE1 and QE2. The complicating factor stems from the fact that the monetary base is not money in the classic sense. It merely represents the reserves that banks must hold in relation to the loans they create. In effect, if a greater amount of bank loans are paid off (or defaulted on) than the amount of quantitative easing, then the effects are not necessarily inflationary. In fact, as we have seen in Japan, we could still see deflation. A further complicating factor is the unpredictable nature of the implosion of the global “shadow banking” system. Shadow banking refers to the extraordinarily complex derivatives positions held throughout the global banking system. Central bankers have no precedent for navigating under these circumstances.
Nevertheless, Ben Bernanke has indicated that there is no theoretical limit to quantitative easing. The Fed can buy assets as it sees fit to provide the banking system with the necessary reserves to keep credit expansion going. Both in practice, and in prevailing theory, the goal of a central bank fighting deflation is to engineer negative real interest rates. The hope of central bankers is that there will be an increase in the expected rate of inflation. If so, the effect is two-fold. First, higher inflation devalues the outstanding stock of debt; making it easier to pay off. Second, if inflation is actually higher than interest rates, the borrower gets to pay back less money than he borrowed in real terms. That is a powerful incentive for speculators! Negative real interest rates entice both investors and consumers to invest or spend now rather than later. However, if you live on a fixed income, or you are attempting to prudently save for retirement, your perspective will be quite different.
Using 10 year swap rates and subtracting year over year consumer price index (CPI) inflation paints a picture of policy makers’ intentions. Swap rates represent a good proxy for the average rate paid by AAA rated banks and corporate borrowers. As charts 7 and 8 show for the U. S. and the Euro zone respectively, these real rates are now in negative territory.
Despite the bluster of the European Central Bank in presenting itself as the staid steward of the Euro zone economy, it has joined the U. S. in the process of debasing the currency by engineering negative real interest rates through programs like the Long Term Refinancing Operation (LTRO). Certainly, a global recession could change things. Inflation may drop substantially, which would turn real rates positive again. However, all indications are that global central bankers would act quickly to implement new monetary stimulus, in order to get real rates back to negative territory. If they did not, the belief is that the U.S. and Europe may follow the path of Japan. Chart 9 shows real 10 year swap rates for Japan over the last 20 years. As we can see, Japan never did maintain negative real rates for very long. Some would say that is one reason it has failed to defeat deflation over the last 20 years. Other governments and central bankers are keen not to fall into that trap.
Negative real 10 year rates have not been seen in the U. S. since the 1970’s (using U. S. treasury yields). Back then, the impetus was financing the Vietnam War, and offsetting oil supply shocks. The situation is different now. Global central bankers are fighting debt deflation. Despite whatever complex new mechanisms of monetary policy they implement, their goal is the same as throughout history. They seek to devalue the currency.
A persistent element of economic history has been the struggle to construct a robust and stable international monetary system that fosters investment and international trade. The only consistency in all the previous regimes has been eventual failure. If there is one particular reason for repeated failure, it is the tendency for the currency issuer to abuse its power. Whether they are individual bankers creating too much bank credit, governments debasing coins, or central banks monetizing government debt, the end result has been the same: instability of the system, followed by its demise.
The general consensus is that modern day central bankers have solved the previous problems, and that the current system is stable. The recurrent crises of the last several years should have created some doubt toward this view. Over the next several years, there is a potential for disharmony similar to the 1930’s. Regardless of the outcome, we expect governments to do what they always have in the past: debase their currencies. If so, investors will increasingly seek to protect the value of their savings. We believe that one good protection lies in holding gold.
Our long-term view can be summed up in the following points:
1. The developed world is overly indebted.
2. So far, there is little indication that heavily indebted countries will be able to grow their way out of debt.
3. Recent measures to cut government spending will create further headwinds to near-term economic growth.
4. Failure to provide added monetary stimulus will likely risk a fall into a debt deflation spiral (this risk is heightened by the Euro zone situation).
5. Central banks will continue to “print money”, as needed, to prevent debt deflation.
The timeline for our thesis to play out is indeterminate. It took decades for the current situation to evolve. Resolution could take many possible paths depending upon the actions of politicians and central bankers. Nevertheless, we have strong conviction that the end result will be more monetary stimulus, and a higher gold price in all currencies.
Balestra Capital Quarterly Newsletter 1Q12