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The Deflationary Climate

“All the factors that will lead to inflation will operate through first weakening balance sheets, whether of the private sector or of the government or both. Credit worries will mushroom, increasing the attractiveness of outside assets such as gold. Finally, the accelerating trend in the world towards the restriction of free capital movements and towards a contraction in the financial services industry in general will reduce the available alternatives to gold.” (Bernard Connolly, AIG International Research, 1/11/02)

Aggressive rate cutting by the Fed and other central banks, historically high rates of monetary expansion, and a return to deficit spending do not suggest that inflation fears are driving economic policy. Those fears have been displaced by the prospects of stagnant to non-existent growth or even worse, a self-feeding contraction of credit in which borrowers are forced to service or repay debt through sales of assets.

Corporate debt totaled $4.9 trillion as of 9/30/01 versus $2.4 trillion at year- end 1989. During the same period, consumer debt reached $7.9 trillion versus $3.5 trillion. The 100% plus increases in both cases far outpaced the 80% cumulative increase in GDP. During 2001, there were three times as many credit downgrades of corporate-credit ratings as upgrades, the fourth consecutive yearly drop in credit quality and the steepest decline in creditworthiness since 1991, as chronicled in a WSJ article by Gregory Zuckerman (12/31/01). Debt is greater today than when the recession started. It would be unusual for an economic recovery to commence before a cycle of debt liquidation. As the chart below shows, if the current recession is indeed ending, it would be the first time that consumer debt relative to disposable income had not declined:


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The precipitous and wholesale abandonment of the anti inflationary policies of the 1990’s, pivotal to the strong dollar, must suggest second thoughts to central bankers sitting on their vast accumulations of dollars. Undoubtedly, the October ’01 downgrade of the dollar by the Chinese was driven by such considerations. In case the first announcement went unnoticed, the Chinese reiterated their intentions rather loudly on January 7th 2002. As reported in the Daily Telegraph, Chinese foreign minister Xiang Huaicheng said “I will instruct the responsible authorities that they should not just have a currency basket but rather that they should buy euros as quickly as possible.” The European Commission added “China and the European Union share a joint suspicion of American ‘hegemony’ in the global economic system and have been edging toward mutual embrace for several years. Beijing has a strong interest in promoting a rival currency, but i. A reversal of capital flows will induce a sharp decline against the euro and the yen, warts notwithstanding, and will be followed by rising interest rates, reported inflation, and a much higher gold price.

The perils of deflation are not unrecognized. In July, the NY Times noted that the strong dollar “is making exporters non competitive in international markets” and could in part be blamed for weak corporate profits, job losses, and faltering stock prices. In June, Bridgewater Daily Observations noted that “when economies are doing well most everyone believes in the beauty and efficiency of the free markets and free trade, but when the economy turns south people come out of the woodwork to decry the evils of unfettered markets.” (Bridgewater Daily Observations, 6/01). Among those to come out of the woodwork has been the steel industry, which has recently succeeded in paving the way for raising tariffs on imported steel by up to 40%. Free trade advocates note that the annual cost to consumers will approach $2.4 billion a year. Another recent protectionist measure was the recent passage of tariffs to limit imports of Canadian lumber. If economic weakness persists, trade barriers will proliferate.

The dilemma for economic policy is that the exigencies of combating deflation have considerable potential to undermine confidence in the dollar. Former Treasury secretary Rubin testified before Congress, “modifying our strong dollar policy could adversely affect inflation, interest rates, and capital inflows and would lessen the favorability of our terms of exchange with the rest of the world.” Despite these dangers, NY Times columnist Paul Krugman recently wrote “the strong dollar is one of the reasons the Fed is having trouble pulling us back from the brink. So right now, a weaker dollar is in America’s interests.” Krugman likens the rising dollar to a Ponzi scheme, which is about to “run out of suckers.”

Does the recently launched euro have unappreciated merits as some think? Will Japan’s fortunes take a turn for the better and lead to surprising appreciation in the yen? Either possibility has to be considered, but it seems more likely that the overcooked bull market in the dollar will unravel like NASDAQ, under the weight of its own overvaluation. As with that mania, skeptics were pariahs until the damage was obvious. Given the excessive central bank and capital market concentration in the US dollar, its extreme overvaluation relative to its counterparts, and the as yet unrecognized erosion of the dollar’s fundamentals, almost any minor event could tip psychology and trigger an Enron-like meltdown. In that scenario, holders of dollars will look for liquid alternatives and ask questions later. Central banks will suspend gold sales and balk at rolling over bullion loans. Market sentiment towards financial assets will sour further. The bear market in financial assets, already underway, will become more widely recognized.

Market Metaphysics

Markets are above all driven by psychology and emotion. The progression from the previous nadir of pessimism in 1974 to the peak bubble optimism was imperceptible in the moment but a powerful determinant of price extremes. The new economy paradigm and the love affair with technology are transient phases that will be replaced by preoccupation with as yet unidentified concerns.

There is no way to figure extremes of valuation without considering psychology and market mythology. While the usual fundamental considerations of real interest rates and earnings are starting points for valuation, expectations or beliefs as to the future course of events are decidedly non- quantitative. Since 1910, the P/E ratio of the S&P has averaged approximately 15x. In that span of more than 90 years, the P/E has exceeded 25x only six times. Bear markets typically end in single digit territory. Recent S&P P/E measures in excess of 30x suggest confidence remains unbroken by the yearlong drubbing in stocks and the recession. Meaningful change in market psychology spans decades. Shifts are imperceptible in the context of shorter- term market and business cycles. However, there is no mistaking the contrast in mood that existed at the peak of the NASDAQ bubble just a short while ago, and the mood that prevailed at the 1974 low and for several years thereafter. How markets travel from one extreme to the other is unknowable. What is clear is the preponderance of confidence or the lack of it at each extreme.

In a 1997 speech (Leuven, Belgium) Alan Greenspan stated “a nation’s sovereign credit rating lies at the base of its current fiscal, monetary, and, indirectly, regulatory


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In isolation, manipulation of the gold market might be dismissed as a well-intentioned exercise in market stability, the thought being that a misbehaving gold price would undermine the very confidence identified by Greenspan as so precious. However, to regard the manipulation of the gold price as an isolated matter would require a suspension of belief greater than for those who found value in dot com stocks. In fact, intervention in all markets including equities, bonds, currencies, and commodities has long been standard operating procedure for the Fed and the Treasury.

The invariable response to market shocks that threatened the now infamous virtuous circle of a strong currency and the bull market was decisive market intervention by the Federal Reserve and US Treasury. For example:<ul><ul>
- Market crises triggered by the Asian meltdown, the Russian default, the collapse of LTCM, and plummeting stock prices post the NASDAQ mania, were countered by injections of liquidity by the Federal Reserve along with high profile public statements of assurance to the markets.

- The cosmetics of low inflation were fortified by debasement of Bureau of Labor Statistics inflation measures through dubious hedonic price adjustments and false productivity measures.

- A flare up in the gold price caused by a short squeeze following the Washington Agreement in 1999 was doused by fresh liquidity solicited from Kuwait, the Vatican, and Singapore. As discussed later, these maneuvers included mobilization of US gold reserves.

- The attempt to bring down long-term rates by suspending issuance of 30-year treasuries is the most recent and clumsiest of actions.

- In the true spirit of globalization, the government of Italy manipulated its own bond market to hide the true size of its budget deficit in order to be admitted to the European single currency. In a report published by the International Securities Market Association (November, 01), a currency bond swap was completed in 1997 to mask the true size of the country’s internal deficit. The transaction was orchestrated by Long Term Capital Management, which counted the Italian Central Bank among its clients.</ul></ul>
Richard Russell, a veteran stock market observer recently concluded that the stock market was being manipulated: “I’ve resisted this idea for a long time, but slowly and surely I’ve come to the conclusion that yes, the Fed does step in at various times and manipulate the market…. One of those ‘manipulation junctures’ is right now. The Enron mess hit the markets, some indices that I follow were right on the edge, and ‘normally’ I would have expected the markets ….to follow through on the downside today. But lo and behold, buying came in at the opening and the market pushed higher.” He goes on to say that “all manipulation does is hold off the inevitable.”

During the Clinton administration, auctions of 30 year treasuries were scaled back, some suggested, in order to lower interest costs to the government by emphasizing low coupon short-term maturities. Perhaps at a time when a wide spread existed between opposite ends of the yield curve, this might have made sense, but how to explain the recent suspension of 30 year issues altogether? With long-term interest rates already low, many saw this move as a not too subtle attempt to manipulate long-term interest rates by creating a scarcity of paper. As quoted in Grant’s Interest Rate Observer, Ron Ryan (Ryan Labs) said, “When interest rates are low, the logical borrower wants to lock it up for as long as possible…Now they have done the Las Vegas bet that the two-year note auction rolled over 15 times, will have an average interest cost lower than the 30-year today.”

In the same article, Grant says: “A…deserving object of anger is the Government’s habitual recourse to market manipulation, whether through interest rates or mind games. We cling to the view that the U.S. dollar is vulnerable to a loss of confidence, with an attendant risk of rising interest rates. Market manipulation by market manipulation, the Treasury and Fed are dissipating this confidence.”

Greenspan reveals the intellectual rationale for market interventions in his Leuwen speech: “open market operations, in situations like that which followed the crash of stock markets around the world in 1987, satisfy increased needs for liquidity for the system as a whole that otherwise could feed cumulative, self-reinforcing, contractions across many financial markets.” Events subsequent to the 1987 market crash that exceed the Fed’s pain threshold included the Asian meltdown, the Russian Defaults, the Y2K scare, the NASDAQ crash, and Enron. While Greenspan is aware that the use of sovereign credit creates moral hazard, i.e., the distortion of incentives that occurs when the party that determines the level of risk receives the gains from but is not exposed to the costs of, the risks taken, he cannot seem to find the appropriate limit for such intervention. To play it safe, the bar for intervention has been steadily lowered while the buildup of debt has multiplied systemic risk.

The Rubin/Summers Treasury and the Greenspan Fed bear the principal responsibility for creating the mania. The liberal use of sovereign credit by the Fed and Treasury over the past decade to bail out bad banks, insolvent hedge funds, and investors in foreign government paper, materially altered the calculation of risk by investors, corporations, and financial institutions. By removing the risk from serious investment mistakes, these policies incentivized the employment of excessive leverage that in turn inflated “the bubble.”

The disrespect for market outcomes reflected in US economic and financial policies is neither new nor inconsistent with the behavior of senior government officials throughout history. The London Gold Pool scheme to hold down the gold price illustrates autocratic anti-market behavior four decades ago. A striking non-economic example came with the recent release of the private tapes of Lyndon B. Johnson, which revealed that his public and private views on the Vietnam War were in complete opposition. It would seem that the grounds for distrust and cynicism are almost always present. What changes is the willingness of the public and the markets to look the other way. That willingness in turn would seem to be driven by whether the course of events appears to be satisfactory or unsatisfactory. The unwillingness of senior officials and policy makers to own up to the adverse consequences of their previous actions explains the phenomenon of digging ever-deeper policy holes. The refusal to accept the retribution of market outcomes explains a “culture of obfuscation”, to employ a former Clinton attorney’s (Lanny Davis) phrase, at the core of all scams, whether in the public or private sector.

The manipulation of the gold price, seen in the context of an autocratic inner circle of policy makers committed to nothing more than their own career advancement, seems highly plausible. The mechanics of this manipulation are murky, at best. However, valuable insight is provided by the work of James Turk in “Accounting for the ESF’s Gold Swaps” (1/7/02 Freemarket Gold & Money Report.) While his complex analysis of the mechanics and the accounting may be less than perfect, it is in my opinion substantially on the money. The bottom line is that US government official gold reserves have been mobilized through swap and loan arrangements to suppress the gold price, particularly in the aftermath of the Sept. 1999 Washington Agreement, which triggered a violent short squeeze. These arrangements in turn have been papered over and covered up by a succession of changes in financial statement nomenclature, accounting artifices, and document destruction ("That Shreddin’ Fed" by Robert Auerbach in Barron’s) reminiscent of Watergate or the most elaborate financial frauds yet known. At the end of the day, far more official sector gold appears to have been squandered to tame the dollar gold price than the generally accepted 5000 tonne short position countenanced by the Bank for International Settlements or Goldfield Mineral Services. Therefore, investors may contemplate a substantially higher dollar gold price target than previously seemed reasonable.

It is not unusual for the perception of a market, such as the dollar gold price, to lag fundamental change to a significant degree. However, the lag in this instance is especially great. Investors need to grasp not only the structural issues pertaining to the market itself, but also the interplay of these issues with the macro aspects of economic policy, currency valuation, and market psychology. This is especially difficult when significant information is withheld or obscured. In light of the substantial shift in fundamentals and the extreme lag in the recognition of these changes, the magnitude of the market adjustment is likely to be surprising. Whether the price adjustment occurs quickly or evolves over several years, the outcome will be a dollar gold price that is comfortably within four-digit territory.

The damage caused by an epic investment mania cannot be undone simply by a one or two year decline in stock prices. A mania causes a vast misallocation of capital. Over investment in high tech was only the most visible manifestation of this capital misallocation. On the other side was under-investment in key areas. We are saturated with computers, cell phones, SUV’s, casinos, lawyers and debt, but there will be shortages of basic materials and industrial capacity when the dollar loses its preeminent status.

What produced the giddy valuations of the mania in part was investor confidence that highly competent management of the economy had produced a new era of business cycle stability, low inflation and continuous growth. In fact, these expectations rest on policies that have increasingly painted their proponents into a corner. In order to maintain credibility, ever more transparent manipulations will be called for and resorted to. In the process, credibility will be destroyed. To quote Grant again, “Mr. Greenspan has become a living symbol of the efficacy of price fixing. But it’s likely that sometime before his career is over, he will become a symbol of the futility of that black art.” (WSJ 4/01)

Greenspan epitomizes the vigorous anti-market culture that has become entrenched at the core of economic policy making. Operating in the shadows of constitutionality, a “plunge protection team” consisting of Rubin/Summers/Greenspan “clones” monitors world financial markets contemplating the need for introducing US sovereign credit to achieve acceptable outcomes. The team was an organic outgrowth of the 1990’s climate of morality that legitimized and institutionalized deception and obfuscation. The intellectual heritage of this group is more in sync with the central planners of the former Soviet Union than with the free market champions they are perceived to be. Unlike their Soviet counterparts, the plunge protection team operates outside the realm of established government institutions and accountability. However, the fate all central planners share is the certitude that market forces will topple their designs.

Conclusion

The new economic paradigm is that credit deflation begets inflationary outcomes. Gold, far from being irrelevant and antiquated, is the ideal lens through which to appraise this reality. As perfect credit, it will become more highly valued when investors attempt to shed assets impaired by decades of imperfect credit. A four-digit handle on the dollar gold price will signify not that the markets love gold. Instead, it will mean that they despise the alternatives. There is no specific reason to think that the movement in this direction should be precipitous. Bear markets have a way of taking their time, the better to deceive and to entrap as many as possible. Those who believe a business upturn will end the bear market will be among them. While there may appear to be no particular rush, violent shifts in market views usually come with little warning. An allocation in favor of gold would seem to be timely. The dollar’s days as the premier global reserve currency are numbered. The repercussions of a dollar revaluation will be profound and long-lived. It is not too soon for investors to assume defensive positions in light of these prospects and it will not be long before they discover that gold is a core component of investment defense.




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