Gold lights up Obama errors
By Hossein Askari and Noureddine Krichene
On February 20, gold prices hit US$1,008 per ounce, having risen from $705 per
ounce on November 13, 2008, for a 43% devaluation of the US dollar with respect
to gold in a matter of about five months.
As inflationary expectations were regaining momentum, the run-up in gold prices
was a general flight from paper currencies. Gold markets have witnessed strong
demand for coins and bars, a renewed interest in gold futures, and huge inflows
into Exchange-Traded Funds (ETFs). The speed of inflows into ETFs has been
remarkable in February. Total ETF gold holdings have jumped by 201 tonnes
already in February, a record inflow.
The rush into gold has sent the strongest signal of safe-haven
buying as a hedge against expected inflation. Gold becomes the asset of choice
when paper money becomes the reichsmark or Zimbabwe dollar.
Are hedgers and speculators mistaken in their move into gold? Certainly not.
Episodes of an unmistaken rush into gold have been numerous. In 1931,
unsustainable British fiscal and monetary policies combined with highly
overvalued wages and rising unemployment made exit from the British currency
into gold a good move, at the same time compelling the UK to exit from the
gold-exchange standard. A similar episode occurred in the context of the
widening US fiscal and external deficits and expansionary monetary policy that
compelled the Richard Nixon administration to exit the gold-exchange standard
in August 1971.
A stampede toward gold, or out of an inflated currency, is not a random event.
It takes place when unsustainable policies and long-term inflationary trends
become strongly footed in the economy and are not perceived as readily
reversible. The flight into gold took place in the context of negative real
interest rates, widening fiscal and external deficits, and overly expansionary
monetary policy.
In the stagflationary period of the 1970s, gold prices remained under constant
pressure as US fiscal deficits and monetary expansion could not be controlled.
Gold prices rose from $34.94 per ounce in January 1970 to a peak of $673.63 in
September 1980, or by a multiple of 19. Gold prices appreciated most against
all commodities in the 1970s. Their rise preceded a drawn-out two-digit
inflation in commodities and consumer prices that spanned 1970-1982.
Their rise was curtailed only when real interest rates became positive and
inflationary expectations extricated. The federal funds rate had to rise to 19%
in 1981 in order to stabilize monetary conditions and uproot inflationary
expectations. Gold price increases preceded a two-digit commodity inflation at
35% per year during 2001 to 2008, when real interest rates became negative and
the US fiscal and external deficits were widening and were not reversible in
the foreseeable future.
With President Barack Obama's $787 billion stimulus package becoming law, US
fiscal deficits in the trillions of dollars, interest rates at zero bound, the
announcement of unorthodox monetary policy and unlimited liquidity creation,
and trillions of dollars in bank, industry and housing bailouts, and
unavoidable bank nationalizations, there is no hope for stabilization in the
foreseeable future and the prospects of out of control inflation cannot be
discounted.
There is no other way to finance multi-trillion dollar fiscal deficits and
multi-trillion dollar bailouts in the next four years except by printing money
around the clock and putting more presses to work. Moreover, in spite of bank
bankruptcies and prospects of bank nationalization, the Fed has been putting in
place many unorthodox facilities to extend multi-trillion dollars loans to
subprime markets.
These facilities are pure credit creation out of thin air and are financed by
printing money. As in previous episodes, the flight into gold foreshadows a
drawn-out inflationary period following the collapse of fiscal and monetary
discipline and unchecked rise in paper money. It could last as long as
unsustainable policies remain effective.
The rush into gold by wealth holders and central banks would accelerate
inflationary expectations and spur inflation further. By substituting gold for
paper currency, wealth holders and economic agents will reduce dramatically
their demand for paper money. This will exert tremendous pressure on prices of
goods and physical assets; the velocity of paper money will accelerate and the
economy may experience hyperinflation if unchecked. High or hyperinflation will
deal a blow to real economic activity. Producers will refrain from selling
worthy goods for unworthy paper. They will reduce their supplies, thus
exacerbating unemployment.
The US fiscal and monetary policies under the George W Bush administration
certainly created a credit boom and speculation; and at the same time, they
bankrupted banks, redistributed free wealth to debtors, reduced real incomes
and pushed the economy into stagflation.
The Obama administration has failed to make a real change in direction and is
amplifying the Bush fiscal and monetary chaos by pushing fiscal deficits and
monetary expansion beyond unthinkable limits, distorting interest rates and
housing prices, and preventing the crisis from running its course. The market
would have worked faster towards efficient adjustment. Ailing banks would have
found, on their own, appropriate solutions; home prices would have adjusted and
excess inventories could be sold.
The banking crisis was instigated by the Troubled Assets Relief Program.
Obama's housing bailout will only prevent exorbitant speculative prices from
adjusting; it will accelerate delinquency as every homeowner wants to be bailed
out by the government; it will disrupt mortgage lending and will make taxpayers
pay for delinquent homeowners to have free housing.
The Obama administration is determined to continue with bankrupting policies.
Both the US Treasury and the Federal Reserve are determined to inflate the way
out of debt, extend the impoverishment of the American people, and force an
indefinite period of lost growth and rapidly declining real incomes. While
media, academics and central banks are calling for compromising fiscal
discipline and intensifying unconventional monetary policy as a way for bailing
out debtors and stimulating economic growth, these policies have been
responsible for the current financial disorder and will only establish a
vicious circle of economic and financial chaos and rising international
economic and political tensions.
Federal Reserve chairman Ben Bernanke's aggressive monetary policy has failed
to produce its promised magic and has so far cost the US huge losses in
economic growth, employment, collapse of stock markets and banking stability.
While banks have taken massive amounts of dollars in write-downs and are being
bailed out, and still are under threat of nationalization, the default rate on
consumer loans and the mortgage delinquency rate are at their highest in spite
of the lowest mortgage rates in recent memory. Yet Bernanke is still determined
to push trillions of loans that will be pure loss and confer massive wealth to
new debtors.
No meaningful financial intermediation can take place at such distorted
interest rates. Such policy will expose banks to huge interest and credit risks
and will prevent prudent banks from lending.
Obama's promise was that the $787 billion stimulus package would create 4
million jobs. By extrapolation, Bernanke's $1 trillion subprime loan will
create another 4 million jobs. The combined fiscal and monetary stimuli could
create more than 8 million jobs! This is easier said than done. Although no one
knows how the Obama team computed 4 million jobs and the figure could have been
invented for pushing further fiscal deficits and making them politically
acceptable, multi-trillion dollars fiscal deficits, notwithstanding potential
Chinese financing, will absorb all real savings and will deprive the private
sector of investment.
In view of already high demand emanating from existing fiscal deficits,
abundant liquidity, and negative real interest rates, more demand expansion
will set off runaway prices in markets where supply conditions are extremely
tight, especially in food and energy markets.
Basic food prices are on average three to four times higher than four years
ago, forcing American families to cut their food consumption. A further
explosion of food inflation will stall recovery. Prices are the rationing
device for limited supplies.
The US economy, or any other economy, cannot grow and create employment in such
a dire fiscal setting, unbounded monetary policy, heightened uncertainties, and
loss of confidence. Many episodes of financial and economic crisis in the past
had to end only with strong stabilization programs. The remedies have been the
same: restraining fiscal and monetary policies, boosting private investment,
enhancing competitiveness, and re-establishing freer markets.
The Obama administration's unrestrained fiscal deficits combined with
Bernanke's new financial engineering will set off inflationary dynamics and
will hardly create millions of jobs. Record gold prices have rarely been
mistaken in forecasting deteriorating economic conditions. Besides causing a
flight to gold and reviving commodity inflation, the Obama administration's
policy will most likely worsen inflation, unemployment and extend the financial
and housing crises over the next four years.
It is the government that created the crisis and it is the government that is
prolonging the crisis.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist at the International Monetary Fund and a former advisor, Islamic
Development Bank, Jeddah.
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