Bernanke's golden heirloom
By Hossein Askari and Noureddine Krichene
On December 1, gold breached the US$1,200 per ounce mark and, despite slight
declines since then, it still looks that the sky is the limit for the precious
metal's price. This shouldn't be a surprise. It was predicted a year ago, a
sure outcome of US Federal Reserve chairman Ben Bernanke's zero interest rate
policy and a US dollar printing press running on overtime.
This is the market's response, pointing to a failure of Fed's policies and a
brewing of other bubbles in commodities and asset prices. It is also a blow to
the Group of 20 countries' approach to restoring economic stability and growth.
While ignoring the link between Fed policies and gold, oil, and dollar exchange
rates, Bernanke has been announcing deflation and the absence of inflationary
expectations. But gold, and along
with it stocks, and commodity prices tell another story - inflation and
inflationary expectations.
Besides destabilizing the banking system in 2007 and inflicting trillions of
dollars in bailouts on taxpayers, Fed policies have pushed the unemployment
rate to over 10% from 4%. Through bailouts and money creation out of thin air,
Bernanke may have rescued banks, bankers and money market funds at the expense
of the rest of the economy and foreign creditors.
With the gold prices on an explosive path, the market's indications are for
inflation and even higher unemployment. The US and world economy could be
entering a replay of the pre-crisis events: a cheap-money policy, near
zero-interest rates, a falling dollar, asset and commodity bubbles, another
banking collapse, and trillions of dollars in bailouts.
The price of gold was at $35 per ounce in 1971, indicating a 34-fold
depreciation of the dollar-gold exchange rate since that time. Gold prices
stood at $801 per ounce in January 2009 and so far in 2009 the dollar has
depreciated by 50% in relation to gold. As major reserve central banks have
been inflating at breakneck speed since August 2007, their currencies have lost
value, and, as expected, gold has appreciated.
The US policy of inflating the economy out of the crisis has essentially
culminated in a tipping point and has triggered the gold alarm bells, spooking
the holders of dollars and dollar-denominated assets. The pending reappointment
of Bernanke is insurance for another four-year of monetary expansion.
The deficits under President Barack Obama's administration, at 13% of gross
domestic product, are only going to get bigger. There will be another three to
four years of fiscal profligacy and mounting US debt. Holders of dollars and
dollar-denominated assets will keep seeking refuge in gold, other commodities,
stocks, and other-inflation proof assets. Although gold does not yield any
interest, it nevertheless constitutes a hedge against the inflationary policies
of major central banks.
The record price for gold is nothing else but a reflection of the Fed's
exploding balance sheet, at rates never seen in the US monetary history.
Since August 2007, the Fed has pumped US$1.3 trillion in liquidity at near zero
interest rates through unorthodox facilities traditionally shunned by central
banks. To circumvent banks that were saddled with toxic assets and would no
longer extend loans with almost certain default risk and at very low interest
rates, the Fed decided to go around the banks and cater directly to the same
subprime sectors.
These are the same subprime sectors that fell into default before and triggered
massive bank losses and government bailouts, namely mortgages and consumer
loans. This risky Fed policy, endangering the Fed's balance sheet, did not add
$1.3 trillion to US GDP in goods, such as corn, oil, sugar, and soybeans. The
US GDP has in fact declined in real terms.
Instead, this has been a policy of wealth redistribution through an
inflationary tax that operates through the exchange rate and price channels, by
confiscating wealth from workers, foreign and domestic creditors, and awarding
it to borrowers. This form of purchasing power redistribution can dry up real
savings and investment and can have unintended consequences for growth and
unemployment.
Seeking refuge in gold is a rational decision for those who hold dollars and
dollar assets. Standing at $2.2 trillion in November 2009, up from $0.8
trillion in February 2006, Fed credit can only move up at record pace over the
next four years under the influence of near zero interest rates, monetization
of fiscal deficits, and direct lending to sub-prime markets and speculators.
Financial markets may be wondering what will be the level of Fed credit at end
of 2012. Based on observed data and on the unorthodox money and fiscal policy
setting, a forecaster would most likely settle for a range of many trillions of
dollars.
In gold, hedgers find protection against a cheapening dollar. Gold is also
sought by speculators. This is a most attractive speculative environment,
namely near zero interest rates and unlimited liquidity. Gold was $741 per
ounce in December 2008. By December 1, 2009, it had appreciated by 62%. Such
gains are fantastic in comparison to an annual yield of 0.67% for two-year US
treasury notes. In view of large likely gains, negligible cost of money, and
abundance of liquidity, speculation can only gain strength and boosting gold
prices.
Gold price increases have invariably been accompanied by increases in the price
of oil, food, and other commodities. The data on commodity prices for the 1970s
and for the commodity price bubble during 2002-2008 shows that gold prices and
other commodity prices rose at similar pace. For instance, when gold prices
raced up to $1,000 per ounce in 2008, oil prices skyrocketed to $147 per
barrel, and food prices climbed at a similar pace.
While the statistical association between gold, oil, and other commodity prices
is very strong, the explanation is that oil and other commodity producers have
been keen about the purchasing power of their commodity in terms of gold. Their
response was to raise prices, restrain supplies, and convert their dollar
holdings into gold and stable currencies. If the past is any indication of the
future, severe commodity price inflation can be expected, with disruptive
effects on growth and employment.
What is the relation between gold price inflation and world economic growth and
unemployment? Based on the stagflation of the 1970s as well as the 2007-2008
gold price bubble, rapid increases in gold prices have been accompanied by
economic stagnation and mass unemployment in the industrial world. If such
association remains valid, the recently explosive gold prices could point to
economic stagnation and rising unemployment. The explanation is that gold price
inflation is a symptom of market instability, an uncertain future and unstable
macroeconomic policies, an environment that is hardly conducive to investment
and economic growth.
The Obama administration has failed to restore economic and financial order. A
gold price explosion will make the foreign financing of the mountainous fiscal
deficit of the US ever more difficult. Unpleasant arithmetic could lead to an
outright monetization of the projected deficits and therefore an escalation of
the run against the dollar and accelerating gold and commodity price inflation.
Furthermore, the fast depreciation of the US dollar will undercut the export
competitiveness of other industrial countries, which might in turn re-inflate
their economies, impose tariffs and other trade barriers. Hence, increased
trade tensions and impediments to world trade could be expected following an
explosion of gold prices.
Since his appointment as chairman of the Fed, it would appear that Bernanke has
been plagued by the era of the Weimar Republic, haunted by the Great Depression
and its deflation. He has, therefore, pushed interest rates to the lowest
levels on US record and unleashed credit.
His theory is simple: cheap money will boost aggregate demand and lead to full
employment. Even though it is this same policy that caused the collapse of huge
financial institutions, institutions established decades ago, and resulted in
trillions of dollars in bailouts, Bernanke still maintains that near-zero
interest rates and unlimited liquidity will boost aggregate demand and
re-establish full employment.
His theory implies that producers maximize quantities, not profits, and face no
resource constraints. It implies, as during 2002-2007, that banks extend credit
to subprime markets regardless of risk and profits. US banks have learned the
hard lesson and are no longer ready to lend freely.
As of November 2009, they hold over $1.1 trillion in reserves as compared with
$6 billion in 2007. Remarkably, near zero interest rates crippled Japan for
nearly one decade; its growth was pulled up in 2002 only by exports and became
negative in 2008 with the fall in exports. Near-zero interest rates did not at
least maintain US unemployment at its 2007 level of 4%, but they pushed it
10.2% and to 17.5% if more encompassing measure is examined.
Are runaway gold prices inevitable? From the little available experience, gold
price inflation stopped when the federal funds rate rose to 20% in 1981 and
when the whole financial system collapsed and financial chaos spread in 2008.
The explanation to the first episode is clear. Very high interest rates deter
speculation, unproductive loans, and ensure that savings is channeled to high
growth sectors. The explanation of the second episode is that bank failure and
de-leveraging caused rapid liquidation of speculative positions and, therefore,
a fast drop in gold and commodity prices.
The Fed's loose monetary policy since 2001 has inflicted tremendous losses,
required massive bailouts and resulted in mass employment. As clearly
reiterated by chairman Bernanke and his supporters, exit from unorthodox
monetary policies will not be considered until the US economy has attained
strong recovery.
The Fed can stay the course until a strong recovery takes hold but, in the
meantime, the demise of the dollar will accelerate and gold will become ever
more attractive.
Hossein Askari is professor of international business and international
affairs at George Washington University. Noureddine Krichene is an
economist with a PhD from UCLA.
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