Taking Gold in the Inflation Olympics

We still don’t know which way this thing is going – the battle between greed and fear, that is. Stocks held steady yesterday. Oil too. The commodity index remains almost right on the 500 mark. Gold is sticking about $920.

And yesterday, the Fed lowered its key lending rate another 50 basis points to 3%. At that level, it is substantially below the nation’s inflation rate.

The official inflation rate was last clocked at a little over 4%. Then, the government helpfully takes out the things that matter most – food and fuel – and comes up with a “core” rate of inflation, which is much lower.

How much are consumer prices actually rising? Nobody really knows. Occasionally an economist or a newspaper will go out and buy things and then figure out how much they’ve gone up in price. Usually, they come up with “inflation” numbers closer to 10%. Naturally, results vary, depending on where you are and what you are buying.

If you measure “inflation” by looking at real money – gold – the current inflation rate is considerably higher. A year ago, an ounce of gold was still under $700. Today, it’s $920 – a jump of nearly 20%. (Colleague John Stepek thinks gold will go much higher…below.)

However you measure inflation, the opportunity to borrow at 3% has got to be a plus for people who want to borrow. In effect, the money is free.

But wait a minute; Mr. Market doesn’t usually give money away. What’s the catch?

The catch is that speculators have to do something with the money. And while consumer prices are rising, asset prices are falling. So, if you take the money you have to find a place to invest it where your money will grow by at least 3%.

Stocks? Maybe not. Bonds – yields are so low…not much margin for error. Real property? Forget it. Borrowing capital in a declining economy rarely makes sense.

But for international speculators, abnormally low lending rates can be a gold mine. When Japan’s economy went into a slump, the government responded with low rates and high government spending – just as the U.S. government is responding now. This created an opportunity in the “carry trade,” where speculators were able to borrow yen (JPY) at low interest rates and then trade the money for dollars to reinvest in U.S. stocks. American stocks rose 13 times from ’82 to ’07, while the yen mostly went down. In other words, the Japanese policies didn’t help warm up their own economy much…but they lit a fire under asset prices in much of the rest of the world.

That trade doesn’t work anymore, because the yen is rising and U.S. stocks are falling. But maybe the opposite trade would work – borrow dollars and invest in Japanese shares? The dollar will go down, thanks to the feds’ efforts to revive the U.S. economy…and Japanese shares are now nearly as cheap, relatively, as U.S. shares were in the early ’80s. We’re not proposing it…but stay tuned; maybe it will be our Trade of the Next Decade.

Another possibility, now, for speculators is the obvious one. One of the surest bull markets on the planet is in gold. The metal has been going up from $260 in the first year of George II’s reign, to over $900 in his last year. And as the dollar continues its decent toward its true value – and indeed the true value of all paper currencies – our Trade of this Decade is one thing that will always be worth having.

No one knows the future, but it doesn’t look like this bull market is going to stop very soon. Speculators can now borrow dollars at rates considerably below consumer price inflation…and then put them into gold, which is rising at 20% per year.

We only bring it up to highlight the tough spot in which our central bankers and politicians find themselves. They can make money cheaper and easier to get. They can pass a “stimulus” program at a cost of $146 billion. But what actually happens to the money? It ends up overseas. The feds can stimulate…but what they are really stimulating is Asian factories…the gold market…and global speculators – not the U.S. economy. Problems in the United States are too deep to be cured by a little more spending money. Besides, as we keep saying, the real problem in America is that people have borrowed and spent too much. Offering them more credit is not a solution; it’s a temptation…like wearing a short skirt while counseling a sex addict…or turning your back on a kleptomaniac and then wondering what is missing.

Now, turning to the rebate package just passed by the House of Representatives, we haven’t looked at the details…just the amount. At $146 billion it is almost exactly the same amount as Frederic Mishkin figures the U.S. economy lost last year in consumer spending because of the bear market in housing. Fed governor Mishkin says that families cut back spending by seven cents for every dollar their houses go down in price (with a lag, we presume). Last year, that comes out to about $150 billion of reduced spending. Assuming consumers spend their rebate checks, the economy comes out even.

But the drop in consumer spending caused by housing is just a small part of the deflation hitting the U.S. economy. Stocks are down 15% from their peak…and finance and housing industry leaders are reporting huge losses that could reach into the trillions before it is over.

What’s more, the collapse in consumers’ purchasing power comes not just from a fall in their house prices, but also from the fact that they aren’t rising. At the peak of the bubble, homeowners were taking out as much as $250 billion per quarter in refinancing, home-equity lines, and other housing related credit. Now, that source is drying up.

The feds can try to replace that money, but they are not likely to succeed.

*** Colleague John Stepek, at MoneyWeek magazine, sees more gains for gold:

“I’m beginning to wonder if my target of a high in gold of $1150 an ounce this year was a little conservative…

“1. The gold-silver ratio will often close considerably, but it has been mired (or ‘consolidating’ as people on the wrong side of the trade like to call it), for ten months now between 57 and 54. Anything below 45 would be a warning sign – and we are a long way from that (see below).


“The reason a spike down in the gold-silver ratio is a sign of an imminent top is that silver tends to makes its move later in the run and quicker. So when silver soars, it’s a sign that a top is not too far away. Silver has been doing well, certainly, but it is still lagging gold.

“2. Another sign of a top would be a period of significant outperformance of gold by the HUI (the index of gold miners). We have not seen that yet (see below).


“3. Another signal would be some irrational overvaluations of the juniors. We are not getting that. In fact, we are seeing irrational undervaluations and the Canadian juniors have dramatically lagged gold. I’d like to see that average get above 4.25 (see the chart below).


“4. There is still a lot of caution among traders I talk to. Even goldbugs are still dubious. If a top were imminent, we would see more recklessness on their part with a corresponding parabolic rise in gold. The gold upmove has been more than steady, but I would not yet describe it as parabolic, like it was in April and May 2006, for example.”

*** Reform! Regulate! Control!

The press is full of meddlers – people eager to use the market’s current troubles as an excuse for more intervention. You can’t trust capitalism, say the reformers. Laissez-faire has failed, they claim. We need more government regulation, they insist.

It is all very predictable, but still remarkable. The Dow rose from under 1,000 to over 13,000…and has given up only 15% from its all-time peak. Still, the critics are claiming that there is something wrong with the system. Wall Street needs to be controlled more carefully, they say, in order to avoid ‘excesses.’

Who’s going to do the controlling? Well, what a surprise…they are!

“What are they talking about,” asked Elizabeth over the breakfast table. “The system has put TVs, air-conditioners, and automobiles into the hands of even the poorest people in the United States. I’m not saying life is easy for them. But the system has done wonders…it has given them a life that even rich people couldn’t dream of a hundred years ago. And it still attracts people from all over the world. Didn’t these reformers learn anything from the experiment in the Soviet Union? That economy was carefully controlled…and it was a disaster.”

Of course capitalism has its disasters too. It’s designed to have them. It’s not a system of steady and relentless progress. It’s a non-system of boom and bust…of two steps forward, one step back…and then another step to the side when no one is looking. It’s a chaos of pride and punishment…delusion and creative destruction…greed and fear…reckless ambition and irrational caution…of boom AND bust.

Is it failing now? Not at all. Capitalism is supposed to separate fools from their money. It is now separating a whole nation of fools from the money they never actually had. In other words, it is working…and working well. That’s why every candidate for public office in America, 2008, wants to stop it.

Until tomorrow,

Bill Bonner
The Daily Reckoning
London, England
Thursday, January 31, 2008

The Daily Reckoning PRESENTS: In an economy so deeply dependent on consumer spending, it is easy to point a finger at the general public as a cause for the recession when they stop buying things. But, as Lew Rockwell points out, the government should probably follow the obvious example of the consumer…and stop consuming. Read on…

by Lew Rockwell

With recession looming or already here, the time has arrived for finding scapegoats. Expect a long list of these. Here is the target of the day: tightfisted consumers. A decline in personal consumption, writes the New York Times, “would be the first since 1991, and it would almost certainly push the entire economy into a recession in the middle of an election year.”

This recalls Bush’s advice after 9-11, when he assumed the mantle of the nation’s personal financial planner. He told everyone to go out and spend money so the economy could avoid recession. Even then, there was confusion about whether he was right or wrong. Some sensible voices pointed out that economic expansion is based not on spending but on capital expansion rooted in savings. That is to say, the only path to future prosperity is delaying current consumption in favor of future investment.

One only needs to think of the household budget here to see the point. If you are planning for the future for your family, what is the wisest course? Does one go into debt as much as possible, buy the largest house and the biggest car, throw lavish parties, hand out all existing liquid funds to friends and strangers? Based on the view that consumption is the way to avoid economic problems, this would indeed be the right course.

But this also defies everything we know about family finance. The path to a secure prosperity is delaying consumption. One should spend as little as possible and save as much as possible for the future, and let that money be used in the service of investments that yield a solid rate of return. Those who have chosen a different path now see the folly: they are being burned in the soft housing market, for example.

The lesson is also true for the nation at large, because the logic doesn’t magically change when moving from the family budget to the national stage. Just because something involves “macroeconomics” doesn’t mean that we should throw out all good sense. But that is precisely what people have done with regard to the economy, since J.M. Keynes somehow convinced the world that up is down and left is right.

In a recession or a crisis, the right approach for individuals is to save. So too for the national economy. A looming recession will prompt a pullback in consumer spending as a rational response to the perception of economic troubles. This action does not cause the economy to fall into recession any more than more spending can save it from recession. The downturn is a fact that cannot be avoided. We don’t blame umbrellas for floods, and, in the same way, we shouldn’t blame tightfisted consumers for recessions.

There is no question that this is what is happening. American Express reports that the rate of spending by its cardholders fell 4% in December. Surveys of consumer satisfaction with the economy report a 15-year low. Retailers report that December was a “blood bath” (NYT’s words) for them, with sales growing at the slowest rate in seven years. Market watchers are mostly concerned that high-income buyers are bailing out.

Again, it is critical to keep cause and effect in mind. The pullback on spending is not going to cause a recession. If we think about the long term, this is not a dangerous trend but a hopeful one. The more people pull back and save, the more the foundation is laid for a recovery after the current correction takes its course.

To see that requires that we take a long view. Government, however, seems constitutionally incapable of seeing the long term, much less doing the right thing to prepare for it. Making matters worse, this is that dreaded event called an election year. Prettying things up to make the economy palatable to voters is priority number one.

What does this mean? More monetary expansion. More government spending. We can fully expect the Bush administration to resort to its old program of sending checks out to every American family with the proviso that the money has to be spent, not saved.

No doubt that many people would be thrilled by this. But look beneath the surface. Government has no money to spend on anything that it doesn’t extract from the pockets of you and me and the whole American public. This is easy enough to see concerning taxes. It is not so easy to see when the government runs up debt that is guaranteed by the printing presses.

The monetary issue can be understood by analogy to orange juice. The more water you add, the less substance it has. If you keep adding, eventually you come to the point when you can no longer tell that it was ever orange. This is the same with money. If you print enough – literally or electronically through the credit markets – it will continue to lose value. If money grew on trees, it would be about as valuable as autumn leaves.

So long as we have a central bank, government will be tempted to take the easy path of easy money. There do not need to be any secret phone calls from the White House to the Fed. The culture of policymaking itself is capable of broadcasting the right signals to all important players.

In any case, it is a myth that the Fed makes policy independent of political pressure. It is subject to the screams and hollers for looser credit in the same way that bureaucracies are responsive to demands for more regulation.

Yes, government can increase consumption, but by doing so it does nothing to care for the long term. The long-term health of a nation is not different from that of a household budget. Tough times require cutbacks and a beefing up of savings.

So let’s not demonize the consuming public for doing what it should be doing. It’s a good rule of thumb that when the government tells you to spend money, you should close your wallet.


Lew Rockwell
for The Daily Reckoning