Putting it in Reverse
Today’s another big day. The 12 members of the Fed’s Open Market Committee will get together in New York and decide what to do. As of this morning, we don’t know what they will do. Our bet is that they don’t either.
Instead, they will do what we do; they will look out the window. Outside the Fed’s meeting room, the war between inflation and deflation continues. As expected, inflation’s gains are so far narrowly focused – on gold and certain global commodities, such as oil. Gold fell back $2 yesterday…but it is at record prices…and beginning to attract wider attention. Even The Wall Street Journal, for example, talks of a “gold rush,” in its headline – quickly warning readers away from it!
Deflation, meanwhile, is advancing on a broad front.
Comes word this morning that the “loss at Countrywide is worse than feared…as sinking house market caused more borrowers to fall behind on payments.” Reuters reports that the mortgage lender posted a loss for the fourth quarter of $421 million.
House prices are still falling in Britain and America, where they have just registered another drop for the eleventh month in a row. It’s a “historic bust,” says Robert Shiller.
The CEO of the Ryland Group (NYSE:RYL) says it’s the “worst housing market in 30 years.” His competitor over at Lennar (NYSE:LEN) reported its biggest quarterly loss in its history, losing $201 million in the fourth quarter of last year.
And the Financial Times says U.S. builders “face a growing bankruptcy threat.”
Ben Bernanke allowed himself a little understatement this week, saying that housing “may be a drag on growth for a good part of this year.” We would say that it will definitely be a drag on growth, and not merely for this year, but for the rest of this decade, if not longer. You can correct the stock market…or the soybeans market…in a couple days. But housing takes time. Houses that were being planned and financed before the housing bubble blew up are still coming on the market today. They are added to already swollen inventories of unsold and foreclosed houses. It will take years to work this inventory down…and years to bring prices down to levels where ordinary buyers can afford ordinary houses.
On that point, former Labor Secretary Robert Reich writes, “America’s middle classes are no longer coping.” He notes that the fixes proposed by Bernanke and Bush will not help much, because the middle classes have run out of “coping mechanisms.” The short version of the story is that the typical man earns less, in real terms, than he did 37 years ago. “The income of a young man in his 30s is now 12 per cent below that of a man his age three decades ago.” Families have struggled to increase their standards of living, first by putting women to work…second, by working longer hours…third, by turning to credit. The workplace is now dominated by over-indebted women who work night and day.
“The typical American now works two weeks more each year than 30 years ago,” says Reich. “Compared with any other advanced nation we are veritable workaholics, putting in 350 more hours a year than the average European, more even than the notoriously industrious Japanese.” And when Americans ran out of time and out of money, they began to borrow with the same vigor that they worked.
“We began to borrow, big time,” says Reich. “With housing prices rising briskly through the 1990s and even faster between 2002 and 2006, we turned our homes into piggy banks through home equity loans. Americans got nearly $250bn worth of home equity every quarter in second mortgages and refinancings. That is nearly 10 per cent of disposable income. With credit cards raining down like manna, we bought plasma television sets, new appliances, vacations.
“With dollars artificially high because foreigners continued to hold them even as the nation sank deeper into debt, we summoned inexpensive goods and services from the rest of the world.”
That final ‘coping mechanism’ has now played itself out. Houses are going down in price. Lenders are wary of credit risks. And foreigners are becoming chary of the dollar too.
So what next? It seems obvious us that the U.S. middle class needs to reverse course. Stop spending so much, stop working so many hours, focus on quality of output and quality of life. In a word: downsize.
Not that people will want to do it at first. But they will have no choice. They need to save for rainy days and retirement. And America needs savings to build factories…and savings to help people learn new trades and new tricks. Yes, dear reader, the light bulbs are finally going on in Debt Nation: you can’t really get rich by borrowing and spending…or even by working day and night parking hedge fund managers’ cars. You get rich by saving, learning and investing. There is no other way.
What this means is a decline in spending…and a decline in Americans’ standards of living. It means a recession too – probably a deep, long recession which the feds will fight every step of the way.
But it is not a battle the feds can win. They cannot really make the situation better with more of their phony cash and credit. That is what caused the problem in the first place. They need to reverse course too…and encourage savings.
Who wants to save when the going rate of return on savings is no higher than the inflation rate? Who wants to buy a U.S. 30-year Treasury bond at 4.28% yield…when the current consumer price inflation level is rising at 4.4% per year?
So here we offer some free advice to the Fed’s Open Market Committee: Don’t cut rates today, raise them. Let the stock market crash. Let the economy retreat. Let the banks go belly-up. Liquidate Wall Street. Liquidate the housing sector. Liquidate bad debts everywhere. Get it over with, so the U.S. middle class can begin building again…after 37 years…on a solid foundation.
We don’t expect any thanks for that advice.
*** Wait a minute, said David Fuller at lunch on Monday, responding to our suggestion of higher interest rates: “When a man is having a heart attack, you don’t lecture him about his bad diet. You can do that later. First, you have to get him back on his feet.”
*** Let’s return to Robert Shiller. His research shows that house prices in America, in real terms, are remarkably stable. For 100 years – from 1890 to 1990 – they went nowhere. In real terms, they barely changed in the entire century. Then, suddenly after 1997, house prices shot up by 71% in real terms.
What this tells us is that housing prices are not likely to remain up so high for too long. Historically, they kept up with inflation, nothing more. America is still a big place; there is no obvious reason why all of a sudden housing should occupy a bigger percentage of the nation’s assets and earnings.
Most likely, the gains of the last 10 years will be given back. But the process is long, slow and hard.
We’re talking about “trillions of dollars, so much bigger than the losses we’ve seen from subprime so far,” says Shiller. He is not talking about the losses in implied wealth by the write-down of America’s housing stock, but about the real losses to financial institutions and investors who have bet on continued housing price increases. As housing rose, ordinary consumers adjusted their spending habits to the increase of wealth they thought they had. Lenders extended them credit – also based on the increase in perceived housing wealth. And then, the mortgage credits were packaged into various derivative instruments and sold all over the world – eventually bankrupting everything from Norwegian fishing towns to French pension funds.
Is it over already? Not likely.
The Daily Reckoning
Wednesday, January 30, 2008
The Daily Reckoning PRESENTS: The effects of a recession on certain aspects of an economy are fairly obvious – stocks go down, unemployment goes up, etc. But what happens to gold if the global economic crisis gets so bad that it trumps any and all inflationary influences and we enter a straight-up deflationary recession? Bud Conrad and David Galland explore…
WILL GOLD CRASH IN A RECESSION?
by Bud Conrad and David Galland
From the 1990s until today, Americans have maintained their lifestyles by borrowing. As the American consumer is about to find out, the bill for that lifestyle is coming due.
So where will that lead the U.S. economy? Simply stated, surveying the landscape of current events, many of which are a direct consequence of excessive debt and an inevitable slowdown in consumer spending, we expect stagflation ahead. Loosely defined, that term refers to a general economic slowdown – a recession – but coupled with rising prices triggered by massive infusions of liquidity into the market.
That liquidity can come from governments – witness the billions upon billions now being thrown into the fray by the world’s central banks – or it can come from, say, some percentage of the 6+ trillion in U.S. dollars held by foreigners coming home to roost. On that latter point, in recent weeks there has been almost daily news about foreign corporations and sovereign wealth funds unloading their greenbacks in exchange for shares in some of America’s largest financial institutions. Doug Casey has correctly pointed out that it is when the trade deficit starts to shrink, which it recently has, that you need to look for cover…because, among other things, it means the tide of U.S. dollars is beginning to wash back up on U.S. shores.
Our view that the stagflationary scenario is the most likely is supported by a steady stream of data. For instance, despite an obvious slowdown in 2007 holiday season shopping, the Bureau of Labor Statistics reports that producer prices in November increased at the fastest rate in 16 years.
Rising prices make a stagflationary environment positive for gold, if for no other reason than that investors reallocate depreciating paper-backed investments into tangibles with a demonstrated ability to float as the intangibles sink.
So, our view remains that we are headed for a stagflation. But what if we are wrong?
What happens if the global economic crisis gets so bad that it trumps any and all inflationary influences and we enter a straight-up deflationary recession?
That is, we are sure, a question on the minds of many gold investors.
Some quick thoughts…
Gold in a Recession
Traditionally, gold has been a safety net against inflation. Inflation is good for gold, a case we don’t need to make again here.
But, in a typical recession, the demand for everything slows and the prices of many things fall. The knee-jerk reaction of most casual market observers, therefore, might be that if inflation is always good for gold, then the opposite is always bad.
Historically, however, that is not the case. The chart below shows the price of gold overlaid against official periods of recession as defined by the National Bureau of Economic Research. As you can see, about half the time gold actually rises in a recession.
(Note: This chart uses monthly averages, so you can see that current prices are, in nominal terms, higher than the 1980 high, based on those averages.)
Simply, there isn’t a specific historical precedent that demonstrates that gold will fall during a recession.
But could we have a general deflation, one that might tip gold into one of the down cycles? Of course.
The developing recession, based as it is on a global contraction in credit, looks to be especially long and deep. Almost daily now we learn of multi-billion-dollar debt defaults. Those, in turn, trigger both a freeze-up in easy credit and a flight from risk.
In response, the government has responded with its predictable “fix-it” tools – stimulus and bailouts. The tools of government stimulus are lowering the Fed funds interest rate, and potential new large-scale bailouts like the Resolution Trust Corporation (RTC) that was put into action to straighten out the Savings and Loan crisis of the 1980s, to the tune of $200 billion. While the Europeans have just unleashed an amazing $500 billion in new liquidity, so far, U.S. Treasury Secretary Paulson and Fed Chairman Bernanke and friends have been surprisingly slow to act. They started with denial and have moved to inadequate Band-Aids.
In the absence of any concentrated and well-funded program – such as the RTC – to try and keep the wheels on (and, at this point, it is not clear that any imaginable measure will suffice), the deflationary pressures of the housing collapse are winning.
But there is an important, longer-cycle pressure that is not talked about much, although it is increasingly obvious to the American consumer: the dollars they’re spending are buying less. They see gasoline and heating prices rise, but don’t think much about the dollar itself as the underlying source of price inflation.
This decline in the purchasing power of the dollar is extremely important for the price of gold. That’s because the pressures on the dollar seem overwhelming when aggregated: huge budget and trade deficits, wars and retirement demands of baby boomers, unprecedented foreign holdings of U.S. dollars. Watching the prices of internationally traded goods, including oil at $90 per barrel and wheat at a record $10 per bushel, it is hard to imagine a situation of serious deflation emerging.
Looking for Alternatives
The flight to quality by investors who no longer trust packages of mortgage loans, or anything that is not strictly labeled as government backed, is unprecedented. The interest rate on government-issued two-year Treasuries dropped to 3%, reflecting the demand for safety. Concurrently, other interest rates have risen in response to increasing mistrust and uncertainty.
Gold, of course, provides a different form of safe harbor alternative – an asset that is not only readily liquid but, unlike government paper, positively correlated with the very same inflation that will erode the purchasing power of paper assets.
Right now, gold is not on the front burner, but this is only to be expected because of the state of flux of global financial markets. Like observers of a war of Titans, the market is confounded by the sheer magnitude of all that is going on, from the devastation being wreaked on the world’s best-known and most established financial institutions, to the unleashing of billions upon billions in experimental new liquidity measures by central banks.
As the fog of war begins to clear and it becomes obvious that not only will economic growth be severely curbed, but that the fiat currencies are going to be sacrificed in the fight, some percentage of the funds now sitting on the sidelines – much of it in U.S. Treasuries – will begin to move into gold and other tangibles. In the face of limited gold supplies, this surge in demand should create strong upward pressure on the price of gold and, for leverage, gold shares.
In sum, even though the relatively sluggish and inept responses from the U.S. government in the face of the current credit crisis could produce a severely slowing economy, creating periods of deflationary fears that put stress on the price of gold, we continue to believe that the most likely case is for massive inflationary bailouts that support a positive outlook for gold.
Bud Conrad and David Galland
for The Daily Reckoning
Editor’s Note: Bud Conrad and David Galland are, respectively, the chief economist and managing editor with Casey Research, publishers of BIG GOLD, an inexpensive monthly advisory dedicated to providing unbiased and actionable research on simple, effective and cautious ways to participate in rising gold markets.
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