Gold Tier 1 capital after January 2012

Safe haven assets should have low credit and market risks, high market liquidity, limited risk of inflation, low foreign exchange risk and low idiosyncratic risk (Erste Gold Report 2012, p87).  Gold fulfills these criteria and with systemic insolvency risks affecting countries, banks and companies likely to lead to further ratings downgrades, a thorough review of asset portfolios should upgrade gold’s status as a safe haven. Gold is already used as collateral by LCH.Clearnet, Intercontinental Exchange, JP Morgan, and the CME Group, and Eurex (Erste Gold Report 2012, p87). Moreover, on June 18th of this year, the Federal Reserve and FDIC circulated a letter to banks that added gold to the list of Tier 1 assets held by banks in proposals to harmonize US regulatory capital rules with Basel III (Washington Post June 2012). The global standard on bank capital adequacy, stress testing and market liquidity risk gives countries the discretion to add gold bullion to the list of "zero-percent risk weighted items," and stipulates that banks must raise such Tier 1 holdings from 4% of assets to 6%. If the US and other national authorities were to exercise this discretion, the implementation of Basel III over a transitional period from 1 January 2013 up to and including 2019, would not only create sustained demand for gold from banks, but will likely expand gold bullion ownership by institutional investors from current very low levels (Deloitte.com, August 2012).

Iran a factor in the timing of Fed QE

Any oil shock resulting from an strike on Iran would widen the trade deficits of net oil consuming countries like the US that import more than then they produce (US Energy Information Administration).

This negative terms of trade and income shock would force net oil consuming countries to depreciate their currencies in order to create a more positive non-oil trade balance.

Relative depreciation against oil exporting countries tends not to occur as the latter typically use the extra income from higher oil prices to build up reserves, thereby preventing the appreciation of their currencies (European Central Bank, June 2012)

In addition, a Middle-East conflict would intensify safe haven flows into US treasuries, strengthening the dollar and further necessitating depreciation to redress the trade imbalance.

If as some analysts argue QE is an instrument of currency manipulation to cheapen the dollar, and the announcement of previous rounds does correlate with periods of dollar depreciation (see chart below), an oil shock resulting from a US-Israeli strike on Iran will likely precipitate or accelerate QE by the Federal Reserve.

Financial Repression & Gold

For the 10 largest mature economies (Australia, Canada, France, Germany, Italy, Japan, Spain, South Korea, UK and US), total debt stood at nearly 350% of GDP in 2011 (GlobalFinance August 2012). As the private sector deleverages and consumption falls government borrowing will likely increase to prevent a deflationary recession, as evidenced by Japan’s public debt-to-GDP ratio rising from 91.2% in 1995 to 226% in 2012 (TradingEconomics 2012).

With the public component of national debt burdens rising, the majority of developed nations are faced with a choice of rigid austerity measures, massive tax hikes, national bankruptcy, or extensive financial repression. Given the political implications and social upheaval that would result from the other alternatives, financial repression is the option being pursued. Central banks create new money to buy government bonds (via the banks), simultaneously funding budget deficits and controlling sovereign borrowing costs by supporting bond prices and therefore suppressing interest rates. Given the resulting monetary inflation tends to raise certain prices in the economy, real interest rates become negative. Financial repression therefore constitutes a transfer of wealth from savers, who receive artificially low interest income, to Governments, whose debt burdens reduce over time relative to nominal rises in GDP and who receive and spend new money before inflation erodes its real value (ErsteGold Report 2012, p16).

Financial repression played an important role in debt reduction after WWII, when between 1945 and 1955 the US and UK cut their debt in terms of GDP from 116% to 66%, and from 215% to 138% respectively. The average inflation in the US was 4.2%, real interest rates were -0.8%. In the contemporary period, real interest rates are now negative in a growing list of countries, including Turkey, USA, UK, the Euro area, India, South Africa, Canada, Mexico and Japan (ErsteGold Report 2012, pp46-47). The implications for gold are twofold:

1)      Negative interest rates benefit gold as a store of value.

During the 20 years of the gold bear market in the 1980s and 1990s, the average real interest rate level was around +4%. Since 2000, real interest rates have been negative 51% of the time. In this environment depositors less and less see cash as a store of value and seek alternatives, typically benefitting gold. This has been the case in China which fixed interest rates at 0.72% in 2002 and kept them there for seven years as official inflation rose to 7.9% by 2008, translating into a negative real interest rate of -7.2%. While Chinese consumption collapsed and the public sector share of the economy grew, China became the leading country for private gold ownership, overtaking India during the period (ErsteGold Report 2012, p47). The fact that the Federal Reserve will maintain its zero-interest policy until 2014 should result in prolonged negative real interest rates and thus create a positive foundation for further increases in the gold price.  

2)      Increased long run risk of critical failure of global monetary-financial system

Financial repression undermines efforts made towards consolidating national finances, while the gradual and at first invisible transfer of wealth entrenches rather than clears misallocations of capital, making economies increasingly vulnerable to collapse from unaddressed problems of surplus capacity and over supply. In any event, financial repression can only ease debt burdens if prices (and therefore nominal GDP) increase at a greater rate than the new money created to fund budget deficits. However, in the long run those deficits should increase at a faster rate due to Tanzi’s Law. This postulates that in an environment of rising inflation rates government fiscal positions are additionally burdened by the fact that increases in public revenues do not keep pace with inflation, eroding their value in the time elapsing between the incurrring and the payment of tax (ErsteGold Report 2012, p17).  Financial repression, therefore is a ‘die later’ rather than ‘die now’ solution.

Yom Kippur war: oil, gold and stocks

If US-Israel strike Iranian nuclear facilities, a rational Iran would find a way to retaliate without risking all out war, which it would lose. Blocking the strait of Hormuz risks such a defeat, but inciting the Shia populated East-Arabian oil fields into rebellion against the Saudi monarchy is a possible proxy move that would put some sand in the wheels of a direct US intervention. This would be Iran's tit-for-tat response to the Saudi-NATO-Israeli backing of the salafi insurgency in Syria, which also provides a bulwark against Iranian retaliation through that country. Will the effect on oil, gold and stocks be similar to that of the 1973 Yom Kippur war?  The impact on oil:

Gold that decade correlated strongly with oil, albeit with a more volatile pattern. A notable divergence was the 1974-5 recession where gold gave back nearly all of the rise attributed to the war.

S&P500 performance during and after the 1973 war: during the war +1.4%; three months -13.2%; one year -37%; three years -9.3%; five years -13.8%.

Why Keynesians love WWII, and should love Romney

Economists still debate what ended the Great Depression but for Keynesians it was the mass mobilisation of WWII that provided the ultimate 'stimulus' for recovery. The argument implies that its proponents may have a predilection towards military spending. If depressions are caused by underconsumption, and the resulting loss of productive capacity in an economy can be prevented by boosting aggregate demand through deficit-financed government spending, then presumably Keynesians would prefer to stimulate consumption in a way that does not also add to production capacity, because that would make it harder to close the output gap between demand and supply. Hence the proposal to pay workman to dig holes and fill them up again. But what better way is there to stimulate aggregate demand in the near term without adding to capacity in the long run than spending on the production of things that get blown up in a war? Enter Mitt Romney who plans to raise US defence spending to $7.9 trillion over the next ten years, $2.1 trillion more than the current Pentagon budget.

Krugman 'The Conscience of a Liberal'

From his New York Times blog, 'The Conscience of a Liberal', this month.

"I haven’t weighed in on the Survey of Consumer Finances, which shows a sharp decline in net worth and real income between 2007 and 2010. I guess the basic response should be “Well, duh” — that’s what happens when you have a massive housing bust and a severe economic slump."  (June 15, 2012)

Krugman in 2002:

"To fight this recession the Fed needs…soaring household spending to offset moribund business investment. [So] Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble." (2002)

Not a one off:

Economic policy should encourage other spending to offset the temporary slump in business investment. Low interest rates, which promote spending on housing and other durable goods, are the main answer." (July 2001)

It seems listening to the 'conscience of liberals' will give you the inside track on the next round of predictable economic devastation and presumably help you profit from the immiseration it causes others.

Smith, Keynes and Central Bankers

Adam Smith: savings are delayed or guaranteed future demand, entrepreneurial projects take time to deliver, therefore societies with high savings rates give investors greater confidence to finance such projects. Savings and investment is therefore key to sustainable and rising economic prosperity.

Keynes in the 1930s concluded the opposite: the "animal spirits" of capitalists could be reignited and prosperity restored by forcing savers to spend and by stimulating aggregate demand through government spending, with the byproduct of the latter - inflation - leading to the desired effect on savers.

The fact such a prescription in the long run impoverishes savers, largely the middle-class, and leaves government the only source of future demand perhaps explains Keynes's palliative: "In the long run we are all dead". But if said 'animal spirits' prove elusive the ultimate outcome of such a policy would be a society and market entirely subordinated to the 'state'.  This feature was common to both National Socialism and Communism.

With some modification from monetarism (inflation through monetary rather fiscal policy) the ideological drift of central bankers and the economics profession is Keynesian.