The following chart is very interesting. I found it in John Mauldin’s latest “Thoughts from the Frontline” letter, although it was created by the Boston Consulting Group. It compares the cost of manufacturing in the top 25 exporting countries.

According to this chart, Australia is now the most expensive country to manufacture stuff. Manufacturing costs in Australia are now 30% higher than in the US, almost 20% higher than in Japan, almost 10% higher than in Germany, and about 5% higher than in Switzerland. The cost of manufacturing in the US is now slightly below the average — at around the same level as South Korea, Russia, Taiwan and Poland. This means that the Fed is almost half way to its goal of reducing US living standards to the point where the average factory worker in the US can compete on a cost basis with the average factory worker in Indonesia.

The above comment is only partly tongue-in-cheek. Many pro-free-market commentators discuss the decline in US living standards as if it were an unintended consequence of the Fed’s policies, but there is nothing unintended about it. It is a deliberate objective. The Fed will never come out and say “we are doing what we can to reduce living standards”, but a policy that is designed to boost asset prices, support capital-consuming businesses and promote investments that would never see the light of day in the absence of artificially low interest rates, all while minimising “wage inflation”, is also designed to reduce real wages and, therefore, to reduce living standards. The Fed surely doesn’t want to reduce US living standards to Indonesian levels, but that’s the direction in which its efforts are deliberately pointed.

I’ve explained in TSI commentaries that the root of the problem is unswerving commitment to bad economic theory. Under the Keynesian theories that all central bankers religiously follow, wealth is something that just exists. There is no careful and deep consideration given to how the wealth came to be and why some countries managed to accumulate a lot of wealth while other countries remained poor. According to these theories, people spend more during some periods due to a vague notion called rising “animal spirits”. This causes the amount of wealth to grow. Then, after a while, the mysterious “animal spirits” begin to subside, causing people to start spending less. This leads to a reduction in the amount of wealth. Under this perception of the world, one of the central bank’s primary tasks is to combat the unfathomable and destabilising natural force that drives the shifts in spending. This is done by indirectly manipulating prices throughout the economy, including the real price of labour.

The so-called counter-cyclical policies are destined to backfire, but the nature of the eventual backfiring is often difficult to predict. In broad terms, there are two possibilities: There could be a surge in inflation fear followed by a collapse in asset prices, a recession and a moonshot in deflation fear, or the collapse in asset prices and its knock-on effects could happen without a preceding surge in inflation fear. In both cases, the asset-price collapse and recession would likely usher-in a new round of ‘stimulative’ policy, because the devotion to bad theory prevents the right lessons from being learned.

The CEOs of commodity-producing companies are usually knowledgeable about the supply of and the demand for their company’s products, but gold-mining CEOs are exceptions. The vast majority of gold-mining CEOs have almost no understanding of supply and demand in the gold market.

For example, like most gold-market analysts and commentators, most gold-mining CEOs wrongly believe that the change in annual gold production is an important driver of the gold price. In particular, they talk about “Peak Gold” as if a leveling-off or a downward trend in global gold-mine production would be very supportive for the gold price. This means that they don’t understand that the gold-mining industry’s contribution to the total supply of gold currently equates to only 1.5% per year, and, therefore, that changes in industry-wide gold production will always be dwarfed — in terms of effect on the gold price — by changes in investment/speculative demand. (And by the way, changes in investment/speculative demand cannot be quantified by looking at transaction volumes.)

Gold CEOs’ general cluelessness about the gold market is reflected by the performance of the World Gold Council (WGC). Every year, the WGC produces a pile of completely irrelevant information about gold.

Fortunately, understanding the gold market has nothing to do with being a good CEO of a gold-mining company. A good gold-mining CEO is someone who a) implements strategies that keep total costs at relatively low levels, b) prudently manages country, local-community, environmental and other political risks, c) ensures that the balance sheet remains healthy, and d) only makes acquisitions that are accretive.

Last Thursday (4th September) the ECB introduced a cunning new plan to spur growth in the euro-zone, the first part of which involves cutting official interest-rate targets by 0.1%. The benchmark refinancing rate has been reduced to 0.05%, because 0.15% was obviously too high, and the deposit rate has gone further into negative territory, because it obviously wasn’t negative enough. The actions have been taken due to “inflation” and inflation expectations being too low.

Inflation of any kind is the last thing that Europe needs, but from the Keynesian perspective, which is the perspective of all central bankers, it is critical that both inflation and inflation expectations are well above zero. The reason is that in the back-to-front world in which Keynesians are mired, consumption spending comes first and is the driving force of the economy. Furthermore, according to Keynesian logic if people believe that prices are going to be lower in the future they will put off their spending, which will set in motion a vicious deflationary spiral of price declines leading to reduced spending, leading to additional price declines, and so on.

Keynesian logic explains why the computer and smartphone manufacturers never sell anything. Everyone knows that if they wait a year they will be able to buy a better smartphone and a better computer at a lower price, so nobody ever buys these products. As a consequence, the entire computer and smartphone industries have zero sales year after year.

Getting back to the ECB, a goal of reducing the cost of credit to zero is to generate some “price inflation”, which, according to the theories that inform the decisions of central bankers, will boost immediate consumption and cause the economy to grow faster. But if a faster rate of price inflation is what they want, then what they will have to do is increase the rate of monetary inflation. In this regard, taking an overnight interest rate down from 0.15% to 0.05% is probably not going to do much. If the ECB is serious about generating “inflation” then what it really needs to do is implement a Fed-style QE program.

Which brings me to the second part of the ECB’s cunning new plan. The ECB announced that it would begin monetising covered bonds and asset-backed securities (ABS)*, including real-estate-backed securities, next month, with the details to be announced at next month’s ECB meeting. Depending on its size and mechanics, this asset monetisation program could certainly cause prices to rise. To the extent that it does cause prices to rise it will benefit banks and speculators at the expense of savers, productive businesses and wage earners.

Fortunately or unfortunately, depending on your perspective, due to the limited availability of eligible collateral the QE program announced by the ECB last week might be restricted in size to about 200B euros. This means that it might not be large enough to have much effect on the euro-zone money supply.

*Banks create asset-backed securities by pooling mortgages and other loans. Covered bonds are similar, but the underlying assets are ‘ring-fenced’ on the bank’s balance sheet, which means that the assets are still there if the bank goes bust.

The gold market is generally weak relative to the industrial metals markets during the boom phase of the inflation-fueled, central-bank-sponsored boom/bust cycle and strong relative to the industrial metals markets during the bust phase of the cycle. In other words, the gold/GYX ratio (gold relative to the Industrial Metals Index) tends to fall during the booms, which are periods when economic confidence rises while mal-investment sets the stage for an economic contraction, and rise during the busts, which are periods when the mistakes of the past come to the fore. This is due to gold’s historical role as a store of purchasing power and a hedge against uncertainty.

By shading the bust periods in grey, I’ve indicated the global booms and busts on the following chart of the gold/GYX ratio. During the 16-year period covered by the chart there have been three busts: the recession of 2001-2002 that followed the bursting of the NASDAQ bubble, the global financial crisis and “great recession” of 2007-2009, and the euro-zone sovereign debt and banking crisis of 2011-2012.

The booms tend to fall apart more quickly than they build up, so the rising trends in the gold/GYX ratio tend to be shorter and steeper than the falling trends.

Gold/GYX’s current situation looks most similar to Q2-2007. At that time the ratio tested its late-2006 bottom and then reversed upward, marking the end of the boom that began in 2003. However, gold will soon have to start strengthening relative to industrial metals such as copper in order for the 2007 similarity to be maintained. If this doesn’t happen and the gold/GYX ratio breaks decisively below its December-2013 bottom, it will indicate that the boom is going to extend into 2015.

I want to stress that gold’s relationship to the boom/bust cycle is primarily about its performance relative to other commodities, especially the industrial metals. It is not about gold’s performance in US$ terms. For example, from mid-2005 through to mid-2006 gold performed poorly relative to the industrial metals, but this was a good time to be long gold and a very good time to be long gold stocks. It’s just that the industrial metals handily outperformed gold during this period, which makes sense considering the global economic and financial-market backdrop at the time. For another example, from May through November of 2008 gold performed extremely well relative to the industrial metals. This makes sense considering the global economic and financial-market backdrop of the period, but it was a bad time to be long gold and a very bad time to be long gold stocks.