Can a US recession occur without an inverted yield curve?

This blog post is a modified excerpt from a recent TSI newsletter.

One of the bullish arguments on the US economy and stock market involves pointing out that a) the yield curve hasn’t yet signaled a recession, and b) the historical record indicates that recessions don’t happen until after the yield curve gives a warning signal. This line of argument arrives at the right conclusion for the wrong reasons.

The bullish argument being made is that every recession of the past umpteen decades has been preceded by an inverted yield curve (indicated by the 10-year T-Note yield dropping below the 2-year T-Note yield). The following chart shows that while the yield curve has ‘flattened’ (the 10yr-2yr spread has decreased) to a significant degree it is still a long way from becoming inverted (the yield spread is still well above zero), which supposedly implies that the US economy is not yet close to entering a recession.

The problem with the argument outlined above is that it doesn’t take into account the unprecedented monetary backdrop. In particular, it doesn’t take into account that as long as the Fed keeps a giant foot on short-term interest rates it will be virtually impossible for the yield curve to invert. It should be obvious — although to many pundits it apparently isn’t — that the Fed can’t hold off a recession indefinitely by distorting the economy’s most important price signal (the price of credit), that is, by taking actions that undermine the economy.

The logic underpinning the bullish argument is therefore wrong, but it’s still correct to say that the yield curve hasn’t yet signaled a recession. The reason is that an inversion of the yield curve has NEVER been a recession signal; the genuine recession signal has always been the reversal in the curve from ‘flattening’ (long-term interest rates falling relative to short-term interest rates) to ‘steepening’ (long-term interest rates rising relative to short-term interest rates) after an extreme is reached. It just so happens that under more normal monetary conditions, an extreme isn’t reached and the reversal therefore doesn’t occur until after the yield curve becomes inverted.

This time around the reversal will almost certainly happen well before the yield curve becomes inverted, but it hasn’t happened yet.

In a recent blog post, Martin Armstrong wrote: “This constant attack on central banks is really hiding what the problem truly is — government. When the Fed was created, it “stimulated” the economy by purchasing corporate paper. The Fed was NEVER intended to buy government bonds. The politicians did that for World War I and never returned it to its purpose.” That’s not entirely true. Also, it’s naive to believe that the Fed would benefit the overall economy if it were restricted to its originally-intended purpose.

Contrary to Mr. Armstrong’s assertion, the Federal Reserve Act of 1913 actually does enable the Fed to buy government paper. Specifically, Section 14 of the Act states:

“Every Federal reserve bank shall have power … [to] buy and sell, at home or abroad, bonds and notes of the United States, and bills, notes, revenue bonds, and warrants with a maturity from date of purchase of not exceeding six months, issued in anticipation of the collection of taxes or in anticipation of the receipt of assured revenues by any State, county, district, political subdivision, or municipality…”

More generally, the Federal Reserve Act gave Federal Reserve banks the power to purchase short-term commercial paper (bills of exchange) and short-term government paper, and to set the discount rates associated with these purchases.

Secondly, the whole concept of economic stimulation by central banks in general and the Fed in particular is one of world history’s greatest-ever cases of mission creep. A central bank cannot possibly stimulate an economy by lowering interest rates and creating money; all it can do is distort an economy and exacerbate the boom-bust cycle. Although the theoretical framework had not yet been fully developed by the likes of Ludwig von Mises, this was generally known by economists at the time of the Fed’s establishment in 1913 and explains why there was no mention in the Federal Reserve Act of the Fed taking actions in an effort to modulate the pace of economic growth. Unfortunately, economics is the one science that has taken a giant step backwards over the past 100 years. Whereas there was originally no intention of having the Fed interfere with market rates of interest and react in a counter-cyclical manner to shifts in economic activity, most economists can no longer even envisage an economy that is free from central-bank manipulation.

Thirdly, while it would be a great improvement if the Fed were limited by the rules that originally governed its actions, it is important to understand that the problems (the periodic bank runs and financial crises) that the Fed was set up to address are the result of fractional reserve banking. Rather than eliminate fractional reserve banking, which would have been the correct solution, a central bank was established as a work-around. This is mainly because some of the most powerful and influential people in the country were bankers. Not surprisingly, most bankers like having the legal power to create money out of nothing.

My final point is that the Federal Reserve Act of 1913 was a foot in the economic door. Once the foot was in the door it was always going to be just a matter of time before the entire body had wormed its way in. The reason is that the powers of central banks grow in the same way as the powers of governments, with each intervention leading to problems that create the justifications for more interventions and with the occasional crisis providing the justification for a quantum leap in power. To put it succinctly, the mission creep was inevitable.

There’s a lot right with John Hathaway’s recent article titled “An ‘Acute Shortage’ in Gold Can Boost Prices“. There’s also a lot wrong with it, beginning with the title. There is not now, there has never been and there never will be a shortage of gold*, the reason being that gold is not ‘consumed’ like other commodities. However, my main bone of contention isn’t with the fatally-flawed argument that a gold shortage is looming.

The main problem I have with Hathaway’s article is that it repeats the nonsensical story that the gold price has been forced downward over the past few years to an artificially-low level by the relentless selling of “paper gold”. Like many gold bulls, Hathaway apparently hasn’t noticed that a major commodity bear market has unfolded and that the gold price has held up incredibly well. So well, in fact, that relative to the Goldman Sachs Spot Commodity Index (GNX) the gold price is at an all-time high and about 30% higher than it was at its 2011 peak.

Rather than imagining a grand price suppression scheme involving unlimited quantities of “paper gold” to explain why gold isn’t more expensive, how about trying to explain why gold is now more expensive relative to other commodities than it has ever been.

Considering only US economic and monetary fundamentals, the gold price is now a lot higher than it probably should be relative to the general level of commodity prices. I think that the strength can be explained by the precarious global economic and monetary situations, but the point is that a knowledgeable and unbiased observer of the markets shouldn’t be scratching his/her head or feeling the need to get creative when coming up with justifications for gold’s current US$ price.

Hathaway actually knows the real reason for gold’s downward trend in US$ terms, because at one point in the article he writes: “The negative investment thesis [for gold] seems to rest upon confidence that central bankers, and the Federal Reserve in particular, will steer a course away from radical monetary experimentation that will return to a normal structure of interest rates and robust economic growth.” Yes, that’s it in a nutshell.

Gold’s perceived value is the reciprocal of confidence in the central bank and the economy. Although some of us strongly believe that the confidence was and is misplaced, it’s a fact that confidence in the Fed and the US economy has generally been at a high level over the past few years.

*Note: If it could be validly argued that a genuine gold shortage (as opposed to a temporary shortage of gold in a particular manufactured form) was likely or even just a realistic possibility, then gold would no longer be suitable for use as money. Fortunately, it cannot be validly argued.

I consider the gold/GYX ratio (the price of gold relative to the price of a basket of industrial metals) to be the ultimate boom-bust indicator. With monotonous regularity, the gold price trends downward relative to the prices of industrial metals during the boom periods and upward relative to the prices of industrial metals during the ensuing busts. Not surprisingly, given economic reality, in addition to being an excellent boom-bust indicator the relative performances of gold and the industrial metals is also an excellent indicator of general (societal) time preference.

Time preference is the value placed on consumption in the present relative to future consumption. In particular, rising time preference involves an increase in the desire to buy consumer goods in the present and, by extension, a decrease in the desire to save or make long-term investments, while falling time preference involves a growing desire to put-off current consumption in order to save or make long-term investments. As an aside, interest rates naturally stem from time preference in that all else being equal — which it often isn’t — people will prefer getting an item now to getting the same item at some future time. For example, even if there is no credit risk, a dollar in the hand today will always have a higher value than the promise of a dollar in the future. The greater perceived value of the present good relative to the future good can be expressed as an interest rate.

Major trends in time preference go hand-in-hand with the boom-bust cycle. During booms fueled by monetary inflation people temporarily feel richer and spend more freely, largely because debt is cheap and easy to come by. This means that booms are accompanied by rising time preference (a greater eagerness to consume). During the ensuing busts, the mistakes and recklessness of the preceding boom come to light. There is a general “pulling in of horns” as the focus turns to the repairing of balance sheets and the building-up of cash reserves. This means that busts are accompanied by falling time preference (a greater desire to save).

Gold is no longer money, in that it is no longer commonly used as a medium of exchange. However, it is widely viewed as a safe and liquid financial asset, rather than a commodity to be consumed. This causes it to perform similarly, relative to other metals, to how it would perform if it were money. In particular, during a period when there’s a general increase in the desire to immediately consume and a concomitant reduction in the desire to hold cash in reserve (a period of rising time preference), the gold price will trend downward relative to the prices of most other metals. And during a period when there’s a general increase in the desire to hold cash in reserve (a period of falling time preference), the gold price will trend upward relative to the prices of most other metals.

In other words, periods of rising time preference are indicated by rising trends in the GYX/gold ratio and periods of falling time preference are indicated by falling trends in the GYX/gold ratio.

On the following chart of the GYX/gold ratio, the periods when the ratio was in a rising trend are shaded in yellow. If you think back to what was happening during these periods you should (hopefully) realise that they were, indeed, periods when societal time preference was rising. Recall how caution was ‘thrown to the wind’ during the NASDAQ bubble of 1999-2000, the real-estate bubble of 2003-2006, the emerging-markets and commodity bubbles of 2009-2010, and the QE-promoted debt bubbles of 2013-2014.

Also, if you think back to what was happening during the unshaded parts of the chart you should realise that these were periods when societal time preference was falling — when investments were revealed as ill-conceived, debts were revealed as unsupportable, and people throughout the economy were collectively spending less in an effort to save more.

The most recent downturn in societal time preference appears to have been set in motion by the bursting of the shale-oil investment bubble. Many people (not including me) thought that the large decline in the oil price would turn out to be a major plus for the US economy. Just like a tax cut, they claimed. It was actually a negative, though, because substantial debt-funded investments had been predicated on the oil price remaining high.

As to how long the current trend will continue, a lot will depend on whether or not the stock market’s cyclical bullish trend is over. If it is over, which it probably is, then the GYX/gold ratio will continue to fall for at least another 12 months.

The final point I’ll make is that in a free economy that didn’t have a central bank, trends in societal time preference would tend to be more gradual and neither a rising nor a falling time preference would be a problem to be reckoned with. Instead, trends in time preference would influence interest rates throughout the economy in such a way as to provide valid and useful signals to businesses and investors.

This post is an excerpt from a commentary posted at TSI about two months ago.

Whenever the government intervenes in the economy in order to bring about what it deems to be a more beneficial outcome than would have occurred in the absence of intervention, there will be winners and losers but the overall economy will invariably end up being worse off. Moreover, it is not uncommon for one of the long-term results of the intervention to be the diametric opposite of the intended result.

A great example of the actual result of government intervention being the opposite of the intended result is contained in a chart that formed part of a recent article at ZeroHedge.com. The chart, which is displayed below, shows the home ownership rate in the US.

Here, in brief, is the story behind the above chart.

During the Clinton (1993-2000) and Bush (2001-2008) administrations the US Federal Government decided that it would be beneficial if a larger number and a broader range of people were home-owners. The government therefore began making a concerted effort to not only increase the US home-ownership rate, but also to make home loans easier to obtain for less-qualified buyers.

This was achieved in part by the more aggressive implementation, beginning in 1993, of the Community Reinvestment Act (CRA) of 1977. Under the cover of the CRA, banks were forced to reduce their lending standards for lower-income groups in general and ‘minorities’ in particular. For example, government regulations created during the 1990s set bank loan-approval criteria and quotas with the aim of increasing loan quantities, and even went so far as to require the use of “innovative or flexible” lending practices to address the credit needs of low-and-moderate-income (LMI) borrowers. Of course, banks that are forced by the government to lower their standards when assessing the loan applications of less-qualified borrowers must also lower their standards for other borrowers, because they can’t reasonably approve an application from one customer and then reject an application from a better-qualified customer.

An increase in the home-ownership rate was also achieved by assigning an “affordable housing mission” to the government-sponsored enterprises (Fannie Mae and Freddie Mac). To make it possible for Fannie and Freddie to achieve this mission their automated underwriting systems were modified to accept loans with characteristics that would previously have been rejected. In addition, Fannie and Freddie cited the new “mission” as a reason that their mortgage portfolios should not be constrained.

At this point we would be remiss not to mention the helping hand provided by the Fed. Without the Fed’s aggressive money-pumping and lowering of interest rates during 2001-2003 there would have been less credit and less money available to the buyers of homes. The Fed’s actions ensured that there would be a credit bubble, while the government’s actions ensured that the residential housing market would be the focal point of the bubble.

The above chart shows that the government was initially — and predictably — successful in its endeavours. The home-ownership rate sky-rocketed as it became possible for almost anyone to borrow money to buy a house. The chart also shows that the home-ownership rate has since collapsed to its lowest level since the 1960s. This collapse was a natural consequence of the credit bubble, in that household balance-sheets were drastically weakened by the taking-on of debt-based leverage during the bubble and the post-bubble plunge in asset prices.

The bottom line is that the interventions designed to increase home ownership ultimately contributed to the home-ownership rate falling to the point where it is now at a multi-generational low. Not just an unintended consequence, but the opposite of the intended consequence.

With the US$ gold price near a 5-year low, the above question probably seems strange. However, the US$ isn’t the only measure of price.

It is also reasonable to measure gold’s price in terms of other commodities. This is because although gold isn’t just a commodity, under the current monetary system its price should never become divorced from the prices of other commodities. Short-term divergences between gold and the broad-based commodity indices will occur in response to macro-economic developments, but, for example, there isn’t going to be a major upward trend in the gold price while the prices of most other commodities are in major downward trends.

When measured in terms of other commodities, gold’s current price is high. For example, the following chart shows that gold made a new 20-year high relative to the Goldman Sachs Spot Commodity Index (GNX) in January and has recently moved back to near its high.

And if we measure gold in terms of other metals rather than commodities in general, it’s a similar story. In particular, the following charts show that a) relative to the Industrial Metals Index (GYX) gold is only 6% below its 2011-2012 highs and within 15% of the 20-year high that was reached at the crescendo of the 2008-2009 global financial crisis, b) gold is at a 20-year high relative to platinum, and c) gold is close to the top of its 20-year range relative to silver.

Gold normally performs relatively poorly during economic booms and relatively well during economic busts. Gold’s current relatively high price is therefore indicative of a weak global economic situation.

If the global economic backdrop becomes superficially better over the months/quarters ahead and the Fed hikes interest rates as per its current tentative plan, then even if the gold price rises in US$ terms next year it will probably fall in terms of the broad-based commodity indices and most other metals. That, of course, is a big if.

One of the interesting aspects of the financial newsletter business is that an incorrect prediction of a market crash will probably drum-up a lot more new business than a correct prediction that there won’t be a crash. Hence, the never-ending popularity of crash-forecasting, despite the fact that such forecasts almost never pan out.

From the perspective of a newsletter writer or any other commentator on the financial markets, the best thing about forecasting a crash is the massively asymmetric reward-risk associated with it. If the market doesn’t crash this year, when it was supposed to according to your original forecast, then you can just say that the event has been delayed and will happen next year instead. You don’t have much to lose because people will soon forget the failed prediction and focus on the next prediction. And if it doesn’t happen next year, then just repeat the process because eventually the market will crash and your amazing prescience will be there for all to see. Furthermore, after you correctly predict a crash there will be thousands of people eager to find out your next big prediction and buy your newsletter/book. In other words, from the forecaster’s perspective the downside of making an incorrect crash forecast is trivial compared to the upside of making a correct crash forecast.

The point is that regardless of how many times you forecast a crash that never happens, you will only have to get lucky once and you will be set for life. From then on you can promote yourself, and be introduced in interviews, as the person who predicted the great crash of XXXX (insert year). From then on a large herd of ‘investors’ will hang on your every word and rush to buy your advice whenever your next big forecast hits the wires.

Having seen how the process works, I’m officially entering the crash forecasting business. My inaugural forecast is for the US stock market to crash during September-October of 2016.

My forecast isn’t a completely random guess, for four reasons. First, stock-market crashes have a habit of occurring in September-October. Second, the two most likely times for the stock market to crash are during the two months following a bull market peak and in the year after a bull market peak (that is, roughly a year into a new bear market). The 1929 and 1987 crashes are examples of the former, while the 1974 and 2008 crashes are examples of the latter. The current situation is that either 1) a bear market began a few months ago, in which case the opportunity to crash during the two months following the bull market peak was missed and the next opportunity will arrive during the second half of 2016, or 2) the bull market is intact, in which case a major peak is likely during the second half of next year. Third, market valuation is high enough to support an unusually-large price decline. Fourth, interest rates are likely to have an upward bias over the next 12 months.

A few months from now a lot of commentators on the financial markets will be forecasting a crash for September-October 2016. If/when the crash happens, remember that you read about it here first and be ready to pay a much higher price (higher than zero, that is) for my next big prediction.

Early last year I gave banking behemoth Goldman Sachs (GS) credit for looking in the right direction for clues regarding gold’s likely performance, which is something that most gold bulls were not doing. In November I again gave them credit, because, even though I doubted that the US$ gold price would get close to GS’s $1050/oz price target for 2014, their overall analysis had been more right than wrong. It was clear that up to that point the US economy had performed better than I had expected and roughly in line with the GS forecast, which was the main reason that gold had remained under pressure; albeit, not as much pressure as GS had anticipated.

But this year it was a different story. Here’s what I wrote in a TSI commentary in January-2015:

“This year, GS’s gold market analysis begins on the right track by stating that stronger US growth should support higher real US interest rates, which would be bearish for gold. Although we expect that the US economy will ‘tread water’ at best and that real US interest rates will be flat-to-lower over the course of this year, GS’s logic is correct. What we mean is that IF the US economy strengthens and IF real US interest rates trend upward in response, there will be irresistible downward pressure on the US$ gold price.

However, the analysis then goes off the rails. After mentioning something that matters (the real interest rate), the authors of the GS gold-market analysis then try to support their bearish case by listing factors that are either irrelevant or wrong. It actually seems as if they’ve taken the worst arguments routinely put forward by gold bulls and tried to use the same hopelessly flawed logic to support a bearish forecast.

For example, they argue that the demand for gold will fall because “inflation” levels are declining along with oil prices. They are therefore unaware, it seems, that “price inflation” has never been an important driver of the gold market and that the latest two multi-year gold rallies began with both “inflation” and inflation expectations low and in declining trends. They also appear to be unaware that the large decline in the oil price is very bullish for the gold-mining industry.

Their analysis then gets even worse, as they imply that the price weakness of the preceding three years is a reason to expect future weakness, whereas the opposite is closer to the truth. They go on to cite outflows from exchange-traded funds (ETFs) and reduced investment in gold coins as bearish influences, apparently unaware that the volume of gold coins traded in a year is always too small to have a noticeable effect on the price and that the change in ETF inventory is a follower, not a driver, of the gold price.

Finally, just when it seems as if their analysis can’t possibly go further off track, it does by asserting that lower jewellery demand and a greater amount of producer hedging will add to the downward pressure on the gold price. The facts are that jewellery demand has always been irrelevant to gold’s price trend and that gold producers are part of the ‘dumb money’ (meaning: they tend to add hedges at low prices and remove hedges at high prices, that is, they tend to do the opposite of what they should be doing based on gold’s intermediate-term risk/reward).”

I concluded by stating that in 2014 the GS analysts were close to being right for roughly the right reasons, but that in 2015 they could not possibly be right for the right reasons. They would either be right for the wrong reasons, or they would be wrong.

At this stage it looks like they are going to be wrong about 2015, but not dramatically so. My guess is that gold will end this year in the $1100-$1200 range, thus not meeting the expectations of GS and other high-profile bears and at the same time not meeting the expectations of the bulls. However, GS is on record as predicting a US$1000/oz or lower gold price for the end of next year. I think that this forecast will miss by a wide margin, but I’m not going to make a specific price forecast for end-2016. Anyone who thinks they can come up with a high-probability forecast of where gold will be trading 15 months from now is kidding themselves.

Here’s an unmodified excerpt from a TSI commentary that was published a few days ago. It deals with something that has garnered more attention than it deserves and been wrongly interpreted in some quarters.

We’ve seen some excited commentary about the recent rise in the dollar volume of Reverse Repurchase (RRP) operations conducted by the Fed. Here’s a chart showing the increase in RRPs over the past few years and the dramatic spike that occurred during the final week of September (the latest week covered by the chart).

For the uninitiated, a reverse repurchase agreement is an open market operation in which the Fed sells a Treasury security to an eligible RRP counterparty with an agreement to repurchase that same security at a specified price at a specific time in the future. The difference between the sale price and the repurchase price, together with the length of time between the sale and purchase, implies a rate of interest paid by the Fed on the cash invested by the RRP counterparty. In short, it is a cash loan to the Fed that is collateralised by some of the Fed’s Treasury securities. The Fed receives some cash, the RRP counterparty receives some securities. Note that the Fed never actually needs to borrow money, but it sometimes does so as part of its efforts to control interest rates and money supply.

As mentioned above, the recent large spike in RRPs has caused some excitement. For example, some commentators have speculated that it signals an effort by the Fed to paper-over a major derivative blow-up. As is often the case in such matters, there are less entertaining but more plausible explanations.

We don’t pretend to know the exact reason(s) for the RRP spike, but here are some points that, taken together, go a long way towards explaining it:

1) The Fed recently enabled a much larger range of counterparties to participate in RRPs. Previously it was just primary dealers, but eligible participants now include GSEs, banks and money-market funds.

2) Reverse Repos involve a reduction in bank reserves, which means that the volume of RRPs is limited to some extent by the volume of reserves held at the Fed. Eight years ago the total volume of reserves at the Fed was almost zero, whereas today it is well over $2T. It could therefore make sense to consider the volume of RRPs relative to the volume of bank reserves.

The following chart does exactly that (it shows RRPs relative to total bank reserves at the Fed). Viewed in this way, the recent spike is a lot less dramatic.

3) Prior to this year RRPs were overnight transactions, but in March of 2015 the FOMC approved a resolution authorizing “Term RRP Operations” that span each quarter-end through January 29, 2016. The Fed has recently been ramping up its Term RRP Operations as part of an experiment related to ‘normalising’ monetary policy.

4) A reverse repo involves the participants parting with the most liquid of assets (cash) for a slightly less liquid asset (Treasury securities), so RRPs are NOT conducted with the aim of boosting financial-system ‘liquidity’. They actually remove liquidity from the financial system.

5) A corollary to point 4) is that because RRPs involve the temporary REMOVAL of money from the financial system, the Fed cannot possibly bail-out or support a bank (or the banking industry as a whole) via RRPs. In effect, a reverse repo is a form of monetary tightening. It is the opposite of “QE”.

6) The recent large increase in the volume of RRPs could be partly due to a temporary shortage of Treasury securities — a shortage that the Fed helped create via its QE and that the US Federal Government has exacerbated by reducing the supply of new securities in response to the closeness of its official “debt ceiling”. That is, the Fed could be using RRPs to alleviate a temporary shortage of government debt securities. However, we suspect that interest-rate arbitrage is playing a larger role, because the RRP participants are getting paid an interest rate that in today’s zero-interest world could look attractive.

7) Lending money to the Fed is the safest way to temporarily park large amounts of cash.

What I mean by the title of this post is that the central-bank tightening that almost always precedes an economic bust is never the cause of the bust. However, it’s a fact that economic busts are indirectly caused by policy mistakes, in that policy mistakes lead to artificial, credit-fueled booms. Once such a boom has been fostered, an ensuing and painful economic bust becomes unavoidable. The only question is: will the bust be short and sharp (the result if government and its agents stay out of the way) or drag on for more than a decade (the result if the government and its agents try to boost “aggregate demand”)?

The most commonly cited historical case of a policy mistake directly causing an economic bust is the Fed’s gentle tap on the monetary brake in 1937. This ‘tap’ was quickly followed by the resumption of the Great Depression, leading to the superficial conclusion that the 1937-1938 collapse in economic activity would never have happened if only the Fed had remained accommodative.

Let’s now take a look at what actually happened in 1937-1938 that could have caused the economic recovery of 1933-1936 to rapidly and completely disintegrate.

First, while commercial bank assets temporarily stopped growing in 1937, they didn’t contract. Commercial bank assets essentially flat-lined during 1937-1938 before resuming their upward trend in 1939.

Second, outstanding loans by US commercial banks were roughly the same in 1938 as they had been in 1936, so there was no widespread calling-in of existing loans. That is, there was no commercial-bank credit contraction to blame for the economic contraction.

Third, the volume of money held by the public was higher in 1937 than in 1936 and was roughly the same in 1938 as in 1937.

Fourth, M1 and M2 money supplies were roughly unchanged over 1937-1938, so there was no monetary contraction.

Fifth, the consolidated balance sheet of the Federal Reserve system was slightly larger in 1937 than in 1936 and significantly larger in 1938 than in 1937, so there was no genuine tightening of monetary conditions by the Fed at the time.

Sixth, an upward trend in commercial bank reserves that began in 1934 continued during 1937-1938.

Seventh, there were no increases in the interest rates set by the Fed during 1937-1938. In fact, there was a small CUT in the FRBNY’s discount rate in late-1937.

What, then, did the Fed do that supposedly caused one of the steepest economic downturns in US history? The answer is that it boosted commercial-bank reserve requirements.

All of which prompts the question: How did a 1937 increase in reserve requirements that didn’t even lead to a monetary or credit contraction possibly cause manufacturing activity to collapse and unemployment to skyrocket?

It’s a trick question, because the increase in reserve requirements clearly didn’t cause any such thing. The economic collapse of 1937-1938 happened because the recovery of 1933-1936 was not genuine, but was, instead, an artifact of increased government spending and other attempts to prop-up prices. The economy had never been permitted to fully eliminate the imbalances that arose during the late-1920s, so a return to the worst levels of the early-1930s was inevitable.

Many analysts are now worrying out loud that the Fed will repeat the so-called “mistake of 1937″, but the real problem is that the Fed and the government repeated the policy mistakes of the late-1920s and then repeated the policy mistakes of 1930-1936. The damage has been done and another economic bust is now unavoidable, regardless of what the Fed decides at this week’s meeting.

This post was inspired by an exchange between Martin Armstrong of Armstrong Economics and one of his readers. In an earlier blog entry Mr. Armstrong wrote: “The wealth of a nation is the total productivity of its people. If I have gold and want you to fix my house, I give you the gold for your labor. Thus, your wealth is your labor, and the gold is merely a medium of exchange. So it does not matter whatever the medium of exchange might be.” One of his readers took exception to this comment and argued that money should be tangible and ideally should be gold or silver.

Mr. Armstrong’s reply is worth reading in full. After giving us an abbreviated history of money through the ages, he sums up as follows:

“Paper money is the medium of exchange between two people where one offers a service or something they manufactured, which is no different than a gold or silver coin requiring CONFIDENCE and an agreed value at that moment of exchange. You can no more eat paper money to survive than you can gold or silver. All require CONFIDENCE of a third party accepting it in exchange. For the medium of exchange to be truly TANGIBLE it must have a practical utilitarian value and that historically is the distinction of a barter system vs. post-Bronze Age REPRESENTATIVE/INTANGIBLE based monetary systems predicated upon CONFIDENCE.”

I agree with Mr. Armstrong’s central point. Many gold advocates assert that gold is “real wealth” and has intrinsic value, which is patently wrong. Value is subjective and will change based on circumstances. For example, you might place a high value on gold in your current circumstances, but if you were stranded alone on an island with no hope of rescue then gold would probably have no value to you. Gold has exactly the same intrinsic value as a Federal Reserve note: zero.

However, he is very wrong when he states: “…it does not matter whatever the medium of exchange might be.” On the contrary, it matters more than almost anything in economics!

The problem with today’s monetary system isn’t that the general medium of exchange (money) has no intrinsic value. As noted above, money also had no intrinsic value when it was gold. The problem with today’s monetary system is that an unholy alliance of banks and government has near-total control of money. Banks have the power to create new money at whim, as does the government via the central bank.

Aside from the comparatively minor problem of causing the purchasing power of money to erode over time, the creation of money out of nothing by commercial banks and central banks distorts the relative-price signals that guide investment. This happens because the money enters the economy in a non-uniform way. In the US over the past several years, for example, most new money entered the economy via Primary Dealers who used it to purchase financial assets from other large speculators. The stock and bond markets were therefore the first and biggest beneficiaries of the new money, which led to an abnormally-large proportion of investment being directed towards strategies designed to profit from rising equity prices and low/falling interest rates. Such investment generally doesn’t add anything to the productive capacity of the economy. In fact, it often results in capital consumption.

Instead of saying “it does not matter whatever the medium of exchange might be”, what Mr. Armstrong should have said was: it does not matter whatever the medium of exchange might be, as long as it is chosen by the free market. Putting it another way, the government should stay out of the money business.

Here’s the wrong way to think about gold supply: “Although gold’s aboveground inventory is huge compared to current production, only a tiny fraction of this gold will usually be available for sale near the current price. Therefore, changes in mine supply can be important influences on the gold price.” I’ll now explain the right way to think about gold supply.

Whenever I point out that the supply side of the gold market consists of the entire aboveground gold inventory, which is probably somewhere between 150K tonnes and 200K tonnes, and that the gold-mining industry does no more than add about 1.5%/year to this inventory, an objection I often get is that only a tiny fraction of the aboveground inventory is available for sale at any time. This is of course true, and nobody who has a correct understanding of gold supply has ever claimed otherwise.

If all, or even most, of the aboveground supply were for sale at the current price then the price would not be able to rise. The price can rise and fall by substantial amounts, however, because there is always a huge range of prices at which the owners of the aboveground supply are prepared to sell. Moreover, this range is constantly changing based on changing personal circumstances and assessments of the market. In addition, some holders of existing aboveground gold will be planning to hold forever. These plans, which are themselves subject to change in response to changing circumstances, also factor into the formation of the gold price, in that a decision to withhold X ounces of supply can have a similar effect to a decision to buy X ounces.

As I write, gold is trading in the $1120s. It is therefore certain that a tiny fraction of the aboveground supply is currently changing hands in the $1120s and that there are plans in place to sell other tiny fractions in the $1130s, the $1140s, the $1150s, and all the way up to some extremely high number. Some people will also have plans to sell gold if the gold price falls below a particular level and there will be millions of people who have no specific selling intentions who will decide to sell in the future for some currently unforeseeable reason. At the same time there will be countless plans in place to buy at certain levels and millions of people with no present intention to buy who will, for reasons that aren’t currently foreseeable, decide to buy in the future.

It is the combination of these myriad plans that determines the price. Furthermore and as mentioned above, over the days ahead many of these plans will change. For example, some gold-buying/selling intentions will change based on what happens to the stock market or the bond market.

How does the gold-mining industry fit into the situation?

The gold-mining industry is not materially different from any other seller except that its plans are not price sensitive. Specifically, every year it will sell an amount that’s equivalent to about 1.5% of the total aboveground supply regardless of price. At this time four years ago it was selling gold in the $1800s and it is now selling roughly the same amount of gold in the $1100s. It is the ultimate price-taker. To put it another way: whatever price arises from the changing plans of gold owners and potential owners, that’s the price at which gold producers will sell.

On a related matter, due to the huge existing aboveground supply of gold there should never be a genuine shortage of physical gold. Obtaining more gold should always be solely a question price. A consequence is that the gold market should never go into “backwardation”, that is, the spot gold price should always be lower than the price for future delivery. Just to be clear: in an abundantly-supplied commodity market the futures price should be higher than the spot price by enough to eliminate the risk-free profit that could otherwise be had by selling the physical and buying the futures. That’s why it would be very significant if the gold market were to make a sustained and sizeable move into backwardation. Such a development would indicate that holders of the aboveground supply were withdrawing their gold from the market en masse and/or that the gold futures market was breaking down due a collapse in trust. Even the small and brief backwardations of the past two years have some significance*, although recent gold backwardation episodes have more to do with near-zero short-term US$ interest rates than gold supply/demand. The point is that gold backwardation is only important because the existing aboveground supply in saleable form dwarfs the rate of annual production.

In summary, the price of gold is where it is because of the range of prices at which existing holders intend to become sellers and the concurrent range of prices at which potential future holders intend to become buyers. These ranges are constantly in flux due to changing perceptions and circumstances.

*Keith Weiner has written extensively about the significance of gold backwardation at https://monetary-metals.com/.

Here are ten basic gold-market realities that are either unknown or ignored by many gold ‘experts’.

1. Supply always equals demand, with the price changing to maintain the equivalence. In this respect the gold market is no different from any other market that clears, but it’s incredible how often comments like “demand is increasing relative to supply” appear in gold-related articles.

2. The supply of gold is the total aboveground gold inventory, which is currently somewhere in the 150K-200K tonne range. Mining’s contribution is to increase the aboveground inventory by about 1.5% each year. An implication is that there should never be a shortage of gold.

3. Although supply always equals demand, the price of gold moves due to sellers being more motivated than buyers or the other way around. Moreover, the change in price is the only reliable indicator of whether the demand side (the buyers) or the supply side (the sellers) have the greater urgency. An implication is that if the price declines over a period then we know, with 100% certainty, that during this period sellers were more motivated (had greater urgency) than buyers.

4. No useful information about past or future price movements can be obtained by counting-up the amount of gold bought/sold in different parts of the gold market or different parts of the world. An implication is that the supply/demand analyses put out by GFMS and used by the World Gold Council are generally useless in terms of explaining past price moves and assessing future price prospects.

5. Demand for physical gold cannot be satisfied by “paper gold”.

6. Prices in the physical and paper (futures) markets are linked by arbitrage trading. For example, if speculative selling in the futures market drives the futures price down relative to the physical (or cash) price by a sufficient amount then arbitrage traders will profit by selling the physical and buying the futures, and if speculative buying in the futures market drives the futures price up relative to the physical (or cash) price by a sufficient amount then arbitrage traders will profit by selling the futures and buying the physical.

7. The change in the spread between the cash price and the futures price is the only reliable indicator of whether a price change was driven by the cash/physical market or the paper/futures market.

8. In a world where US$ interest rates are much lower than usual, the difference between the price of gold in the cash market and the price of gold for future delivery will usually be much smaller than usual. In particular, when the T-Bill yield is close to zero, as is the case today, there will typically be very little difference between the spot price of gold and the price for delivery in a few months. An implication is that in the current financial environment the occasional drift by gold into “backwardation” (the futures price lower than the spot price) will not be anywhere near as significant as it would be under more normal interest-rate conditions.

9. Major trends in the US$ gold price are determined by changes in the general level of confidence in the Fed and the US economy. An implication is that major price trends have nothing to do with changes in jewellery demand, mine supply, scrap supply, central bank buying/selling, and the amounts of gold being imported by India and China.

10. The amount of gold in COMEX warehouses and the inventories of gold ETFs follow the major price trend, meaning that changes in these high-profile inventories are effects, not causes, of changes in the gold price.

In a blog post a couple of weeks ago I noted that it’s normal for large and fast price declines in the major financial markets to be accompanied by unusually-high trading volumes, meaning that it’s normal for large and fast price declines in the major financial markets to be accompanied by increased BUYING. I then wondered aloud as to why it is held up as evidence that something nefarious or strange is happening whenever an increase in gold buying accompanies a sharp decline in the gold price. Right on cue, ZeroHedge.com (ZH) has just published an article marveling — as if it were an inexplicable development — at how the recent sharp decline in the gold price was accompanied by an increase in buying.

As is often the case in the realm of gold-market analysis, the ZH article incorrectly conflates volume and demand. The demand for physical gold must always equal the supply of physical gold, with the price rising or falling by the amount needed to maintain the balance. If sellers are more motivated than buyers, then price will have to fall to restore the balance. The key point to understand here is that for every buyer there must be seller, and vice versa, so the purchase/sale of gold does not indicate a change in overall demand — it only indicates a fall in demand on the part of the seller and an exactly offsetting increase in demand on the part of the buyer. It is also worth noting — even though it should be obvious — that demand for physical gold cannot be satisfied by paper gold.

Trading in paper gold (gold futures, to be specific) clearly does have an effect on the price at which physical gold changes hands. The paper and physical markets are inextricably linked, but this link does not make it possible for the demand for physical gold to rise relative to the supply of physical gold in parallel with a falling price for physical gold.

What happens in the real world is that when the futures market leads the physical market higher or lower it changes the spread between the spot price and the price for future delivery. For example, when the gold price is being driven downward by speculative selling in the futures market, the price of gold for future delivery will fall relative to the spot price. In a period when risk-free short-term interest rates are being pegged at or near zero by central banks, this can result in the spot price becoming higher than the price of gold for delivery in a few months’ time. This creates a financial incentive for other operators in the gold market to buy gold futures and sell physical gold. For another example, when the gold price is being driven upward by speculative buying in the futures market, the price of gold for future delivery will rise relative to the spot price. This creates a financial incentive for other operators in the gold market to sell gold futures and buy physical gold.

The bullion banks are the “other operators”. They tend to focus on trading the spreads between the physical and futures markets. In doing so they position themselves to make a small percentage profit regardless of the price trend and therefore tend to be agnostic with regard to the price trend.

After harping on about the dislocation between the physical and paper gold markets, a dislocation that doesn’t actually exist but makes for good copy in some quarters, the above-mentioned ZH article moves on to the level of the CME (often still referred to as the COMEX) gold inventory. To the sound of an imaginary drumroll, the author of the article breathlessly points out that the amount of “registered” gold at the COMEX has dropped to a 10-year low and that the amount of “open interest” in gold futures is now at a 10-year high relative to the amount of “registered” gold.

The information is correct, but isn’t relevant other than as a sentiment indicator. It’s a reflection of what has happened to the price over the past few weeks and the increase in negativity that occurred in reaction to this price move. It is not evidence of physical-gold scarcity.

I currently don’t have the time to get into any more detail on the COMEX inventory situation. However, if you are interested in delving a little deeper you could start by reading the July-2013 article posted HERE. I get the impression that this article was written in response to the scare-mongering that ZH was doing on the same issue two years ago.

Thanks largely to the unprecedented measures taken by the senior central banks over the past few years, there have been many strange happenings in the financial world. However, the increased buying of physical gold in parallel with a sharply declining gold price and the reduction in COMEX “registered” gold cannot be counted among them.

The answer to the first question is ‘sort of’. The answer to the second question is no. The effects of having an institution with the power to manipulate interest rates and the money supply at whim are equally pernicious whether the institution is privately or publicly owned. However, if you strongly believe that the government can not only be trusted to ‘manage’ money and interest rates but is capable of doing so to the benefit of the economy, then please contact me immediately because I can do you a terrific deal on the purchase of the Eiffel Tower.

The fact is that the Federal Reserve would be a really bad idea regardless of whether it were privately owned or owned by the US government. The question of ownership is therefore secondary and the people who stridently complain about the Fed being privately owned are missing the critical point. In any case and as I explained in an article way back in 2007, the Fed is not privately owned in the true meaning of the word “owned”. For all intents and purposes, it is an agency of the US Federal Government.

In addition to the work of G. Edward Griffin referenced in my above-linked 2007 article, useful information about the Fed’s ownership can be found in a 2010 article posted at the Mises.org web site. This article approaches the Fed’s ownership and control from an accounting perspective, that is, by applying Generally Accepted Accounting Principles (GAAP), and concludes that:

“…the Fed, when tested against GAAP as the Fed itself uses it in the Fed’s assessments of those it regulates, is a Special Purpose Entity of the federal government (or, according to the latest definition, is a Variable Interest Entity of the federal government). The rules of consolidation therefore apply, and the Fed must be seen as controlled by federal government, making it indivisibly part of the federal government. The pretence of independence is no more than that, a pretence.

There is, however, no denying that the banks have tremendous vested interest in influencing the policies of the Fed, nor that the power being so narrowly vested in the president makes him a special target for influence. Still, the power to control the Fed is not in the hands of its “owners” but firmly in the hands of the federal government and the president of the United States.”

It is clear that the Fed was established by the government at the behest of bankers with the unstated aim of facilitating the expansions of the government and the most influential banks. It is effectively a government agency, but due to the influence that the large banks have on the government it will, if deemed necessary by the Fed Chairman, act for the benefit of these banks at the expense of the broad economy. The happenings of the past eight years should have left no doubt about this.

A popular view these days is that the euro is a failed experiment because economically and/or politically disparate countries cannot share a currency without eventually bringing on a major crisis. Another way of expressing this conventional wisdom is: a monetary union (a common currency) cannot work without a fiscal union (a common government). This is unadulterated hogwash. Many different countries in completely different parts of the world were able to successfully share the same money for centuries. The money was called gold.

The fact that a bunch of totally disparate countries in Europe have a common currency is not the problem. The problem is the central planning agency known as the European Central Bank (ECB), which tries to impose a common interest rate across these diverse countries/economies. This leads to even more distortions than arise when such agencies operate within a single country (the Fed in the US, for example), which is really saying something considering the distortions caused by the Fed and other single-country central banks.

I’m reticent to pick on John Hussman, because his analysis is usually on the mark. However, his recent comments on the Greek crisis and its supposed relationship to a common currency make for an excellent example of the popular view that I’m taking issue with in this post. Here is the relevant excerpt from the Hussman commentary, with my retorts interspersed in brackets and bold text:

“The prerequisite for a common currency is that countries share a wide range of common economic features. [No, it isn't! Money isn't supposed to be a tool that is used to manipulate the economy, it is supposed to be a medium of exchange.] A single currency doesn’t just remove exchange rate flexibility. It also removes the ability to finance deficits through money creation, independent of other countries. [Removing the ability to finance deficits through money creation is a benefit, not a drawback.] Moreover, because capital flows often respond more to short-term interest rate differences (“carry trade” spreads) than to long-term credit conditions, the common currency of the euro has removed a great deal of interest rate variation between countries. [No, the ECB has done that. In the absence of the ECB, interest rates in the euro-zone would have correctly reflected economic reality all along.] It may seem like a good thing that countries like Greece, Spain, Italy, Portugal, and others have been able to borrow at interest rates close to those of Germany for nearly two decades. But that has also enabled them to run far larger and more persistent fiscal deficits than would have been possible if they had individually floating currencies. [This is completely true, but it is the consequence of a common central bank, not a common currency.]

The euro is essentially a monetary arrangement that encourages and enables wide differences in economic fundamentals between countries to be glossed over and kicked down the road through increasing indebtedness of the weaker countries in the union to the stronger members. [The ECB, not the common currency, encourages this.] This produces recurring crises when the debt burdens become so intolerable that even short-run refinancing can’t be achieved without bailouts.

Greece isn’t uniquely to blame. It’s unfortunately just the first country to arrive at that particular finish line. Greece is simply demonstrating that a common currency between economically disparate countries can’t be sustained without continuing subsidies from the more prosperous countries in the system to less prosperous ones. [If this is true, how did economically disparate countries around the world use gold as a common currency for so long without the more prosperous ones having to subsidise the less prosperous ones?]“

Money is supposed to be neutral — a medium of exchange and a yardstick. It is inherently no more problematic for totally disparate countries to use a common currency than it is for totally disparate countries to use common measures of length or weight. On the contrary, there are advantages to the use of a common currency in that trading and investing are made more efficient.

In conclusion, the problem is the central planning of money and interest rates, not the fact that different countries use the same money. It’s a problem that exists everywhere; it’s just that it is presently more obvious in the euro-zone.

Keith Weiner often posts thought-provoking stuff at his Monetary Metals blog. A recent post entitled “Interest – Inflation = #REF” is certainly thought-provoking, although it is also mostly wrong. It is mostly wrong because it is based on a fundamental misunderstanding about saving.

Before I get to the main point, I’ll take issue with the following paragraph from Keith’s post:

“Normally, you don’t spend your savings, only the income on it. In ancient times, people had to hoard a commodity like salt when they worked. In retirement, they sold it to buy food. Modern economies evolved beyond that, with the development of interest. Retirees should not have to liquidate their life savings.”

Who says you shouldn’t have to spend your savings? One of the main reasons to save today is so that you can spend more in the future. Also, interest isn’t a modern development, it has been inherent in economic activity since the dawn of economic activity.

Now, the main point: When people save money, it’s not actually money that they want to save. Money is just a medium of exchange. What they want to save is purchasing power (PP). For example, if I have a million dollars of savings to live on over the next 20 years, what matters to me is what the money buys now and what it will probably buy in the future. If a million dollars is currently enough to buy a mansion in the best part of town and if a dollar is likely to maintain its PP over the next 20 years, then I’ll probably be able to live quite comfortably on my savings. However, if a million dollars only buys me a loaf of bread, then I have a problem.

A consequence is that, contrary to the assertion in Keith’s post, the real interest rate is very important to the average retiree. The easiest way to further explain why is via a hypothetical example.

Fred, our hypothetical retiree, has $1M of savings at Year 0. At the dollar’s current purchasing power his cost of living is $20K per year. Also, the interest rate that he receives on his savings is ZERO, but the dollar is gaining PP at the rate of 5% per year.

At Year 1, Fred’s monetary savings will have declined to $980K, because he spent $20K and received no interest. However, $980K now has the same PP that $1029K had a year earlier. That is, over the course of the year Fred’s PP increased by 29K Year 0 dollars. Furthermore, his annual living expense will have declined to $19K.

At Year 2, Fred’s monetary savings will have declined to $961K, because he spent $19K and received no interest. However, $961K now has the same PP that $1059K had at Year 0.

That is, after 2 years of receiving no nominal interest on his savings, our hypothetical retiree is in a significantly stronger financial position. Thanks to the receipt of a positive real interest rate he now has more purchasing power than he started with. The fact that he has less currency units is irrelevant.

I could provide a second hypothetical example of a retiree who, despite earning a superficially-healthy positive nominal interest rate and ending each year with the same or more currency units, has a worsening financial position over time thanks to a negative real interest rate. I could, but I won’t.

The upshot is that the real interest rate is not only important, for savers and investors it is of greater importance than the nominal interest rate. The problem, today, is not only that central banks have pushed the nominal short-term interest rate down to near zero, it’s also that they have done this while reducing the PP of money. The great sucking sound is wealth being siphoned from savers via negative real interest rates.

(This post is an excerpt from a recent TSI commentary.)

The stock market is not a machine that assigns prices based on a calm and objective assessment of value. In fact, when it comes to value the stock market is totally clueless.

This reality is contrary to the way that many analysts portray the market. They talk about the stock market as if it were an all-seeing, all-knowing oracle, but if that were true then dramatic price adjustments would never occur. That such price adjustments occur quite often reflects the reality that the stock market is a manic-depressive mob that spends a lot of its time being either far too optimistic or far too pessimistic.

The stock market can aptly be viewed as an emotion pendulum — the further it swings in one direction the closer it comes to swinging back in the other direction. Unfortunately, there are no rigid benchmarks and we can never be sure in real time that the pendulum has swung as far in one direction as it is going to go. There’s always the possibility that it will swing a bit further.

Also, the swings in the pendulum are greatly amplified by the actions of the central bank. Due to the central bank’s manipulation of the money supply and interest rates, valuations are able to go much higher during the up-swings than would otherwise be possible. Since the size of the bust is usually proportional to the size of the preceding boom, this sets the stage for larger down-swings than would otherwise be possible.

The following monthly chart of the Dow/Gold ratio (from Sharelynx.com) clearly shows the increasing magnitude of the swings since the 1913 birth of the US Federal Reserve.

According to the fellow in the video shown below, the Chinese are invading Australia. It isn’t a military invasion, it’s an economic invasion that involves the buying-up of Australian real estate and has caused young Australian families to be priced out of the property market. The solution, apparently, is for the Australian federal government to stop turning a blind eye to this flood of foreign investment and, instead, to put a stop to it, thus resuscitating the “Australian dream”. Unfortunately, the star of the video is both ethically and economically wrong. He is ethically wrong because he is advocating the widespread violation of property rights (he wants the government to dictate who Australian property owners can sell to, with the particular aim of preventing the sale of property to buyers who live in China), but it’s the economic error I’m going to deal with in this post.

Our ‘the-government-oughta-do-something-to-stop-the-Chinese-real-estate-invasion’ protest organiser and You-Tuber is unaware of two important economic realities, the first and lesser important of which is that Australia runs a large current-account deficit. This deficit, which comprises dividend payments, interest payments on foreign debt and a surplus of imports over exports, is running at around A$40B per year. This means that about $40B per year is ‘flowing’ out of the country on the current account, which means that about $40B/year of new investment MUST flow into the country (since nobody has any use for Australian dollars outside Australia). In other words, the current account deficit necessitates $40B per year of net foreign investment, approximately a quarter of which goes into real estate.

The more important economic reality of which our irrepressible video presenter is unaware is Australia’s rapid rate of monetary inflation. Thanks to the activities of the Reserve Bank of Australia (RBA) and the commercial banks, the supply of Australian dollars has risen by 13% over the past 12 months and 44% over the past 4 years. With this rate of money-supply growth and low interest rates it is no wonder that houses have become very expensive. With this monetary backdrop, houses would almost certainly have become very expensive even if China didn’t exist. Furthermore, a rapid rate of monetary inflation tends to increase the current account deficit and weaken the currency on the foreign exchange market, thus putting more of the currency in the hands of foreign investors and simultaneously making domestic property prices look cheaper to foreign investors.

So, if the guy in above video had a better understanding of economics he’d be organising a protest outside the RBA headquarters instead of the Chinese consulate.

The title of this post refers to the debate between Jeff Clark and Harry Dent about gold’s prospects over the next 2 years, with Harry Dent arguing for a collapse in the gold price to less than $700/oz and Jeff Clark arguing in favour of a bullish outcome. I put inverted commas around the word great, because neither participant in this debate made a good argument. However, while the Clark side of the debate could have been a lot better, the Dent side was a stream of complete nonsense. In this post I’ll deal with a couple of the flaws in Dent’s analysis and also briefly address the extremely persistent deflation fantasy that lies at the core of Dent’s latest big prediction*.

An important point to understand is that gold is not now, and has never been, a play on “CPI inflation”. As I stated in an earlier post: “Gold is a play on the economic weakness caused by bad policy and on declining confidence in the banking establishment (led by the Fed in the US). That’s why cyclical gold bull markets are invariably born of banking/financial crisis and/or recession, and why a cyclical gold bull market is more likely to begin amidst rising deflation fear than rising inflation fear.” Jeff Clark barely touches on this key point, while Harry Dent believes that the point is invalidated by the fact that the gold price fell by 33% during part of the 2008 financial crisis.

Harry Dent keeps returning to gold’s performance during 2008 and provides no other historical examples of gold performing poorly in times of financial crisis. He therefore either has very little knowledge of gold’s historical record or he believes that hundreds of years of history were negated by what happened during 2008. Either way, he is misinformed, because gold outperformed the US$ over the course of 2008. The 33% decline is from the best level of the year to the worst level of the year, but even this sizeable peak-to-trough loss was fully eradicated by the first quarter of 2009. Moreover, if we consider the entire Global Financial Crisis (GFC), with the 10th October 2007 closing high for the S&P500 marking its beginning and the 10th March 2009 closing low for the S&P500 marking its end, we find that gold gained 24% in US$ terms and 34% in euro terms over the course of the crisis.

Information that must always be taken into account when assessing gold’s performance in reaction to events is the gold-price starting point. The reason that gold was initially hit hard in US$ terms during the general market crash of 2008-2009 is largely due to the US$ gold price being ‘overbought’ and at a multi-decade high just prior to the crash, which is obviously not the case today. Furthermore, as I mentioned above it quickly recouped its losses.

And information that must be taken into account when assessing the performances of all the financial markets during the GFC of 2007-2009 is that the Fed did not begin to pump-up the US money supply (properly measured via TMS) until September of 2008. From September of 2007 through to August of 2008 the Fed cut interest rates, but the monetary inflation rate remained at a low level. Since there is no longer any scope to cut interest rates, it’s a virtual certainty that the Fed’s initial response to a deflation scare in the not-too-distant future would involve ramping-up the money pumps.

In addition to presenting gold’s GFC performance in a misleading way, there are numerous problems with Dent’s argument. Due to time constraints I’m only going to deal with one of them. Here’s the relevant excerpt:

“The gold bug camp is constantly telling us that governments are debasing our currency, especially the almighty US dollar and destroying the value so that the dollar is not a good store of value. I 100% disagree.

Here’s an analogy to explain: Since its invention in 1971, the microchip has been multiplied by the trillions, creating a revolution in human communications. Its evolution is a crystal-clear sign of progress and of a higher standard of living. Translating that back to the dollar argument, if the exponential multiplication of the microchip was (is) a good thing, why would the multiplication of dollars not also be a sign of progress that similarly fosters a revolution in urbanization, more complex and rich specialization of skills, and an improved standard of living? Increasing urbanization leads to rising affluence and the need for greater dollars for transactions in a more complex urban society!”

This may be the stupidest economics-related comment I’ve ever read from a trained economist, which is saying something considering the competition. It implies that he doesn’t know the difference between a rise in the quantity of the medium of exchange and a rise in the quantity of real wealth. It implies that he sees no difference between the private sector increasing the supply of labour-saving or life-sustaining or life-enhancing products and central banks creating new money out of nothing. Also, he apparently perceives the factual decline in the US dollar’s purchasing power as a goldbug delusion.

Harry Dent should not be taken seriously, but the view that deflation is coming should not be dismissed out of hand. Also, it is possible to make a legitimate gold-bearish argument, it’s just that Harry Dent hasn’t done it.

Under the current monetary system and the theories that dominate central banking, true deflation — such as occurred in the US during 1930-1932 — has a near-zero probability of happening. In the future there could (almost certainly will) be changes to the monetary system and/or the political environment that pave the way for true deflation, but that’s not something that has a realistic chance of happening over the next two years. In the meantime, there will probably be another deflation scare.

While it’s in progress a deflation scare will look and feel like 1930s-style deflation to most people. The difference is that you don’t get the economic ‘reset’ that would be caused by true deflation. Instead, policy-makers react to the scare by 1) aggressively injecting new money into the economy, 2) ensuring that the total volume of credit continues to grow, and 3) generally doing whatever it takes to prop-up prices. In doing so they add new imbalances to the existing imbalances.

Deflation scares are very bullish for gold. That’s why the deflation scare of 2001-2002 set in motion a large multi-year advance in the gold price and why the deflation scare of 2007-2009 set in motion a large multi-year advance in the gold price. If another deflation scare gets underway this year then so, in all likelihood, will another large multi-year advance in the gold price.

Looking out over the coming 1-2 years, the risk for gold isn’t that there will be true deflation, because that’s a virtual impossibility under the current monetary set-up. Nor is the realistic possibility of a deflation scare a risk for gold, since such a development would create a very gold-bullish fundamental backdrop. Rather, the risk for gold is a continuation of the monetary-inflation-fueled boom of the past few years.

In effect, the main risk for gold is an economic outcome that is almost the OPPOSITE of what Harry Dent is predicting.

*Harry Dent’s modus operandi is to come out with a new ‘big prediction’ almost every year. This creates a media buzz that facilitates the sale of books. If a big prediction doesn’t pan out, no problem — just make another one. Eventually, one will hit the mark. In the early-1990s he got lucky and correctly predicted the ensuing boom (it was blind luck because his reasoning was wrong). If he gets lucky again, he’ll have a track record to shout from the hilltops.