Gold Prices, Monetary Policies, and Outlook

Gold Prices, Monetary Policies, and Outlook
June 6, 2013

Edmund Contoski

Edmund Contoski has had a varied career. He is a former director of planning for an internationally... (read full bio)

GOLD

The World Gold Council on May 16 issued it summary report for the first quarter of 2013.  Central banks added 109.2 metric tons of gold to their reserves, the ninth consecutive quarter of net purchases.  Note that these purchases occurred before the big drop in the gold price in mid April.  I would expect the second quarter report will show much larger purchases by the central banks, due to bargain prices that became available.

First quarter investments in gold ETFs were down 177 tons—but bar and coin demand increased by 378 tons.  (Three-fourths of the ETF losses occurred in the U.S.)  Jewelry demand accounted for 551 tons, an increase of 12 percent.  Supply was flat: mine production increased 4%, but recycling decreased by the same amount.

India and China both showed big increases in buying during the quarter.  India bought 256t, for a 27% increase; jewelry was up 15%, and investment was up 52%.  In China, overall gold demand was up 20% with jewelry up 19%, and investment up 22%.

The precipitous $200 drop in the gold price in April was triggered by a single very large sell order in the futures market on the Comex exchange.  Despite claims by some that this signaled the end of the bull market in gold, price action said otherwise.  Physical buyers turned out in droves.   The US Mint sold a record 63,500 ounces—a whopping 2 tonnes—of gold on April 17 alone.  It's total for the month was more than the two previous months combined.

Reuters reported: “on Tuesday [following the big price drop], buyers outnumbered sellers by a wide margin. At Ginza Tanaka, the headquarters shop of Tanaka Holdings, gold buyers waited for as long as three hours for a chance to complete a transaction.”

Bullion traders reported trading volumes doubled and the buy/sell ratio was 95 to 1.  Two precious metals refiners—who deal only in large trades—said they had no sell orders; a third said they had one sell order out of 100 transactions.  The World Gold Council reports central bank buying shows no signs of abating.

Demand for gold in India, the biggest consumer, was double the level for this time of year, said Rajesh Mehta, chairman of Bangalore-based Rajesh Exports Ltd (RJEX)., the nation's largest exporter of gold jewelry and a retailer.  UBS AG said on April 23 that physical-gold flows to India approached the highest since 2008.  India's Ministry of Commerce and Industry reported gold bullion imports rose 138% in April from March.

Japanese individual investors doubled gold purchases yesterday [April 17] at Tokuriki Honten, the country’s second-largest retailer of the precious metal.  In Australia, “the volume of business… is way in excess of double what we did last week,… there’s been people running through the gate,” said Nigel Moffatt, treasurer of Australia’s Perth Mint.

A jewelry salesman in Mumbai’s Zavery Bazar was quoted in the Wall Street Journal: “We have not seen such strong demand in many years. Our order books are already 30%-40% more than last year’s festival day… We don’t have enough staff to keep up with this kind of mad demand.”

In the weeks since the April drop, there has been strong demand for jewelry and investment in China, India, and the Middle East.  Coin purchases have increased in Western markets, and some refineries are reporting 2-week waiting periods for delivery of their products.

MONETARY POLICY

In a previous posting we pointed out “quantitative easing”—printing money—has been employed by the Fed, the European Central Bank, the Bank of England and the central bank of Japan in efforts to stimulate national economies.  The economy of Japan has stagnated for two decades—because of Keynesian policies—and has reached the point where deflation is now more feared than inflation.  Japan's monetary policy had been aimed at creating inflation of one percent. The recently elected government in Japan has stated it aims to improve the economy with 2 percent inflation by doubling the money supply.  It said it will engage in “unlimited” or “open ended” printing of money to achieve that goal.  Thus Japan has now reached its “Havenstein moment,” a moment already reached by the other three central banks just mentioned.  It is a moment when the person in charge of the money supply decides that massive printing of money is better than the alternative.  Rudolf Havenstein was the head of German Central Bank (Reichsbank) from 1908 to 1923 and presided over the great hyperinflation in Germany.

Obviously fearing the alternative would be worse, the Fed is currently printing $85 billion per month—that's over a $1 trillion per year—to try to improve the economy.  And it has more than trebled its balance sheet from $924 billion on Sept. 10, 2008 to $3.32 trillion now.  After 4 and 1/2 years of quantitative easing, the U.S. economy is still weak, unemployment high and labor-force participation actually down.

European Central Bank president Mario Draghi has provided euros amounting to $1.3 trillion to European banks and says he will do “whatever it takes” in the way of future printing of money to save the euro.  But the euro-zone economy is still in trouble.  The Bank of England has engaged in quantitative easing amounting to $593 billion, with disappointing results.  Is it likely that larger doses of the Keynesianism that failed to produce economic growth in Japan for two decades will now produce a different result?

Hunter Lewis, author of Where Keynes Went Wrong, said in a 2011 interview:

Back in 2009 when we were coming out of the crash, in the first interview I had about the book with the BBC, they said, “Are you proposing to take the patient off life support?”' And I said, “That’s the wrong way to look at it. It’s not life support, it’s just more alcohol for the alcoholic, or it’s more heroin for the drug addict. Then of course, you need more and more of that to keep an addict from being in withdrawal, but it doesn’t help the problem, it just makes it worse, and that’s essentially what has been going on.”...Not only has our government not changed, but every government in the world is continuing to follow the same Keynesian policies, and of course, they haven’t worked, they aren’t working, but we just keep doing more of the same....

None of the Keynesian economists who were propounding, “Let’s have more stimulus,” are providing any justification for it, on a theoretical basis, or an evidence basis....because the truth is, there is no logic and there is no evidence for it.

When you have high unemployment, that tells you that there is something wrong with the price system, that there are prices that are not in the right relationship to each other, and yet, the government keeps messing up the biggest, most important prices of all, one of which is interest rates. The system really can’t function if the information that the market is providing in the form of the interest rate, is not available.

And of course, it makes no sense at all, as Keynes advocated, to keep driving interest rates down to zero and hold them there.

Lewis stated Keynes' policies were “ideologically driven,” or, as interviewer David McAlvany put it, “Keynesian economic theories were simply a justification for his own personal choices and ethical leanings.”  One of these was his advocacy of progressive taxation, taking more money from the wealthy and redistributing it.  Lacking economic justification for this, Keynes invented an uneconomic one.  Lewis explained that Keynes:

suggested that the government could print new money. That money would flow into the economy in the form of debt, and that would take the place of savings, but there is just no evidence for that at all, there is no logic behind that. In fact, if you want a good economy, what you need is savings, and you need then to invest those savings, and you need to invest those savings in a wise way...Of course, Keynes completely ignores the issue of how you are investing. For him, not only is any investment equivalent to any other investment, but spending is equivalent to investment. It just doesn’t make any sense at all.

Keynes believed progressive taxation would promote increased spending, which he favored.  He even endorsed printing money with expiration dates so  people would be forced to spend it.  Of course, that would eliminate not only saving but the essential function of money as a store of value.  But for Keynes, spending was what really mattered to the economy.  Naturally that idea was very appealing to politicians anxious to spend for causes they favored, including their own elections.

OUTLOOK

In the U.S. the recent modest upturn in housing construction and home prices and new highs in the stock market have been trumpeted as signs of economic recovery.  But improvements in those areas are exactly what one would expect from the Fed's policies.

Of the $85 billion the Fed prints every month, $40 billion is for mortgage securities, which favors the housing industry.  Throw in the Fed policy of maintaining ultra-low interest rates—meaning low-cost mortgages—and it is not surprising to see a plus effect on this market despite a still large oversupply of homes.  Furthermore, despite recent increases in home prices, more than 14 million homeowners nationwide—one in four people with a mortgage—are still making payments on debts that exceed the value of their homes by more than $1 trillion.  “Negative equity will remain a major factor in the market for the foreseeable future,” says Zillow's chief economist, Stan Humphries.

As for the highs in the stock market, the Fed policy of depressing interest rates has led to a loss of income from CDs and other safe investments.  This has resulted in people trying to obtain higher yields by switching to riskier investments, such as the stock market.  The inflow of funds to the stock market has led to stock valuations outrunning the performance of the companies.  A future rise in interest rates will be a further risk to the stock market as money will flow out of it and back into safer investments with higher yields.

U.S. unemployment is now officially at 7.5%, compared to 7.2 % in December 2007, before Obama's stimulus program.  The real current rate is actually twice as high as the official rate if involuntary temporary and part-time employment and those who have stopped looking for work are included.  Most people who obtain new jobs are taking significant pay cuts, and 11.7 million are still unemployed.

European economic problems are no longer much in the news, but the crisis is not over.  In fact, it has worsened.  The euro-zone economy shrank in the first quarter 2013, for a record six consecutive quarters.  The Organization for Economic Cooperation and Development this week predicted the euro-zone will contract 0.6% in 2013, compared to its November estimate of 0.1% contraction.  On May 31,  the euro-zone unemployed  rate reached 12.2%, a new record.

Unemployment in Spain rose to 27.2% from 26%, and 240,000 jobs were lost in the first quarter.   Unemployment in Greece was also 27.2%.  On May 28 the Greek central bank said the recession will likely get worse this year, with the economy likely to contract 4.6% and unemployment reaching 28%, both numbers worse than previously predicted.  The Organization for Economic Cooperation and Development predicts Greece will remain in recession in 2014, unemployment will remain at 28.4%—and the country may require another bailout.

While other European countries were cutting minimum wage rates and raising retirement ages to improve employment numbers and slash government costs, France's socialist President Hollande did just the opposite.  He increased the minimum wage and lowered the minimum retirement age from 62 to 60, reversing the raise by former president Nicolas Sarkozy.  France fell into recession in the first quarter, and unemployment, now above 10%, increased for the 23rd month in a row.  France's debt to GDP ratio, now over 90, is the highest of any European country not receiving a bailout.

As the economies in various euro-zone countries have worsened, it became obvious that they could not meet their fiscal targets.  On May 30 the European Commission, the executive arm of the European Union, agreed to allow more time for seven countries to bring their budget deficits in line.  France, Spain, Poland and Slovenia were given an extra two years to limit their budget deficits to the EU standard of 3% of GDP.  The Netherlands and Portugal were given one year extensions.

This was the third extension for Spain.  Given the difficulties of Spain and other countries in meeting current fiscal targets, as well as previous ones, will they also need further extensions when the ones just issued expire?  This becomes an interesting question because, as I explain in my new book, the ECB loaned almost a half trillion euros to 523(!) European banks in December 2011 and an even larger amount to 800(!) banks in February 2012.  Together, these two loan programs amounted to over $1.3 trillion.  The loans were made for three years, three times longer than any loans ever made by the ECB.  They will start coming due about the time the newly announced budget extensions for the troubled countries expire.  In addition, Spain and Italy have almost a trillion dollars worth of government securities coming due in the next two years.  Now, if those loans cannot be repaid or government securities cannot be rolled over, can anyone believe that there will not be a colossal creation of new money and credit to prevent the collapse of the whole system?  Just as with Havenstein, creating more money will seem better than the alternative.

But even before that would occur, the entire monetary structure is already so fragile it could be toppled by a major adverse economic event.  This might be a crash in the U.S. stock market, fallout  over raising the U.S. debt ceiling, a continued worsening in certain euro-zone economies, including perhaps more bailouts—maybe even the collapse of the euro.  It might also be a far more widespread  flight to gold than we have just seen, which would indicate massive distrust of the monetary system that in itself would cause the price of gold to skyrocket and accelerate the collapse of the monetary system even before the unlimited printing of money would bring about its end.

Bernanke said he believes when the time is appropriate he can manipulate the Fed policies to avoid runaway inflation.  Good luck with that.  It's never been done before.  The great economist Henry Hazlitt said, “If a government resorts to inflation, that is, creates money in order to cover its budget deficits or expands credit in order to stimulate business, then no power on earth, no gimmick, device, trick or even indexation can prevent its economic consequences.” I think Hazlitt is far more likely to prove right than Bernanke.

There is a final issue that will accelerate monetary revolution and the restoration of gold in the monetary system: changing the rules of the game.  International banking rules, known as the Basel Accords, are produced by the Basel Committee on Banking Supervision, which is part of the Bank for International Settlements.  The committee is composed of regulators from 27 nations, including the U.S., U.K., and China.  The Bank for International Settlements includes 58 major central banks.

As I pointed out in my book, the new Basel III Accords will henceforth classify gold as a Tier 1 capital asset instead of its present Tier 3 classification.  The significance of this is that a Tier 3 asset has a risk weight of 50 percent while a Tier 1 asset is 100 percent, the same as cash or U.S. treasuries.  Currently, if a bank has an ounce of gold valued at $1,700, it can only include $850 as part of the bank's Tier 1 capital; if the bank sells that ounce of gold, it can count the $1,700 it receives.  Obviously a bank is more likely to hold gold as part of it capital if it can be counted the same as cash.  And the current Tier 1 requirement of banks for 4.5% capital will be raised to 5.5% in 2014 and 6% in 2015.  Gold is likely to be more attractive as a Tier 1 asset to banks at all levels, not just the central banks—which  are already loading up on gold—as quantitative easing takes it toll on the value of U.S. dollars and the Tier 1 requirement is raised.

In April 2013, the Bank for International Settlements issued a report stating:

Basel Committee members agreed to begin implementation of Basel III’s capital standards from 1 January 2013, requiring that they translate the Basel III standards into national laws and regulations before this date. Since the Basel Committee’s October 2012 report, eight more member jurisdictions have issued final Basel III-based capital regulations, bringing the total to 14. Eleven Basel Committee member jurisdictions now have final Basel III capital rules in force: Australia, Canada, China, Hong Kong SAR, India, Japan, Mexico, Saudi Arabia, Singapore, South Africa and Switzerland.... Argentina, Brazil and Russia have issued final rules and will bring them into force by end 2013. The other 13 member countries that missed the 1 January 2013 deadline for issuing final regulations have published their draft regulations [The report names the U.S. as one of them]....The Basel Committee is urging those jurisdictions to issue final versions of their regulations as soon as possible and to align their implementation with the internationally agreed transition period deadlines.

Not surprisingly, the U.S. is not among those nations that have already put the new Basel rules into force, but it is clearly on a track to do so.  It is a member of the Basel Committee that formulated the new rules and has agreed to them.  The U.S. cannot backtrack now and fail to adopt those rules.  The value of the dollar would plummet, as would U.S. exports and world trade generally.  No, that won't happen.  The U.S. will comply with the new rules, and that will be the end of the global financial bubble the U.S. has been inflating since it severed the last link of the dollar to gold in 1971.

[First published at American Liberty.]

Edmund Contoski

Edmund Contoski has had a varied career. He is a former director of planning for an internationally... (read full bio)