Beyond the Gold and Bond Bubbles Shouldn't the Fed Try to Improve Incentives to Invest in Growing Businesses?

By David Malpass
The Wall Street Journal
Wednesday, August 31, 2011
http://online.wsj.com/article/SB1000142405311190487540457653292173566499...

Treasury bond yields have been at near-record lows and gold prices at record highs, attracting millions of investors into idle assets through coins, exchange-traded funds, and even warehousing facilities. This reflects fear about inflation and the stability of the financial system and, for some, the coming breakdown of society under the weight of $3.6 trillion in annual Washington spending and transfer payments.
Last week's letup in the gold and bond-buying bubbles was good news. It meant less fear that the financial system will collapse. The Federal Reserve and the Obama administration should pile on by championing sound money and fiscal restraint as a way to rechannel capital into growth.
Fed Chairman Ben Bernanke's Jackson Hole speech last Friday, in which he did not announce still more quantitative easing, was a welcome step back from the frenetic central-bank activism that has been adding uncertainty to an already weak economy. The Fed has bought over $2 trillion of bonds since 2008 and forced interest rates to near zero, which hasn't helped small businesses or created jobs.

Mr. Bernanke should directly confront the fear index imbedded in high gold prices and low bond yields. Gold at more than $1,800 per ounce is a loud public statement of no confidence in our central bank. It means people would rather buy gold than hire workers or start businesses -- that they don't trust the central bank to maintain the value of their money.

Former Fed Chairman Paul Volcker thought of high gold prices as his enemy and repeatedly said so as a way to build confidence in the central bank. In the 1970s, high gold prices reflected Fed incompetence that had produced inflation, stagnation and malaise. Jimmy Carter named Mr. Volcker to replace G. William Miller as Fed chairman in 1979, a rare moment of Washington accountability. Gold then fell in the 1980s and '90s in what was called affectionately "The Great Moderation." Inflation and oil prices followed gold prices down, tax rates were cut, and jobs became plentiful. Foreign capital beat a path to America's door, the mirror image of the exodus of growth capital the Fed's weak dollar is fueling.
Equally harmful in our current environment, low bond yields (negative yields in some cases) signal fear of deflation and a collapse in the financial system. Investing on these fears hurts growth -- investors buy billions in gold to protect from inflation and billions in government bonds to protect from deflation. It's like a farmer plagued by both floods and droughts and having to buy insurance against both extremes.
It's not an abstract fear. The Fed caused high inflation in the 1970s and participated in a weak-dollar policy in the 2000s that made gold a vital investment for capital preservation. And the Fed has repeatedly warned of a Japan-style deflation over the last decade, itself buying bonds in huge quantities and now forcing more capital into dead-end government bonds by assuring near-zero interest rates into 2013.
Reinforcing investor fears, the Fed has caused extraordinarily wide and harmful swings in interest rates, the value of the dollar, gasoline prices, and inflation in recent decades. This makes precautionary investments like gold, bonds, and foreign diversification more profitable than investing the old fashioned way in small, growing businesses.
The result: Growth has stagnated. With gold prices flying through the roof, interest rates at near-zero and 10-year bond yields at only 2%, too much capital has been diverted into protecting investors from monetary-policy extremes.
The Fed takes the view that gold prices have limited meaning and that low bond yields are desirable as stimulus, not a market-based indicator of slow growth and high risks to the financial system. This leaves the financial world in suspense over whether the Fed will buy back more of the national debt or even new types of assets as some are urging. The uncertainty is great for the Fed-watching community and Wall Street, which profits by buying bonds in advance of Fed purchases. But the suspense hurts growth and jobs.
To break this cycle, the Fed needs to rebuild a monetary system in which the dollar is a strong and stable store of value and capital is allocated based on interest rates and market forces rather than the rationing of regulatory capital. Gold prices would be lower and bond yields higher in anticipation of a growing economy and a safer financial system.
Unless the Fed breaks the cycle, many of the arguments for buying gold and bonds still pertain. The Fed owes $2.8 trillion in liabilities, undercutting confidence in the dollar and the financial system. It is willing to promise zero interest rates for years but not willing to criticize the declining value of the dollar, one of the most important metrics of central banking.
These missteps aren't fatal. The Fed's plump balance sheet can be pared back when growth starts. Last week's improvement in the gold/bond fear index provides an opportunity for the Fed and the administration to talk up the economy and put a bullish top on the price of gold.
Instead of locking in 2013 interest rates, as it has done, the Fed should reassure markets that sound monetary policy will produce lower gold prices and higher bond yields over time, an important step in restarting growth. The status quo -- piling trillions into foreign countries, gold, and idle Treasury bonds -- sucks capital away from growth. The Fed should put an end to it.

Falling Oil Prices: A Worrying Trend That May Be a Saving Grace

When oil prices start to decline, investors and economists get worried. Oil prices in large part reflect global sentiment towards our economic future – prosperous, growing economies need more oil while slumping, shrinking economies need less, and so the price of crude indicates whether the majority believes we are headed for good times or bad. That explains the worry – those worried investors and economists are using oil prices as an indicator, and falling prices indicate bad times ahead. But oil prices have to correct when economies slow down, or else high energy costs drag things down even further. And the current relationship between oil prices and global economic output is not pretty. In fact, every time the cost of oil relative to global production has hit current levels – and that’s after the sharp corrections earlier this month – an economic slump, if not a recession, has followed, according to a Reuters article. The “warning signal” that is currently flashing red is the Oil Expense Indicator, which is the share of oil expenses as a proportion of worldwide gross domestic product (specifically, it is oil price times oil consumption divided by world GDP). Since 1965, this indicator has averaged roughly 3% of GDP and has only exceeded 4.5% during three periods: in 1974; between 1979 and 1985; and in 2008. Each period saw severe global recessions. In 1973/‘74, the Arab oil embargo sent oil prices rocketing skywards in the world’s first “oil shock.” In 1979, a revolution in Iran knocked out much of that country’s oil output and catalyzed the world’s second oil shock. And, of course, in 2008 the housing bubble collided with speculative buying of new debt instruments and a commodities boom to propel oil prices to a record high of US$147 a barrel, which helped to trigger the global financial crisis and the worst slump since World War II. So where are we right now? Well, Brent crude prices would have to fall to the low US$90s per barrel for the Oil Expense Indicator to drop below 4.5%. Instead of that, Brent prices have been above US$100 per barrel for more than six months (aside from an intraday low of US$98.97 on August 9) and are still hovering between US$105 and US$110. Oil prices play a major role in global economic growth because oil is crucial to every part of the economy. It powers manufacturing as well as food and commodities production, it fuels transportation, and it is a building block for industries like plastics and electronics. When oil prices stay too high for too long, they choke out economic growth. Merrill Lynch analysts agree, writing in a recent note: “The last two times that energy as a share of global GDP neared … the current level, the world economy experienced severe crises: the double dip recession of the 1980s and the Great Recession of 2008.” So we face two options: oil prices come down sharply, or we enter a recession, which will drag oil prices down. Either way, crude has to get cheaper. That being said, remember that there are many forces at play in the oil markets, not the least of which is supply. At present the world’s most important supplier, Saudi Arabia, is pumping out more oil than it has for 30 years. In July the country produced 9.8 million barrels per day (bpd), lifting total OPEC production to 30.05 million bpd. If they want, the Saudis can exert considerable influence over prices by reducing supply. And they may want to do just that. Oil analysts generally agree the Saudis want to see oil prices remain above US$85; lower oil prices would impair the country’s ability to meet its spending obligations. Iran, Kuwait, and other OPEC countries similarly want to see oil prices remain strong, to meet their spending requirements. Current OPEC governor Mohammad Ali Khatibi, of Iran, recently said that the cartel’s members have not set a desired price level but some think US$80 to US$90 is appropriate, while others want prices to remain above US$100 a barrel. On top of that, no one is yet predicting a reduction in global oil demand. The International Energy Agency (IEA) reduced its forecast for demand growth, but still expects the world to consume 1.2 million more barrels of oil each day next year than this year. Similarly, OPEC reduced its demand growth estimate, but still foresees oil demand rising by more than 1 million barrels of oil a day over the next 12 months. So, oil prices will come down when the economy falls too, but if oil goes on a tailspin à la 2008, expect to see OPEC step up to the plate, tighten the market, and support prices, so that its members can continue to pay their bills.

Gold gained 12% in August in US dollars and Euros

Gold prices gained 12% in August in US dollars. In Euros, the gain was about the same, reflecting the very narrow  range in which these troubled currencies manage to trade in these troubled times.