A Brief History…

Here is a piece about the price of gold and the future of the economy that has the ring of truth. Of course, I am a pessimist.

The rise in the gold price above $1,100 per ounce last week is a pretty good indicator that something has changed. For 18 months, the gold price had been in a trading range topping out around $1,000. It has now broken out decisively from that range. The opportunity for the world’s central banks to change policy and affect the economic outcome has been lost. The world economy is now locked on to an undeviating track towards another train wreck.

At most times, the gold price is not an economically significant indicator. In 1980-2000, it declined irregularly from $850 to around $280, and movements in it seemed to have had little or no effect on the global economy. That’s what you’d expect; even at $1,000 per ounce, the global production of gold is only around $100 billion annually, which would put the entire world’s gold extraction industry only 17th on the Fortune 500. When Gordon Brown sold Britain’s entire gold reserves in 1999, at a price below $300 per ounce, it seemed a defensible decision. I went to a meeting in 2001 hosted by a diverse group which believed that the U.S. Treasury was conspiring to suppress the gold price, and my main thought was: why would Treasury bother?

The decline was, I believe, an indicator that inflation, at great cost, had been wrung out of the economy for decades. I bought gold at $405 an ounce in 1978 and sold it six months later for $810. Thereafter, it slowly declined. When Bill Clinton was elected, I bought gold shares and they made a nice profit his first year in office. After 1994, I sold them and made about an 80% profit on the deal. A few years ago, when gold had been slumping along around $300, I thought about buying again. I wish I had.

However, in relatively few periods, gold becomes of immense importance. When investors lose trust in conventional currencies, because monetary policy appears set to debauch them, gold is the immediately available safe haven. During such periods, gold’s former importance as a store of value becomes uppermost in the public mind, and its price becomes a major economic indicator.

Gold became important from about July 1978 to early 1980, during which period its price rose from $185 to $850 per ounce. For that 18 month period, the price of gold was the most important factor in day-to-day market fluctuations. The gold price, more than the inflation rate directly, moved markets and by extension moved monetary and to some extent fiscal policy in the major economies. Only after Paul Volcker took over at the Fed in late 1979 did M3 money supply begin to supplant it in investors’ analyses.

We now appear to be at the beginning of another such period.

I agree and am very worried about the future. Obama seems locked in a leftist ideology that nothing can change. He has no experience in the world, academia and “community organizers” being sheltered from reality. I wonder sometimes about his progress from college student to Senator and tend to be a bit paranoid about it. He really is a mystery man.

Ben Bernanke’s Fed is ignoring this. It insists that it will maintain interest rates at the current near-zero level for an extended period, regardless of what the gold price does. By this, it is ensuring that the present bubble in gold and commodities will play out to its full extent. Had the Fed begun to tighten gently during the late spring or early summer, when it had become obvious that the U.S. economy was bottoming out, but while stock markets remained subdued and gold remained within its 2008-09 trading range, it’s possible that it could have deflated the incipient bubble, steering the U.S. and global economies back on to a sustainable growth path. The U.S. Treasury would have had to cooperate by beginning to reduce the federal deficit, but at this stage with unemployment in the 10% range, there would have been no need for draconian action on that front.

With current Fed policy, gold is headed rapidly toward $2,000 per ounce, probably within six months. The forecasters who see such a price, but suggest it would take four to five years to get there, are ignoring history. Since gold was able to get from $185 to $850 in 18 months in 1978-80, there is no reason why it cannot get from $1,100 to $2,000 in six months now. What’s more, although 1980’s peak seemed madness at the time, and was equivalent to nearly $2,400 today, there is no reason why gold cannot go much higher if it is given another year or so to get there.

If I had a store of liquid funds available, I would buy gold now, even at $1100. Instead I have two houses and a child in college so my options are limited. Houses, even with mortgages, are probably better to hold than dollars for the next few years but they are not very liquid. I remember very well the survivalist mentality of the late 70s when people were stocking up dried food and other supplies for a period of unrest. If we get to 15% unemployment, and I think we will, those lessons may need to be learned again.

We only thought that Carter was the worst president ever. Who knew that the lesson would have to be learned again?

Read the rest of that piece. Here is another segment:

At some point, probably before the end of 2010, the bubble will burst. The deflationary effect on the U.S. economy of $150 plus oil will overwhelm the modest forces of genuine economic expansion. The Treasury bond market will collapse, overwhelmed by the weight of deficit financing. Once again, the banking system will be in deep trouble. The industrial sector, beyond the largest and most liquid companies and the extractive industries, will in any case have remained in recession – it is notable that, in spite of the Fed’s frenzy of activity, bank lending has fallen $600 billion in the last year. Unemployment, which will probably enter the second downturn at around current levels, will spike further upwards. The dollar will probably not collapse, but only because it will have been declining inexorably in the intervening year, to give a euro value of $2 and a yen value of 60 to 65 yen to the dollar.

In the next downturn, the Fed will not be able to cut interest rates, because inflation will be spiraling, as in 1980. Instead it will need to raise them while dealing with a profound crisis in the bond markets. Capital in the U.S. will become still more difficult to come by, and unemployment will approach 15%.

Maybe another 1994 Congressional turnover will save us but I think it may be too late.

UPDATE: We are now learning that some of the actions taken last year were unnecessary, which makes us wonder why they were taken.

In the fall of 2008 the New York Fed drove a baby-soft bargain with AIG’s credit-default-swap counterparties. The Fed’s taxpayer-funded vehicle, Maiden Lane III, bought out the counterparties’ mortgage-backed securities at 100 cents on the dollar, effectively canceling out the CDS contracts. This was miles above what those assets could have fetched in the market at that time, if they could have been sold at all.

The New York Fed president at the time was none other than Timothy Geithner, the current Treasury Secretary, and Mr. Geithner now tells Mr. Barofsky that in deciding to make the counterparties whole, “the financial condition of the counterparties was not a relevant factor.“

Whaaat ??? Read the rest.

UPDATE # 2: The story of TARP and it isn’t pretty.

Tags: economy, energy policy, Obama, politics

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