Dear Reader,

Red Ink,  Animal Spirits and the Price of Gold

Today's Newsletter is authored by John Katz - Co-Author:  The Goldwatcher.

John Katz is an analyst, strategist and financial writer based in London, U.K.  To gain experience and qualifications in the Financial Services Industry he first completed the necessary exams to qualify as an approved Securities Dealer and Trader. While working for a London based hedge fund he was accredited by the United Kingdom Regulatory Authorities. He has contributed articles to the financial press, commentated for business television, and is the author of Portfolio 2001 - How to Invest in the World's Best Companies, Random House Business Books, 1999.  John was co-author with Frank Holmes of The Goldwatcher: Demystifying Gold Investing, John Wiley & Sons, 2008.  He is also writes  The Goldwatcher blog www.thegoldwatcher.com

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'Conventional Wisdom' on gold prices:

Gold was on course to breaching the magical $1000 threshold again at the end of May when Goldman Sachs published a Research Note 'The US Dollar - As Good as Gold.' The report set out  why at current prices they were not recommending gold . Unsurprisingly the gold price retreated  within days of the research being published falling from $975 on May 29th  to  $919 on 22nd June. I say 'unsurprisingly' not because Goldman's Wall Street consensus analysis was specially insightful or revealing. Rather,  because packs of speculators and all to often also investors  get carried away when they scent blood in the air.  Then,  when they hear a warning shot,  they panic.
 
The 'Dollar As Good As Gold Report' concluded: 'With the average cost of production estimated at $500 per ounce, the marginal cost of demand at $700 per ounce and no shortage of gold for real long term use, a price of $950 seems enough to provide mining companies with very attractive returns on their capital.'  The analysts  added 'if worries about the debasement of paper currencies persist, or any signs of inflation appear, the demand for additional gold could push prices above $1,250. Between March 1973 and August 1975, the moving 3-year average of year-on-year inflation was 10% and gold rallied 27%. Between May 1978 and November 1981, when inflation measured 12% per annum, gold rallied 47%. So clearly, unanticipated inflation is favourable for gold prices.'
As they didn't expect either inflation shocks or that the dollar would  will be debased by lax monetary policy when global economies recovered Goldman were not recommending gold.  They noted, however, 'just like crude oil in mid-2008, if enough people worry about the dollar and inflation, momentum can carry gold to much higher levels beyond any measure of fair value.'

Though not everyone will agree  gold production cost is as low as $500 an ounce  Goldman's arguments were in line with a general Wall Street consensus on gold and with 'conventional wisdom.'  We all generally  expect gold to perform well when inflationary pressures build up. The statistics quoted above confirm this view. However contrarians and out of the box thinkers won't be impressed by analysis that doesn't address deflation.  Many among them, including the writer of this article, see both deflation and global overcapacity  as  menaces  to the global economy.

We all have a pretty good understanding of the effects of inflation. But most of us know literally nothing about deflation and that's only to be expected. It's three quarters of a century since the deflation associated with the Great Depression.  Other than knowing  that since the 1980s Japan has endured a multi decade deflation experience most people aren't familiar with the causes and effects of deflation,  don't know when there is a real danger of deflation or understand why gold is ultra important when there is a chance of deflation.

Leading economists, including Nobel Laureate Dr Paul Krugman are questioning old views on Japan and warning 'we may or may not be about to face our own lost decade, but the sheer misery millions of Americans will face in the near future probably exceeds anything that happened in Japan during the 90s.'

Gold, deflation and capital preservation:

The comments that follow are from an exceptionally thorough, well informed and insightful article written in 1986 by Dr. Sam Hewitt, founder of Sun Valley Gold Company. The essential message from the analysis is  the 'conventional wisdom' that because gold performed badly during recent decades in a period of  disinflation it will do even worse during deflation is flawed. The lesson from history is that currency hoarding is a common feature in deflationary episodes and 'the interaction between declining credit quality and currency hoarding is key to understanding the role of gold as an alternative currency.  Each historical episode of deflation confirms that whenever confidence has declined in the issuer of paper currency gold was favoured over paper currency as a capital preservation asset.'

Deflation is defined in the Sun Valley report as : 'Falling levels in economic activity and falling price levels on an absolute basis. Contraction of economic activity is generally preceded by an unsustainable boom period and usually kicked off by an event which causes economic confidence to be lost. Characteristic of most deflationary periods are deteriorating credit quality and  the shift by investors from capital growth to capital preservation.  Deflations typically end after crisis conditions force policymakers to enact large-scale inflationary policies designed to counteract deflationary conditions.'

Reading the definition of deflation its tempting to say the current financial crisis is a poster child for the unsustainable boom,  loss of confidence and the associated poor credit quality that follows. But that's only half what needs to said. The current crisis is also a crisis of solvency at all levels from State to household.  Further,  policymakers have made a global commitment to do whatever is necessary to restore economic growth.  In attempts to reflate economies trillions of dollars have already been committed to supporting liquidity, bailing out banks and industries. Yet the world is still faced with overcapacity and solvency crises.  The State of California's inability  to meet its commitments reflects the solvency crisis at state level. The General Motors and Chrysler bailouts reflect industry examples. We are on the second anniversary of the global financial crisis and have to question why the reflating formula hasn't worked. The answer appears to be excessive credit fed the unsustainable boom,  lax regulation made it possible and financial leverage is amplifying the consequences.

Putting Humpty Dumpty together again:

To describe the global financial collapse commentators have used the analogy of Humpty Dumpty's fall and have been questioning whether he can be put together again.  A Goldwatcher blog "Has Bernanke whizzed the Humpty Dumpty economy into a Hunky-Dory economy? dates back to March 2008.

How little we  knew about Humpty then! In their recently published book 'Animal Spirits' the celebrated economists Nobel Laureate Dr. George Akerlof and Dr. Robert Shiller inform us Humpty's misfortune hails from a time before  children's story books were illustrated. This explains why over the years we have forgotten  Humpty was an egg. So, the authors conclude, 'all the King's horses and all the King's men could not put him back together again.'  And, they add (emphasis mine) 'that tale well describes the current financial crisis.' Out of the box analysis in their book 'Animal Spirits,' discussed later in this article,  contributes to a better understanding of the crisis and  suggests innovative solutions.

Also discussed in The Goldwatcher is Nobel prize winner  Paul Krugman's comment on prospects for a dollar plunge resembling the bad tempered  road runner cartoon character Wile E Coyote at the moment  he stepped over the edge of a  cliff with his legs flailing in thin air and realized, alas  too late,  he was about to plunge into a chasm.

Dr. Krugman concluded if creditors find they had been myopic there may yet be a Wile E Coyote moment for the dollar. Ironically,  it wasn't the dollar that faced a Wile  E Coyote moment when the financial crisis hit. It was the global economy. And,  as the crisis developed,  the dollar has remained in demand as a perceived safe haven.
 
 Debtor creditor imbalances  between the U.S., China and other dollar surplus countries  are often  cited as a root cause of global economic instability. In whitewashing President George W. Bush's borrowing binge Fed Chairman  Ben Bernanke made the case that a global savings glut had literally foisted  trillions of dollars of cheap money on U.S. consumers.  Indeed, as cheerleader for the global savings glut theory  Bernanke  may have been the most myopic of all concerned parties.   Commenting on his whitewash  The Goldwatcher quoted  the well respected investment banker and economist Donald Coxe's acerbic comment  that  it was really a case of a  global savings glutton gobbling up the savings of the rest of the world.  In any event the global savings glut story is now history. Harvard Professor Jeffrey Frankel, authoritative on currency issues,  sees the global saving glut issue as stone dead. In a recent paper on Global Currencies prepared for Central Banks. Frankel writes  'Regardless who is right about the last 8 years  over the next 8 years national saving will fall globally.   In the short run, governments are responding to the most severe recession in 70 years by increasing their budget deficits.  In the long run, the spending needs created by the increased retired population and rising medical costs will continue to reduce saving, both public and private.  In response, long-term real interest rates should rise, from the recent low levels.'  
 
Contrarian and out of the box thinking:

While Bernanke and others were hyping the global savings glut and other patently flawed theories contrarians and other out of the box thinkers were anticipating and warning of a pending  crisis. In his  book Debt and Delusion,  published in 1999,  a British economist Dr Peter Warburton  made the case that central bankers were so obsessed with rooting out inflation they only looked at credit statistics relating to  banks -  ignoring the enormous,  burgeoning and largely unregulated credit explosion taking place in what we now call the 'shadow banking' system.  As a consequence in the boom years linkages between reported expansion of credit in the major Western economies  and real world money were grossly understated and misleading. Further the impressive reduction in inflation reported was an illusion 'obtained largely by substituting one set of serious problems for another.' The effect was tipping economies into over capacity and deflation.

Warning now of an imminent return to inflation Warburton is  again running contrary to the consensus view that a global excess capacity glut and deflationary pressures will keep inflation at bay.  He accepts consumers can expect to be the beneficiary of inventory liquidation for an extended period of time. But  lean inventories and 'the fracturing of the supply chain mean that obtaining products will become not only more difficult  but also more expensive.'  It's worth remembering that when Chrysler & G.M. sought  bailout  taxpayer funds among the most compelling reasons for  support  were repercussions that would follow  for the industry's component supply chain if they went out of business. Even Ford,  still able to survive without government support, informed Congress if G.M. or Chrysler went our of business they would be vulnerable to supply interruptions and would also require government support.  Foreign  owned auto manufacturers in the US were  in the same boat.

Auto component suppliers remain vulnerable as, apart from dire conditions in the industry,  they have been obliged to accept an expanded role in the supply chain involving  finance for just in time manufacturing programmes and associated customer support obligations.

The message from Dr Warburton's analysis is a Keynsian focus on the consumer will not be sufficient for economic revival. The supply chain can't be ignored. If it's broken the economics of the industry will be affected and prices are likely to rise.

In spite of a cash for clunkers scheme introduced to support  car sales in the U.K. manufacturers put their prices up. Many, including  Ford have already increased prices twice this year  It's unlikely now auto prices will ever be as low as they were over the last few years. So, while there is a strong case to make that deflationary pressures will keep inflation tame, there are also instances where  inflationary pressures will prevail.

Animal Spirits, credit and unemployment:

The phrase 'animal spirits' was introduced into the economics lexicon by Lord Maynard Keynes who recognised people are not always rational in their financial decisions. They also act following their animal spirits - ' a spontaneous urge to action rather than inaction... our innate urge to activity that makes the wheel go round.'  In their book 'Animal Spirits' mentioned above  Akerlof and Shiller approach macroeconomics from the perspective of human behaviour and find conventional macroeconomists failed to anticipate and prevent the financial crisis because they ignored essential behavioural characteristics. These  include confidence, fairness, concerns over corruption, bad faith, and money illusions.  I can add with some satisfaction that the chapter in The Goldwatcher addressing  gold prices starts with a quote from Lord Keynes on animal spirits followed by the sub heading 'Introduction : A crisis of Confidence.' Not only do Akerlof and Shiller  make a convincing case for the imperative to restore confidence but they also find confidence and lack of confidence have multiplier effects.

Bantering with the phrase animal spirits in a book  addressing economics and behaviour  makes for some entertaining reading and also for some confusion. But the key conclusions Akerlof and Shiller reach are substantial contributions to improving monetary policy. They identify the credit crunch as 'the overwhelming threat to the current economy, and argue 'it will be difficult and perhaps even impossible to achieve the goal of full employment if credit falls considerably below its normal levels.' To bridge the gap they propose a credit target for policy makers and note 'achieving the credit target is urgent for several reasons. Most pressing is that  firms that count on outside finance will go bankrupt if they can not obtain credit and, if the credit crunch continues and many firms go bankrupt, it would take an impossibly large fiscal and monetary stimulus to achieve full employment.'  Akerlof and Shiller approach issues of credit and unemployment from a different perspective to Dr. Warburton but their conclusions aren't far apart.  Talk of green shoots in the economy isn't convincing while unemployment is rising and while firms that can't access credit are going our of business.

Nouriel Roubini's red alert:

 Dr. Nouriel Roubini,  the economist who has most consistently identified the causes and evolution of the financial and economic crises has written that while he sees light at the end of the tunnel with the U.S.  and global recessions over by late 2009 he also forecasts an anaemic and vulnerable recovery with a peak unemployment rate of close to 11% in 2010. Such a large unemployment rate he notes will have negative effects on labour,  income,  consumption and growth; will postpone the bottoming out of the housing sector; will lead to larger defaults and losses on bank loans (residential and commercial mortgages, credit cards, auto loans, leveraged loans); will increase the size of the budget deficit (even before any additional stimulus is implemented); and will increase protectionist pressures.'

A vulnerable dollar:

Against this background of uncertainty and doubt gold has already made a comeback in  central bank reserves. This is after years when its retention in their vaults was often seen as pointless. The revived interest in gold is, of course,  because of concerns over the stability of fiat currencies.

David Rosenburg, former Chief Economist for Merrill Lynch and now chief economist and strategist with Gluskin Sheff & Associates,  comments the US dollar ".. is the only policy tool that has not budged one iota since the crisis erupted two years ago. But we are sure that as the unemployment rate makes new highs and increasingly poses a political hurdle in a mid-term election year, it would make perfect sense for a country that always operates in its best interest - even if it may not be in everyone's best interest - to sanction a US dollar devaluation as a means to stimulate the domestic economy."  With  downside potential for the dollar he suggests investors protect their portfolios from the consequences of a declining dollar with a range of investments investments including gold.

David Rosenberg's analysis is consistent with the view that to escape the consequences of unsustainable booms policy makers are prone to take whatever steps they can  to revive economic growth  -  even if they devalue  their currencies in the process. Gold attracts again as an investment that retains purchasing power regardless of manipulations eroding the value of fiat currencies.'
Reports from national mints and gold dealers in all major centers confirm that physical gold is in short supply and the reasons why are obvious. Currencies are vulnerable to debasement and when confidence declines in the issuers of paper currency gold is favoured  as a capital preservation asset.

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The views expressed in this Newsletter are those of the author(s).  They are offered to readers for information and general guidance only. Nothing in this Newsletter is intended, and should not be taken, to constitute economic or investment advice.

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Copyright 2009, John Katz and Stock Research DD Inc.  All rights reserved. This article is protected by copyright and other intellectual property laws and may not be reproduced, rewritten, distributed, re-disseminated, transmitted, displayed, published or broadcast, directly or indirectly, in any medium without the prior written permission of John Katz or Stock Research DD Inc.