China and the future of Gold

Note: I am not an investment advisor and nothing I state should be taken as investment advice. Please consult your own private professional financial advisor for help in making investment decisions.

The whole world is talking about gold breaking $1,000 in price.

Many people are asking: is this price sustainable? Where will gold go from here?

I can't really answer these questions myself as I'm not an expert on gold or on precious metals in general. I will note that gold is not really an asset in the normal sense, it is quite simply a form of money. So the question of whether or not gold will go higher can also be framed as "Will the U.S. Dollar (or whatever the currency may be where you live) go lower/weaken?" If so, then the answer is likely yes, the price of gold will go higher vis-a-vis that currency.

We all know the U.S. Dollar (USD) is in the dumps. The Federal Reserve's "quantitative easing" policy and climbing federal deficits are working a one-two combo on the USD. This makes me think that the gold rally isn't unwarranted and that a "gold bubble" probably isn't in effect right now, contrary to what some pundits have postulated.

A lot of news about gold has been coming out of Asia as of late.

To begin with, an Internet publication related to the mining industry and precious metals (Mineweb) is reporting that China's state-run Central Television network has aired a news program extolling the benefits of investing in precious metals and seemingly advocating that the Chinese public engage in precious metals investing by promoting the Chinese mint's bullion products. [1] A recent Wall Street Journal article seems to confirm this news report. [2] Several websites are repeating rumors first published by an employee of SinoLatin Capital, a merchant bank which specializes in transactions between Chinese and Latin American firms, that China may attempt to ban the export of gold. [3] These are just rumors and the author mentions that his firm has several Chinese mining companies as clients, so make of that what you will. All of this comes on top of the admission earlier this year that the Chinese Central Bank has been purchasing gold in order to build up its reserves.

If you want to get an idea of what the "gold mania" in China is like at the layman's level, I suggest you read this article. [4] Apparently you can buy gold at most retail bank branches in China and the Chinese mint is opening shops from which to sell bullion in many cities.

Elsewhere in Asia, it was announced today that Pakistan is abolishing import duties on gold in order to encourage legal imports of gold and discourage black market imports. [5]

Now for the "but." In the past I've mentioned the possibility of a debt-fueled deflationary depression in the U.S. (see Debt Deflation and False Dawns) I thus have to bring to your attention this article which states that in a deflationary decline gold would not be a good hedge. [6] The article's authors make a convincing argument, especially if you're a fan of the gold standard and a critic of fiat currencies.

Regardless of what happens in the future, my judgment right now is as follows. We have to remember that the price of gold is notoriously volatile. The fact that gold is so strong right now and so many people are talking about investing in it reveals how little confidence there is in the current financial order and how much unease and uncertainty continues to exist out there. That's the only conclusion I can positively take away from this situation at the moment.

Sources:
1: http://www.mineweb.co.za/mineweb/view/mineweb/en/page33?oid=88452
2: http://online.wsj.com/article/SB125249222381695221.html
3: http://www.commodityonline.com/news/China-may-ban-export-of-gold-silver-21219-3-1.html
4: http://www.sovereignman.com/finance/gold-mania-in-china/#more-650
5: http://www.dailytimes.com.pk/default.asp?page=2009\09\18\story_18-9-2009_pg5_11
6: http://www.speculative-investor.com/new/article060902.html

The Japanese Obama?

Ambrose Evans-Pritchard, International Business Editor for the Telegraph, wrote an article on the Japanese fiscal situation at the beginning of this month.

The article informs us that, fiscally, Japan is in very dire straights. The article states that:
1. The IMF is expecting the Japanese budget deficit to top 10% of GDP this year (for some perspective, the U.S.'s deficit-to-GDP level will likely end up being around 12% this year).
2. Japan's Gross Public Debt will reach 215% of GDP in 2009, the highest in the world.
3. Corporate tax revenues are negative in Japan due to "a collapse in profits."
4. The Japanese savings rate has fallen from 14% in 1990 to 2% today.

Wow. My perspective? Its important to keep in mind that Japan has reached this point after nearly 2 decades of on-and-off (mostly on) deflationary decline, numerous corporate bailouts and several rounds of attempted fiscal stimulus. Even with all that effort expended, Japan is still experiencing record year-over-year deflation and it has accumulated alarming levels of debt (which, in turn, is alarming bond investors). The Japanese deflationary period is not exactly analogous to the U.S.'s current situation but, in some ways, its a better fit than the Great Depression of the 1930s is. If the stimulus ends up being incapable of resuscitating the economy people should definitely pause, take a look at the Japanese historical experience of the past 2 decades and ask ourselves what exactly happened there and how can we avoid the same fate? That's especially true if policy-makers begin pushing for a second major stimulus package or a string of more "Cash for Clunkers"-type subsidies.

So why'd I label in this post "The Japanese Obama"? Well, as we can see, while in some ways Japan is trending years ahead of us in regard to being in a debt-fueled slump, in other ways they're just catching up.

The Japanese just elected the Democratic Party of Japan (unseating the Liberal Democratic Party for only the second time in the post-war period). The DPJ brings with it Mr. Yukio Hatoyama as the new Prime Minister. Hatoyama and his party were partly elected on the promise of Obama-style social reform including, as Evans-Pritchard's article points out, $180 billion "for child allowances and social policy." The people of Japan have invested a lot of hope in the idea that the new blood of the DPJ will re-invigorate Japan. I think the changes to the savings rate tell us everything. Japanese culture emphasizes saving and frugality. Thats why the savings rate was at 14% in 1990. It didn't come down because the Japanese suddenly became rabid consumers. My supposition is that it came down primarily because people had to utilize their savings to "make ends meet" quite often. According to Evans-Pritchard, PM Hatoyama is already backing away from some of his social policy promises after realizing the costs involved.

A lot of attention is being focused on China. This is justified of course since China is the rising star on the global stage. However, we should still pay attention to the second biggest economy in the world. Considering our similar predicaments, we potentially have a lot to learn from their experience(s).

Read the article here: Bond vigilantes fret over Japan

Marc Faber Foresees Inflation

What lies in store for the American economy? Inflation or deflation? The financial world has been debating this question for a while now.

Famous investor Marc Faber spoke publicly on Wednesday (9/9/09) and reiterated his opinion that the U.S.'s extremely high deficit, near-zero interest rates and the Federal Reserve's quantitative easing policy will combine to spur inflation in the future.

Faber predicted the current stock market rally last October, when he advised his readers to invest in stocks again. Apparently Faber is still quite bullish on stocks but not because he has much faith in a recovery or in the current state of the economy. Quite the opposite, actually.

“Money printing will be unprecedented because the deficit will need to be financed,” Faber said. “The weaker the economy, the more the stock market will go up because the money that is being printed will go into” speculative assets.

The bold emphasis was added by me. I'm in complete agreement with Faber on this point. I argued that the stock market is not at all an accurate barometer of the nation's economic health in two of my previous posts (Nouriel Roubini and the Future of the Stock Market and Desperate Investors Embrace Risky Moves).

“If the dollar is weak, there is a very good chance that equity prices could rise quite substantially,” Faber said. A weaker dollar is “good for asset prices.”

Faber also recommended investing in precious metals and raw materials as a hedge against a weakening dollar.

Faber also challenged the idea that we're in the midst of the beginning of a recovery, pointing out the continuing weakness in consumption.

Read the entire article at Bloomberg news by clicking here: Faber Says ‘High’ U.S. Deficit Will Spur Inflation (Update1)

Note: I am not an investment adviser and this is not intended to be taken as investment advice.

So, whats your take? Whats the U.S. economy in store for? Inflation? Deflation? Is Faber right or wrong? Why? Make your case here.

Second Poll: Which is the bigger threat to the global economy? Deflation or Inflation?

For the second poll on this blog, I posed the following question to you readers: "Which is the the bigger threat to the global economy?" The options were (1) deflation and (2) inflation.

148 people voted.

The results were as follows ...

Deflation: 56 votes (37%)
Inflation: 92 (62%)

Its clear that a majority of my readers believe that inflation is currently the biggest threat to the global economy. Yet, a sizable number of readers (nearly 40%) thought deflation was the biggest threat. I'm glad to see that kind of diversity of opinion among my readers. My take? I'm still undecided. I know that sounds like a "cop-out" but its the truth, I see both inflationary pressure and deflationary pressure working on the economy right now. That's one of the reasons why I'm committed to continue covering this topic in the future.

If you voted in this poll (or even if you didn't) feel free to use the comments section attached to this thread to defend your opinion or your take on this question.

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For my next poll question I've decided to ask about the plan for nationalized healthcare in the U.S. Please vote!

Debt Deflation and False Dawns

There's a debate raging in the financial world right now over whether the biggest threat to the American economy's health is deflation or inflation.

Off to the top left of the screen you'll see a poll I put up asking that very question. Please vote, if you feel inclined.

Today, somebody linked me to a rather old article from January of this year. Its an interview of economist Dr. Lacy Hunt by the Business Spectator publication from Australia. You can find the article here.

Despite the fact that it was published over half a year ago, I felt strongly compelled to share this article with my readers because it presents a coherent, cogent argument that not only supports the case for deflation but, if true, puts the broader economic picture into sharper focus.

Dr. Hunt essentially argues that:

1. We are entering a period of deflation. Debt deflation to be exact. Other historical instances of debt deflation include (a) the U.S. during the 1870s-1880s, (b) the global Great Depression of the 1930s, and (c) Japan, beginning in 1988 and continuing until the present.

2. What pulled the U.S. out of its debt deflation during the Great Depression was its participation in World War II and not President Roosevelt's New Deal program. Furthermore, the Japanese have also run stimulus programs funded by large deficits over the past two decades which have led to minor, cyclical growth but which have been unable to shake off the stronger, overall deflationary trend.

3. Debt deflation lasts a long time. The deflationary period beginning after 1873 in the U.S. lasted approximately 20 years. The Japanese debt deflation that begin in 1988 is ongoing until today. As a side note, her argument is corroborated by a report from Friday which states that Japan experienced record year-over-year deflation of 2.2% in July. Click here to read a report on this development from Bloomberg. Hunt comments that in her view it is quite possible that we're entering a 15-year deflationary period right now.

4. The markets are very susceptible to what she calls "false dawns." I'll let her explain it:

Well, one of the things that has happened in these debt deflations is you get a number of false dawns. People believe that the normal business cycle is going to take control and you're going to get a cyclical recovery and the model that soon prevails is that you get three to 10 years of expansion. You have one year, maybe a year and a half of a recession or nasty economic conditions, but after a year and a half at most, the economy then has another expansion for 3 to 10 years.

When we have these very rare debt bubbles occurring at these long irregular intervals, the normal business cycle model doesn't really apply. We do get some false dawns. Some intermittent cyclical recoveries but the unwinding of the debt process proves to be very very long and difficult. One of the reasons for that is that borrowers don't know anything about paying back loans in harder times, which is what's now beginning to occur and as a consequence there is a major behavioural shift or there has been historically in which consumers decide to live inside of their means as opposed to living outside of their means and normally the saving rate goes up for a long time.

Keep in mind that this was published on January 30th of this year, when the Dow Jones Industrial Average closed at 8,000.86 points. Today (August 30th, 2009) the DJIA closed at 9544.20 points[1]. This backs up the argument I and others have made that the current rally is unsustainable. Nouriel Roubini refers to it as a "dead cat bounce" while Dr. Hunt refers to it as a "false dawn," but the premise is the same.

5. The government stimulus program is not working and actually may be making things worse. She states:

The most recent academic research that I have seen, published in 2008, indicates that the multiplier on government expenditure is just close to zero. If the government spends an additional dollar it has to fund that dollar either by raising taxes on the private sector or borrowing funds in the capital markets that would have gone to the private sector. Government spending, the government sector in the US, the productivity is at best zero and perhaps slightly negative, so when we enlarge the government sector and shrink the private sector we reduce the growth, potentiality, of the US economy. We shrink the pie and we make things worse off.

She thinks the TARP program could have gone another, alternative way:

The alternative, which the Japanese would have done and the better way to go, is to use the treasury borrowing capacity to protect the depositors and the customers of the banks and the insurance companies and perhaps extend unemployment benefits for their employees that are laid off. Zombie-like institutions intact with wholesale federal dollars, borrowed federal dollars – those institutions are really not able to grow or contribute to the economy. If instead we had protected the savers and the depositors, then institutions would have failed, but the healthy banks and insurance companies would have taken over the business of the institutions that made the mistakes and then we would have a growth trajectory going forward. So it's quite possible that the actions that we've taken and cost hundred of billions dollars, hundreds of billions of dollars have actually not helped the situation and may have had severe unintended negative consequences.

6. The U.S. trade deficit is narrowing and may be eliminated in the next few years.

She also has some advice for investors, but I'll let you visit the site and read for yourself. Overall, I thought Dr. Hunt presented one of the most compelling arguments in favor of deflation. She managed to fit her take on the current crisis into a coherent historical context and made some predictions that are strongly supported by the current financial data available.

Sources:

1: http://finance.yahoo.com/q/hp?s=^DJI&a=00&b=30&c=2009&d=07&e=30&f=2009&g=d

Deflation Danger

Most of the alternative financial media has focused on inflation as the primary danger for the American economy. The reasons are obvious. The Federal Reserve has released untold amounts of U.S. dollars into the economy through its "quantitative easing" program. On top of that, China and other economies are publicly expressing doubts about the dollar and indicating that they intend to lower their holdings of U.S. dollars, which would surely put inflationary pressure on the dollar.

However, over at Reuters, writer Christopher Swann argues that deflation is still a major danger to the U.S. economy.

First, the argument that deflation is benign:

A swelling dollar can clearly be good news for shoppers as well as for those who are sitting on cash. Deflation is often a result of economic progress — productivity improvements that increase spending power. This was the friendly species of deflation caused by surging Chinese output from the 1990s onwards.

Is this the case now? No.

The current variety of deflationary pressure is far less benign. It stems not from efficiency savings but rather from weak demand. Worse still, it is accompanied by record levels of debt.

Despite frantic efforts to pay off loans, household debt is still around 130 percent of disposable income. This was precisely the combination that Irving Fisher warned about in his celebrated 1933 article on debt deflation.

Under these conditions, the rising real value of debts encourages households and businesses to sell their assets to pay down loans. As fire sales reduce asset prices — stocks and property — real net worth declines further. Output and employment decline, accelerating the slide in prices.

To add to the pain, real interest rates increase whether central bankers like it or not, discouraging borrowing and promoting even more savings.

“The more debtors pay, the more they owe,” Fisher wrote, since “the liquidation of debts cannot keep up with the fall of prices which it causes.”

Swann's argument is compelling. Consumer demand is extremely low in historical terms and appears set to go even lower. However, we can't deny the monumental inflationary pressures that also exist. Swann has hit upon an important point, however: debt is still the primary obstacle to any significant economy recovery.

But with the U.S. economy clawing its way out of recession, surely the danger has passed? Not quite. Prices are the ultimate economic straggler.

In Japan, for example, the country only started to experience falling prices roughly three years after the start of the recession in 1991. Wages didn’t start to fall until 1997. The United States could still follow Japan’s lead.

Proponents of recovery should keep this in mind. The current U.S. recession already mirrors the Japanese "lost decade" in a variety of important ways. What Japan experienced was extremely protracted. We're only one or two years into this recession, depending on perspective. Claiming we're in recovery already is extremely premature, in my opinion, and this historical example supports that perspective.

Downward pressures on prices in the United States continue to intensify, according to the latest research by Capital Economics. Core inflation may have held at a respectable 1.5 percent, but this is deceptive. U.S. goods inflation has defied gravity in part because of hefty increases in tobacco taxes over the past six months. A 28 percent increase in tobacco prices from a year ago is adding one percent to core goods inflation, according to Paul Ashworth of Capital Economics.

“Without this, core inflation would already be matching the lows reached at the end of 2003,” he says. The tobacco effect will soon fade.

Services inflation, meanwhile, has been very weak. Here the key factor has been weak rental prices, which account for about 40 percent of the total core index. Unemployment and foreclosure will continue to put relentless downward pressure on rents. Already the rental vacancy rate is at a record 10.6 percent.

Interesting. I had no idea about tobacco prices keeping up core inflation. When it comes to the rental market, supply is keeping the vacancy rate up and prices down. Homes that individuals and banks are unable to sell are being transformed into rentals until the housing market turns around. Seeing as how there are untold numbers of foreclosed homes that are purposefully being kept off the market by banks at the moment, I foresee continued downward pressure on rental prices for the time being.

Related post: Deflation or Inflation?

Deflation or Inflation?

Nathan A. Martin writes the Economic Edge blog. Martin is the author of the 'Flight to Financial Freedom' book and is certainly a guy who knows what hes talking about when it comes to finance and the economy.

I bring his blog up for a reason. During this recession, the alternative and independent media has focused in on the idea that the outcome of this recession will be inflation, if not out-and-out hyperinflation like the Weimar Republic of Germany faced earlier this century. Much of this sentiment originates from the so-called Austrian School of economics. Dr. Ron Paul is one notable politician who has warned about the hazards of hyperinflation (and who I respect quite strongly).

Mr. Martin is also quite pessimistic about the future of the American, and world, economy, judging by his blog posts. However, he argues that, rather than inflation, the U.S. is about to enter a deflationary cycle. I don't really feel capable of answering this question, of predicting whether we'll face inflation or deflation, but I found his argument to be enlightening and educational nonetheless and really quite compelling. So I strongly urge you to visit his website and read his post, which you can find *here*.

Here is an excerpt from his post:

No, I’m not being over-dramatic. It is time to buckle the heck up. The resonant disconnect between reality and the pumping that is going on in the media and among supposed “experts” is at an all time historic, never been here before, Economic Mass Psychosis, HIGH.

To Quote John Kenneth Galbraith, “The majority is always wrong.” Right now the majority believe we are exiting the crisis. They are just plain old fashioned WRONG – again.

To prove my point, I’m going to show you the week in charts courtesy of the St. Louis Fed. This week, however, I’m issuing a WARNING. The evidence in these charts points to the beginning of a DEFLATIONARY SPIRAL. The PPI data comes out next week and will be a key piece of evidence in this regard. The results of a deflationary spiral will be UGLY if entered. You will see another round of deleveraging to go with locked credit markets. Equities will get hammered and the real cleansing of the economy will accelerate. This process will be PAINFUL but necessary to end the malinvestment. It will be the phase where more businesses who were hanging on HOPING for recovery will simply run out of cashflow to maintain operations. The same thing is necessary to cleanse a way over-bloated government and military.

The fallout will affect everyone. These charts are HISTORIC, they are NOT indicative of a short recession. As you view these charts, pay attention to the negative trends and look at them from a historic perspective. Many market callers are looking for immediate inflation due to the money pumping. I challenge them to point out inflation anywhere in these charts besides the money aggregates, which, by the way, are not growing at the rate they were. Those who look solely at the money aggregates are not seeing the destruction of credit which is very real and has hobbled the consumer. Never ending growth was a fantasy and is over for the time being, there is simply too much debt/credit in the system.

*Please* go over and read the rest of his post right now for the rest.