Client Q&A on the Gold Surge Jude Wanniski, Michael Churchill and Michael Darda February 8, 2002

We have received numerous good questions on our  recent "Gold’s Surge, When Does It Stop? 2/5/02. We believe it would be valuable to share our responses, which appear below.

Q. Your “Gold’s Surge” report implied that a decrease in the demand for dollars would cause the fed funds rate to rise. I assume the process would go like this: "Given a constant supply of dollars, a decrease in the demand for dollars would cause the price of each dollar to rise, thereby causing the price of all goods and services denominated in dollars to fall."  I would think that the decrease in the demand for dollars would be analogous to a decrease in the demand for credit. Again, assuming a constant supply of credit, the price of each unit of credit (i.e., treasuries) would fall, tautologically causing yields to rise.  Is this the connection? 

A. The price of credit and the price of money are two different things. The price of credit is the interest rate. The price of money is its purchasing power against real goods. The Fed is targeting the former, the market determines the latter with the Fed`s clumsy interest-rate target a secondary or tertiary factor. The rise in the gold price, if it sticks, simply implies less deflation adjustment will need to occur than otherwise would have been the case (dollar prices FALLING to adjust to HIGHER value of the dollar). Treasuries should do well as long as gold does not move above $350 or so and the market does not price in more rate hikes.

The supply of Fed liabilities to the banking system under an interest-rate targeting paradigm is totally a function of the pressure on the overnight lending rate. This "pressure" is not the same as the market-wide demand for dollar liquidity, which can be moving in the opposite direction. In other words, inflations can occur against the backdrop of high and rising bank rates (U.S. in the 1970s, Brazil in 2001) and deflations can occur against the background of low and falling bank rates (Japan). In the U.S., deteriorating tax policy on the state level has created a situation in which the dollar money stock needs to do less work. This pushes against the deflation, but at the expense of more "contraction." Stepped up global political and financial risk also have made gold more attractive than liquidity at the margin, across currency areas. Lastly, with the market expecting the funds rate to rise and not fall any more in the near term, banks` demand for "reserves" rose following the Fed’s decision not to cut rate. This caused the Fed to add reserves to hit its 1.75% target on overnight loans. These things seem to be occurring simultaneously during recent weeks. MD

Q. In your “Gold Surge” report I understand why a decline in demand for dollar liquidity would cause gold to rise. However, I DO NOT understand the last sentence of the first paragraph regarding the Fed adding reserves in the context of the decline in dollar liquidity. Does it mean that velocity is rising?

A. System-wide global financial risk has risen because of global contraction and the fallout from Sept. 11. That increases velocity across currency areas, with actors liquidating currency balances for that asset that is most like "money" i.e.,the one that has established a constancy of value relative to usable goods over long stretches of time. This likely is an important reason for the gold spike, as it has occurred across currencies with heavy retail buying reported by the Japanese where the risk of a financial meltdown is rising. MD

Q. The argument in your Gold Surge report makes absolutely no sense to me and seems to contradict what you have been pleading for since I began reading your work. A rise in the the dollar price of gold which should be a signal that there is enough liquidity in the system to end deflation and sustain a recovery and the rise in the price of gold is pure evidence of that. The only potential risk to the recovery is an "Enronitis" related credit crunch.

A. We have argued from day one that there are two ways to end a deflation, one good and one bad. The bad way would be to add a contraction to the deflation in the form of a fiscal or political disturbance. The "terrorist tax" and deteriorating state and local fiscal policy are "negative disturbances." Both interfere with real and anticipated commerce, which means the existing money stock, either dollars, yen, euros, or pesos, has to do less work. This is not a "good" way to raise the gold price, for it simply implies less downward price-level adjustment in exchange for slower growth in output and profits. MD

The Enron debacle of course adds another layer of uncertainty to the current mix of political and economic risk. Enron and the accounting scandals are the flip side of the S&L scandals, which were inflation induced. They should persuade every thinking businessman that we simply cannot run the world with a floating unit of account, that there must be a gold anchor, somewhere above $325 and below $350/oz. The GAAP rules were changed at the turn of the century to reflect the deflation experience of the late 19th century, and they then had to be altered in the 1970s -- all that LIFO/FIFO business -- to reflect the inflation experience. It is becoming impossible for accounting firms to figure out all the stuff that goes on in the big banks. They have to take the word of the bankers that everything is fine, when it isn`t.. JW

Q. If gold goes to $325 -- even for "bad reasons" -- would you turn bullish on equities?

A. A good question and a complex one to answer. It is best addressed in pieces. We would be bullish on those raw commodities whose prices had not adjusted upward to meet the higher gold price. Whether we would be bullish on commodity stocks would depend on how much of the move each individual company already priced in. (For instance, when I analyzed Phelps Dodge in 11/01, it was pricing in close to 90 cents/lb copper, making it unattractive even though we thought the copper price likely would rise.)

For the bulk of sectors, we actually would remain bearish. Changes in the value of money work through the economy with an uneven time lag. We likely would find ourselves in a situation where pricing pressure would remain intense for most sectors for the near term. Don`t forget we also have foreign currency weakness to deal with, which is negative for firms that calculate earnings in dollars.  Two additional factors would leave us net-bearish: First, since most equity sectors have not really priced in much deflation to begin with (investment banks, advertising agencies, media, heavy equipment -- all are pricing in a rebound) a rise in gold to $325/oz. simply would make it a little more likely that consensus expectations would be met. Second, we cannot forget that the core reasons gold is rising (higher political risk, worsening tax policy, Japan risk) are indicative of negative fiscal and political factors at work in the real economy. These are legitimate negatives that would weigh on economic growth even if the dollar`s value fell. MC

Q. The news media has had many stories about a jump in productivity that began in 1995. Mr. Greenspan has attributed this to the application of computer technology. I don`t believe it. I believe that computer tech was the mechanism, not the fundamental cause. However, I am having trouble pinpointing the cause. The reduction in the capital gains tax would make sense, but timing doesn`t fit because the capital gains tax reduction occurred in 1997 when the rise in the trend rate of productivity apparently began in 1995 or so.

A. We have a confluence of factors that have driven the productivity jump since the mid 1990s. One is that Greenspan, for the first ten years of his tenure i.e., pre-deflation, watched the $/gold price closely as a guide to the dollar’s value. This helped him eliminate inflation, which brought great efficiencies -- "a real tax cut" to financial intermediation, risk taking, capital and labor. This is especially true for parts of our tax system that are un-indexed, such as the capital gains tax which always rises in an inflation and falls under stable money or deflation. The capgains cut of 1997 boosted after-tax returns to capital even more. In addition, you have to factor in the long-term effect of reducing the top marginal tax rate on labor to 40% from a prohibitive 70%. The lessening of the dual tax/inflation wedge increases the amount of both labor and capital offered in the marketplace. Productivity rises. Of course, the tech revolution has been a part of making all capital more efficient, too. The 3.5% rise in 4Q labor productivity, however, is a bit misleading. The 0.2% rise in 4Q GDP would have been -1.4% if we were to remove the big jump in government spending. Because payrolls were slashed at the same time that GDP went up, output/worker rose markedly. In other words, if payrolls or hours worked are falling faster than output, productivity rises, even if the economy is shrinking. MD