The Current Account and Gold Jude Wanniski January 12, 2005

Why would the price of gold shoot up $5 this morning on the news that the current account deficit topped $60 billion in November, a new record? Almost all Wall Street analysts will say it's because foreigners will get tired of selling us more stuff than they are buying from us and will unload dollars instead of piling them up at home in the form of Treasury bills and bonds: the dollar weakens against the euro, yen and other major currencies, and the price of gold goes up in sympathy.

This is nonsense, but it is spouted morning, noon and night on Bloomberg radio and on the thumbnail financial reports Americans hear on almost all radio stations throughout the country. The euro strengthens, they say, so it takes more dollars to buy gold. The real reason markets have reacted to the current-account number is because the Federal Reserve, which has a monopoly over the creation of dollar liquidity, tells us that it is very worried about it. This means it may have to continue to raise interest rates to slow the economy. Accordingly, we won't have to import as much from the rest of the world (ROW) as we did in November, and businesses and households will buy less of our stuff, the surplus being bought up by foreigners.

The market isn`t irrational. It is dutifully reacting to the misplaced warnings of the Fed. But we wonder if any of the Fed governors or regional presidents this morning noted that gold climbed $5, and correctly realized the market fear of the Fed not only sent the stock market down but also knocked down the value of the dollar in commodities and foreign exchange. We did e-mail all the FOMC members the open letter Paul Hoffmeister and I wrote Monday for their consideration and did get back some encouraging feedback that some are actually taking a peek at the gold price on a daily basis. In the recent minutes of FOMC meetings, the word 'gold' never appears, although hope springs eternal that someone will mention it at next month`s meeting. The stock market would love to climb and the economy would love to grow, but at any sign of exuberance, rational or not, the Fed worries that interest rates are too low.

Our classical model, as we remind our newer research clients, tells us that the daily exchange rate between the dollar and the euro is the intersection of that day`s errors by the Federal Reserve and the European Central Bank. The banks are supposed to be in the business of supplying the correct amount of liquidity to meet the demand in their currency realm. We can`t tell which central bank got it right yesterday simply by looking at the dollar/euro exchange rate. We have to look at the price of gold in each currency. If it didn`t budge in euros, we know the ECB got lucky yesterday (because it does not target gold directly). If gold went up in dollars, we know the Fed goofed, either by adding more liquidity than the market demanded, or by not draining surplus liquidity the market decided it did not want.

One of our clients asked last week if China's decision to slow its economy by raising interest rates or adding regulatory restraints on lending could cause the dollar price of gold to change. The answer is: Absolutely not. Because the People's Bank of China pegs the yuan at 8.2 to the dollar, it has to add or subtract yuan liquidity during the course of the business day to keep to the 8.2 peg. This also determines the yuan price of gold, which will always be 8.2 times the dollar/gold price. Does this mean China will grow as fast as the U.S. because of the peg? Certainly not. In our own monetary system there are 12 separate Federal Reserve districts that issue separate dollars. Even though each of the dollars circulated by the regional Feds will buy the same amount of gold, some parts of the U.S. are always growing slower and some faster than the other parts. This happens mainly because of local fiscal policies. California raises income tax rates and people move to Nevada. California growth slows and Nevada growth increases. The same thing occurs when two currency zones are linked together by a peg. China sees prices rising across all of its time zones and, worried about inflation, takes measures to slow the economy. But it has imported the inflation from the U.S., so all its measures to slow its domestic economy can only hold prices down by causing stress to people who are trying to build businesses and now find that`s harder to do. The net result is more bad debts in the state banks. It also means China will buy less from the ROW than it would otherwise, and it will have more of its own production pile up in surplus inventories. Its current account surplus grows, as a result, and because most of China's trade deficit is with the United States, our current account deficit increases, as it did in November.

If you think of this scenario, you will realize that when I said earlier that China absolutely couldn`t affect the dollar/gold price, I was right that only the Fed controls the dollar/gold price but I was wrong in the sense that China can affect what the Fed does in managing the dollar. Because the Fed has been telling everyone that it is concerned about the current account deficit, and might have to raise interest rates faster or longer to rein it in, China actually can cause the dollar/gold price to climb by shooting itself in the foot with higher interest rates or credit controls or higher taxes. In a few months, we would be told that the current account deficit now has topped $65 billion, and the dollar/gold price would shoot up another $5 due to the market`s anticipation of even more Fed rate increases. 

If China really wanted to fight domestic inflation, it would reverse direction on interest rates and credit controls, cut income-tax rates, and increase spending out of its giant dollar hoard to build national infrastructure at a greater rate, especially up-to-date nuclear power plants. Those measures would mean it would have to import more stuff from the ROW and export less of its domestic output. Its trade deficit with the U.S. would shrink and that would duly show up in our current account, which would drop back to the $50 billion range or less. The Fed members would eyeball those numbers and signal that maybe it wouldn`t have to raise interest rates anymore. The dollar/price of gold would fall, and because China is pegged to the dollar, the inflation it imports from the U.S. would decline. It would be another roundabout way for China to affect the Fed`s conduct, but this time in a way that helps to stabilize the dollar while, at the same time, helping to stabilize its own currency. It would be much easier for the Fed to use its monopoly powers to stabilize the dollar/gold price directly. Wouldn`t you say?