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Ben Bernanke's Gold Puzzle - Outside View
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Ben Bernanke's Gold Puzzle
Jun 18, 2010

Ben Bernanke, the current Chairman of the United States Federal Reserve, said he was 'mystified' about the recent rise in Gold. He said that he couldn't make any sense out of the rise in the gold price, because with the prices of most other commodities in declining trends there is obviously no "inflation" threat. With realization that he's out of ammunition, the strategy is to launch a direct attack on gold. Rising gold prices are the biggest testament of the fact that the paper currencies are being devalued. People have been slowly waking up to this debasement of fiat currencies and shifting to the real monetary asset - gold. Gold remains the sole option because in the complete pack of currencies, everyone's the same. Rather, at this point of time, with the problems being highlighted in the European Union, the dollar seems to be the least ugly (just on a relative basis). Politically speaking, gold is the only opposition to the dollar's victory, no matter how unjust they may be in driving their economic and monetary policies.

Chart: Is the Fed running out of ammunition
Source data: Bloomberg

In the attached chart, the amber line represents monetization of securities and blue line represents S&P 500. It can be seen that recovery as measured by rising stock markets moved hand in hand with monetization. Now, with the end to the QE policy, even the markets have turned lower.

The above chart was first sighted in an article by Mr. James Turk in Free Gold Money Report

Bernanke further adds "There is a great deal of uncertainty and anxiety in the financial markets right now," "Some people believe that holding gold will be a hedge against the fact that they view many other investments being risky and hard to predict at this point."

Bernanke can certainly point to current inflation numbers and insist that buyers of gold are simply "uncertain and anxious." Indeed, the short term trends are uncertain and that is on account of central banks powers to shape things in the short term by generating excess liquidity and launch stimulus programs to make things look better. What is of essence here is that people are becoming more certain about the long term effects of this central bank jugglery to postpone the pain using their magic wand to printing money.

People have recognized central banks tendency to resort to print money in order to solve any and all problems. Going by reaction to Europe's debt crisis, there's a shift of money on any signs of currency debasement. Bernanke seems to have realized that it would indeed be difficult for more stimulus and quantitative easing in current scenario if the economy shows signs of slowing. With Europe's problems, money was moving to the refuge of dollar and gold. If the problems get highlighted in the US, then, to quote Bill Bonner, the founder of Agora Finance LLC, "Gold remains the last man standing."

What lies ahead?

Let us first analyse as to what steps have been taken by the policymakers and what drives their decision making. Keeping in mind what we have discussed above and to get a better picture; below given are a few excerpts from the speech made by Bernanke in 2002. (below given text in Italics is an excerpt from the speech).

Bernanke’s speech in 2002 In sync with what’s happening today
Deflation is in almost all cases a side effect of a collapse of aggregate demand--a drop in spending so severe that producers must cut prices on an ongoing basis in order to find buyers This is what was seen in the midst of the financial crisis in 2008
Likewise, the economic effects of a deflationary episode, for the most part, are similar to those of any other sharp decline in aggregate spending--namely, recession, rising unemployment, and financial stress. World economies saw recession and are still in a nascent recovery at best. There is still high unemployment in the developed world.
Deflation of sufficient magnitude may result in the nominal interest rate declining to zero or very close to zero. Deflation great enough to bring the nominal interest rate close to zero poses special problems for the economy and for policy.  
Beyond its adverse effects in financial markets and on borrowers, the zero bound on the nominal interest rate raises another concern--the limitation that it places on conventional monetary policy. When the short-term interest rate hits zero, the central bank can no longer ease policy by lowering its usual interest-rate target. Interest rates in the US fell to zero and are still lingering at those levels.
Fed would take whatever means necessary to prevent significant deflation in the United States The bail outs, stimulus packages, asset purchases and quantitative easing...and quantitative easing...
The central bank's inability to use its traditional methods may complicate the policymaking process and introduce uncertainty in the size and timing of the economy's response to policy actions. It is expected that there would be increased anxiety and uncertainty and people are flocking to gold on realization of the long term implications of poor policy making...
Because central banks conventionally conduct monetary policy by manipulating the short-term nominal interest rate, some observers have concluded that when that key rate stands at or near zero, the central bank has "run out of ammunition"--that is, it no longer has the power to expand aggregate demand and hence economic activity.  

What are they doing and what to expect further?

Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.

The conclusion that deflation is always reversible under a fiat money system follows from basic economic reasoning. If we do fall into deflation, however, we can take comfort that the logic of the printing press example must assert itself, and sufficient injections of money will ultimately always reverse a deflation.

Therefore, on any signs of slowing growth, the printing presses would be working nights and there would be more stimulus programs and money pumped in an effort to get economy on track, which may worsen the problem at hand in the long run.

Solving Bernanke's ambiguity in his own words…

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

Bernanke should avoid speculating on the fundamental reasons for gold's rising popularity: the prime reason why more and more people are turning to gold is the fear about government's solvency and dwindling faith in the financial system. Given the scenario of rising deficits, unsustainable debts and large unfunded liabilities, many Western governments can only afford to pay their tremendous loads of debt only by printing money. The impact may not be felt in the immediate future, but somewhere down the line, the world will be flooded with massive amounts of paper currency. This is always an available option in a world of near-zero interest rates, as he admits.

To sum up, paper currencies are unsteady; the Euro has taken a beating in the past thanks to the Greek crises, thereby artificially improving the standing of the dollar. However gold's bull run is bound to continue as it is the only currency unit that cannot be printed at will and is thus back to becoming the only 'real' monetary asset.

So continue to invest in gold as an 'insurance policy' for your portfolio.

The Golden Truth is authored by Chirag Mehta. Chirag is Fund Manager - Commodities at Quantum Mutual Fund. Views expressed in this article are entirely those of the author and should not be regarded as views of Quantum Mutual Fund, Quantum Asset Management Company Private Limited and Equitymaster. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. Equitymaster has not verified the facts contained in this column and it does not accept any responsibility for the same. Please read the detailed Terms of Use of the web site.

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