Among the many opinions expressed by billionaire investor George
Soros over the course of the 2010 World Economic Forum in Davos,
Switzerland was his statement on January 28 in an
interview with Maria Bartiromo, host of
CNBC's Closing Bell, that
"When
interest rates are low we have conditions for asset bubbles to develop,
and they are developing at the moment. The ultimate asset bubble is
gold." New York spot gold closed at $1085.40 down $1.80, but the
price of gold is not as much about gold as it is about the value of
currencies, particularly the US dollar.
Since new currency is created through lending activity, very low or 0%
US interest rates and government deficit spending are fueling a US
dollar carry trade and monetary inflation in the US dollar resulting in
rising asset prices and global speculation.
According to Zhu Min, deputy governor of the People’s Bank of China,
“[The US dollar carry trade] is a massive issue; estimates are that it
is $1.5 trillion, which is much bigger than Japan’s carry trade.” The
close relationship of global commodity prices, particularly the gold
price, to the value of the US dollar can be seen by comparing the
changing value of the US Dollar Index to an inverted US dollar spot
gold price chart.
The inverted gold price chart follows the USDX closely and while
the fluctuations are not strictly proportional the overall trends as
well as the peaks and troughs generally correspond, thus the asset
price bubbles noted by Mr. Soros are reflections in asset prices of
both the US dollar carry trade (the effective value of the US dollar)
and, ultimately, of the long-term devaluation of the US dollar, thus
the value of the US dollar in real terms.
An “ultimate bubble” in gold could be an offspring of the
mother of all carry trades,
but its magnitude would depend not only on the effective value and rate
of change in value of the US dollar while the carry trade is booming,
but also on the actual, eventual value of the US dollar (in real terms)
after the carry trade has come to an end. Although the value of the US
dollar will certainly recover to some degree when the carry trade ends,
it will remain significantly lower in value for other reasons.
US Dollar DevaluationIn the above mentioned interview, Mr. Soros went on to say that "Some
countries, like the US and European countries have plenty of room to
increase their deficits; [although] the political resistance to doing
so increases the chances of a double dip [recession] in the [global]
economy in 2011 and after that." Since further monetary inflation
as a consequence of government deficit spending may be necessary to
maintain economic stimulus measures and financial system life support,
Mr. Soros anticipates further devaluation of the US dollar. Devaluation
of the US dollar will have both beneficial and harmful effects on the
US economy.
Devaluation of the US dollar will reduce the value of debts in real
terms, reducing the overall debt to GDP ratio of the US economy, and
stimulate nominal GDP growth as domestic prices and wages (at different
rates) adjust to the altered value of the US dollar, while at the same
time helping to create conditions where US banks can resume lending to
consumers and small businesses. Unfortunately, currency devaluation
also has deleterious effects, such as higher prices, a loss in the
value of savings and a reduction in the real value of wages. There is
also a risk of uncontrolled domestic price inflation (although prices
can be held in check without raising interest rates by curtailing the
flow of money and credit to consumers and small businesses).
In addition to reducing the US debt to GDP ratio, devaluation of
the US dollar will lessen the risk of higher interest rates resulting
in greater deficit spending by the US government as a consequence of
increased debt service (
$145.4 billion in fiscal 2009)
since it will allow the US federal government’s tax receipts to grow
faster than the increase in debt service resulting from higher interest
rates.
Currently projected US federal government borrowing (or, alternatively,
quantitative easing) will maintain downward pressure on the value of
the US dollar through the year 2019. According to the US Office of
Management and Budget’s (OMB) baseline projection of current policy,
federal deficits will total between $7 and $9 trillion for fiscal 2010
through fiscal 2019 and the US public debt will grow from
$12.3 trillion to more than
$16 trillion in 2019. Other estimates indicate that US federal government debt will exceed $18 trillion in 2019, setting aside the net
present value of unfunded federal liabilities based on Generally
Accepted Accounting Principles (GAAP). According to David M. Walker,
former Comptroller General of the United States from 1998 to 2008 and
current President and CEO of the Peter G. Peterson Foundation,
current federal liabilities and unfunded obligations total approximately $63 trillion. As a result, further devaluation of the US dollar is inevitable.
Disparate US Dollar ValuesCuriously, the US dollar has two different and diverging values,
one within the US financial system and another in the broad US
economy. As a result of the US financial system rescue, which included
purchases of various assets from banks at book value by the US Treasury
and Federal Reserve, the US monetary base has expanded roughly 150%
since the beginning of the global financial crisis in 2008, but the
newly created currency has not filtered into the broad US economy
where, in contrast, deflationary pressures persist.
Although it is not apparent in the broad US economy, the value of
the US dollar has been dramatically altered and its devaluation cannot
be isolated indefinitely within the financial system independent of the
broad US economy. The counterbalancing, but much smaller, contraction
of the broad US money supply, as measured by
the M3 monetary aggregate, also cannot continue indefinitely.
At some point, the two disparate values of the US dollar (that
found within the financial system versus that found in the broad US
economy) will be reconciled and, unless current policies are reversed,
the outcome will be a substantially less valuable US dollar. The
consequences of the eventual reconciliation will certainly include
price inflation in the US, higher US dollar prices for commodities that
are subject to global demand, such as oil and gold, as well as higher
nominal values for US dollar denominated assets. However, the potential
unintended consequences of a falling US dollar include high domestic
price inflation, a further reduction in international demand for US
debt or a collapse in demand, a disruptive decline in trade, i.e., US
imports, or in the worst case, rejection of the US dollar as the world
reserve currency or a hyperinflationary collapse of the US dollar.
Is Gold in an Asset Price Bubble?
Diversification for the purposes of risk mitigation and wealth
preservation is a rational response to unstable market conditions and
is not comparable to a market mania, like the dot-com
bubble. Similarly, a long-term shift in asset allocation favoring one
general category of assets over another based on fundamentals, while it
may result in rising prices, does not by itself describe an asset price
bubble.
An asset price bubble, such as the
Dutch tulip mania of the 1630s,
is an irrational and economically unsustainable investment trend that
holds sway over investors only temporarily and that inevitably
collapses violently. Asset price bubbles end when a tipping point is
reached where the awareness of and tolerance for escalating risk exceed
irrational exuberance producing a panic. So long as the great majority
of market participants discount risk, individual participants may rely
on the irrational exuberance of others. In contrast, rational
confidence does not depend on a majority of market participants
behaving irrationally and is based instead on sound fundamentals.
The view that rising global commodity prices, fundamentally, are asset
price bubbles in various stages of formation unreasonably discounts the
risks associated with financial institutions, governments and
currencies. If we are to learn anything from Iceland, the Baltic
states, Dubai, and Greece it is that if irrational exuberance exists in
the financial markets today it is exactly confidence that is not based
on sound fundamentals in financial institutions, governments and
currencies.
In the 1980 asset price bubble, gold rose from an inflation adjusted
low using constant 2009 dollars of $392.57 per Troy ounce on August 31,
1976 ($104 1976 dollars) to its January 21, 1980 peak of what would
have been $2,358.04 in 2009 dollars ($850 1980 dollars), a gain using
constant 2009 dollars of more than 500% in 4 years. The 1980 asset
price bubble in gold violently collapsed in same year, returning to
1979 levels by 1982.
On April 4, 2001, the gold price would have been $315.78 in
constant 2009 dollars, the lowest value since 1970 adjusted for
inflation. From that point, the gold price rose from a nominal low of
$255.95 on April 4, 2001 to a nominal high of $1,212.50 on December 2,
2009 (London PM fix), a gain of roughly 375% over approximately 10
years (284% using constant 2009 dollars).
Over the past decade, the US dollar has declined from its 2002 high by roughly 33% compared to other major currencies and
approximately 40% from is 2000 high compared to the Euro. At
the same time, most of the currencies in the major indices have been
debased alongside the US dollar since 2008 for the same reasons, thus
the value of the US dollar in real terms is not apparent from the index
alone.
The alternate US Dollar Indices published by
Shadow Government Statistics
(SGS) suggest that the Federal Reserve’s trade weighted exchange index
of major currencies, which includes the Euro zone, Canada, Japan, the
United Kingdom, Switzerland, Australia, and Sweden, may be an
optimistic formulation.
The decline of a national currency, particularly that of a nation
with a large trade deficit, is first apparent in international trade
while domestic prices do not at first fully reflect the devaluation of
the currency. As a result, the prices of commodities that are subject
to global demand tend to rise before the general increase in domestic
prices that results from currency devaluation, thus the prices of
commodities such as gold would be expected to rise faster than domestic
measures such as the US Consumer Price Index (CPI).
The alternate CPI measure provided by SGS may represent a more
accurate method of estimating the US dollar prices of commodities that
are subject to global demand. The SGS alternate data show accelerating
price inflation over the past decade leading up to the global financial
crisis in 2008.
While gold certainly has enjoyed tremendous gains over the past decade, including the effect on the gold price of
central bank gold demand,
the current gold price, following on the heels of an unprecedented
global financial crisis, has little in common with the 1980 asset price
bubble. The current gold price reflects a rational diversification into
hard assets for the purposes of risk mitigation and wealth preservation
and can be explained in terms of monetary inflation and associated loss
in the value of the US dollar independent of the US dollar carry
trade. The continuing devaluation of the US dollar will result in a
further rise in the prices of commodities that are subject to global
demand, thus the gold price will continue to rise also.
Mr. Soros is certainly correct in that low interest rates contribute to
the formation of asset price bubbles, but neither the value of the US
dollar or the price of gold depend only on interest rates or on the US
dollar carry trade. The view that a gold price over $1000 per Troy
ounce represents the “ultimate bubble” ignores the ongoing devaluation
of the US dollar, discounts risks associated with the stability of
financial institutions, governments and currencies, and does not
reflect confidence consistent with sound fundamentals.
Posted
Jan 31 2010, 07:14 AM
by
Ron Hera
Filed under: US dollar, CPI, inflation, GDP, China, Gold, World Economic Forum, M3, MB, Euro, Davos