The rally in gold and the related decline in the dollar have been hard to miss these past few months. What is this telling us about monetary and fiscal policy, and what might an investor do?
The Federal Reserve (Fed) has an incredibly tough job these days. It deserves credit for helping prevent a second Great Depression a year ago, which it did by not only lowering short-term interest rates to near zero but also by expanding the monetary base. But now comes the even harder part: What is the exit strategy? Withdraw the stimulus too soon and the Fed risks triggering another economic relapse, but withdraw too slowly and it risks raising inflationary expectations, not to mention renewed asset bubbles. It’s like threading a needle.
Complicating matters even further is that the same thing is playing out on the fiscal side. Congress responded to the crisis with a huge dose of fiscal stimulus. But when does it stop the cycle of deficit spending? How many years of trillion-dollar deficits will our foreign creditors tolerate? Is the United States inflating its way out of trouble by printing money and debasing its currency, as so many countries have unsuccessfully tried to do throughout history?
These are difficult questions indeed, and there are no clear answers right now. This is why gold is rallying and the dollar is declining: they smell a policy error.
Lessons from the Great Depression
To help understand the choices the Fed is facing, it’s instructive to take a page from past crises, especially the Great Depression. Doing so is especially relevant because Fed Chairman Ben Bernanke is known to be a student of that period in our country’s history. So, if his decisions at the Fed are influenced by what he has learned from the Great Depression, then it’s important for us to know about it as well.
The Great Depression was actually two depressions. It started with World War 1, which essentially bankrupted Europe in the 1920s. Via the Fed, the U.S. lent a helping hand by extending easy money to Europe from around 1925 to 1927. However, in a classic example of the “laws of unintended consequences,” some of this easy money ended up in our own stock market, thus contributing to the massive bubble that burst in 1929. This episode shows that the concept of “moral hazard” is not new. It existed as far back as the 1920s.
When the bubble burst in 1929, it unleashed a wave of deflationary debt deleveraging onto the U.S. economy, much like that which occurred in 2008 after the housing bubble burst. However, during the 1930s the Fed was on the gold standard, which made it impossible to just open up the liquidity spigot like it did last year. In fact, the gold standard acted somewhat like a straight jacket and the Fed actually raised rates for a while, which is obviously the last thing one should be doing during an economic crisis. This policy error undoubtedly contributed to the 87% blood bath in stocks from 1929 to 1932.
Bernanke knows this well, which is probably why he responded with such overwhelming force in the fall of 2008 following the collapse of Lehman. Not only did the Fed lower rates to zero, but it expanded the monetary base. We call this “quantitative easing” or, more simply, “printing money.”
The idea behind quantitative easing is that the Fed creates (out of thin air) excess banking reserves. These reserves end up on the balance sheet of banks, which are then supposed to lend out these new reserves to consumers and businesses. That triggers what is known as the money multiplier, which then expands the money supply and brings the economy back to life, and creates inflation (which under these circumstances is a desired outcome).
The problem in the early 1930s was that the gold standard prevented the Fed from doing this, until Franklin D. Roosevelt (FDR) came into power in 1933. FDR realized that the gold standard was limiting his ability to respond to the crisis, and in April of 1933 he changed it. He did this by making it illegal to own gold. Holders of gold had to turn in their bullion, receiving the stated conversion price of $20/oz. FDR then changed the conversion price to $35/oz., and with the stroke of a pen he increased the money supply and devalued the dollar at the same time. That was the catalyst for a 150% rally in the stock market and several years of very strong economic growth.
Today the Fed doesn’t need to worry about the gold standard. While that gives the Fed more freedom to expand its balance sheet and print money, it also has a consequence. The dollar can go down in value, which is of course what is happening now. And when the dollar goes down, gold goes up. After all, gold is the ultimate currency because unlike a fiat (paper) currency, it is not someone else’s liability. Consequently, it may be useful to view gold less as an inflation barometer and more as a hard currency. This is especially the case because other countries are doing the exact same thing in terms of monetary and fiscal policy.
Inflation or deflation?
So here we are with the printing presses running at full speed. Is that inflationary? Not necessarily, or at least not yet. Printing money is only inflationary if the banks end up lending it out via the above mentioned money multiplier. That isn’t happening right now. This is a liquidity trap, because banks haven’t been increasing their lending. As long as we are stuck with this liquidity trap, the velocity of money will stay low and the risk of deflation will outweigh the risk of inflation.
What if the banks do start lending out some of these excess reserves at some point? After all, that is what banks are supposed to do for a living. If and when that happens, the money multiplier will start multiplying, which could set the stage for both growth and inflation. At that point, it will be important for the Fed to start withdrawing some of this unprecedented stimulus.
To give you a sense of just how high the stakes are, the chart below shows declines in GDP in the bottom panel and the monetary policy response in the top panel. The latter is defined as the ratio of excess banking reserves to required banking reserves (as a proxy for how fast the printing presses are running).
Take a look at the left side and then at the right side of the chart. There is no question that the current degree of policy response relative to the decline in the economy is far greater than that which occurred during the 1930s. Whether the current policy response is excessive or necessary is beside the point right now. The question: How do we get out of this when the time comes?
Gold and dollar are on the move because some investors are wondering whether or not the Fed has the willingness or ability to exit qualitative easing at just the right time and by the right amount. It’s not so much an issue of inflation, as an issue of confidence in our policy makers. In a way, gold is providing a hedge against mismanagement in Washington.
If the Fed is able to thread that needle when the time comes, and that’s a big “if,” then the run-up in gold and the corresponding decline in the dollar could reverse very quickly. If that happens, the dramatic rally in gold will be seen as nothing more than a one-off bubble.
But if the Fed finds itself unable or unwilling to exit when the time comes, especially if at the same time Congress continues to run massive deficits, then the moves in gold and the dollar could still have a long way to go.
What’s an investor to do?
So how do you play this potentially binary outcome?
The immediate impulse might be to buy gold, either physical gold or a gold mutual fund or exchange-traded fund exchange-traded fund (ETF). If you believe we’re headed for a fiscal train wreck, then allocating a small portion to a well-diversified portfolio may make sense. But what if the Fed pulls it off? Then gold could come crashing down. A tough call indeed.
Another option might be to allocate a small portion of your portfolio to stocks and bonds of emerging market countries (like China and India) and natural resource-rich countries (like Brazil, Canada, and Australia). This might buy you two things: geographic and currency diversification. As the dollar falls, the appreciation of foreign currencies can provide an extra boost in return to U.S. investors. That’s because foreign securities are worth more when translated back to dollars.