Even though the gold price has resumed its advance for the wrong reasons – a decline in the demand for dollar liquidity instead of a discrete mini-devaluation by the government – it is still positive news for debtors and creditors. But not enough to help sustain a rally on Wall Street. Please note our client report a week ago, “Gold Stuck at $293,” said there was still an upward bias to the price, a bias we first noted in early February when gold was at $273. When gold poked above $300 today, Michael Darda flagged me: “There is a diminished level of commerce due to the following fundamental forces: a higher risk profile due to the political/economic fallout of 9/11, a higher state/local tax wedge and a higher tariff structure. Press accounts of higher tariffs in Europe and Canada have dominated headlines this week. This reduces the demand for dollar liquidity, but instead of draining, the Fed has been ADDING liquidity in order to comport with its clumsy interest rate peg.”
One example of the fiscal pressures arising from deflation is the dire condition of finances in New Jersey. The state is the most intensive user of intellectual capital in the nation. It largely escaped the first phase of th deflation due to its low reliance on agriculture and basic commodities. However, its budget problems are now out of control. Doing the best he can, the new Democratic governor, James McGreevey, is forced to raise taxes and cut spending by $5 billion, a small amount relative to the national economy, but the tip of the iceberg when projected across the nation. Another manifestation comes with the increase in first-class mail postage to 37˘ from 34˘, another cost of doing business that seems small enough, but at the margin also chips away at the demand for liquidity, putting marginal enterprises out of business and discouraging marginal entrepreneurs from trying. It is hardly a surprise to read in the <I>NYTimes</I> this morning that low- and moderate-income families in the NYC metropolitan region are defaulting on mortgages at a record pace and defaults (90 days or more behind in payments) are soaring across the country. Relief comes first in the sectors reliant on commodity production, but that only compounds the problem for the manufacturing sectors that must absorb higher input costs without having the pricing power to pass them on.
The defense sector is of course flying on Wall Street and on the ground with contractors and their suppliers, as the Bush administration gears up for a military campaign in Iraq and more fighting in Afghanistan – and who knows where else. The April 1 New Yorker has an excellent, scary piece by Nicholas Lemann on the serious planning for an Iraq campaign in the administration, "The Next World Order," including a scenario that in light of 9-11 assumes the public would accept casualties of 30,000 or more in such a campaign! The breakdown in the Arab summit in Beirut this week adds to the political risks associated with war at that level, but of course if those risks recede, so will projected defense outlays and upward pressures on gold.
Similarly, if loan demand is kicked up because of expectations of interest-rate increases by the Fed, this process should reverse itself in the wake of weaker-than-expected growth, which would cool expectations that rates are going up. Otherwise, we would need to see genuine uses for new loans, i.e. a real expansion in commercial activity. Darda notes we have only seen a very preliminary rise in commercial and industrial loans since the end of January -- about $10 billion or so -- which is the first rise in a long time but still tentative. There seems no other new deflationary pressures on the horizon. Even if market interest rates fall dramatically, the Fed would have to drain liquidity to “fight off” an expected inflationary impulse, and the Fed has no operating mechanism in place to make that happen.
We are then left pondering how long it will take for more bad news to show up to offset the deflation still built into gold at the $300 level. If there is an Iraqi adventure, we could easily get there by the end of August. But let us assume Saddam Hussein will agree to sign the protocols to permit unlimited access of inspection to the International Atomic Energy Agency. This should satisfy most people here and abroad that he is not getting close to nuking Israel and sharply reduce the threat of a military campaign. That said, we believe the other factors at work would not get us to gold at $325, where the deflation becomes bearable, until mid-2003. Mind you, these are just educated guesses, but given the multitude of variables, it is the best we can do.
The three-cent increase in postage reminds us that we really must see a gold price at least at $325, a $350 ceiling better yet, to accommodate those enterprises public and private that have been banking on an increase in pricing power for their output. USPS will lose enough market share to the Internet by raising prices instead of cutting them. Unless there is mini-inflation to stave off what remains of deflation, it will show horrendous deficits. It is hard enough to get private enterprise to trim wages and benefits to adjust to a deflated dollar. Imagine cutting the wages of postal workers and all other government employees, including the armed forces. The Economist of March 27 makes the related point that S&P 500 operating profits do not count certain costs, such as options, as wages, which of course do subtract from the bottom line when they are exercised. Unhappily, the GDP statistics rest on these profit measures. A separate measure of the “national accounts profits,” which includes these extras, shows real profits half of what are indicated in the S&P. Is this something new? You bet. Until 1997, the two measures of profits tracked perfectly, with the wide divergence opening since then. That is when we began warning that deflation was upon us. Convergence in the two measures will occur to a degree with gold climbing, as nominal and real prices converge. Gold has to come the rest of the way or a great many companies whose unfunded liabilities are underwater will get clobbered.
We are aware that many of our clients, perhaps most, do not fully understand the deflation process, just as we do not fully understand what our clients do in allocating assets. You take our arguments on faith. We have remained firm in our stance these many years because long ago we were persuaded that the Law of One Price is as reliable as its companions, the Law of Diminishing Returns or the Regression to the Mean or Say's Law of Markets. You cannot change the terms of trade by changing the value of the unit of account. Once you accept the idea that gold is the unit of account favored by the market, that it is constant in that attribute, you must accept the logic that all other goods priced in floating currencies must converge toward it. In that light, the dollar must lose at least another 10% of its purchasing power relative to gold before other downward price adjustments are made unnecessary. Commodity prices at this gold level will creep up and take some of the wind out of those profit projections of the S&P 500. It would be much nicer if we devalued by that amount, of course, because we are making a mess of our public finances meanwhile, not to mention all the homeowners who cannot make their payments.