Gold at $320 Jude Wanniski July 9, 1997

The announcement that the Australian central bank had sold 167 metric tons of gold in the last six months tells us there is someone at the bank down under who was smart enough to sell when the price was higher than $380 and soon to head down. It doesn’t tell us that other central banks are now going to sell gold from their reserves because they will follow the Australian lead. They would first have to guess that gold will fall from $320 to a price that would give them a profit, when there is now just as much chance of gold rising as falling. Remember, prices of all goods are based on expectations of where the price will go tomorrow. Buyers and sellers of gold are always in balance at the spot price. Because it is the most monetary of all commodities, the gold price is different than all other prices, which is readily seen by noting that its price on the futures market pays no interest rate other than the inflation premium.

The amount of gold sold into the market by Australia was 9% of total annual production, but it is a teeny amount compared with the total stock of gold in the world, which the World Gold Council, a longtime Polyconomics client, tells us is roughly 120,000 metric tons. The amount sold by Australia is thus 0.00139% of the total. At the margin, the sale could depress the dollar price a bit, but is certainly not responsible for the $65 decline over the sale period. The gold price, remember, is a ratio of two ratios: the supply and demand for dollars relative to the supply and demand for the specie itself. The dramatic rise of the stock market in the last six months tells us several things about the future of the economy, one of which is that the market will be demanding more dollar liquidity. If it does not get that liquidity from the Federal Reserve, the price of gold will decline, as dollars at the margin become more attractive than the most monetary of commodities. The only other logical possibility, which we reject, is that Australia’s gold sale has caused the boom on Wall Street.

Will the price of gold fall further from this point, stabilize here, or climb back  to a higher level? The most important consideration is that the gold price over the last 11 years has most often traded at or around $350. Debtors and creditors have thus become comfortable at this rate, a de facto gold standard.  Speculation that the Federal Reserve will add or subtract liquidity in a way that will upset this balance can cause the price to rise or fall around $350. When Saddam Hussein invaded Kuwait in 1990, for example, the gold price shot up to $415 from $350 but soon fell back to $350 when the Fed stood fast, refusing to add liquidity as demanded by the gold bulls. The price now, at $320, may reflect some digestion of the news from Australia. For the most part, though, it reflects an equilibrium of today’s supply and demand for dollar liquidity -- most certainly tied to the prospect of a tax bill that will be signed by the President. If this does happen, gold may resume its downward drift, unless the Fed moves in the direction of adding liquidity to meet demand. Like a train with an engine at each end pulling in different directions, gold will then settle at the price where monetary deflation is pulling back with the same force as fiscal stimulation is pulling forward. When the Clinton tax increases of 1993 took effect, driving down demand for liquidity, gold rose to $383 from $350 before finding balance.

Gold has to stay at $320 for some months before the pain it is causing to dollar debtors accumulates to the point where the Fed has to take notice. At the margin, the first people who are hurt are only those who are borrowing dollars against gold at $350 and now have to pay back in much heavier dollars. Those who borrow dollars against oil are the second to feel the squeeze. As time passes and new dollar debtors are being pressed to the wall, the crowd begins approaching critical political mass, which is what it takes to push the Fed into a mood of monetary accommodation, which will move gold back to $350. It is easier for the crowd to gather in a deflation, because when debtors can’t pay, creditors don’t get paid, and they also join the clamor for ease.

What does Fed Chairman Alan Greenspan think about this? My guess is that he now thinks some significant piece of the gold price decline is the result of Australian gold coming into the market. Perhaps he is also tempted to think that the $350 gold price to which he has been tending for the last decade really should be $300. Former Fed Governor Wayne Angell would love to hear that from Greenspan. He should resist all such temptations, which simply allow him to rationalize away the fact that the Fed should be supplying more liquidity and isn’t.

One of the worst effects of gold at $320 is that the Fed’s monetary error on the deflation side is being transmitted to all countries in the world, to one degree or another. Small countries that have been tying their currencies to the dollar are dragged into a deflationary squeeze with far greater rapidity than the U.S. itself. In our Global Report last week, we noted that Thailand’s devaluation of the baht was not really a devaluation, but an adjustment to offset the dollar’s strength against gold. In other words, the baht’s gold price is back where it was seven months ago, and the stock market has run up in line with the end of the mini-deflation. The other countries of Asia that are pegged to the dollar are also being hammered by the deflation, with the Philippines now at the edge of devaluation (which they should do explicitly on the argument that the Fed has pulled it into a deflation.) Unless Greenspan can soon get out of the corner into which he has painted himself, he will do more damage to Hong Kong than Beijing could do if it tried. Greenspan’s monetary-policy testimony before House Banking on July 23 will be critical. Greenspan absolutely must lay the groundwork for monetary ease, at a time when Fed Gov. Lawrence Meyer is pushing for even greater monetary tightness.

Pity the Japanese, who are tightening at the Bank of Japan even though the yen gold price has been plummeting faster than the dollar’s, to ¥37000 from ¥44000 since April, a 16% fall. The Japanese government has been trying to appreciate the yen for political purposes, to satisfy the U.S. Treasury, at exactly the time the dollar has been appreciating because of unheeded legitimate demands for liquidity. The pain in the Tokyo financial structure must be excruciating, which is why we have to believe there will soon be an easing to get gold at least above ¥40000. The alternative is a steady decline in the Nikkei. How much nicer it would be, Alan, if the dollar were pegged to gold at $350. Wouldn’t it? The problem for the world is that because of the movement toward a budget agreement here, with at least a reduction to 20% in the capital gains tax, there is relief on that score to the deflating dollar. It gives the Fed a sense of domestic security, even though it is causing international trouble. As long as Greenspan does nothing, the rest of the commodity universe has to gradually follow in train, with oil first in line. Managing the world’s key currency is a big responsibility.