Gold and Deflation


On September 8, 1933, almost four years after the October 1929 stock market crash, the new American president, Franklin Roosevelt, raised the domestic price of gold by 44 percent from $20.67 an ounce, where it had stood for more than a century, to $29.82 per ounce. The objectives of this change were to raise commodity prices and weaken the dollar in foreign exchange markets. More broadly, the aim was to help end the deflation that was crushing American businesses and households, especially those with debts, the burden of which was magnified by falling prices.

So virulent was the deflationary pressure, however, that prices continued to fall during the balance of 1933 while the dollar strengthened, thus exacerbating the deflation gripping the American and global economies. Therefore, on January 15, 1934, President Roosevelt proposed further reflationary measures to Congress, which promptly passed the Gold Reserve Act on January 30. The result was to fix the price of gold at $35 an ounce on February 1, bringing to 69 percent the total increase in the price of gold over the space of just five months.

Gold Hedges Inflation and Deflation

For those who were trying to preserve, not to mention enhance, wealth in an environment of persistently falling stock prices, shaky government finances, and governments vying for a weaker currency, to have bought gold in 1931, 1932, or early 1933 proved to be a brilliant move. The price of gold, which climbs steadily in a world of rising inflation (as it did during the 1970s, from $35 to over $800 per ounce), jumped suddenly and spectacularly between September 1933 and February 1934 amidst deepening global deflation.

Gold can be a hedge against the risks of both more inflation and more deflation because both phenomena entail the prospect of serious trouble for financial assets. Rising inflation depresses the value of outstanding bonds and riles foreign-exchange markets. Rising inflation also distorts relative prices and increases uncertainty about the market value of stocks; remember the stock market crash of 1973 and 1974 after the quadrupling of oil prices. Gold becomes the asset of refuge in periods of rising inflation.

During periods of intensifying deflation, stocks suffer as the real value of company debts rises and the profit outlook deteriorates. Companies are unable to cover the cost of production (especially when excess capacity is in place) that was financed with the issuance of debt or equity. Initially, deflation makes sovereign (government) bonds more attractive. But advancing global deflation raises the possibility that governments will have to engage in competitive currency devaluations as each, by means of a weaker currency, tries to export deflation. That is what happened in 1933 as President Roosevelt joined the rush and pushed down the dollar by sharply devaluing against gold. In the middle of a global deflation, that was the only convincing way to accomplish a reflationary devaluation. Roosevelt wanted to send up a rocket that would explode high up and spell out the words "higher prices in America" for all the world and for America's debtors to see as a sign of hope.

Post-Bubble America Today

In the United States at the outset of 2003, while inflation is very low, there is no widespread deflation. Globally, countries are not overtly engaging in competitive devaluations, although many are preventing a rise in their currency's value by purchasing dollars. President Bush is not intoning that the only thing we have to fear is fear itself. Nor is the Federal Reserve dragging its feet about easing monetary conditions. The federal funds rate has been cut by 525 basis points since the abrupt initiation of easing with a 50-basis-point rate cut on January 3, 2001. The latest reduction came on November 6, 2002, when another cut of 50 basis points exceeded expectations by a wide margin. The November 6 action reduced the federal funds rate to 1.25 percent--its lowest level since 1958.

The recent rate cut by the Fed has been followed by extraordinary assurances from Fed chairman Alan Greenspan and Fed governor Benjamin Bernanke that the central bank is prepared effectively to print money should the aggressive interest rate cuts by the Fed prove inadequate to stimulate demand sufficiently to produce a sustainable recovery, in which the economy grows steadily at about 3.5 percent. That trend level of sustainable growth is sufficient to sustain higher employment and the growth of profits that is, perhaps unfortunately, already assumed by many analysts to be on tap for 2003.

American policymakers have not relied entirely on stimulative monetary policy to revive economic growth. Stimulative fiscal policy, an alternative to global devaluation of currencies against gold as a means to spur demand growth in a weakening global economy, has also been enacted by the United States. The deflationary experience of the 1930s gave birth to the Keynesian notion of active fiscal stimulus as a means to boost demand growth. This occurred partly as a result of the limited success achieved with occasionally disruptive currency devaluations during the 1930s. A Republican Bush administration, in the face of persistent hand wringing and complaining from Democrats gripped suddenly by a new fervor for fiscal rectitude--the Rubin fallacy syndrome--cut taxes to provide fiscal thrust worth nearly 2 percentage points of GDP growth in 2002.

Now, as we enter 2003, the Bush administration is preparing to offer another dose of fiscal stimulus in the form of more tax cuts, worth as much as 1 percent of GDP. Wisely, no action has been proposed to offset federal revenue losses that have accompanied the weaker economy and stock market. Still, one wonders whether the Rubinites are just biting their tongues. Apparently, voters saw through the silly policy corollary to the Rubin fallacy syndrome--do not cut taxes, even during a recession, because lower deficits were supposed to have been the key to the boom of the 1990s--and voted to increase Republican margins in the House while returning control of the Senate to Republicans. Perhaps it is not surprising to find that in a recession, as in a tepid recovery with falling stock prices, lower tax rates constitute a happy combination of good politics and good economics.

Stocks Fall While Gold Rises

After more than two years of proactive, stimulative monetary and fiscal policy measures and despite an absence of overt deflation and the return of modest growth in America, something is definitely still disturbing investors, households, and businesses. The stock market, as it did after 1929, has gone down for three years in a row and now the price of gold, as it did in 1932, also a third down year for the stock market, has started to rise. Over the past two years, since January 2001 when the Fed began easing, the price of gold has risen from $260 an ounce to more than $345 an ounce or by nearly 39 percent. The biggest part of that increase--more than 20 percentage points--has come over the past year.

The history of the post-bubble scenarios both in the United States in the 1930s and in Japan in the 1990s is rich with suggestions to explain a sharp rise in the price of a sterile metal--gold--during a period of intensifying global disinflation and deflation. The recent weakening of the dollar coupled with a two-year period of rising gold prices suggests that investors are searching for a safe-haven asset at a time when equities have suffered and government finances--especially in Japan and Europe--are beginning to come under increasing strain. Until now, and in two episodes this year when investors fled riskier assets, including stocks, junk bonds, and emerging arket securities, they rushed into U.S. Treasuries and U.S. dollars. But more recently, over the first three weeks of December 2002, in what looks to be the early stages of another flight from risk, investors bought more gold, adding $25 an ounce, or nearly 8 percent, to the price in that short span.

Other symptoms of the rising disenchantment of investors with financial assets, especially stocks, appeared during the third consecutive year of falling stock prices. The search for alternatives to equity assets coupled with a change from a focus on wealth enhancement to a focus on wealth preservation has resulted in the adoption of two separate strategies by many investors. The disinflation and deflationary environment in the global economy, together with uncertainty, causes investors to abandon risky assets and to acquire claims on reliable sovereign governments such as the United States. Rising uncertainty also leads to an increased desire to hold cash or other highly liquid assets.

However, as extensive monetary and fiscal stimulus measures have failed to produce a sustainable recovery, investors are beginning to display a preference for other assets that would benefit from an aggressive and successful--perhaps global--effort at reflation. This behavior follows an initial, more benign flight from equities when the opportunity cost of not investing in the stock market fell sharply. Then, households shifted to consumer durables, especially cars. This shift became pronounced after the September 11 tragedy. Aided by sharply falling interest rates, households have also been encouraged to substitute larger investments in residential housing. Perhaps the most enduring symbol of wealth preservation for middle-income American households, especially for those who indulged in a brief flirtation with the stock market, is the comforting tangibility of a larger house.

But the rise in the price of gold is different. It serves as a sign that many investors perceive that reflation efforts have not been successful and will have to be intensified. This is not too surprising. While widely discussed, reflation efforts in Japan have neither been sufficiently aggressive nor successful. The other major economic area outside of the United States--Europe--seems to be stuck in a worsening disinflationary recession, and its central bank has been reluctant to ease as aggressively as the Fed has eased, while fiscal policy is actually moving in a contractionary direction.

In the United States, substantial monetary and fiscal stimulus has helped to produce a recovery of sorts, but a disconcerting underlying reality persists. After nearly two years of aggressive monetary stimulus and one year after one of the largest fiscal boosts in half a decade, year-over-year nominal GDP growth stands at just 4 percent--the lowest level in postwar history for this stage of an American economic recovery. We also learned in the third quarter that the year-over-year growth of corporate profits (after tax), based on the government's NIPA (National Income and Product Accounts), is more than a standard deviation below the norm for postwar cycles. With real growth in the fourth quarter of 2002 looking to be below 1 percent while the GDP deflator is below 2 percent, nominal GDP growth will fall far short of the 5 or 6 percent level necessary to sustain growth of profits at a rate currently forecast by most analysts for 2003. Meanwhile, the implicit GDP deflator (base index) for nonfinancial businesses is falling at an annual rate of 1.7 percent--also the worst performance in the postwar period. No wonder corporate managers complain of a lack of pricing power.

If U.S. GDP growth, with the help of substantial monetary and fiscal stimulus, is still insufficient to support the growth of profits and employment in 2003, the outlook for U.S. demand growth, the sustaining force for the global economy over the past two years, is not bright. While the United States is proposing additional fiscal stimulus at the federal level worth up to 1 percent of GDP during 2003, the fiscal drag from deteriorating state and local finances will erase that positive impact.

Beware Higher Gold Prices

Optimists, making comparisons between the current post-bubble period and the United States in the 1930s, have been consoled by the notion that widespread deflation has not taken hold in the U.S. today. That is a dangerously misleading source of comfort. What we have learned over the past year is that low nominal GDP growth, the sum of modest real growth and tepid price increases confined to the services sector, is insufficient to produce widespread profit growth consistent with the forecasts--or perhaps the hopes--of most equity analysts. Therefore, the search for alternatives to equity assets together with a desire for wealth preservation, which has initially led to purchases of government securities and a movement into cash, will continue. If investors should conclude, and it would be premature to do so at this point, that the only option left to policymakers is to print money in quantities sufficient to create rising prices and perhaps dollar depreciation, the continued search for wealth preservation will lead to further purchases and a higher price of gold.

John H. Makin is a resident scholar at AEI.

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