State of the Union...

Ughh...I'm reeling from the recent price drop in gold...all the way to my favorite gold dealer to buy more! Why? Simply because gold serves as the ultimate barometer of the "perceived" value of a country's currency even though there can be short-term events that cause things to appear to be otherwise. In the '90s, when the NASDAQ went from 500 to 5000, the common expression was "buy the dips". People that did that made out handsomely...until the year 2000.

Briton's Chancellor Gordon Brown has come out from under his rock, once again, to suggest that the IMF sell some of its gold to alleviate the debt of third-world countries. The possibility of this event has made a huge contribution to the recent decline in the gold price (even though such sales would only be to central banks meaning the gold would not appear on the open market). While appearing to be a champion of people of low economic status, consider this article

So I interpret such news as efforts to distort economic reality. If you look at a long term graph of the price of gold, you can see that it's not uncommon for it to pull back anywhere from 50% to 100% of its previous rise. Then it turns around and goes to new highs. The important thing to keep in mind is that the fundamentals (trade and budget deficits) that have caused the price to be where it is from its low of $260 in the year 2000 are still firmly in place and as long as they are, the price over the longer term will continue to trend upward. Any short term moves are temporary anomalies.

Now let's look at another component of the economy that motivates me to "go for the gold"...

From Stephen Roach of Morgan Stanley:

The Federal Reserve is trapped in a moral-hazard dilemma of its own making. It dates back to the Great Bubble of the late 1990s and the central bank's unwillingness to take away the proverbial punch bowl just when the party was getting good. The close brush with deflation that then ensued was a painfully classic post-bubble aftershock. That experience underscores the greatest shortcoming of modern-day central banking -- the inability of monetary policy to cope successfully with asset bubbles and the deflationary perils they engender. The history of the 1930s and Japan in the 1990s are grim reminders of that shortcoming. Alan Greenspan's confession finally sets the record straight on how he got us into this mess.

And for you odds players out there, this link from his article in November where he says:

The chance we'll get through OK: one in 10. Maybe.

To finance its current account deficit with the rest of the world, he said, America has to import $2.6 billion in cash. Every working day.

That is an amazing 80 percent of the entire world's net savings.

Sustainable? Hardly.

Meanwhile, he notes that household debt is at record levels.

Twenty years ago the total debt of U.S. households was equal to half the size of the economy.

Today the figure is 85 percent.

Nearly half of new mortgage borrowing is at flexible interest rates, leaving borrowers much more vulnerable to rate hikes.

The U.S. has become the consumer of last resort for the world's goods brought to you by 40 year low rates of interest from the Federal Reserve and, as a result, the typical U.S. consumer has been refinancing their mortgages and financing their consumption by borrowing against the equity in their homes. Stephen Roach says:

"through home income extraction [home equity loans] income-short households pushed the consumption share of US GDP up to a record 71.1% in early 2003 (and still 70.7% in 4Q04) -- an unprecedented breakout from the 67% norm that had prevailed over the 1975 to 2000 period."

This will end and it will end badly and this is why. Today, the engine of consumption is enabled by the lowest interest rates in 40 years. Interest rates are a tool that is used by the Fed to control the flow of dollars into the economy. When rates go up, it chokes the supply of new dollars into the economy, decreasing inflation. Remember that dollars are "borrowed" into existence. The Fed could print a billion dollars but that has no impact on the economy until someone borrows them. So if rates don't rise people and businesses are more inclined to borrow.

The bigger issue is that the Fed doesn't have total control of interest rates. There comes a time when they are forced to raise them because too many dollars are being pumped into the economy. That's what happened in the '70s when Paul Volker raised rates to 18%. He had to do this because inflation was showing up in the general economy in terms of higher prices of consumer goods. Today it's showing up in the stock market and housing.

On the other hand, with the dollar dropping in value against other currencies, the U.S. is forced to raise interest rates to make the Treasury bonds foreign countries buy more attractive so they continue to buy them. Those Treasuries are how the U.S. finances it's trade deficit. In other words, the Fed is in a no win situation. If they raise rates, they might continue the trade deficit but tank the economy.

Just the other day, the latest employment numbers were disappointing yet the stock market surged. Why? Because this was perceived as an indicator that interest rates would stay low to help a still-struggling economy. But if the Fed keep rates low, inflation will go out of control.

If anyone finds fault with my reasoning I sure would appreciate hearing from you for an alternative interpretation of what is going on. But in the mean time, it's "Katie, bar (as in gold bar) the door."

As always, thanks for reading.