the atlantic

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Is the Gold Price Dependent on China?

China now buys more gold than the Western world:

Gold_Demand_China_WGC

Does that mean, as some commentators are suggesting, that future price growth for the gold price depends on China? That if the Chinese economy weakens and has a hard landing or a recession that gold will fall steeply?

There’s no doubt that the run-up that gold has experienced in recent years is associated with the rise in demand for gold from emerging markets and their central banks. And indeed, the BRIC central banks have been quite transparent about their gold acquisition and the reasons for it.

Zhang Jianhua of the People’s Bank of China said:

No asset is safe now. The only choice to hedge risks is to hold hard currency — gold.

Indeed, this trend recently led the Telegraph’s Ambrose Evans-Pritchard to declare that the world was on the road to “a new gold standard” — a tripartite reserve currency system of gold, dollars and euros:

The world is moving step by step towards a de facto Gold Standard, without any meetings of G20 leaders to announce the idea or bless the project.

Some readers will already have seen the GFMS Gold Survey for 2012 which reported that central banks around the world bought more bullion last year in terms of tonnage than at any time in almost half a century.

They added a net 536 tonnes in 2012 as they diversified fresh reserves away from the four fiat suspects: dollar, euro, sterling, and yen.

The countries driving the movement toward gold as a reserve currency by building their gold reserves is that they are broadly creditor nations whose dollar-denominated assets have been relatively hurt by over a decade of low and negative real interest rates. The idea that gold does well during periods of  falling or negative real rates held even before the globalisation of U.S. Treasury debt.

The blue line is real interest rates on the 10-year Treasury, the red line change in the gold price from a year ago:

fredgraph (15)

The historical relationship between real interest rates and the gold price shows that it is likely not “China” per se that has been driving the gold price so much as creditors and creditor states in general who are disappointed or frustrated with the negative real interest rate environment in dollar-denominated assets. What a slowdown in the Chinese economy (or indeed the BRICs in general) would mean for the gold price remains to be seen. While it is widely assumed that a Chinese slowdown might reduce demand for gold, it is quite plausible that the opposite could be true. For instance, an inflationary crisis in China could drive the Chinese public and financial sector into buying more gold to insulate themselves against falling or negative real rates.

Of course, this is only one factor. That are no hard and fast rules about what drives markets, especially markets like the gold market where many different market participants have many different motivations for participating — some see gold as an inflation hedge, some (like the PBOC) as a hedge against counterparty risk and global contagion, some as a buffer against negative real interest rates, some as a tangible form of wealth, etc.

And with the global monetary system in a state of flux — with many nations creating bilateral and multilateral trade agreements to trade in non-dollar currencies, including gold — emerging market central banks see gold — the oldest existing form of money — as an insurance policy against unpredictable changes, and as a way to win global monetary influence.

So while emerging markets and particularly China have certainly been driving gold, while U.S. real interest rates remain negative or very low, and while the global monetary system remains in a state of flux, these nations will likely continue to gradually drive the gold price upward.

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Not Rational Utility Maximisers

One cornerstone of neoclassical economic thought is the assumption in microeconomics (and microfounded macroeconomics) that humans behave as “rational utility maximisers”.

Yet this assumption is increasingly outdated. Empirical findings in behavioural economics show that the neoclassical assumption of utility maximisation has very little basis in reality.

First, it is crucial to define what we mean by utility maximisation. Paul Samuelson, one of the grandfathers of the neoclassical New Keynesian school defined consumer rationality as follows:

• Completeness — Given any 2 bundles of commodities A & B , the consumer can decide whether he prefers A to B (A≻B), B to A (B≻A), or is indifferent between them (B≈A).

• Transitivity — If (A≻B) and (B≻C) then (A≻C).

• Non-satiation — More is preferred to less.

• Convexity — Marginal utility falls as consumption of any good rises.

This definition remains dominant in neoclassical economics today.

Sippel (1997) tested whether consumers really adhered to these four rules. He gave his student test subjects a budget, and a set of eight priced commodities to spend their budget on:

UtilityMaximisation

This was repeated ten times, with ten different budget and price combinations. Sippel found that 11 out of 12 of his test subjects’ behaviour failed to meet Samuelson’s criteria for rational utility maximisation. Sippel repeated the experiment later with thirty test subjects, finding that 22 out of 30 did not meet Samuelson’s criteria. Sippel concluded:

We conclude that the evidence for the utility maximisation hypothesis is at best mixed. While there are subjects who appear to be optimising, the majority of them do not.

It is interesting that some individuals obey the rules set out by Samuelson, and that some don’t. Human behaviour is highly variable from individual to individual. If the hypothesis of utility maximisation is right about a subset of individuals, but wrong about much of the general population, then this underlines the variability of human behaviour. And different circumstances call for different decision-making frameworks — some individuals may act like rational utility maximisers under some sets of circumstances and not others. This is really an area that deserves much, much more empirical study.

The evidence so far suggests that humans are complex animals whose decisions are multi-dimensional. This could be because our brains have evolved to use different neuro-circuitry for different decisions. According to the behavioural economist Daniel McFadden:

Our brains seem to operate like committees, assigning some tasks to the limbic system, others to the frontal system. The “switchboard” does not seem to achieve complete, consistent communication between different parts of the brain. Pleasure and pain are experienced in the limbic system, but not on one fixed “utility” or “self-interest” scale. Pleasure and pain have distinct neural pathways, and these pathways adapt quickly to homeostasis, with sensation coming from changes rather than levels. Overall, presumably as a product of evolution, our brains are organized well enough to keep us alive, fed, reproducing, and responsive to but not overwhelmed by sensation, but they are not hedonometers.

All of this points to the idea that microeconomics needs a new framework based on neurological and behavioural evidence, not decades-old assumptions that are unsupported by empirical evidence.

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Krugman’s Inflation Target

The Keynesian blogosphere is up in arms at Ben Bernanke’s response to Krugman’s view that he should pursue a higher inflation target as a debt erasure mechanism.

According to Chairman Bernanke:

We, the Federal Reserve, have spent 30 years building up credibility for low and stable inflation, which has proved extremely valuable in that we’ve been able to take strong accommodative actions in the last four, five years to support the economy without leading to an unanchoring of inflation expectations or a destabilization of inflation. To risk that asset for what I think would be quite tentative and perhaps doubtful gains on the real side would be, I think, an unwise thing to do.

Krugman responded:

This is not at all the tone of Bernanke’s Japan analysis; remember, Japan had nowhere near as high unemployment as we do, and his analysis back then was not simply focused on ending deflation.

Disappointing stuff.

The basic Keynesian logic is as follows:

The economy is performing far below its potential, due to an ongoing slump in aggregate demand caused by a contraction of confidence. Simply, there is plenty of money, but far too many people are risk averse and thus are not spending (and thus creating economic activity) but instead just holding onto their money. The Fed should ease some more, so as to create inflation that turns holding cash into a risk, and so encourage investment and consumption. What’s more, residual debt overhang is a burden on the economy, and additional inflation would decrease the relative value of  debts, giving some relief to debtors.

Matthew O’Brien presented this chart to make the case that output is far below its potential:


I am deeply sceptical that GDP is a sufficient measure of output, and I am even more sceptical that the algorithmic jiggerypokery involved in calculating what the Federal Reserve calls “Potential Nominal GDP” has anything whatever to do with the economy’s real potential output. But I will accept that — based on the heightened unemployment, as well as industrial output being roughly where it was ten years ago — that potential output is far below where it could be, and that the total debt overhang at above 300% of GDP is excessive.

The presupposition I really have a problem with, though, is the notion that this is a problem with hoarding:

Simply, the United States is a consumption-driven economy. And that isn’t so much of a fact as it is a problem. More and more money is going toward consumption, and less and less is going toward investment in companies, in ideas and in businesses. Exemplifying this, less and less money — even in spite of the Fed’s “pro-risk” policies (QE, QE2, ZIRP, etc) is going into domestic equities:

The fundamental problem at the heart of this is that the Fed is trying to encourage risk taking by making it difficult to allow small-scale market participants from amassing the capital necessary to take risk. That’s why we’re seeing domestic equity outflows. And so the only people with the apparatus to invest and create jobs are large institutions, banks and corporations, which they are patently not doing.

Would more easing convince them to do that? Probably not. If you’re a multinational corporation with access to foreign markets where input costs are significantly cheaper, why would you invest in the expensive, over-regulated American market other than to offload the products you’ve manufactured abroad?

As Zero Hedge noted:

In the period 2009-2011, America’s largest multinational companies: those who benefit the most from the public sector increasing its debt/GDP to the most since WWII, or just over 100% and rapidly rising, and thus those who should return the favor by hiring American workers, have instead hired three times as many foreigners as they have hired US workers.

So will (even deeper) negative real rates cause money to start flowing? Probably — but probably mostly abroad — so probably without the benefits of domestic investment and job creation.

Then there is the notion that inflation will effect debt erasure. This chart tends to suggest that at least for government debt it may not make much difference:

There’s no real correlation between government debt erasure and high inflation.

Paul Donovan of UBS explains:

The fundamental obstacle to governments eroding their debt through inflation is the duration of the government debt portfolio. If all outstanding debt had ten years before it matured, then governments could inflate their way out of the debt burden. Inflation would ravage bond holders, and governments (with no need to roll over existing debt for a decade) could create inflation with impunity, secure in the knowledge that existing bond holders could do nothing to punish them. In the real world, of course, governments roll over their debt on a very frequent basis.

Consumer debt may also not experience significant erasure.

From Naked Capitalism:

Inflation only reduces debt overhang in a significant way for households who are fortunate enough to see their nominal wages rise along with the general rise in prices. In today’s economy, workers are frequently not so fortunate.

The deeper reality though, is that even if my concerns are unfounded and Krugman is correct, and that a higher inflation target would achieve precisely what Krugman desires, I don’t think it would solve the broader problems in the economy.

As I wrote in November:

The problem is that most of the problems inherent in America and the West are non-monetary. For a start, America is dependent on oil, much of which is imported — oil necessary for agriculture, industry, transport, etc, and America is therefore highly vulnerable to oil shocks and oil price fluctuations. Second, America destroys huge chunks of its productive capital policing the world, and engaging in war and “liberal interventionism”. Third, America ships even more capital overseas, into the dollar hoards of Arab oil-mongers, and Chinese manufacturers who supply America with a heck of a lot. Fourth, as Krugman and DeLong would readily admit, American infrastructure, education, and basic research has been weakened by decades of under-investment (in my view, the capital lost to military adventurism, etc, has had a lot to do with this).

In light of these real world problems, at best all that monetary policy can do is kick the can, in the hope of giving society and governments more time to address the underlying challenges of the 21st Century. When a central bank pumps, metrics (e.g. GDP and unemployment) can recover, but with the huge underlying challenges like the ones we face, a transitory money-printing-driven spike will in no way be enough to address the structural and systemic problems, which most likely will soon rear their ugly heads again, triggering yet more monetary and financial woe.

On the other hand, it would be interesting to see Bernanke go the whole hog and adopt a fully-blown Krugmanite monetary policy, just to see Krugman’s ideas get blown out of the water by the cold, dark hand of falsification.

Of course, there was an opportunity to achieve debt erasure in 2008, when the world faced a default cascade and a credit collapse. Had economists and planners let the system liquidate, a huge portion of bad debt and bad companies and systems would have been erased, and — after a period of pain — we might well be well into a new phase of organic self-sustaining growth. But we live in a different world; where zombie systems, companies and their assets are preserved by government bailouts and interference, and very serious people like Paul Krugman earnestly push dubious solutions to problems that their very interventionist worldview created.

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No! Currency Wars Are Not Good!

Matthew O’Brien claims that competitive debasement is good for the global economy:

Currency wars get a bad rap. The trouble starts with that second word. Wars, as we all know, are very bad. And a currency war — where countries compete to lower their exchange rate to boost their exports — reminds people of the kind of trade protectionism that killed some economies in the 1930s. But currency wars are the best kind of war. Nobody dies. Everybody can profit. In fact, currency wars didn’t contribute to the Great Depression. They ended it.

The downside of devaluation is that no country gains a real trade advantage, and weaker currencies means the prices of commodities like oil shoot. But — and here’s the really important part — devaluing means printing money. There isn’t enough money in the world. That’s the simple and true reason why the global economy fell into crisis and has been so slow to recover. It’s also the simple and true reason why the Great Depression was so devastating. We know from the 1930s that such competitive devaluation can turn things around.

The world needs more money. Currency wars create money. It’s time for policymakers to forget the wrong lessons from history, get competitive, and start pushing down their currencies.

Since the last recession every major central bank in the world has fluffed up its balance sheet with purchases, pushing out new money into the system, and driving down exchange rates. So we already have a currency war.

The most obvious point is that the last thing the global geopolitical system — already knotted and twisted — needs is more strain, or more abrasions, and to some degree a currency war could strain relations. The biggest players in the developing world — China, Brazil, Argentina, India — are already experiencing elevated inflation. China and Russia and Brazil have all recently expressed deep unease at America’s policy.

Under such conditions, is it not reasonable to foresee that greater competitive debasement might lead to a full-blown trade war? An easy means for developing nations to stanch the decline in dollar-denominated holdings (FOREX, Treasuries, etc) would be to constrain the flow of dollars coming into their nations. How might that be done? Export quotas, and capital controls. I have long been of the view that the hyper-productive Eurasian nations do not “need” American consumption when they already have a big enough dollar hoard to recycle in domestic and regional consumption. America’s real economy is not being sustained by The Fed (that is sustaining the financial system), but rather by the ongoing free flow of goods and resources and energy from the developing nations to America. That’s the main reason why America spends so much money policing the world, to keep global trade flowing, and goods flowing into America. America consumes far more than she produces in terms of energy, in terms of finished goods, and in terms of components.

Simply, America has enjoyed a humungous free lunch on the back of the dollar’s reserve currency status. Nations throughout the world were willing to trade out their productivity, their resources and their energy for dollars, the international medium of exchange. America could sit back and diversify out of domestic productivity and into unproductive but nominally-higher-yielding financial services, consultancy, communications and entertainment. But dollars are no longer in such short supply; America has traded trillions and billions of them away. So some nations appear to be asking: Why do we need dollars? Why should we subsidise the Americans, when our own people go without? And of course, the Eurasian ASEAN bloc — and all the various new bilateral currency agreements, where Eurasian nations have agreed to ditch the dollar, and instead trade in their respective national currencies — is growing precisely to further this end, to diminish the American economic hegemony, and end the American free lunch. A series of currency wars could very easily be the thing that pushes the system into chaos.