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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary. Each article or essay is selected on the basis of its long-term relevance for understanding the role gold plays in the individual's portfolio, the overall political economy, or both.
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 The Four Horsemen of the Apocalypse / Albrecht Durer |
Dark Vision for the World Economy, the new Four Horsemen of the Apocalypse are the Financial Collapse of the G3, Political Instability and Unrest, Debt Repudiation and Default, and Worldwide Inflation. |
Dark Vision for the World Economy
by Bernard Connolly, Chief Global Strategist, AIG
Editor's Note: Every once in awhile an article comes along by a commentator/analyst who has found the key to a clearer understanding of the forces at work in the world economy. This article by AIG's chief global strategist, Bernard Connolly, offers that degree of insight. The picture he paints is an interesting one. Far from a world moving toward global world government and co-operation precisely orchestrated by the G-3 (Japan, Europe and the United States), Connolly describes a world perilously at odds with itself, fracturing along old pre-World War II fault lines, and heading toward a catastrophic inflation in all three nations -- a circumstance brought by their own inability to reconcile long-standing differences among themselves and the failure of each to come to grips with their own internal problems. In a world of three structurally weak currencies, gold, he says, will be the primary beneficiary because it is the one asset which stands apart from this governmental and central bank currency destruction. We would like to thank theminingweb.com and Mr. Connolly for permission to reprint this important contribution to the current analysis and we highly recommend that USAGOLDers take the time to thoroughly digest it. This article will be a source of discussion and support documentation for some time to come. Beyond that, Mr. Connolly provides some very convincing reasons for gold ownership on the part of citizens in all of the three G-3 nations. MK
PostScript: This article prompted a USAGOLD Discussion Forum contest. You can access the "Dark Visions" submitted by the participants at the highlighted link below:
FORUM: A Dark Vision for the Future
You can also download Connolly's commentary as a pdf file -- connolly.pdf (140K)
GOLD'S DEPRESSING BULL MARKET
The first half of 2002 has seen a strong rally in gold. There have been previous, always short-lived, rallies in the past twenty years or so. Is this one different? Has it got more staying power? Sentiment has certainly changed. Nothing illustrates that more clearly than the gold market's absence of reaction, beyond a few hours, to the comments four months ago by Ernst Welteke that the Bundesbank would consider selling gold under a new Washington Agreement. A year ago, those remarks could easily have knocked twenty dollars off the gold price -- and on a permanent basis. What has changed?
One can adopt a bottom-up approach to this question, looking at it in terms of producer hedging behaviour, the attitudes of the banks to the financing of forward sales, the impact of the Washington agreement and the increase in retail demand in Japan. And one can supplement such an approach by noting the increase in political [unrest] in the world: the Middle East, the war against terrorism, the India-Pakistan dispute over Kashmir. Of course, many of those factors could swing around again: the renewal of the Washington Agreement might allow for bigger central bank sales; new production could come on stream and some of it might be hedged. The current period of relative calm about the financial system in Japan might continue for little while longer, perhaps reducing retail demand for gold. One prays that India and Pakistan will step back from the brink. There might be some miracle that brings peace to the Middle East. But even if all that happened -- and if it did the current rally would be knocked back in the short term -- a top-down approach would continue to suggest that the longer-term prospects for gold are good. Sadly, the reason for that are rather depressing: the world is getting worse, in political terms and in financial terms.
If one looks just at the economic
factors, one sees a world in which three currencies predominate.
Of those three, one -- the euro -- was created in the knowledge,
and perhaps with the intention, that it would provoke financial,
economic and political crisis in at last some of the countries
trapped in its embrace; it is quite simply a congenitally bad
currency. A second, the yen, is plagued by an intractable financial
system and public debt problems; it will at some point become
a highly inflationary currency. The third, the dollar, is backed
by a strong, well-rooted polity and the best economic system,
among major countries a least, in the world; but is overvalued,
at risk from financial system vulnerabilities and tarnished by
worries both corporate governance and about terrorism. In such
an environment, gold can be seen as the least bad currency.
THINGS CHANGING FOR THE WORSE
Linked to the problems of the
major currencies, and in part an explanation of those problems,
is the unmistakable fact that the factors of geopolitics and political
sociology affecting financial markets are changing for the worse
and will continue to deteriorate. What will be the longer-term
impact of September 11 on financial markets? No-one can say with
confidence how the global war against terrorism will develop.
But one thing should already be clear: the key assumption that
did most to sustain and encourage the world financial system over
the past decade or so -- an assumption about the pre-eminence
of economics versus politics -- was an illusion. It would have
been an illusion even if the events of September 11 had not happened,
or had not yet happened. What those events did was to make it
clear just how illusory the assumption had been. With enlightenment,
unfortunately, will come a realization that the brief Golden Age
of free-market international capitalism is ending.
The period from around 1982 until about a year or two ago was
marked by great secular trends in financial markets: a bull market
in stocks; a bull market in bonds; and a bear market in gold.
Underlying all these trends was more or less continuous world
disinflation, a falling equity premium related to perceptions
of increased economic and political stability in the world, an
improvement in public finances (except in Japan, which was of
course, from the beginning of the 1990s onwards, the great outlier
in terms of world equity market movements), reduced levels of
taxation, a greater role for the private sector, reduced government
regulation and intervention in the economy and, perhaps most important of all, a remarkable
move away from government control of international capital movements
and of financial markets in general.
One can summarize these trends by saying that what underpinned
the bull market in stocks and bonds and the bear market in gold
was a bear market in government -- the most desirable bear market
one could wish for.
No market trend ever lasts forever. There has been a global bear
market in stocks which, except in parts of non-Japan Asia, is
intensifying again; and any projection of a revival would have
to depend on assumptions that either are untenable or would imply
a recrudescence of world inflation. The bull market in bonds may
have come to an end, despite what has been a dramatically weak
period for world growth. The bear market in gold has, on some
readings, come to an end. And, sadly, the bear market in government is definitely
over.
It is this last development that is now destroying the assumption
that underpinned the Golden Age: the assumption that 1989 and
the fall of Communism marked the end of history and, along with
history, of politics. At a seemingly trivial level, the assumption
meant that the media of countries such as the US and Britain was
dominated, in the years before September 11, by the so-called
celebrity culture. In fact, this phenomenon was not trivial at
all: it was part of the illusion of "One World", a uniform
anti-culture whose tawdry attractions were supposedly so great
that all political, religious, social and economic divides in
the world would melt away before it. At a seemingly less trivial
level, the assumption implied that governments would take decisions
essentially on the basis of economic rationality and subject to
financial market disciplines: economics ruled, not politics. In
financial and economic terms, "One World" meant the
dominance of what Eisuke Sakakibara described as the Anglo-Saxon-dominated
free-market international finance system. In the terms of the
triumphalist book by Daniel Yergin and Joseph Stanislaw, "The
Commanding Heights" of the world economy had been captured
for free-market capitalism. But such conclusions were naive and
premature.
The illusion of the visceral attractiveness of the "Anglo-Saxon"
model should, perhaps, have been obvious in respect of Islamic
countries. It wasn't. That error betrayed a lack of cultural understanding.
But the illusion was just as complete in respect of continental
Europe. Here, the error of understanding on the part of US strategists,
of market analysts and of respected media commentators was much
more culpable: it was a deliberate averting of the eyes from evident
truths. Nowhere was the error more egregious than in the view
taken, in the US and by the more naïve -- or cynical -- interests
in Britain, of the drive towards economic and monetary union (EMU)
in Europe.
TROUBLING IMPLICATIONS OF ONE WORLD VIEW
In the US, that drive was seen
as a prime instance of the triumph of economics over politics,
as representing the sincerest form of flattery of the US model
and as signalling further near-inevitable moves towards a "One
World" of effective economic union and world government.
The first two elements of this view were simply wrong: the third
pointed to paradox in the notion of "globalization",
one with far-reaching and very troubling implications. Let us
look at them in turn.
On the face of it, EMU might seem to have involved member governments'
accepting a sacrifice of some supposedly empty concept of "national
sovereignty" in return for the economic benefits, in terms
of transparency, elimination of conversion costs, reduction of
exchange-rate uncertainty and the impetus given to the development
of integrated capital markets, supposedly flowing from the establishment
of a continental-sized currency area. And that trade-off -- of
political independence versus economic benefit -- was seen as
inevitable in an increasingly-integrated world. Nothing could
be farther from the truth. The structure of EMU flies in the face
of all economic rationality. The project was politically-motivated from the beginning.
It meant, in short, the creation of a rival to, and a defence
against, the importation of the "Anglo-Saxon" socioeconomic
and political model. European politicians were quite explicit
about that: just a few years ago the then-Finance Minister of
Belgium (now the president of the European Investment Bank) said
outright that, "The purpose of the [European] single currency
is to prevent the encroachment of Anglo-Saxon values in Europe".
In the face of such comments, it is very, very hard to understand
how Americans could delude themselves about the nature and purpose
of EMU. But they did.
In the event, every EU country whose government was not politically
bound by a commitment to a popular referendum on the issue ended
up being part of monetary union. This is proving disastrous. Why?
To answer that, we have to turn for a while from geopolitics to
economics -- while never forgetting that geopolitics has dictated
why the economic disaster of a wide monetary union was accepted
by its progenitors.
THE ROOTS OF THE EU IMMIGRATION PROBLEM: WHY IT MAY BE HERE
TO STAY
The greatest advantage of the
present world of internationally-integrated financial markets
is that it has restored divergences in the rate of return on capital
to their rightful position as prime driver of economic developments.
Such divergences may be sector-specific, firm-specific or even
person-specific in their origin, but what is important to recognize
is that their macroeconomic impacts tend to be country-specific:
that is, they affect some countries more than others. The probability
of country-specific disturbances to the rate of return on capital
is greater the initial differences in the economic, political,
social, cultural and financial structure, differences which are
often, though not invariably, summarized by differences in levels
of productivity and incomes among countries. Such differences
may exist within countries, too, of course. But they tend to be
diminished by common political and economic structures and by
mechanisms such as internal labour force mobility and by inter-regional
government transfers within countries.
Within the EMU, inter-country income differentials are substantial
and will become even greater as before the end of the decade EMU
will expand to include countries such as Poland, Bulgaria, Romania,
even Montenegro -- countries with vastly greater income disparities
compared with the EU average. Now, either the poor countries make
significant progress in catching up with the average or they do
not. Either outcome spells massive economic and political instability
within the present structure of EMU.
Suppose there is no "catch up". Then, given the freedom
of labour movements within the EU, there will either be massive
migration from poorer to richer countries or massive transfers
from richer to poorer countries to induce people to stay at home.
In the present political climate in Europe, massive migration
is just not going to be politically acceptable in the richer countries.
But, with budgetary constraints weighing heavy, neither will massive,
ongoing transfers. EMU, indeed the EU, will not be able to stand
the incorporation of poor countries who just do not catch up in
terms of productivity and domestic income levels.
But how does "catch up" come about? What we have seen
throughout the world over the past twenty years or so -- the period
of the new Golden Age -- is that involves structural reforms that
increase the anticipated rate of return on capital in the poorer
countries. The experience of the past twenty years has confirmed
what Wicksell and the Austrian economists had deduced theoretically
during the previous period of more-or-less free capital movements
in the world: macroeconomic stability requires the ex ante real
rate of interest to move in step with the anticipated rate of
return on capital. But in internationally-integrated financial
markets, ex ante real interest rates in a particular country can
rise above the "world" real rate of interest only if
the currency of the country concerned is expected to depreciate
in real terms. In turn, generating that expectation in circumstances
of, by construction, strong confidence about domestic economic
prospects must involve an initial spot appreciation of the real
value of domestic currency to a level above its long-run equilibrium
value.
If these movements can be accomplished through movements in the
nominal exchange, there is a chance that all will be well and
good. Of course, monetary policy can get things wrong even in
a floating exchange rate regime; but while a floating rate is not a sufficient
condition for overall stability, it is certainly a necessary one. If the nominal exchange rate is abolished
and national monetary policy eliminated through membership of
a monetary union that is not also a political union, disaster
is almost bound to strike. In the boom phase, when strong rate-of-return
expectations are producing a simultaneous boom in investment and
consumption, interest rates cannot rise and the nominal exchange
rate cannot appreciate. Instead, asset prices are forced up, further
stimulating both investment -- as the cost of capital is reduced
and consumption as perceived household wealth increases. The economy
overheats, and eventually inflation sets in.
But as capital accumulation proceeds, the rate of return on capital
gradually subsides back towards its starting point, even if the
process takes several years. As it does, business investment does
not just decelerate -- it falls in absolute terms. A similar story
can be told about consumer investment -- residential construction
and purchases of consumer durables. As domestic demand falls back,
net exports need to rise to fill the gap, a gap made bigger by
the increase in capacity produced by the preceding years of strong
investment. But, by definition, the exchange rate cannot adjust
to aid this process. Instead, the lagged effects of past overheating,
showing up in inflation, actually worsen international competitiveness.
With domestic demand falling and competitiveness worsening simultaneously,
the economy goes into a tailspin. Unemployment rises; inflation
begins to fall back, even though for some time it remains above
levels in competitor countries. Since nominal interest rates are
set outside the domestic economy, falling inflation pushes real
interest rates up while the rate of return on capital is coming
down -- this combination produces falling asset prices, worsening
the decline in domestic demand. To re-balance the economy, domestic
inflation has to fall below that in other countries under the
influence of recession and rising unemployment. But the process of disinflation
(perhaps even deflation) constantly pushes real interest rates
up. Worse, asset deflation weakens
balance sheets, including
the government's. Bankruptcy
and default, including government default, become real possibilities. Credit spreads widen, exacerbating
the problem of excessively high real interest rates. Asset markets
weaken further. The
circle is vicious indeed.
If nothing is done to break into it, the outcome will be not just economic and
financial collapse but social and political chaos.
THE UNPLEASANT FINANCIAL IMPLICATION OF A SINGLE CURRENCY
This story is a sadly familiar
one. In the past, it described the experience of many countries
subjected to Gold Standard constraints. Default, and political
revolution, usually preceded "going off gold". It also
describes the experience of Britain, Scandinavia and Iberia in
the late 1980's and early 1990's. In the countries concerned,
government default and political regime change were avoided by
breaking free from the exchange-rate constraint -- whether ERM
membership or pegging to the ECU -- that had caused the problem.
Within EMU, there is no political, legal or financial mechanism
for leaving the single currency short of leaving the EU altogether.
So what happens to countries that get themselves into a cycle
of this sort?
In Europe the advocates of monetary union have always been quite
clear about the unpleasant financial implication of a single currency.
For them, the crisis that will be created by the euro represents
the route to establishing colonial administration in the smaller
EMU countries. As the chairman of the European Commission, Romano
Prodi, put it earlier this year, the euro will oblige the EU to
provide itself with a whole new set of centrally-administered
powers, powers it is now politically unacceptable to claim, but
powers which will be grabbed after the crisis created by the euro
has come to pass. One should be prepared to take him at his word.
But what crisis? What powers?
Within EMU, Ireland, Portugal and Finland have all gone through
the up phase of a cycle generated by a discrepancy between the
anticipated rate of return on capital and the ex ante real rate
of interest. They are now clearly in the down phase of that cycle.
In Ireland's case, the boom was so fierce that cock-eyed optimists
can contemplate a sharp fall in the growth rate as perfectly absorbable.
But in none of these countries -- with Greece to follow rather
soon -- will the process end with a nice, smooth return to a "sustainable"
long-run growth rate. All of them will face depression, deflation
and potential default. Public sector financial positions in all
of them will deteriorate with amazing speed (in the "peripheral
Europe" boom-bust cycle a decade ago, for instance, government
borrowing as a percentage of GDP increased in several countries
by more than a dozen percentage points of GDP in just three or
four years), yet all of them begin with public sector debt ratios
higher than was Argentina's at the beginning of its recession.
And the accession countries will assuredly follow a similar path
when they join EMU.
Can the EU stand idly by and watch this happen? At first, yes.
The ECB will claim that individual country developments are not
its concern. And the EU as whole may argue that the countries
concerned knew the rules, including the budgetary rules of the
so-called Stability Pact: they have made their own beds, now they
must lie on them. But that attitude cannot possibly persist. For
however small these countries may be, financial markets will be
aghast once the full horror of the slump, and it sociopolitical
implications, becomes apparent. Ultimately, the ECB will be forced
to behave as if it were the central bank of the small countries,
easing monetary conditions massively depreciating the euro to
keep the small countries afloat -- at the expense of inflation
elsewhere in the area -- until a "political" solution
can be arranged. What the politicians will decide will be to change
the rules that currently prohibit EU bailouts of individual member
countries. Bailouts will be instituted in return for the forced
signature of the smaller countries on a new treaty which will
extinguish what remains of national political independence in
Europe. The progenitors of EMU knew exactly what they were doing.
Thus Jacques Delors, for instance, said in 1995 that, "Monetary
union means [our emphasis] that the Union acknowledges
the debts of the member states of the monetary union". The
syntax is contorted, but the logic is clear: the "no bailout"
provisions in the original EMU setup were a sham, designed merely
to reassure the German public, which had always intuitively tended
to believe that a monetary union without a political union must
become a debt union.
What would a European political union, necessary though not sufficient
for superpower status, look like? It would certainly be plagued,
as was the Austro-Hungarian empire, by a resurgence of nationalism.
But things would be worse than that. For Europe is now multi-ethnic and multi-cultural. Such features have not been a problem-free
even for the United States. But the United States has, at least
in terms of its national myth, been a melting-pot in which races,
languages, ethnic origins are fused in the pure flame of patriotism,
a patriotism which is defined by allegiance to the constitution,
to political institutions and political traditions. The American nation,
that is, is a politically-defined nation. In Europe, it beggars belief to imagine that
a politically-defined nation could be forged (although one should
note, with horror, the recent press reports that five years ago
the EU Commission wrote a secret paper arguing that political
union would not come about without the perception of an external
threat and that a terrorist outrage could contribute to producing
such a perception). No, a political union in Europe would be created
out of the deliberate destruction of existing politically-defined
nations. And in that vacuum, populations would search for other
sources of identity. It is all too clear that they would convince
themselves, or be convinced by demagogues, that they had found
their identity in terms of race, ethnic origin, language or religion.
Europe would become a powder-keg of prejudices and hatreds. That
is a horrifying prospect.
What of the third element of
the American illusion about EMU, that EMU was a milepost on the
way to some marvellous form of "global governance"?
Well, it is certainly the intention of the EMU proponents to use
the putative superpower status of "Europe" to take the
US "hyperpower" down a few pegs and force America to
engage in negotiations across a wide range of issues. But that
desire is not flowering of a global "solidarity": it
is a quite explicit attempt to subjugate the US and to move the
world away from the dominance of market forces and towards a more
bureaucratic mode of international decision-making.
A former member of the Monetary Policy Council, as it then was,
of the Banque de France put it very clearly a few years ago: monetary
union in Europe, he wrote, would increase the attractiveness of
the euro to international investors. That would, it was hoped,
suck capital out of the US, drive up American interest rates,
create unemployment in the US and force the a weakened and chastened
US to the negotiating table with "Europe". One can argue
about the economic reasoning he employed, and things have certainly
not worked out as he intended, but the intention was perfectly
clear.
The economic analysis above certainly points to problem in the
concept of economic "globalization" and international
capital market integration. There is definitely an inconsistent
triad. Global financial market integration,
national political independence and imperfectly flexible exchange rates cannot all exist together. One of the three has to go. In the Bretton Woods
era, it was capital market integration that was sacrificed, a
sacrifice that kept most of the non-OECD world in poverty. Under
the Classical Gold Standard, fixed exchange rates in peripheral
countries were abandoned from time to time, even though the social
and political acceptability of the safety valve of mass migration
was much greater then than now. One can, it is to hoped, remain
confident that the
US will not, despite the
ominous utterances of the "world governance" advocates,
ever willingly
give up its political independence.
But if the US neither wishes to nor is capable of enforcing a
global empire as away of producing world political union, and
if Europe is willing to do so but is incapable of doing so, which
of the two other elements of the inconsistent triad will be abandoned?
Europe has
never abandoned a preference for fixed exchange rates and has no intention of doing so: leaving
the exchange rate to be determined by the private sector has always
been anathema to many European, particularly French, minds. There
is undoubtedly a current of opinion even within the United Sates
that would like to see a return to fixed rates, preferably via
a system of pegs to the dollar or even widespread dollarization.
'THIRD WAY' COULD INCLUDE WORLDWIDE CAPITAL, FINANCIAL CONTROLS
The outcome is far from clear.
But it does seem likely that we shall go through a "mixed"
period, a kind of "Third Way" if you like, in which
there are more and more attempts to restrict the ability of the
private sector to move exchange rates around and that this restriction
takes the from not only of government-imposed pegs, target ranges
and the like (and a collapse of the yen under the strain of Japan's
unsustainable public finances could well provide an excuse for
such G-3 target ranges this year) but also from capital controls,
whether explicit or, more likely, implicit.
Measures against money laundering, however necessary and justified
in current circumstances, will, one has to fear, be used for all
sorts of purposes other than fighting terrorism, including that
of imposing implicit exchange controls. The Market Abuse Directive
currently going through the EU legislative mill, which allows
the authorities almost unlimited discretion in deciding, ex post,
what constitutes a criminal offence of abuse, will be a weapon
of ex ante intimidation in their hands. The ominous and sinister
article 59 of the EU treaty permits the imposition of capital
controls between the EU and the rest of the world. Like every
other article of the treaty it is there for a purpose -- it is
intended to be used. It can be activated by a qualified majority
vote of the member states -- a financial nuclear weapon aimed
at London above all. All in all, there are just too many straws
in the wind to be ignored.
This, too, is an aspect of the bull market in government which
has now begun. It is by no means the only one. Fiscal policy is
back in vogue everywhere. Budget deficits will rise and, soon
after, so will taxes. Government subsidies to firms are back in
a big way, everywhere. In Europe, just in one three-week period
in the autumn of 2001 one saw: the effective nationalization,
socialization, corporatization, or whatever, of Swissair; the
effective re-nationalization by the Swedish government of the
forestry interests of the firm, Assidomän; and the expropriation
by the British government of Railtrack. It is possible that telecommunications
companies in Europe, only recently de-nationalized, will face
some from of re-nationalization in the next few years. The airline
sector will be "rationalized", "restructured"
or "consolidated" not by market forces but by Brussels
fiat. In
Japan, further bailouts of the banking system so extensive as
to amount to de facto nationalization appear close to inevitable. Former Communists are now in power
in Poland, and former Communists have made stunning gains in local
elections in Berlin.
Free trade
is coming under strain: the US government has imposed import duties
on steel and the EU is likely to retaliate. The recriminations begun by the Merrills suit
and the Tyco and similar affairs will be carried further, bringing
the possibility of re-regulation both of financial markets and
of corporate America.
The problems afflicting the dollar and the yen are not so nakedly
political in origin: certainly, they are not deliberately pre-programmed
in the way the manifold disasters that will engulf Europe have
been, at least in part, deliberately pre-programmed. But they
still pose serious risks for world financial markets.
JAPAN: MASSIVE INFLATIONARY DEBT REPUDATION POSSIBLE
The problems of Japan are wholly
intractable. The public debt catastrophe alone is enough to justify
that conclusion. A crisis, although its precise timing cannot be predicted, cannot be avoided for very much longer.
With a debt-to-GDP ratio of around 250% and a true budget deficit
in double figures as a percentage of GDP, there is no feasible
alternative to a
choice between outright default,
government expropriation
of private sector assets
and a massive inflationary
repudiation of government debt.
Default or expropriation would bankrupt the life insurance sector,
with potentially alarming social and political consequences. Inflation is the more
likely outcome. The route
to very rapid inflation will be through a massively-depreciating
yen. What would that involve? Once the process began, no-one in
the private sector would willingly hold any government debt except
at massively-increased yields. So the BoJ would have to acquire the whole
government debt stock. That
would involve something like a twenty-fold increase in the monetary base.
All economists, whether monetarists or not, would accept that
such an increase would mean hyperinflation and a dollar/yen level of at least
1000 if there were no attempt by other countries to restrain yen
depreciation. In response,
even though yen depreciation on such a scale would soon create
Japanese inflation and claw back some of the initial real depreciation,
other countries would panic and intervene to attempt
to support the yen, implying
excessive liquidity creation and inflation at home (if foreign governments bought up the
Japanese debt stock and were ultimately forced to leave interventions
unsterilized, the world monetary base would about double). An
attempt to institute exchange
rate target zones would be very likely.
And in the changing political environment in the world, governments
would be much more likely than in recent years to attempt to buttress their exchange-rate
policies with capital controls,
whether implicit or explicit.
In the United States, the late-80's boom got out of hand, involving
over-investment, over-consumption, a stock-market boom and generalized
financial excess, largely because the Fed did not raise interest
rates aggressively enough and soon enough. As a result, the downturn,
when it came, was violent as far as the business sector was concerned.
A similar adjustment has not yet taken place in the household
sector. That is largely because the Fed's very substantial rate
cuts last year provided households with ample incentives -- via
increased housing market wealth; equity release made possible by mortgage
refinancing; and zero-rate
financing offered by car firms -- not to adjust their balance
sheets. Just last week Greenspan was implicitly encouraging households
to carry on spending by assuring them that their balance sheets
were sound, especially if, he claimed, they owned their own homes.
To an extent, the Fed's hand has been forced by the ongoing appreciation
of the dollar last year, an appreciation that has only recently
begun to reverse. Unless the dollar's depreciation is much bigger
than we have seen so far -- which is possible but not assured
-- and, importantly, a weaker dollar is maintained for several
years -- unlikely given the problems of Japan and euroland --
the Fed will have to maintain interest rates below "neutral"
levels for a long time to come, in an attempt to keep the consumer
spending. But such a strategy will only delay, not avoid, the
necessary balance sheet adjustment and lay the ground for a crisis,
in two or three years' time, that will involve a choice between liquidation
and inflation. The choice
will dictated by whether or not it has to be made just before
or just after the next presidential election, but on balance inflation is likelier
to be chosen.
WORLDWIDE RETURN TO INFLATIONARY 1970s, GOLD TO SHINE
In short, there are many politico-economic
trends in place or clearly in prospect that suggest a return to
the world of the 1970's: inflation (probably triggered first in
Japan, but with euroland and the US also prone to inflation);
deficits; taxes; subsidies; regulation; government intervention
and control; reduced freedom of financial markets and perhaps
of international capital movements in particular; political instability
and social unrest. All of these trends will be aggravated by the
efforts of the European imperialists to achieve their ends through
an economic and financial disaster deliberately created by EMU.
With a bull market in government in place, the prospect of prolonged
period of a high rate of return on capital looks remote. Given
that, the recent bear
market in stocks will be reversed
-- as the Fed is currently unsuccessfully trying to reverse it
in the US -- only
through deliberate action by central banks to sustain stock prices at overvalued levels,
a policy
that ultimately must lead either to general inflation or a crash
in stocks. The inflation
route -- more likely to be chosen -- would mean a bear market
in bonds. So what about gold?
In the absence of a return to the Gold Standard, a return that
is neither
likely nor desirable (though
it would be less bad than inevitably-politicized world monetary
"co-ordination"), three things are necessary for the secular bear
market in gold to be replaced by a bull market. First, there must be inflation or expectations of inflation.
Second, investors must seek an inflation-proof asset that is an "outside" asset -- that is, an asset that is not the corresponding
liability of someone else. Third, the palate of available
financial assets must be restricted. Sadly, these preconditions are likely
to be met within the next few years.
Inflation
is likely for the reasons
analysed above. And all the factors that will lead to inflation
will operate through first weakening balance sheets, whether of
the private sector or of the government or both. Credit worries
will mushroom, increasing
the attractiveness of "outside" assets such as gold.
Finally, the accelerating trend in the world towards the restriction
of free capital movements and towards a contraction in the financial
services industry in general will reduce the available alternatives to gold.
There are many dark clouds in the sky. If they have a bright lining,
it is perhaps, if not gilt-edged, at least gold-coloured.
This article prompted a USAGOLD Discussion Forum contest. You can access the "Dark Visions" submitted by the participants at the following link:
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by Bernard Connolly, Chief
Global Strategist, AIG
June 11, 2002
This transcript of Connolly's presentation to the 2002 LBMA conference in San Fransisco first appeared at theminingweb.com, an international mining publication focusing on mining finance and corporate news. It is reprinted here with permission.
Copyright © 2002. All Rights Reserved.
Reprinted by USAGOLD with permission of theminingweb.com and Mr. Connolly. Further reproduction without consent is prohibited.
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