"The state of confidence so necessary to the functioning of any economy has been torn asunder. Vicious cycles of ever rising and reinforcing fears have become contagious. Some exchange rates have fallen to levels that are understandable only in the context of a veritable collapse of confidence in the functioning of an economy."
"The exchange rate changes appear the consequence not of the accumulation of new knowledge of a deterioration in fundamentals but its opposite: the onset of uncertainties that destroy previous understandings of the way the world works. That has induced massive disengagements of investors and declines in Asian currencies that have no tie to reality."
"With the new more sophisticated financial markets punishing errant government policy behavior far more profoundly than in the past, vicious cycles are evidently emerging more often. For once they are triggered, damage control is difficult. Once the web of confidence, which supports the financial system, is breached, it is difficult to restore quickly."
"Such market panic does not appear to reflect a simple continuum from the immediately previous period. The abrupt onset of such implosions suggests the possibility that there is a marked dividing line for confidence. When crossed, prices slip into free fall--perhaps overshooting the long-term equilibrium--before markets will stabilize."
Confidence, which is linked to future expectations, can turn on a dime. When a change occurs, global financial networks ensure that the effects are quickly felt throughout the world.
The above are quotes from Alan Greenspan's February 12 testimony before Congress during which he analysed the causes of the Asian financial crisis and supported an increase in US funding of the IMF. Greenspan's message is clear: in today's financial systems, confidence is everything. Although he recognizes the moral hazard inherent in IMF bail-outs, whereby banks reap the rewards of their investments when things go well but do not suffer the consequences when they go badly, he strongly advocates increased IMF funding in an attempt to maintain the web of confidence.
During his testimony Greenspan mentions the greater sophistication of modern financial markets as a contributing factor to the increased prevalence of financial breakdowns. It is this author's opinion, however, that the systems simply provide for the more efficient transfer of information. The root cause of today's problems is a floating currency system in which every currency unit is a liability which comes into existence through the creation of debt. Each currency is therefore underpinned by confidence in the ability to repay debt. Confidence, which is linked to future expectations, can turn on a dime. When a change occurs, global financial networks ensure that the effects are quickly felt throughout the world.
As confidence in any national currency reduces due to inflation fears, high debt levels or political turmoil, the price of gold increases in terms of that currency.
Confidence in the US dollar is at an all time high, leading to a huge demand for dollars from all parts of the world. The EMU countries are seeing an exit of capital into the perceived safety of dollar denominated assets. In Japan massive non-performing loans within the financial system continue to inhibit any hope of recovery, leading to large capital outflows to the US. Throughout the rest of East Asia we are witnessing a scramble for dollars due to a complete lack of confidence in the local currencies and the need to repay foreign debt.
As confidence in any national currency reduces due to inflation fears, high debt levels or political turmoil, the price of gold increases in terms of that currency. In the same way, the high level of confidence in the US dollar naturally corresponds to a low level of investment demand for gold and a low US dollar gold price. The past 17 years have seen an on-going increase in confidence in government backed currency (and a corresponding reduction in the demand for monetary gold). Like any bull market, a point is reached when all news becomes positive. For example, in recent times we have seen confidence in the US government grow in parallel with the White House scandal and escalating prospects of Middle East war. Similarly, we are witnessing the US share market surge to new highs at a time when earnings growth will be significantly reduced due to Asia's economic problems. When the turning point in confidence arrives, the gold price will rise irrespective of Central Bank sales or lending. It is also likely that the gold price will rise the most in terms of the currencies of the countries which have sold their gold reserves (with the probable exception of the large gold producing nations such as Canada and Australia which will attract capital as gold prices rise).
When the turning point in confidence arrives, the gold price will rise irrespective of Central Bank sales or lending. It is also likely that the gold price will rise the most in terms of the currencies of the countries which have sold their gold reserves.
During the late 1970s a crisis in confidence in government and government backed currency occurred which lead to panic buying of precious metals. Rapid changes in the money supply, with an overall strongly upward bias, resulted in much higher prices for tangible assets, a misallocation of resources, and lower productivity. Expectations of future high inflation became ingrained in the psyche of investors and continued to exert a strong influence on investment decisions throughout the 1980s. Expectations have undergone a change in the 1990s to the point where we now have a 180 degree shift from the mentality of 1980. Despite the fact that money supply is now growing at 1970s levels, there is a widespread belief that inflation is no longer a threat. If you believe in a future which offers no inflation, robust economic growth and low interest rates as far as the eye can see, thenprice/earnings ratios of 25, 30, or even 40, may not be an issue. A problem only arises when something happens which disrupts this utopian view of the future.
Anyone who reads the minutes of the FOMC meetings will realise that the Fed has been concerned about the high levels of money supply growth for some time. Their target growth rate for M3 is between 2% and 6%, yet last year M3 grew by 9%. They are balancing money supply factors and a tight labour market against a potential economic slow down due to the Asian crisis. If they over-estimate the effects of the Asian crisis on the US economy, then the continued infusion of liquidity will certainly cause a resurgence of price inflation, necessitating higher interest rates. If they under-estimate the effects, then corporate profits will be harder hit than expected and we will have a stock market with P/Es way above historical norms in parallel with substantially reduced earnings growth, a recipe for a severe bear market.
It is also unrealistic to think that a cure will be implemented in the absence of a worldwide financial breakdown...
It is likely that the monetary authorities will err on the side of caution, that is, on the side of liquidity. In fact, at this stage in the cycle of confidence momentum has built to the point whereby inaction by the Fed will lead to higher money supply growth rates and a higher stock market. The reason is that if the expectations of economic nirvana remain in tact, people will continue to borrow money will little fear of the consequences and with each new loan more money is potentially added to the total supply.
|
|
The Asian crisis is a natural and inevitable consequence of confidence based money. It is unrealistic to think that such crises will not occur with increased severity and frequency in the future. It is also unrealistic to think that a cure will be implemented in the absence of a worldwide financial breakdown because, as Greenspan says, "it is very difficult for political leaders to incur what they perceive as large immediate political costs to contain problems that they see (often dimly) as only prospective". What we can realistically expect in the future is more of the same. If confidence-based money can be likened to a cancer which has spread throughout the body of the global economy, then governments will continue to perform radiation treatment (read increased regulation and supervision) and surgical operations (read IMF bail-outs) in order to keep the patient alive just a little bit longer.
Milhouse
25 February 1998
The reader is invited to respond to Milhouse's wisdom via email: sas@hk.gin.net
Also by Milhouse:
Understanding Buffett's Silver Play
What Is Greenspan Really Saying?
Currency Turmoil In 1998
Japanese Monetary Problems
Gold Versus The Dollar
European Monetary Union
US Money Supply and the Demand For Gold
US / Japan Trade - Reality Versus Perception
Is Gold Still a Store of Value ?
Central Banks and Their Gold
The Intrinsic Value of Gold
Gold & Disintegration of U.S. Economic Influence
Back to Gold Digest Copyright © 1997 - 1999 vronsky and westerman