Jim Rogers’ recent comments regarding the price of gold eventually moving beyond $2000 must provide warmth to the cockles of the god bug heart. But the press excitement as usual emphasized the $2000 figure far more than the word “eventually,” which may in fact be the key to building wealth through gold ownership.
Recent excitement anticipating a sudden upward ride on gold appears a little simplistic, given the historic precedent and the current market conditions. In the economies of North America and Europe which combine enormous financial leverage with massive productive overcapacity, we should first expect a climax of deflation. And, as 2008 showed, even gold is vulnerable to deflation.
Of course the debts and off-balance sheet obligations being generated by the big governments are too large. Of course they will be ultimately be printed away. But to expect the major fiat currencies to go down without a fight is unrealistic in the extreme. The most likely expectation of what is unfolding can be summarized as “First Deflation, then Inflation.” It is a path that has been well-worn in dozens of serious debt crises of the past hundred years.
The History: High Inflation Arises from Severe Distress
A very short history of public sector finance on planet Earth can be outlined as follows. There is more love than there is money. And there is less wealth than either of the foregoing. These truths are driven home from time to time as people re-learn the lesson that although money can be printed, wealth cannot. Where we see governments that spend beyond their means, we eventually also find governments that default on debt and print away paper obligations. The winners in these events own gold and the losers own bonds.
There are many piecemeal accounts of such circumstances as they relate to, say, Argentina in 2002, or the US Confederacy during the Civil War, or Mexico in the 1980’s or Japan in 1945-46 or Germany between the Wars. Interestingly, the defaulters each find their own unique formula to offload debts. Some refuse payment outright, while others choose the back-door road of printing currency. Some try to hold onto a punishing hard-currency peg long past the point of sustainability and are undone by riots in the streets. But the starting point is always the same – too much debt.
Fortunately for those readers who do not have the patience for the individual case study, two American professors, Carmen Reinhart and Kenneth Rogoff have produced a comprehensive analysis. Put together in 2008, Reinhart and Rogoff’s fascinating study of more than eighty historic sovereign defaults on domestic obligations in sixty-four countries allows one to look systematically at crises which were generally regarded as a series of one-off problems.
Some of the most interesting data was summarized in Reinhart and Rogoff’s figure six, which shows the average length and depth of the crises.
Figure 1: Economic Growth in Defaulting Countries by Year
Source: Reinhart & Rogoff, 2008. Note source data are displayed graphically only.
Reinhart and Rogoff go on to quantify the inflationary impacts of the crises. External defaults tend to be associated with inflation of more than 300 per cent by year three. Inflation from domestic debt defaults tend to be more severe, averaging more than a cumulative 8000 per cent three years after the crisis.
One interpretation of the data with respect to our current situation would be as follows. First, if we are heading down the path towards some kind of eventual default on government obligations in the big economies, then we haven’t nearly reached the distress level of economic decline that precipitated default/inflation climaxes in the past. Default/inflation scenarios had large GDP declines associated with them (on average a cumulative decline of 8%) and the declines tended to take a long time (3-4 years on average).
Based on a review of the Reinhart & Rogoff cases, it is also worth noting that, by the yardstick of debt as a ratio of government revenues, both the US and Japan are within the rough ballpark of obligations that led to default/inflation scenarios in the past.
The Present: Looks Like Deflation
There are several reasons why, after a brief and enjoyable relief, I believe deflation is not yet done with us.
The first factor is an underlying economic weakness that belies our strong market rally. Equity markets do often lead recoveries, agreed, but the stark divergence between the slumping path of the underlying economy and the soaring stock market cannot be sustained. Against new year-to-date highs in equity indices we observe weakening consumer credit and persistently higher unemployment. To pick the most glaring example, defaults on US commercial property mortgages are now spiking. Another broad-based indicator, is the Baltic Dry Index, a leading bellweather for global trade. This index peaked in May and has looked sick ever since. What isolated rays of economic sunshine we do see (such as Canadian housing starts and American auto sales) exhibit the telltale signs of pedal-to-the-metal government subsidy.
In reality, the fire hoses of central bank cash appear at this stage to have sparked a short-covering rally, but little more.
And the stimulus itself appears vulnerable. Now that the panic of the moment has subsided, people are, quite rightly, beginning to ask questions. Who voted for permanent and unlimited government-backed mortgage lending, and how exactly did the guiding economic principle of our time become “Too Big To Fail?” Shutting down the printing presses even momentarily to debate the validity of these policies could well exacerbate a relapse in credit and equity markets.
A Golden Calendar Trade
So how does one capitalize on the current situation? In the long run, it is hard to see a way for most major democracies to avoid printing away a significant portion of the obligations that are related either to past deficits or future promises related to entitlement programs. In looking at the fiscal hand President Obama has been dealt, my only question is whether it more closely resembles that of Jimmy Carter, who presided over “stagflation,” or Jefferson Davis, the Confederate President who oversaw America’s only true hyper-inflation episode.
But in the short run we could be looking at a fall almost as steep as that of 2008. A last dash for cash could up-end gold, silver, oil and the rest of the hard asset trade. One of the key insights of Reinhart and Rogoff is that it takes a long time for a financial crisis of the type we are experiencing to progress to high inflation. In their study of dozens of such debt crises, they observed an average peak to trough period of three to four years. As bad as it seems, our downturn is just an infant, approaching the two year mark.
There are a number of ways to put together a position that hedges short-term deflation in light of longer-term inflationary pressure. One of the simpler ways to execute this would be through what the futures traders refer to as a “calendar trade.” Selling short term gold contracts (October 2010 gold futures traded recently at $1016) and using the proceeds to fund longer term long positions (December 2013 contracts are priced for gold at $1108) is a trade in keeping with this “first deflation, then inflation” hypothesis.
Another approach may be just to steel oneself for a choppy six months or year, while markets test the southern end of the recent trading range. Trading in-and-out may be hard to execute from the breathless excitement of the moment. My own approach is to mix a pinch of the hedge within a strategy that generally takes this latter approach.
Geoff Castle
www.marketdepth.typepad.com
Recent excitement anticipating a sudden upward ride on gold appears a little simplistic, given the historic precedent and the current market conditions. In the economies of North America and Europe which combine enormous financial leverage with massive productive overcapacity, we should first expect a climax of deflation. And, as 2008 showed, even gold is vulnerable to deflation.
Of course the debts and off-balance sheet obligations being generated by the big governments are too large. Of course they will be ultimately be printed away. But to expect the major fiat currencies to go down without a fight is unrealistic in the extreme. The most likely expectation of what is unfolding can be summarized as “First Deflation, then Inflation.” It is a path that has been well-worn in dozens of serious debt crises of the past hundred years.
The History: High Inflation Arises from Severe Distress
A very short history of public sector finance on planet Earth can be outlined as follows. There is more love than there is money. And there is less wealth than either of the foregoing. These truths are driven home from time to time as people re-learn the lesson that although money can be printed, wealth cannot. Where we see governments that spend beyond their means, we eventually also find governments that default on debt and print away paper obligations. The winners in these events own gold and the losers own bonds.
There are many piecemeal accounts of such circumstances as they relate to, say, Argentina in 2002, or the US Confederacy during the Civil War, or Mexico in the 1980’s or Japan in 1945-46 or Germany between the Wars. Interestingly, the defaulters each find their own unique formula to offload debts. Some refuse payment outright, while others choose the back-door road of printing currency. Some try to hold onto a punishing hard-currency peg long past the point of sustainability and are undone by riots in the streets. But the starting point is always the same – too much debt.
Fortunately for those readers who do not have the patience for the individual case study, two American professors, Carmen Reinhart and Kenneth Rogoff have produced a comprehensive analysis. Put together in 2008, Reinhart and Rogoff’s fascinating study of more than eighty historic sovereign defaults on domestic obligations in sixty-four countries allows one to look systematically at crises which were generally regarded as a series of one-off problems.
Some of the most interesting data was summarized in Reinhart and Rogoff’s figure six, which shows the average length and depth of the crises.
Figure 1: Economic Growth in Defaulting Countries by Year
| Years to Climax of Crisis | Real GDP Index in Domestic Default Crises | Real GDP Index In External Defaults |
| Four years before | 100 | 100 |
| Three years before | 99.8 | 101.8 |
| Two years before | 99 | 102.2 |
| One year before | 96.5 | 101 |
| Year of Crisis | 92.3 | 99.8 |
| One year after | 93.8 | 100.2 |
| Two years after | 96.4 | 101 |
| Three years after | 100.5 | 102 |
Reinhart and Rogoff go on to quantify the inflationary impacts of the crises. External defaults tend to be associated with inflation of more than 300 per cent by year three. Inflation from domestic debt defaults tend to be more severe, averaging more than a cumulative 8000 per cent three years after the crisis.
One interpretation of the data with respect to our current situation would be as follows. First, if we are heading down the path towards some kind of eventual default on government obligations in the big economies, then we haven’t nearly reached the distress level of economic decline that precipitated default/inflation climaxes in the past. Default/inflation scenarios had large GDP declines associated with them (on average a cumulative decline of 8%) and the declines tended to take a long time (3-4 years on average).
Based on a review of the Reinhart & Rogoff cases, it is also worth noting that, by the yardstick of debt as a ratio of government revenues, both the US and Japan are within the rough ballpark of obligations that led to default/inflation scenarios in the past.
The Present: Looks Like Deflation
There are several reasons why, after a brief and enjoyable relief, I believe deflation is not yet done with us.
The first factor is an underlying economic weakness that belies our strong market rally. Equity markets do often lead recoveries, agreed, but the stark divergence between the slumping path of the underlying economy and the soaring stock market cannot be sustained. Against new year-to-date highs in equity indices we observe weakening consumer credit and persistently higher unemployment. To pick the most glaring example, defaults on US commercial property mortgages are now spiking. Another broad-based indicator, is the Baltic Dry Index, a leading bellweather for global trade. This index peaked in May and has looked sick ever since. What isolated rays of economic sunshine we do see (such as Canadian housing starts and American auto sales) exhibit the telltale signs of pedal-to-the-metal government subsidy.
In reality, the fire hoses of central bank cash appear at this stage to have sparked a short-covering rally, but little more.
And the stimulus itself appears vulnerable. Now that the panic of the moment has subsided, people are, quite rightly, beginning to ask questions. Who voted for permanent and unlimited government-backed mortgage lending, and how exactly did the guiding economic principle of our time become “Too Big To Fail?” Shutting down the printing presses even momentarily to debate the validity of these policies could well exacerbate a relapse in credit and equity markets.
A Golden Calendar Trade
So how does one capitalize on the current situation? In the long run, it is hard to see a way for most major democracies to avoid printing away a significant portion of the obligations that are related either to past deficits or future promises related to entitlement programs. In looking at the fiscal hand President Obama has been dealt, my only question is whether it more closely resembles that of Jimmy Carter, who presided over “stagflation,” or Jefferson Davis, the Confederate President who oversaw America’s only true hyper-inflation episode.
But in the short run we could be looking at a fall almost as steep as that of 2008. A last dash for cash could up-end gold, silver, oil and the rest of the hard asset trade. One of the key insights of Reinhart and Rogoff is that it takes a long time for a financial crisis of the type we are experiencing to progress to high inflation. In their study of dozens of such debt crises, they observed an average peak to trough period of three to four years. As bad as it seems, our downturn is just an infant, approaching the two year mark.
There are a number of ways to put together a position that hedges short-term deflation in light of longer-term inflationary pressure. One of the simpler ways to execute this would be through what the futures traders refer to as a “calendar trade.” Selling short term gold contracts (October 2010 gold futures traded recently at $1016) and using the proceeds to fund longer term long positions (December 2013 contracts are priced for gold at $1108) is a trade in keeping with this “first deflation, then inflation” hypothesis.
Another approach may be just to steel oneself for a choppy six months or year, while markets test the southern end of the recent trading range. Trading in-and-out may be hard to execute from the breathless excitement of the moment. My own approach is to mix a pinch of the hedge within a strategy that generally takes this latter approach.
Geoff Castle
www.marketdepth.typepad.com
