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History replaying
One of the most
frequently asked questions from my readers is the title above. Conventional
gold-bug wisdom holds that in 1979 the new Chairman of the Federal Reserve,
Paul Volcker, raised interest rates drastically,
thereby putting an end to the galloping inflation then raging, and aborting
the bull market in gold. Volcker’s
high-interest policies are credited with the feat of turning the dollar back
from the brink where it looked into the chasm of worthlessness, the chasm
into which the French assignat, the German Reichsmark, and the Chinese yuan
(of 1949 vintage) among countless other national currencies have fallen. Conventional
wisdom goes on to conclude that Bernanke,
hopelessly committed as he is to a regime of low interest rates, will be
fired. A new chairman with the outlook and resoluteness of Volcker will be named who will repeat the feat of his tall,
cigar-smoking predecessor, in saving the dollar once more in a nick of time. History
will replay itself.
Lessons
of Kondratieff
My view of the
events then and now is quite different. History is not made by men, tall or
short; rather, events are the product of cycles, in particular,
Kondratieff’s long-wave cycle (K-cycle). By that standard the situation
we find ourselves in now is diametrically opposite to that
thirty years ago. In 1977 the world was approaching the end of an upswing in
the K-cycle that had started in 1947. It took prices and interest rates to
unprecedented heights. Now we are approaching the end of a downswing in the
K-cycle. As a rule turning points in the K-cycle are calamitous events,
resembling a blow-off. So it was in 1979. At that time interest rates and
prices were sky-rocketing and hyperinflation appeared likely. But these
events were just a smoke-screen camouflaging an incipient deflation that
burst on the scene unexpectedly, bringing dramatically lower interest rates,
wide-spread bankruptcies, and the folding of firms that have lost
pricing-power. This deflation has not run its course yet. The worst is still
in store.
The replay of
history in 2007 will be similar except with the opposite signature. Interest
rates are still declining, and so are prices adjusted for inflation. Deflation
is being imported into the United States
from Japan,
through the mechanism of the carry-trade. It appears to confirm and surpass Bernanke’s worst fears. Lethargy is spreading. Businessmen
decline to take the loans offered at historically low rates. Production keeps
contracting; unemployment may follow with a lag. We may even see, horribile dictu,
some genuinely falling prices! Yet these events could be just a smoke-screen
camouflaging an incipient hyper-inflation that would wipe out the dollar for
once and all.
The
China-enigma
I admit that China is in
the position to render these predictions worthless. She could initiate a
cascading of the dollar here and now, wiping out its value before a
deflationary scenario could unfold. To the extent that this is a real
possibility, my deflationary predictions are, of course, conditional on the
outcome of the recent negotiations in Beijing.
However, I would expect that Treasury Secretary Paulson and Federal Reserve
Chairman Bernanke would cut a deal. Most likely the
deal would save the dollar from an ignominious collapse just now. The dollar
would get a new lease on life. All this would be in keeping with my motto:
“expect the unexpected”. The U.S. will go to any length, pay
any price, and meet any challenge to defend the dollar. On the other hand China has the
power, and the skill, to extort a bribe. No bribe is too high. After all, it
is just a matter of printing it, Bernanke-style. Considering
the alternative, it is still cheap.
This is not to
suggest that China
is not in an incredibly strong bargaining position. She is. Even after a
complete collapse of the dollar that could cost China up to $1 trillion, her
economy could emerge relatively unscathed, more so than any other economy on
the face of the globe. Inflations and deflations could rage around; China could
feel safe inside of a cocoon of autarky. She has done it before; she can do
it again. You say that China
cannot insulate herself from a world-wide depression? Oh yes, she can. By
allowing the wage level to creep up, she could keep producing for her
domestic markets without any major setback. China has the potential to absorb
everything what she can produce domestically.
True, it is no
fun to write off as worthless a $1 trillion bank account. This is why a deal
between China and the U.S., vastly favorable
to China, is the most
likely outcome of the current negotiations under way in Beijing. It would be naive to expect that
details of the deal will be revealed to the public. But we may guess that no
genuine progress towards stabilization would be made.
Bond
conundrums
I think most
commentators on the bond market got it wrong. They take it for granted that
any new bonds issued by the U.S. Treasury will be received negatively from
now on, in view of the fact that the saturation point for dollars at large,
in their opinion, has now been reached. The only thing foreigners consider
worse than owning dollar balances is owning dollar
bonds: promises to pay dollars in the future. Yet the bond market shows irrational
exuberance in the face of persistent dollar weakness, even in the face of
dollar-devaluation as part of the deal now being cut in Beijing. If there has ever been a true
conundrum, the bond market it is.
A typical
commentary is Peter Schiff’s, dated December 8, on “So what is really holding up
the bond market? It could be foreign central bank buying; Fed monetization;
hedging by the mortgage industry; speculative hedge-fund strategies; a
combination of all these factors; or something entirely different. However,
whatever the prop may be, it will not be there forever. The longer it
remains, the bigger the deluge will be when it finally gives way. The bond
market is in fact a powder-keg. The fuse is lit; we just don’t know its
length. But when it blows, carnage in the bond market and, by implication, in
an economy addicted to low rates will be brutal.”
No, I
don’t think the fuse has been lit. What then is the explanation of the
mystery? It is the $400 quadrillion derivatives market growing exponentially.
That’s what. It represents
a latent demand for new bonds, unlimited quantities of it, so that the game
of musical chairs could go on and on. Moreover, demand is
further fueled by the carry trade. The carry trade sells
the high-priced Japanese bonds and buys the low-priced U.S. bonds. As
I have pointed out, it is the mechanism whereby deflation is imported from Japan to the United States. This arbitrage
results in a narrowing of the interest-rate spread. But that spread is still
far from disappearing and, as long as it is positive, the carry trade will
thrive and interest rates in the U.S. will keep falling. Bond
speculation on the long side of the market will continue, giving further
boost to the game of musical chairs. All this means deflation, even
depression. Bernanke will keep stoking its fires by
printing more dollars, hoping that the new money will go into commodity
speculation, ending the depression. It won’t. The new money will go
into bond speculation, deepening the depression. That’s where smart
money is made. In the bond market. On the long side. This is what makes the depression feed
upon itself.
It is not likely,
although neither is it impossible, that China will pull the rug from
under the bond market. The game of musical chairs will probably go on,
possibly for several more years. The sky is the limit for derivatives, and
for the monetization of the U.S.
government debt.
Part of that
scenario is the price of gold. It will not be allowed to escape the gravity
of earth, as it would do in the absence of clandestine official intervention.
Although they will be able to limit the rise in the gold price, the powers-that-be
will not be able to limit the rise in its volatilility.
Gyrations of gold will assume galactic dimensions, increasing uncertainty in
its wake. Enormous fortunes will be made — and lost — both by the bulls and the bears
betting that “the trend is their friend”.
The second
coming of Paul Volcker is a myth. In 1979 the United States
was in a much stronger financial and economic position than it is now and it
could take the strong medication of high interest rates without danger of
succumbing to the ‘sudden death syndrome’.
Presently, the United States
economy is on a life-supporting system. China’s hand is on the
switch. Paul Volcker’s regimen of high
interest rates would be tantamount to turning the switch off.
Antal E. Fekete
December 14, 2006.
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