Gold and Cheap Money Bubbles: Expert Analysis

Posted On Friday, Aug 20, 2010

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Do you know about the "Housing Bubble Story of 2008"?

It all began when Alan Greenspan, former Federal chairman, kept rates at rock bottom levels and left the regulation to indulge itself, leading to the worst financial crisis since the Great Depression. The primary villains in this economic tragedy were "cheap money" and "loose regulations", and when the saga moved towards its climax, the bubble burst; banks failed, unemployment surged, recession worsened and ordinary citizens stayed desolate.


Alan Greenspan defended his stance with a display of naivety: Who could have predicted that United States’ sub-prime housing situation would end in an economic calamity? It seemed to have just missed everybody - Academia, the Federal Reserve, regulators.

Moral of the story: Low rates, cheap money and high liquidity when combined, are the ideal catalysts for the creation of "bubbles".

In hindsight, theorists suggest that keeping rates too low for a long time was the main trigger of the housing bubble fiasco. If drastic rate cuts and rates kept low for too long led to the previous bubble, then is Bernanke repeating the same mistake?


Chart: Comparison of Fed rate cut cycles
Quantum Mutual Fund Comparison of Fed rate cut cycles
Source: Bloomberg


We have repeatedly heard Ben Bernanke’s (present chairman, United States Federal Reserve) pledge of "keeping rates low for an extended period". Bernanke has already lowered rates to almost zero levels, and would most likely surpass his predecessor on a time horizon basis as well. Greenspan’s tenure saw misguided Fed actions create a monstrous housing bubble; a fix which the real estate sector is still battling out.

If the existing situation persists, it remains to be seen - which would be the next bubble to pop?


Bernanke’s current assessment


The Federal Reserve stated that the pace of economic recovery was "more modest than anticipated", a downgrade from the "moderate" pace in June. This could be viewed as a symbolic step towards the additional easing of the monetary policy.


The Fed exit strategy has tried to focus on reducing the size of its blown up balance sheet, and unwind the excesses doled out in an effort to bail out the "too-big-to-fails". The downward economic spiral was supposed to play a significant role in revival and pundits were confident that a methodical exit strategy would help bring the wayward balance sheets to book. But, in the present scenario, the Fed has abandoned the slightest notion of implementing an "exit strategy", and has signaled that it will "recycle" its debt holdings. Simply put - No exit strategy in the foreseeable future.


As per the Fed’s statement, it will buy sufficient new government debt securities to prevent it’s balance sheet from contracting as existing debt securities are paid off. With such a route employed, how exactly is the Fed planning to pull back from the ultra-easy monetary stance of the past two years? Does the Fed have even the intention to pull back? Most unlikely.


The next move


Quantitative Easing

So is this the initiation of round two of Quantitative Easing? Well, not really, since it currently does not involve doling out of more quantity of money; this is just a form of conversion from one form of asset to another.

But, yes, this is surely a preparation for QE II.

It’s like oiling the gun to stay prepared for the war - a very expected announcement by the Fed could trigger it off: Due to further deterioration in the pace of economic recovery it could choose to expand its balance sheet by ramping up the purchases of government debt securities.

Now that would be QE II and we might be closer to it than we anticipate.

However the Fed has maintained that it "will employ its policy tools as necessary". With fund rates basically at zero, policy tools are limited to further Quantitative Easing, where the Fed buys Treasuries in much larger quantities. Their basic aim is to avoid the deflationary trap, and a move towards Quantitative Easing would only serve as a reminder of the same.


When will the Fed step in with "Quantitative Easing"? Well, just as soon as the Administration`s "stimulus-fueled recovery" for the past three quarters evidently fades. But, the problem here is that any further stimulus will have to be much bigger than earlier ones to have a material impact even in the short term.


The Outcome


Monetary stimulus will most definitely fail to spark a genuine recovery, and would also create a never-ending need for successively larger doses. And hence, the only exit strategy this course allows is an overdose - Hyperinflation.


It’s a simple fact that you cannot counter deflation by creating money out of thin air. This may increase liquidity in the economy but it does not lead to actual wealth creation, and hence its actual purpose is defeated. The new money that is pumped in is most often directed towards the problem areas. In an alternate perspective, this is actually destruction of real wealth, because the utilization of new funds to support weak areas is in a way wastage of scarce resources.


So what is the real problem behind this all? The real problem lies in the dearth of political will to suffer any short term shock. These economic cycles need to run their own course to get the economy on track, functioning efficiently with proper allocation of resources. Prices cannot be supported at artificial levels for a long time; markets should be allowed to determine the correct level. It’s highly probable that implementation of exit strategy would bring on a severe contraction in GDP, but on the other hand it benefits the long term growth. Unfortunately, the current regime of more stimulus only helps to increase economic imbalances. It results in increased government deficit, exaggerated economic disparity, mal-investments, wastage of limited resources, over consumption and artificially inflated asset prices.


In such a scenario, more bubbles are bound to evolve, unless misguided interventions are replaced with a solid foundation of savings, capital investment, and industrial production upon which a real recovery can be built.

The natural economic balancing act is disturbed by the shoddy state of paper currencies. Unless policymaking embarks on rational policies and implements a methodical exit, staying invested in gold is an evidently sound option for the while.



Disclaimer:

The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.

Above article is authored by Quantum.

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