The economy and gold

It has long been clear to interested observers that the gold price has displayed some very anomalous behaviour since the mid 1990’s. Evidence eventually surfaced – or was dug out through persistent effort by a small group of people – that the explanation for this anomalous behaviour lay in the fact that gold never lost its monetary role, despite being effectively demonetized when Nixon closed the so-called “gold window” in 1972.

In the mid 1990’s the Clinton Administration brought in Robert Rubin as Secretary of the Treasury and subsequently launched the official “Strong Dollar” policy. Keep in mind that when Nixon took the radical if necessary step in 1972 to close the option that foreign central banks had to exchange dollars for US gold at /oz, the dollar was trading at ¥357 and at the equivalent of 487 to the Euro.

Since then the US greenback has consistently lost value to the major currencies, except for two earlier rallies, starting in 1973 and in 1978 respectively. The latter one ended in 1985 with the Plaza accord when the US and Japan among other terms agreed to weaken the dollar again, after it had firmed from ¥180 in 1978 to ¥260.

A weaker dollar suited the US in 1985; however, ten years later when the value of the US currency had sunk to just ¥80, the Clinton Administration believed that a stronger dollar and a concomitant improvement in the US economy was necessary to improve Clinton’s chances for re-election at the end of 1996.

At the time, Japan and the US had been engaged in lengthy negotiations on trade and these were successfully concluded in 1id 1995. One of the terms in this agreement was that both nations would work to restoring the strength of the dollar. This suited Japan as well, as the Bank of Japan (BoJ) immediately released a flood of Yen into the Japanese financial system, allowing financial institutions to borrow cheap Yen well below 1% with which to buy US dollars that offered returns of up to 7% on US Treasuries. This generous spread helped Japanese banks loaded with bad debt to build up new reserves.

In the US the strong dollar policy enabled a sustained steep increase in the money supply – priming the economy so that Clinton could run a second campaign based on the “It’s the economy, stupid” slogan that proved so successful for him in 1992 when the economy was in recession and Bush senior got lambasted at the polls – without fear that foreign investors would be frightened off by the risk of inflation and having the Fed increasing interest rates to combat rising prices.

At that time, much of US industry was already in the process of moving manufacturing plants outside the US and even off-shore to where labour was cheap. A strong dollar had the effect that all imports, including those manufactured by US corporations, remained cheap, which was a major factor in the ‘war on inflation’ that helped keep interest rates low and ensured that foreign funds kept flowing into the US.

One problem of course was that the gold price was sensitive to all the manipulation going on in the US economy. As barometer of potential problems in the financial world it was imperative that the gold price should not increase to signal trouble, a was beginning to happen early in 1996, when the price rise above 0 for the first time in years. Enter the “Gold Carry” and the gold price slumped back below 0 on its way to 0.

That was then. Today we find that quite out of the blue and on very flimsy evidence Wall Street takes off into the biggest 7-day rally since the heady days of 1973; the dollar firms substantially, in sympathy to Wall Street it would seem and also for no other discernible Reason, while the gold price slips back below 0 and even threatens to dip below 0 again. Of course, the fact that the US have elections early in November and that Bush’s Republican Party desperately needs to get ‘ firm hold on Congress by capturing some seats from the Democrats have nothing to do with this quite fortuitous rally in equities and the dollar. Just a pity that US Treasuries are being sold off and that the rising long bond yields could bring the property boom to an end.

In the mean time we have to wait and see whether the markets will extend the trend or at least hold firm near current levels long enough to exert some influence on the voting pattern three weeks from now. And what the effect of all this on gold will be.