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Ronald Stoeferle

Ronald Stoeferle

Ronald is a metals analyst at Erste Group. Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4…

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Gold in the Context of the Financial Crisis

The paradox is the trigger of the crisis, i.e. too cheap money, is now being treated as its medicine. This could be regarded as an absurdity of historical proportions. Three years ago probably nobody would have expected the Federal Reserve to take USD 1,250 worth of mortgage-backed securities (MBS) onto its balance sheet. This is certainly not a step that would be beneficial to building confidence in paper money– and neither are the countless desperate stimulus and bailout packages of the past few years. On the other hand this represents a clear argument in favour of gold and should thus ensure a positive environment for gold investments. 

The following quote is an impressive reminder that history tends to repeat itself:

“We have tried spending money. We are spending more than we have ever spent before and it does not work... We have never made good on our promises.... I say after 8 years of the Administration we have just as much unemployment as when we started, and an enormous debt to boot!”

Henry Morgenthau, Secretary of the Treasury during the New Deal, May 1939

The Federal Reserve has not been publicly audited a single time since its incorporation in 1913. Now, after years of discussion, a watered-down proposal seems to be close to signing, although it will still have to pass the Senate. The Fed has so far shown dismay at the idea, and only Jeffrey Lacker, President of the Federal Reserve in Richmond, has had open ears for the proposal. The claim that the stability of the value of money was the highest priority seems like a case of cheap talk. Since the incorporation of the institution in 1913, the dollar has lost 95%, and 82% since the end of Bretton Woods in 1971. On top of that, government debt has increased by a factor of 44. The closure of the “golden window” on 15 August 1971 by President Nixon was tantamount to the USA declaring bankruptcy, and the US dollar lost almost 40% relative to the German mark within 20 months. The depreciation against gold was even more dramatic: in 1971 USD 1,000 would have still bought you 25 ounces of gold, ten years later the same amount only bought you 2 ounces.

The question of the optimum timing to abandon the zero-interest rate policy is difficult to answer and - as is often the case - would require the benefit of hindsight. In their study “Exits from recessions”, the two US economists John Landon Lane and Michael Bordo show that the Federal Reserve tends to raise interest rates too late. Even in “normal” recessions that were not accompanied by severe banking and financial market crises the Fed would usually react too late. Since the end of the 1960s, the Fed has attached greater importance to the labour market. Only once the labour market had recovered on a sustainable basis, would the Fed increase rates. The current situation is somewhat similar to the period of the late 1990s. At the beginning of 1997 the fed wanted to start to gradually increase interest rates. The Asian crisis, followed by the Russian crisis and the LTCM collapse rendered the increases obsolete, in fact, the Fed even continued to cut rates, which further fuelled the Nasdaq bubble.

A few decades ago the USA was still the biggest creditor nation. In the 1960s private consumption started to grow faster than production, and wealth was gradually being consumed. Household debt in the USA (as measured by the ratio of debt to disposable income) increased from 55% in 1960 to 65% in 1985. In the course of the following two decades debt almost doubled to 133% in 2008. During this period the savings ratios were on a steep decline, which is why private consumption increased faster than disposable income and fuelled the US economy.

Real household debt, wealth and income

Real household debt, wealth and income
Source: Federal Reserve San Francisco

This means that deleveraging on a household level cannot be avoided. If it were achieved through an increased savings ratio, this would affect US consumption and in turn the global economy. The other option is to shift the problems to the banking sector in the form of more foreclosures. The process will be painful in either case. The share of public transfers in the household income has recently increased to 17.5% – from 5.6% in 1960. The following chart shows that the US willingness to save experienced but a short renaissance. Currently around 3% of the disposable income ends up on savings books, whereas the historical median is 7.5%. The fact that wealth cannot be created by excessive and hedonistic conspicuous consumption seems to remain unknown to many.

US Personal Savings
Sources: Datastream, Erste Group Research

But not only private households are heavily indebted – governments are faced with the same problem. The “Long Term Budget Outlook“  of the Congressional Budget Office (CBO) paints a bleak picture. The report for the period of 2010 to 2080 (!) starts with the words “Under current law, the federal budget is on an unsustainable path – meaning that federal debt will continue to grow much faster than the economy over the long run…” According to the report the USA will not be able to produce a budget surplus in the next 70 years.

CBO Budget Projection
Source: CBO Budget Estimates, Datastream

Even though at the moment the limelight is on Greece and the other PIGS countries, the situation in the USA and the UK is just as precarious. We cannot see any austerity measures in the USA. In August 2009 the forecast for the new debt of the coming decade was revised upwards from USD 7 trillion to 9 trillion. From May 2009 to April 2010 debt increased by USD 1,710bn or 11.7% in terms of GDP. A little side note – in 2000, Bill Clinton had announced that by 2010 all US government debt should be paid off. Currently US government debt amounts to USD 13 trillion, which equals USD 42,000 per capita.

If it is impossible to generate a surplus even in prosperous times, clearly the problems are of a systemic nature. Due to compound interest, debt grows exponentially, which causes massive problems in the long run. As soon as debt plus interest is growing faster than revenues, a vicious circle of debt is set off. The following chart illustrates the gradual divergence of expenditure and income (or outlays and receipts).

US Federal Outlays, Receipts (left scale) and Federal Debt (right scale)

US Federal Outlays, Receipts and Federal Debt
Source: www.fgmr.com, James Turk

The USA is expected to issue more Treasury bonds in 2010 than the rest of the world combined. The balance sheet of the Federal Reserve has deteriorated dramatically as well. Between December 2008 and March 2009 it purchased fixed-rate securities worth USD 1,700bn, or almost 12% in terms of GDP. The majority (USD 1,250bn) was made up by mortgage-backed securities of highly dubious value.

In one of its reports, McKinsey  analysed 45 deleveraging phases since 1930. In 50% of cases the debt was paid off through a stepped up savings ratio, which would typically lead to deflation almost every time. The growth path has been chosen three times in the more recent history, but this often turned out expensive and bloody, i.e. it would typically involve war. On average the payoff would commence two years after the onset of the financial crisis and last six to eight years according to the study. From 1929 to 1933, i.e. in the thick of the Great Depression, the private household debt fell by 32%. As a result of the reduction of private debt, the public sector had to step up its debt so as to offset the lack in demand. Thanks to these measures, the economic growth rates are positive, but clearly below the potential.


History offers a number of interesting analogies with regard to the status quo. In the Roman Empire, the silver content of the denarius coin was gradually reduced. Bread and circuses, the bloated bureaucracy, and the rising military expenses led the public finances to get out of hand. In addition, the production of goods was moved further and further into the peripheral areas of the empire. The overall tax ratio increased to two thirds of income, and the size and complexity of the administrative organisation were constantly rising. Therefore the currency was subject to a gradual depreciation. In the 1st century B.C. the silver content was close to 95%, but by 286 AD the denarius only consisted of 0.5% of silver . The example of the decline of the Roman Empire highlights impressively how swelling bureaucracy and the misallocation of resources can lead to inflation and in the long run to collapse.

Silver content of the Roman denarius

Silver content of the Roman denarius
Sources: Société Générale, Tulane University

“The Budget should be balanced, the Treasury should be refilled, public debt should be reduced, the arrogance of officialdom should be tempered and controlled, and the assistance of foreign lands should be curtailed lest the Republic become bankrupt. People must again learn to work, instead of living on public assistance.” Marcus Tullius Cicero, 55 BC

By. Ronald Stoeferle of Erste Group

Erste Group is the leading financial provider in the Eastern EU. More than 50,000 employees serve 17.4 million clients in 3,200 branches in 8 countries (Austria, Czech Republic, Slovakia, Romania, Hungary, Croatia, Serbia, Ukraine). As of 31 December 2010 Erste Group has reached EUR 205.9 billion in total assets, a net profit of EUR 1,015.4 million and cost-income-ratio of 48.9%.

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