Five years after Lehman Brothers went bust, the same mistakes are being made

A logo of Lehman Brothers is seen outside its Asia headquarters in TokyoVivek Kaul 
Graham Greene’s fascinating book The End of an Affair starts with these lines: “A story has no beginning or end: arbitrarily one chooses that moment of experience from which to look back or from which to look ahead.”
If the current financial crisis were a story (which it is) its beginning would be on September 15, 2008, when Lehman Brothers, the smallest of the big investment banks on Wall Street, went bust. It was the largest bankruptcy in the history of the world. Lehman Brothers started a crisis, from which the world is still trying to recover.
While the American government and the Federal Reserve(the American central bank) let Lehman Brothers go under, the got together to save AIG, one of the largest insurance companies in the world, a day later. This was followed by a spate of other rescues in the United States as well as Europe. These rescues cost the governments around the world a lot of money. As Mark Blyth writes in Austerity – The History of a Dangerous Idea “The cost of bailing, recapitalizing, and otherwise saving the global banking system has been depending on…how you count it, between 3 and 13 trillion dollars. Most of that has ended up on the balance sheets of governments as they absorb the costs of the bust.”
It’s been five years since Lehman Brothers went bust. Hence, enough time has elapsed since the financial criss started, to analyse, if any lessons have been learnt. One of the major reasons for the financial crisis was the fact that governments across the Western world ran easy money policies, starting from the turn of the century. Loans were available at low interest rates.
People went on a borrowing binge to build and buy homes and this led to huge real estate bubbles in different parts of the world. Take the case of Spain. Spain ended up building many more homes than it could sell. Estimates suggest that even though Spain forms only 12 percent of the GDP of the European Union (EU) it built nearly 30 percent of all the homes in the EU since 2000. The country has as many unsold homes as the United States of America which is many times bigger than Spain.
Along similar lines, by the time the Irish finished with buying and selling houses to each other, the home ownership in the country had gone up to 87%, which was the highest anywhere in the world. A similar thing happened in the United States, though not on a similar scale.
Housing prices in America had already started to fall before Lehman Brothers went bust. After that the fall accelerated. As per the Case-Shiller Composite-20 City Home Price Index, housing prices in America had risen by 76% between mid of 2001 and mid of 2006. The first time the real estate prices came down was in January 2007, when the Case-Shiller Composite-20 City Home Price Index suggested that housing prices had fallen by a minuscule 0.05% between January 2006 and January 2007. This fall came nearly two and half years after the Federal Reserve started raising interest rates to control the rise in price of real estate.
The fall gradually accentuated and by the end of December 2007, housing prices had fallen by 9.1% over a one year period. The fall continued. And by December 2008, a couple of months after Lehman went bust, housing prices, had fallen by 25.5%, over a period of three years. The real estate bubble had burst and the massacre had started. Similar stories were repeated in other parts of the Western world. Soon, western economies entered into a recession.
Governments around the world started tackling this by throwing money at the problem. The hope was that by printing money and putting it into the financial system, the interest rates would continue to remain low. At lower interest rates people would borrow and spend more, and this in turn would lead to economic growth coming back.

Hence, the idea was to cure a problem, which primarily happened on account of excess borrowing, by encouraging more borrowing. The question is where did this thinking come from? In order to understand this we need to go back a little in history.
As Nobel Prize winning economist Robert Lucas said in a speech he gave in January 2003, as the president of the American Economic Association: “Macroeconomics was born as a distinct field in the 1940s, as a part of the intellectual response to the Great Depression. The term then referred to the body of knowledge and expertise that we hoped would prevent the recurrence of economic disaster.”
Given this, the economic thinking on the Great Depression has had a great impact on American economists as well as central bankers. This is also true about economists across Europe to some extent.
In 1963, Milton Friedman along with Anna J. Schwartz, wrote 
A Monetary History of United States, 1867-1960, which also had a revisionist history of the Great Depression. What Friedman and Schwartz basically argued was that the Federal Reserve System ensured that what was just a stock market crash in October 1929, became the Great Depression.
Between 1929 and 1933, more than 7,500 banks with deposits amounting to nearly $5.7 billion went bankrupt. This according to Friedman and Schwartz led to the total amount of currency in circulation and demand deposits at banks, plunging by a one third.
With banks going bankrupt, the depositors money was either stuck or totally gone. Under this situation, they cut down on their expenditure further, to try and build their savings again. This converted what was basically a stock market crash, into the Great Depression.
If the Federal Reserve had pumped more money into the banking system at that point of time, enough confidence would have been created among the depositors who had lost their money and the Great Depression could have been avoided.
This thinking on the Great Depression came to dominate the American economic establishment over the years. Friedman believed that the Great Depression had happened because the American government and the Federal Reserve system of the day had let the banks fail and that had led to a massive contraction in money supply, which in turn had led to an environment of falling prices and finally, the Great Depression.
Hence, it was no surprise that when the Dow Jones Industrial Average, America’s premier stock market index, had a freak crash in October 1987, and fell by 22.6% in a single day, Alan Greenspan, who had just taken over as the Chairman of the Federal Reserve of United States, flooded the financial system with money.
After this, he kept flooding the system with money by cutting interest rates, at the slightest hint of trouble. This led to a situation where investors started to believe that come what may, Greenspan and the Federal Reserve would come to the rescue. This increased their appetite for risk, finally led to the dotcom and the real estate bubbles in the United States.
In fact, such has been Friedman’s influence on the prevailing economic thinking that Ben Bernanke, who would take over as the Chairman of the Federal Reserve, after Greenspan, said the following at a conference to mark the ninetieth birthday celebrations of Friedman in 2002. “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
At that point of time, Bernanke was a member of the board of governors of the Federal Reserve System and hence, the use of the word “we”. What Bernanke was effectively saying was that in the days and years to come, at the slightest sign of trouble, the Federal Reserve of United States would flood the financial system with money.
And that is precisely what Bernanke and the American government did once the financial crisis broke out in September 2008. The Bank of England, the British central bank, followed. And so did the European Central Bank in the time to come. Recently, the Bank of Japan decided to join them as well.
Central banks around the world have been on a money printing spree since the start of the financial crisis in late 2008. Between then and early February 2013, the Federal Reserve of United States has expanded its balance sheet by 220%. The Bank of England has done even better at 350%. The European Central Bank came to the money printing party a little late in the day and has expanded its balance sheet by around 98%. The Bank of Japan has been rather subdued in its money printing efforts and has expanded its balance sheet only by 30% over the four year period. But during the course of 2013, the Bank of Japan has made it clear that it will print as much money as will be required to get the Japanese economy up and running again.
The trouble is that people in the Western world are not interested in borrowing money again. Hence, the little economic recovery that has happened has been very slow. The Japanese economist Richard Koo calls the current state of affairs in the United States as well as Europe as a balance sheet recession. The situation is very similar to as it was in Japan in 1990 when the stock market bubble as well as the real estate bubble burst.
Hence, Koo concludes that the Western economies including the United States may well be headed towards a Japan like lost decade. In a balance sheet recession a large portion of the private sector, which includes both individuals and businesses, minimise their debt. When a bubble that has been financed by raising more and more debt collapses, the asset prices collapse but the liabilities do not change.
In the American and the European context what this means is that people had taken on huge loans to buy homes in the hope that prices would continue to go up for perpetuity. But that was not to be. Once the bubble burst, the housing prices crashed. This meant that the asset (i.e. homes) that people had bought by taking on loans lost value, but the value of the loans continued to remain the same.
Hence, people needed to repair their individual balance sheets by increasing savings and paying down debt. This act of deleveraging or reducing debt has brought down aggregate demand and throws the economy in a balance sheet recession.
While the citizens may not be borrowing, this hasn’t stopped the financial institutions and the speculators from borrowing at close to zero percent interest rates and investing that money in various parts of the world. And that, in turn, has led to other asset bubbles all over the world.
These bubbles have benefited the rich. 
As The Economist points out “THE recovery belongs to the rich. It seemed ominous in 2007 when the share of national income flowing to America’s top 1% of earners reached 18.3%: the highest since just before the crash of 1929. But whereas the Depression kicked off a long era of even income growth the rich have done much better this time round. New data assembled by Emmanuel Saez, of the University of California, Berkeley, and Thomas Piketty, of the Paris School of Economics, reveal that the top 1% enjoyed real income growth of 31% between 2009 and 2012, compared with growth of less than 1% for the bottom 99%. Income actually shrank for the bottom 90% of earner.”
Once these bubbles start to burst, the world will go through another round of pain. Satyajit Das explains the situation beautifully 
in a recent column for the Financial Times, where he quotes the Irish author Samuel Beckett “Ever tried. Ever failed. No matter. Try Again. Fail again. Fail better.”
To conclude, there are many lessons that history offers us. But its up to us whether we learn from it or not. As the German philosopher Georg Engel once said “What experience and history teach is this – that nations and governments have never learned anything from history, or acted on principles deduced from it”
And why should this time be any different?
The article originally appeared on www.firstpost.com on September 16, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek) 

Why Federal Reserve ‘really’ wants to go slow on money printing

ben bernankeVivek Kaul 
Over the last few months, there has been talk about the Federal Reserve of United States, the American central bank, wanting to slowdown its money printing and gradually doing away with it altogether.
Every month the Federal Reserve prints $85 billion and puts that money into the American financial system, by buying bonds of different kinds. The idea is that with enough money floating around in the financial system, the interest rates will continue to remain low.
At lower interest rates people are more likely to borrow and spend more. And this in turn will help economic growth, which has been faltering, in the aftermath of the financial crisis, which started in late 2008.
Some economic growth has returned lately. Recently the GDP growth for the period of three months ending June 30, 2013, 
was revised to 2.5% from the earlier 1.7%. But even an economic growth of 2.5% is not enough, primarily because the country needs to make up for the slow economic growth that it has experienced over the past few years.
The fear is that with all the money floating around in the financial system, too much money will start chasing too few goods, and finally lead to high inflation. But that hasn’t happened primarily because even at low interest rates, borrowing has been slow. Hence, what economists call the velocity of money (or how fast money changes hands) has been low. Given this, inflation has been low. Consumer price inflation in the United States, for the period 
of twelve months ending June 2013, stood at 1.3%.
The rate of inflation is well below the inflation target of 2% that the Federal Reserve is comfortable with. So if inflation isn’t really a concern, and the economic growth is still not good enough, why is the Federal Reserve in a hurry to go slow on printing money?
As Gary Dorsch, the 
Editor – Global Money Trends newsletter, writes in his latest column “The fragile US-economy might find itself sinking into a full blown recession by the first quarter of 2014. However, the Fed’s determination to start scaling down QE-3 is essentially in reaction to the demands of the Bank of International Settlements (BIS), – the central bank of the world – which says it is time to rethink US-monetary policy. The BIS argues that blowing even bigger bubbles in the US-stock market can do more harm to the US-economy than the old enemy of high inflation. Thus, going forward, the costs of continuing with QE now exceed the benefits.”
Quantitative easing or QE is the technical term that economists have come up with for money printing that is happening across different parts of the western world.
What Dorsch has written needs some detailed examination. The argument for keeping the money printing going has been that it has not led to any serious inflation till now, so let us keep it going. While inflation may not have cropped up in everyday life, it has turned up somewhere else. A lot of the money printed by the Federal Reserve has found its way into financial markets around the world, including the American stock market. And this has led to investment bubbles where prices have gone up way over what the fundamentals justify.
The Federal Reserve, meanwhile, has continued with the money printing because it hasn’t shown up in inflation. Central banks work with a certain inflation target in mind. If the inflation is expected to cross that level, then they start taking steps to ensure that interest rates go up.
At 1.3%, inflation in the United States
 is well below the Federal Reserve’s target of 2%. Some recent analysis coming out suggests that inflation-targeting might be a risky strategy to pursue. Stephen D King, Group Chief Economist of HSBC makes this point in his new book When the Money Runs Out. As he writes “the pursuit of inflation-targetting…may have contributed to the West’s financial downfall.”
King gives the example of United Kingdom to elaborate on his point. As he writes “Take, for example, inflation targeting in the UK. In the early years of the new millennium, inflation had a tendency to drop too low, thanks to the deflationary effects on manufactured goods prices of low-cost producers in China and elsewhere in the emerging world. To keep inflation close to target, the Bank of England loosened monetary policy with the intention of delivering higher ‘domestically generated’ inflation. In other words, credit conditions domestically became excessive loose…The inflation target was hit only by allowing domestic imbalances to arise: too much consumption, too much consumer indebtedness, too much leverage within the financial system and too little policy-making wisdom.”
Hence, the Bank of England, kept interest rates too low for too long because the inflation was low. With interest rates being low banks were falling over one another to lend money to anyone who was willing to borrow. And this gradually led to a fall in lending standards. People who did not have the ability to repay were also being given loans. As King writes “With the UK financial system now awash with liquidity, lending increased rapidly both within the financial system and to other parts of the economy that, frankly, didn’t need any refreshing. In particular, the property sector boomed thanks to an abundance of credit and a gradual reduction in lending standards.”
So the British central bank managed to create a huge real estate bubble, which finally burst, and the after effects are still being felt. And all this happened while the inflation continued to be at a fairly low level.
But this focus on ‘low inflation’ or ‘monetary stability’ as economists like to call it, turned out to be a very narrow policy objective. As Felix Martin writes in his brilliant book 
Money- The Unauthorised Biography “The single minded pursuit of low and stable inflation not only drew attention away from the other monetary and financial factors that were to bring the global economy to its knees in 2008 – it exacerbated them…Disconcerting signs of impending disaster in the pre-crisis economy – booming housing prices, a drastic underpricing of liquidity in asset markets, the emergence of shadow banking system, the declines in lending standards, bank capital, and the liquidity ratios – were not given the priority they merited, because, unlike low and stable inflation, they were simply not identified as being relevant.”
The US Federal Reserve wants to avoid making the same mistake that led to the dotcom and the real estate bubble and finally a crash. As Dorsch writes “A BIS working paper that traces booming stock markets over the past 110-years, finds that they nearly always sink under their own weight, – and causing lasting damage to the local economy. Asset bubbles often arise when consumer prices are low, which is a problem for central banks who solely target inflation and thereby overlook the risks of bubbles, while appearing to be doing a good job.”
Over the last 25 years, the US Federal Reserve has been known to cut interest rates at the slightest sign of trouble. But only on rare occasions has it raised interest rates to puncture bubbles. Alan Greenspan let the dotcom bubble run full steam. Then he, along with Ben Bernanke, let the real estate bubble run. By the time the Federal Reserve started to raise interest rates it was a case of too little too late.
A similar thing seems to have happened with the current stock market bubble, where the Federal Reserve has printed and pumped money into the market, and managed to keep interest rates low. But this money instead of being borrowed by American consumers has been borrowed by investors and found its way into the stock market.
As Claudio Borio and Philip Lowe wrote in 
the BIS working paper titled Asset prices, financial and monetary stability: exploring the nexus (the same paper that Dorsch talks about) “lowering rates or providing ample liquidity when problems materialise but not raising rates as imbalances build up, can be rather insidious in the longer run. They promote a form of moral hazard that can sow the seeds of instability and of costly fluctuations in the real economy.”
Guess, the Federal Reserve is finally learning this obvious lesson.

 The article originally appeared on www.firstpost.com on September 6, 2013 
(Vivek Kaul is a writer. He tweets @kaul_vivek) 
 

Wall St rules: Why the Fed will continue to print money

ben bernankeVivek Kaul
 Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, announced on June 19, that the Federal Reserve would go slow on money printing in the days to come.
Speaking to the media he said “If the incoming data are broadly consistent with this forecast, the Committee(in reference to the Federal Open Market Committee) currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
The Federal Reserve has been printing $85 billion every month and using that money to buy American government bonds and mortgage backed securities. By buying bonds, the Fed has managed to pump the newly printed dollars into the financial system.
The idea was that there would be no shortage of money going around, and as a result interest rates will continue to be low. At low interest rates banks would lend and people would borrow and spend, and that would help in getting economic growth going again.
The trouble is that quantitative easing, as the Federal Reserve’s money printing programme, came to be known as, has turned out to be terribly addictive. And anything that is addictive cannot be so easily withdrawn without negative repercussions.
As Stephen D King writes in 
When the Money Runs Out “Bringing quantitative easing to an end is hardly straightforward. Imagine, for example, that a central bank decides quantitative easing has become dangerously addictive and indicates to investors not only that programme will be put on hold…but it will come to a decisive end. The likely result is a rise in government bond yields…If, however, the economy is still weak, the rise in bond yields will surely be regarded as a threat to economic recovery.”
This is exactly how things played out before and after Bernanke’s June 19 announcement. With Federal Reserve announcing that it will go slow on money printing in the days to come, investors started selling out on American government bonds.
Interest rates and bond prices are inversely correlated i.e. an increase in interest rates leads to lower bond prices. And given that interest rates are expected to rise with the Federal Reserve going slow on money printing, the bond prices will fall. Hence, investors wanting to protect themselves against losses sold out of these bonds.
When investors sell out on bonds, their prices fall. At the same time the interest that is paid on these bonds by the government continues to remain the same, thus pushing up overall returns for anybody who buys these bonds and stays invested in them till they mature. The returns or yields on the 10 year American treasury bond reached a high of 2.6% on June 25, 2013. A month earlier on May 24, 2013, this return had stood at 2.01%.
An increase in return on government bonds pushes up interest rates on all other loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that. This means a higher interest.
The average interest rate on a 30 year home loan in the United States 
jumped to 4.46% as on June 27, 2013. It had stood at 3.93% a week earlier.
Higher interest rates can stall the economic recovery process. It’s taken more than four years of money printing by the Federal Reserve to get the American economy up and running again, and a slower growth is something that the Federal Reserve can ill-afford at this point of time. In fact on June 26, 2013, the commerce department of United States, revised the economic growth during the period January-March 2013, to 1.8% from the earlier 2.4%.
These developments led to the Federal Reserve immediately getting into the damage control mode. William C Dudley, president of the Federal Reserve Bank of New York, the most powerful bank among the twelve banks that constitute the Federal Reserve system in United States, said in a speech on June 27, 2013 “Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC(federal open market committee) statements and the expectations of most FOMC participants.”
What this means in simple English is that the Federal Reserve of United States led by Ben Bernanke, has no immediate plans of going slow on money printing. There will continue to be enough money in the financial system and hence interest rates will continue to be low.
After Dudley’s statement, the return on the 10 year American treasury bond, which acts as a benchmark for interest rates in the United States, fell from 2.6% on June 26, 2013, to around 2.52% as on July 3, 2013. The market did not take remarks made by Dudley (as well as several other Federal Reserve officials) seriously enough. Hence the return on 10 year American treasury bond continues to remain high, leading to higher interest rates on all other kind of loans.
It also implies that the market will not allow the Federal Reserve to go slow on money printing. As King writes “It (i.e. money printing by central banks), is also, unfortunately, highly addictive. If the economy should fail to strengthen, the central bank will be under pressure to deliver more quantitative easing.”
V. Anantha Nageswaran put it aptly in a recent column in the Mint. As he wrote “Financial markets will force the Federal Reserve to delay any attempt to restore monetary conditions to a more normal setting. Further, as and when such attempts get under way, they will be half-hearted and asymmetric as we have seen in the recent past. Since the Federal Reserve has tied the mast of the economic recovery to a recovery in asset prices, any decline in asset prices will unnerve it. Hence, the eventual outcome will be an inflationary bust due to the prevalence of an excessively accommodative monetary policy for an inordinately long period.”
If interest rates do not continue to be low then the recovery in real estate prices, which has been a major reason behind the American economic growth coming back, will be stalled. To ensure that real estate prices continue to go up, the Federal Reserve will have to continue printing money. And this in turn will eventually lead to an inflationary bust.
In fact, Jim Rickards, author of 
Currency Wars, feels that the Federal Reserve will increase money printing in the days to come. As he recently told www.cnbc.com “They’re not going to taper later this year. They’ll actually going to increase asset purchases because deflation is winning the tug of war between deflation and inflation. Deflation is the Fed’s worst nightmare.” Deflation is the opposite of inflation and refers to a situation where prices are falling.
When prices fall people postpone purchases in the hope of getting a better deal in the future. This has a huge impact on economic growth.
Hence it is more than likely that the Federal Reserve of United States will continue to print money in order to buy bonds to ensure that interest rates continue to remain low. If interest rates go up, the economic growth will be in a jeopardy. As King puts it “The government will then blame the central bank for undermining the nation’s economic health and the central bank’s independence will be under threat. Far better, then, simply to continue with quantitative easing (as money printing is technically referred to as).”
This means that a strong case for staying invested in gold still remains. Rickards expects the price to touch $7000 per ounce (1 troy ounce equals 31.1 grams).
(The article originally appeared on www.firstpost.com)
(Vivek Kaul is a writer. He tweets @kaul_vivek)

 
 

Why you should be nice to your mom – and buy some gold

 

Vivek Kaul
So let me start this piece by admitting Ben Bernanke, the Chairman of the Federal Reserve of United States (the American central bank) has proven me wrong.
I was wrong when I recently said that the Federal Reserve would not initiate a third round of quantitative easing (QE), before the November 6 presidential elections in the United States. (you can read about it here).
Bernanke announced late last night that the Federal Reserve would buy mortgage backed securities worth $40billion every month. This will continue till the job scenario in the United States improves substantially. The Federal Reserve will print money to buy the mortgage back securities.
I concluded that the Federal Reserve wouldn’t announce any QE till November 6, primarily on account of the fact that Mitt Romney, the Republican nominee for the Presidential elections, has been against any sort of QE to revive the economy.
“I don’t think QE-II was terribly effective. I think a QE-III and other Fed stimulus is not going to help this economy…I think that is the wrong way to go. I think it also seeds the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation’s needs,” Romney told Fox News on 23 August. This had held back the Federal Reserve from initiating QE III.
But from the looks of it Bernanke doesn’t feel that Romney has a chance at winning and that he is more likely than not going to continue working with Barack Obama, the current American President.
This round of quantitative easing is going to help Obama and hurt Romney. Let me explain. The theory behind quantitative easing is that when the Federal Reserve buys mortgage backed securities (in this case) by printing dollars, it pumps in more money into the economy. With more money in the economy, banks and financial institutions it is felt will lend that money and businesses and consumers will borrow. This will mean that spending by both businesses and consumers will start to up. Once that happens the economic scenario will start improving, which will lead to more jobs being created.
But as I said this is the theoretical part. And theory and practice do not always go together. Both American businesses and consumers have been shying away from borrowing. Hence, all this money floating around has found its way into stock and commodity markets around the world.
As more money enters the stock market, stock prices go up and this creates the “wealth effect”. People who invest money in the market feel richer and then they tend to spend part of the accumulated wealth. This, in turn, helps economic growth.
As Gary Dorsch, an investment newsletter writer, said in a recent column, “Historical observation reveals that the direction of the stock market has a notable influence over consumer confidence and spending levels. In particular, the top 20% of wealthiest Americans account for 40% of the spending in the US economy, so the Fed hopes that by inflating the value of the stock market, wealthier Americans would decide to spend more. It’s the Fed’s version of “trickle down” economics, otherwise known as the “wealth effect.””
When this happens, the economy is likely to grow faster and hence, people are more likely to vote for the incumbent President. As Dorsch explains “Incumbent presidents are always hard to beat. The powers of the presidency go a long way…In the 1972 election year, when Nixon pressured Arthur Burns, then the Fed chairman, to expand the money supply with the aim of reducing unemployment, and boosting the economy in order to insure Nixon’s re-election.”
Bernanke is looking to do the same, even though he has denied it completely. “We have tried very, very hard, and I think we’ve been successful, at the Federal Reserve to be non-partisan and apolitical…We make our decisions based entirely on the state of the economy,” the Financial Times quoted Bernanke as saying. Given this, Romney has been a vocal critic of quantitative easing knowing that another round of money printing will clearly benefit Obama.
Other than Obama and the stock markets, the other big beneficiary of QE III will be gold. The yellow metal has gone up by around 2.2% to $1768 per ounce, since the announcement for QE III was made. In fact the expectation of QE III has been on since the beginning of September after Ben Bernanke dropped hints in a speech. Gold has risen by 7.3% since the beginning of this month.
This is primarily because any round of quantitative easing ensures that there are more dollars in the financial system than before. The threat is that the greater number of dollars will chase the same number of goods and services. This will lead to an increase in their prices. But this hasn’t happened till now. Nevertheless that hasn’t stopped investors from buying gold to protect themselves from this debasement of money. Gold cannot be debased. Unlike paper money it cannot be created out of thin air.
During earlier days, paper money was backed by gold or silver. When governments printed more paper money than the precious metals backing it, people simply turned up with their paper at the central bank and government mints, and demanded that paper money be converted into gold or silver. Now, whenever people see more and more of paper money being printed, the smarter ones simply go out and buy that gold. Hence, bad money (that is, paper money) is driving out good money (that is, gold) away from the market.
But that’s just one part of the story. The governments and central banks around the world, led by the Federal Reserve of United States and the European Central Bank, are likely to continue printing more money, in the hope that people spend this money and this revives economic growth. This in turn increases the threat of inflation which would mean that the price of gold is likely to keep going up. “Gold tends to benefit from easy-money policies as investors utilize the precious metal as a hedge against potential inflation that could ultimately result from the Fed’s policies,” Steven Russolillo, wrote on WSJ Blogs.
Market watchers have also started to believe that the Federal Reserve is now only bothered about economic growth and has abandoned the goal of keeping inflation under control. Growth and inflation control are typically the twin goals of any central bank.
“They are emphasizing the growth mandate, and that means they don’t care about inflation other than giving lip service to it,” Axel Merk, chief investment officer at Merk Funds, told Reuters. “The price of gold will do very well in the years to come,”he added.
Something that Jeffrey Sherman, commodities portfolio manager of DoubleLine Capital, agrees with. “The Fed’s inflationary behavior should be bearish for the dollar in the long run and drive investors to seek protection via the gold market,” he told Reuters.
Also unlike previous two rounds of money printing there are no upper limits on this QE, although at $40billion a month it’s much smaller in size. QE II, the second round of money printing, was $600billion in size.
Something that can bring down the returns on gold in rupee terms is the appreciation of the rupee against the dollar. Yesterday the rupee appreciated against the dollar by nearly 2%. This is happening primarily because the UPA government has suddenly turned reformist.  (To understand the complete relationship between rupee, dollar and gold, read this).
In the end let me quote William Bonner & Addison Wiggin, the authors of Empire of Debt — The Rise of an Epic Financial Crisis. As they say “There is never a good time to die. Nor is there a good time for a crash or a slump. Still, death happens. Be prepared. Say something nice to your mother. Offer a bum a drink. And buy gold.”
So be nice to your mother and buy gold.
Disclosure: This writer has investments in gold through the mutual fund route.
(The article originally appeared on www.firstpost.com on September 15,2012. http://www.firstpost.com/investing/why-you-should-be-nice-to-your-mom-and-buy-some-gold-456915.html)
(Vivek Kaul is a writer. He can be reached at [email protected])