Is the US facing a recession? July 19, 2001 It has become quite boring to talk about the gold price since many analysts are now focusing on its relationship to the US dollar and there must be thousands of people who are more qualified to analyze the dollar than what I am. But since I am not overcharging for this communication, I will give you my opinion anyway.
The gold price is up $2.40 an ounce today and the dollar is down almost 1.2% (according to an index on Bloomberg) in response to Alan Greenspan's testimony before the House Finance Committee. According to Mr. Greenspan, the US economy has not yet shown signs of a recovery, making the Chairman sufficiently concerned to suggest that further rate cuts are not out of the question. Wow!
Let me see. Hmmm... The problem in the US is that so much foreign capital poured into the country that the cost of capital declined precipitously causing both US consumers and corporations to go on a spending binge and whenever their appetite exceeded their income, they turned to debt. The end result is record bankruptcies and debt levels during one of the most pronounced economic booms in the history of the United States. Not to mention the egregious allocation of capital and gross asset inflation that resulted. This is of course where the current danger lies.
But Greenspan is not worried. Even though he has had to lower his estimates for US growth yet again, he is predicting a much rosier picture next year. If all goes well, the interest rate cuts, as well as the tax rebates are going to kiss US consumers and make them feel all better. This appears to be highly unlikely. The amount of the tax rebate is nothing in comparison to the size of the economy and how can short term interest rate cuts solve the problems of over-extended balance sheets when long term interest rates are actually increasing.
Looked at another way - why would interest rate cuts help the economy if consumers are already leveraged to the hilt with debt. If they cannot borrow any more, they cannot borrow any more regardless of what the interest rate is. Didn't Japan clearly illustrate this point?
According to the Wall Street Journal, "Much of the economic slowdown comes from businesses rapidly and sharply cutting back on production in the face of sagging demand...Economists say once companies work off excess inventories, they will be in a position to rev up production..." Herein lies another problem.
During the expansion of a business cycle, when demand is strong, companies tend to increase inventories which become a burden if demand declines again. A recession occurs when demand declines and companies have to work off excess inventory, thus temporarily cutting back on production. This usually lasts only a few quarters and seems to be what Chairman Greenspan is predicting.
But this was not a normal business cycle. What we had was "irrational exuberance" on steroids. Not only did consumer demand increase, it increased so much that companies went on a capital spending spree. The problem now is that corporations don't just need to work off excess inventory, they stand to lose billions from the misallocation of capital. That, by the way, is also the hard lesson that investors are busy learning. When the cost of capital gets too low, capital is squandered and once misallocated is hardly ever recovered.
So the problem we are facing, which no-one yet wants to talk about, is the misallocation of capital during the recent "New Era". Usually it takes far more than a mere recession to correct for the gross misallocation of capital. It almost always occurs only after a prolonged depression.
Due to the size of the US economy, such an event has the potential to slow worldwide economic growth as well.
What does any of this have to do with gold? Only that the price of gold is inversely correlated to the US dollar and if the US faces the prospects of a depression, do you think that foreign investors are going to continue to pour in the order of $400 billion a year into the US economy? Especially after what they did with the capital during the past ten years?
I bet that when analysts start calculating return on equity and return on capital for US corporations, on capital invested during the past five years, it is not going to be pretty.
When this financial storm finally blows into town, hold on to your hat. Hold on to your gold stocks too.
Paul van Eeden
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