The Global Economy Is Beginning to Resemble 1982
The global economy is beginning to resemble 1982, a deflationary environment that climaxed with that summer's Peso Crisis and aggressive intervention by Federal Reserve Chairman Paul Volcker. Although certainly not as strong as thirty-two years ago, another bout of deflation (or ‘disinflation') is underway. The bad news is: Federal Reserve officials are only slowly recognizing it. The good news is: they have time to avert its destructive consequences.
The parallels between 1982 and 2014 are eerily similar, although the circumstances are wholly different. During the lead-up to both years, the dollar had been strengthening significantly, after prolonged weakness.
This can be seen in the roller-coaster behavior in gold prices during the 1977-1982 and 2009-2014 periods. Both periods are characterized by sharp dollar weakness (a steep increase in gold prices), followed by sharp dollar strength (a steep decline in gold prices).
Between 1977 and January 1980, gold rallied from $135 to $850, then quickly retraced to $457 by the end of 1982. Between 2009 and September 2011, gold rallied from $882 to $1900. During the last three years, gold has quickly declined; trading at $1245 in recent days.
The late 1970's devaluation of the dollar was driven, in part, by worries over the expansion of Soviet power and influence around the world. It reached a crescendo during the last week of 1979 with the invasion of Afghanistan, which led to concerns that the Soviet Union would outflank the United States in the Persian Gulf. Capital fled out of paper currency and into gold, the ultimate safe-haven.
In less than a month following the invasion, gold rallied from $470 to $850. Gold's climb was arrested when President Carter began to make concrete efforts to restore the Truman Doctrine, the American foreign policy of Soviet containment that had emerged after the Second World War and had been maintained until the start of the Carter Administration. The revival of the Truman Doctrine and the credible, money supply-limiting policy at the Volcker Fed caused capital to flood into the dollar and out of gold. By the end of 1982, commodity prices had collapsed, with gold trading at $457.
In recent years, the dollar narrative has been starkly different, although its associated events have had a similar effect on the dollar. In late 2008, the dollar began to weaken as Federal Reserve officials telegraphed the prospect of quantitative easing, a strategy that intentionally sought to print new currency to inflate the economy. As the likelihood for quantitative easing grew, gold quickly rallied from a November 2008 low of $712 to $880 by December 31. The actual expansion of the Fed's balance sheet throughout 2009 pushed gold even higher.
In 2010, the Fed-engineered devaluation of the dollar was compounded by the European Debt Crisis, which created new concerns that the euro, the world's second-most important currency zone, would disintegrate. Capital sprinted into gold, and away from paper currency.
Policymakers in fiscally struggling EU-member countries contemplated leaving the monetary union in a desperate attempt to manage their excessive debt obligations through inflation, as well as to escape the austerian demands by policymakers in Berlin and Brussels for tax increases that would worsen the already-imploding economies of the distressed countries. Some policymakers in the fiscally sound EU-member countries welcomed the idea as well, on the argument that it would shield their governments from being responsible for their fiscally imprudent counterparts.
From a near-term economic perspective, a disintegration of the euro would have produced an earthquake to global commerce, with Europe at the epicenter. Risk-taking would have stopped until new currencies and contracts were established and previous euro-denominated contracts were assessed to be valid (or invalid). Meanwhile, the inherent savings and efficiencies of a common currency zone would have vanished. The economic shock could have paralyzed major financial institutions, and threatened their solvency.
Amidst these fears gold reached a record high of $1900 by September 2011, at which point it became increasingly clear that EU-wide measures were going to be pursued to prevent any defaults by EU-member governments. Subsequent policy actions and pledges to maintain the integrity of the euro currency zone, particularly ECB President Mario Draghi's now-famous pledge in July 2012, as well as policy drifts throughout Europe away from counter-productive tax policies, lubricated Europe's recovery. Capital rotated out of gold, back into the paper dollar (as well as the euro).
By early 2013, the fading concerns about Europe's currency and economy pulled gold lower toward $1600, at which point the Bernanke Fed's telegraphing of an ultimate end to quantitative easing pulled the rug out from under gold and strengthened the dollar even more. Today, as the Fed's quantitative easing program winds down, gold stands at $1245.
In the floating money, post-1971 modern economy, market-moving variables and their financial and economic impacts can be dizzying. But the implications of the underlying monetary shifts can also be basic.
During a deflation, when the dollar strengthens (gold declines) and growth slows, bonds are the most attractive asset. Last week's 10-year Treasury yield of 1.97% and 10-year Bund of 0.71% are the clearest examples.
On the other hand, commodities become the least attractive asset class. Hard, risk assets prosper in an inflationary economy, which is the polar opposite economic scenario facing us today.
The commodity sector is beginning to feel the pain. Oil prices are down approximately 25% to $82 from $107 in June. And, the CRB Index is down nearly 13%, with wheat and corn lower by 16% and 23%, respectively.
Herein lays the danger that Federal Reserve officials who have monopoly power over the dollar must focus on: dollar deflation and decelerating economic growth wreak havoc on commodity-producing economies, industries and companies, and create the potential for financial crisis.
The slow growth, deflation period that started in 1980 caused oil to decline nearly 20% by the summer of 1982, from $38 to $31. The government of Mexico had been borrowing heavily when oil traded at $35 and higher. With oil prices selling off, it became increasingly difficult for the government to pay its dollar-denominated debts. In August 1982, out of fear of U.S. financial institutions suffering irreparable losses from a Mexican sovereign default, Chairman Volcker was forced to buy $3 billion in Mexican peso bonds, which the Mexican government used to pay its creditors.
Volcker's debt monetization had the virtuous effect of reflating the dollar. Gold catapulted from an August 1982 low of $333 to $476 by year-end. Stocks skyrocketed into the end of the year, rallying 43% from their August low. The Volcker reflation, coupled with the Reagan tax cuts that were being implemented at the time arguably marked the beginning of the Great American Turnaround.
Despite the happy ending, the experience was painful. In 1982, the S&P 500 declined nearly 17% before Volcker's intervention in August. The U.S. suffered a recession between July 1981 and November 1982, with GDP contracting 2.7% year-over-year in the third quarter of 1982. And the American farming industry was a notable victim of the falling commodity prices.
Volcker finally acted to end the deflation when his hand was forced. The lesson of the Peso Debt Crisis is that economies and financial markets prefer currency stability, and excessive currency strength coupled with decelerating growth is ruinous to commodity-related producers, exposed financial institutions, and the global economy.
The deflationary pressures that exist today are less severe than in 1982. Moreover, today's economy has a lower overall tax rate and lower cost of capital to better support it. Nonetheless, the current deflation is creating underlying economic and financial distress.
Given that gold has traded in a range between $1200 and $1400 during the last twelve months, today's deflationary pressures have not sprung up overnight. But recent global economic weakness has quickly transformed the marketplace environment from "deflationary growth" to "deflationary slowdown." As a result, the weakening economy will now magnify what was previously a gradual decline in prices.
A common criticism of the Federal Reserve is that it is reactionary, rather than proactive. The degree to which the Federal Reserve will identify and prevent the maladies of its present policy course will determine the degree of financial and economic pain ahead.
One market-positive scenario in the near-future would be for Federal Reserve officials to ensure that the dollar does not strengthen any further, which in turn would help to support commodity prices. Additionally, new blood and perhaps new control of the chambers in Congress could lead to new fiscal stimulus legislation that, rather than spending to ignite temporary economic demand, improves the incentives for producers to take risks and make long-term investments. This, in turn, would improve structural economic growth.
Forward-looking, rather than rearview policymaking is vital today.
