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Should we return to a gold standard?

Ralph Benko and Charles Kadlec, both long-time supply-siders (even longer than me), recently published a nice booklet, The 21st Century Gold Standard," that can be downloaded for free at the link. It covers gold standards throughout history and how and why they have been successful in maintaining a constant purchasing power for currencies, and it makes a strong case for returning to a gold standard today. The authors back up their arguments with solid reasoning and plenty of facts, and they convincingly counter all the standard arguments against a gold standard. The booklet is short, well-written, eminently sensible, and accessible to everyone. If you've ever wanted to know more about how and why a gold standard is the best hope for a stable currency and a strong and prosperous economy, this booklet is for you.

One important detail about returning to a gold standard gets only a brief mention in the book: at what gold price should the dollar once again be tied to gold? The authors say only that "one of the key principles for the transition to a gold standard is to allow a market price discovery period to ensure, with complete confidence, that the current price level is maintained and there is no downward pressure on wages." That's important, because if the dollar is pegged to a gold price that is too high, then it will lead to inflation, while pegging to a gold price that is too low would lead to deflation. How to find the right gold price might well be the most difficult and critical part of transitioning to a new gold standard. By announcing the advent of a new gold standard well in advance, markets would have a chance to get used to the idea and its implications. Right now the price of gold reflects a significant amount of uncertainty and fear of higher inflation. If a new gold standard were done right, the gold price would likely decline significantly before being pegged, because these uncertainties would be eliminated. My guess is that the price would be closer to $500/oz., the average real price of gold over the last century, than to its current price.

The aftermath of the housing bubble looks good for equities

Back in the early 1980s, when I was working for him at Claremont Economics Institute, John Rutledge came up with a version of this chart. He used it to argue that relative prices of things can and do change as inflation fundamentals change. With inflation soaring throughout the 1970s, households responded by attempting to increase their holdings of tangible assets. That's a rational response, since tangible assets tend to hold their value during periods of inflation, whereas financial assets (especially bonds) tend to lose their value. The attempt by households to increase their tangible asset exposure was most noticeable in the real estate market, and it resulted in a sharp rise in housing prices relative to the prices of financial assets (indeed, bond prices collapsed and stock prices went sideways). When inflation began to fall in the early 1980s, he argued that households would reverse their earlier plunge into real estate, with the result that financial asset prices would experience a boom. And he was right.

In updating his chart, I'm struck by how the surge in real estate prices in the early 2000s was not accompanied by rising inflation. It was a bubble that was inflated not by the desire to acquire inflation protection, as happened during the 1970s, but by other factors, such as the invention of mortgages that required little or no down payment or documentation, and creative financing options like interest-only or negative-am loans. It was a massive leveraging-up spree that inflated the housing bubble.

The chart now suggests that housing prices have come back down to earth, and are consistent with the relatively low and stable inflation of the past two decades. In the process of coming back down to earth, the sudden collapse of the housing market and the ensuing financial panic of late 2008 sent households scurrying for the shelter of savings deposits (up over $2 trillion in the past three years), and for the relative safety of bonds—everyone wanted to deleverage and de-risk. That phase is winding down now, however, and the next phase is underway. As households regain confidence in the economy, they are beginning to attempt to shift the money socked away in savings accounts and bonds into both housing (which has become incredibly cheap given the plunge in financing costs) and equities. That's why we're likely to see rising housing prices, rising equity prices, and falling Treasury bond prices in coming years. A shift in households' desired portfolio holdings could create more than enough demand to absorb all the foreclosed houses that banks may end up dumping on the market.

It's not that all the cash on the sidelines goes into the equity market, it's that the desire of households and investors to shift the composition of their portfolios causes a change in relative prices. If the urge to reduce cash holdings is strong enough, and if the Fed doesn't act to offset the decline in the demand for money (by raising rates) this process could fuel a rise in a wide range of prices, and this could show up as higher inflation.

Ongoing improvement in the jobs market

The three-year downward trend in seasonally adjusted unemployment claims continues, as shown in the top chart. New claims for unemployment are down more than 10% from the same period last year, and relative to the size of the labor force, claims today are lower than at any time prior to 1997. As the bottom chart shows, the number of people receiving unemployment insurance continues to fall as well: there are 15% fewer people "on the dole" today than at this same time last year. The number receiving "emergency" claims has fallen by more than half (over 3 million people) since the high of early 2010. There is undeniable progress being made on all fronts.

As the pace of layoffs approaches levels that are about as low as they are likely to get, it is very difficult to believe that the pace of hirings won't continue to increase.

And with no sign whatsoever of any increase in claims or any deterioration in the jobs market, it is also very difficult to believe that the economy is on the verge of another recession.

Should another recession happen, however, it would almost surely be very mild, because employers have done just about all the cost-cutting they need to do. The economy has spent the past three years adjusting to a huge oversupply of housing and a big increase in energy prices, by shifting resources massively away from residential construction and into new areas such as the booming oil and gas industry. What other shocks might we have to adjust to? Shocks always come out of the blue, so it's hard to rule them out at this point, but we've all been subject to shocks of one kind or another in the past four years, and markets are still priced to grim conditions, as evidenced by today's 2.3% 10-yr Treasury yield, and below-average PE ratios despite record-high corporate profits. When you're braced for the worst, it's easy to deal with minor setbacks. In short, I think the economy is far more likely to continue to improve than it is to suffer renewed deterioration.

Anecdotally, I'm hearing that mortgage originators have seen a big increase in new applications in the past week or so, which if true, is likely a response to the recent uptick in the 10-yr Treasury yield. A "buy now before mortgage rates go higher" mentality may have been triggered. I'm also seeing scattered reports that housing prices in several areas of the country appear to be on the rise.

Heard on the beach today

Why higher interest rates are not bad news

10-yr Treasury yields (top chart) hit bottom last September (1.72%), and are now 66 bps higher (2.38%). Conforming 30-yr fixed mortgage rates hit bottom last December (3.94%) and are only marginally higher today (4.09%). There's a bit of a lag between the two, and the spread between 10-yr Treasuries and Fannie Mae collateral has compressed to about as tight as it's going to get. So the recent rise in 10-yr Treasury yields will almost surely result in a significant increase in conforming mortgage rates in the weeks and months to come. If the recent rise in Treasury yields holds, then the bottom chart is depicting what will prove to be the all-time low in mortgage rates.

If mortgage rates are headed higher, won't this slow or possibly halt the nascent housing market recovery? No, and here's why:

To begin with, Treasury yields and mortgage rates fell to historically low levels last fall primarily because a) the demand for safe-haven Treasuries and agency mortgages was intense, since the market fully expected the U.S. economy to fall into another recession, and b) the demand for home mortgages was historically weak, because potential homebuyers were fearful that prices would decline further. In short, the intense demand for safe-haven Treasuries and relatively safe mortgages coupled with the very weak demand for home mortgages resulted in a surfeit of loanable funds which, in turn, pushed interest rates to historically low levels.

Today's rising interest rates signal an important reversal in investor psychology and in the prospective health of the economy. Things are getting better, and the demand for safe-haven Treasuries is therefore declining. An improving economy should bolster the demand for mortgages, even as interest rates rise. Rising interest rates go hand in hand with an improving economy; higher interest rates don't weaken the economy, because they are a direct reflection of a stronger economy. Higher rates only become a threat to the economy when they are driven higher by tight monetary policy, but that is manifestly not the case today. Moreover, prospective homebuyers are likely to be encouraged to buy even as rates rise, because they will begin to see that it is better to buy now than to wait for rates to rise even more. At today's prices and even with substantially higher interest rates, housing is more affordable than ever before for the majority of households.

This chart comes from the National Assoc. of Realtors, and shows that a family earning the median income has about twice the amount needed to purchase a median-price home using conventional financing.

A Eurozone recovery is in sight

This chart of U.S. and Eurozone industrial production shows the huge divergence in economic activity that has opened up in the past several months between the U.S. and Europe. From the looks of this chart, the Eurozone economy has probably been in the grips of a modest recession since last September, no doubt sparked by the financial turmoil created by the Eurozone sovereign debt crisis. 

In any case, the behavior of swap spreads—a reliable indicator of systemic risk and a good leading indicator of economic behavior—suggests that the financial strains which have slowed the Eurozone economy have diminished significantly this year. That points to a Eurozone recovery that should be getting underway soon, if not already.

The first of the above two charts tracks German business confidence, and it is noteworthy that it has turned up in the first two months of this year after a sharp contraction which paralleled the decline in Eurozone industrial production. The second chart measures German Industrial Production, and here too we see emerging signs of what could prove to be a bottom.

Finally, I note that the Euro Stoxx Index has turned up, albeit quite modestly. Stocks typically are able to sniff out recoveries before they officially happen (e.g., the U.S. equity market turned up about 3 months prior to the mid-2009 recovery started), and there's no reason to think that isn't the case today. The Eurozone recovery is likely to be a modest one, however, because Europe is still burdened by excessive government spending. Nevertheless, progress is being made, and simply halting the growth in spending ought to be enough to improve sentiment and, in turn, growth.

Housing recovery still intact

February housing starts declined a bit, but the larger picture is that the housing recovery remains very much intact. Starts are up 35% over the past 12 months, and up 46% from their recession low. Starts of course still very low from an historical perspective, but they are improving and that is a very good sign that the residential real estate market has hit bottom, thanks to the combination of market-clearing low prices and low interest rates.

Mountains of cash are still on the sidelines

As a follow-up to this morning's post, here are some charts that survey the state of liquidity in the U.S. economy. It's unambiguously the case that the public is still desperate for the safety of cash and cash equivalents, and risk-aversion (e.g., a preference for bonds over stocks) is still very high. Liquidity is in abundant supply; the Fed has supplied trillions of cash to a dollar-cash-hungry market; bank loans are expanding; consumer credit is expanding; savings deposits in U.S. banks are still increasing at double-digit rates. Taxable bond funds continue to receive $5-6 billion in net inflows every week, while equity funds are still experiencing net outflows.

Banks are definitely lending again. In fact, lending has been increasing since October 2010. Commercial & Industrial Loans (i.e., bank lending to small and medium-sized businesses) are up $170 billion, and they are up at a robust 15.8% annualized pace over the past three months. Consumer Credit (second chart above) is experiencing a similar increase, up by $240 billion, for an annualized rate of increase of 9% in the three months ending January 2012.

M2 is growing above its long-term average annual rate of 6%, even though the economy is 12-13% below its long-term trend. Strong demand for money is the explanation, with a lot of that dollar demand likely coming from the Eurozone. Money demand is likely to begin to decline going forward, however, now that the Eurozone crisis is beginning to fade.

By far the biggest source of growth in M2 is savings deposits. These have increased by over $2 trillion since late 2008, and have grown at a blistering 15.7% annualized pace over the past three months. This is unusually strong growth that can only reflect great fear and caution on the part of investors everywhere, especially when one considers that savings deposits pay virtually no interest.

According to ICI, taxable bond funds in recent months (through February '12) have experienced strong net inflows, while domestic equity funds have experienced net outflows. No sign here of any unusual enthusiasm for stocks on the part of investors. Indeed, the strong preference for bond funds reflects unusual caution.

This all adds up to a pretty clear picture of a market that continues to be dominated by caution and a strong preference for cash, cash equivalents, and relatively "safe" assets such as bonds. Should the strong performance of equities, the continued signs of economic growth, and the recent sharp selloff in Treasuries manage to change investors' preferences, the consequences could be difficult to imagine given how much cash is parked on the sidelines.

The equity rally has legs

The equity rally that began almost six months ago has legs, since it's being driven by improving economic and financial fundamentals, and the rise in Treasury yields is a key indication that this is the case. Yields had been (and remain) severely depressed because global investors had almost no hope that the U.S. economy would improve or that the world would avoid another painful recession. Instead, we see a steady stream of better-than-expected economic reports suggesting the U.S. economy is slowly improving. This forces investors to reconsider their love of Treasuries and their aversion to equities. In that sense, this is a rally driven not by optimism but by reduced pessimism. Treasury yields would need to be much higher before I would consider the market to be driven by optimism.

This chart shows how the improvement in Eurozone banks' ability to acquire dollar funding (as represented in a declining blue line) has led the reduction in Eurozone swap spreads, which in turn is a good indication of improved general liquidity conditions and reduced systemic risk. When financial markets are liquid they can and do function as shock absorbers for the physical economy, because they allow market participants to shift the burden of risk to stronger players. Spreading the burden of risk, in turn, facilitates economic growth, and growth is the best remedy for the problems that still plague Europe.

Financial conditions in the U.S. have returned to "normal" and Eurozone financial conditions have improved significantly, although they remain somewhat precarious. Europe needs more convincing structural reforms (e.g., lower tax burdens and a reduction in the size of the public sector) before the outlook can turn positive.

This chart shows the market's 5-year, 5-year forward inflation rate, a good measure of near-term inflation expectations. Note that expected inflation has increased by half a point since last October, from 2.0% to 2.6%. I take this to be an indication of how, on the margin, the market has become less concerned with the threat of deflation, and more concerned with the risk that the Fed's ultra-accommodative monetary policy may be exacerbating inflation risks.