David P. Goldman, in our view, one of the most outstanding and relevant essayists of this time and age, has been in the past the global head of the fixed income research department at Bank of America (2002-2005) and global head of credit strategy at Credit Suisse (1998-2002). In addition, he worked in senior positions at Bear Stearns, Cantor Fitzgerald, and Asteri Capital. Today he runs the consulting service Macrostrategy.
During the 1980s, he served Norman A. Bailey, then Director of Plans of the National Security Council of the United States. From 1994 to 2001, Goldman was a columnist of Forbes magazine.
At Asia Times Online he regularly publishes since 2000 his “Spengler” essays (named after Oswald Spengler, the German historian and philosopher). An overall index of those columns can be found here
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“Ask anyone in the intelligence business to name the world’s most brilliant intelligence service, and we’ll all give the same answer: Spengler. David P. Goldman’s ‘Spengler’ columns provide more insight than the CIA, MI6, and the Mossad combined.” — Herbert E. Meyer, Special Assistant to the CIA Director and as Vice Chairman of the CIA’s National Intelligence Council, Reagan Administration.
In addition, Goldman writes for the monthly magazine First Things essays that also address a wide range of topics – from Jewish theology and economics to literature, mathematics, and foreign policy. Moreover, he is a columnist at PJ Media, while at Tablet he contributes music reviews. Goldman is the author of the book “How Civilizations Die (and why Islam is Dying, Too)”, published by Regnery Press. A collection of his essays, “It’s Not the End of the World – It’s Just the End of You,” was published by Van Praag Press.
He has spoken at many important business conferences, such as the annual meetings of the World Bank. His chapter on market failure in the “Bloomberg Book of Master Market Economists” (2006) is one of the examination scripts for the Certified Financial Analyst exam. He received a B.A. from Columbia University and entered a doctoral program at the London School of Economics. At the City University of New York he studied music theory. He taught music appreciation at Queens College of New York. At Mannes College of Music he taught music theory. He currently serves there on the Board of Governors. He also sits on the Board of Directors of the America-Israel Cultural Foundation and is a Fellow of the Jewish Institute for National Security Affairs. David P. Goldman lives in New York City, U.S.A.
Lars Schall: Mr. Goldman, what are your thoughts in general on the re-emergence of gold in international finance?
David P. Goldman: Gold is essentially a political issue. As long as you have positive real interest rates on relatively safe debt either of governments or private issuers, there is in my opinion no real reason to hold gold at all except as an emergency fallback. Gold is costly to store, you have to put it in a vault, you have to hire guards, and it’s inconvenient to transfer (if you want to pay somebody in gold you have to physically load it on some means of conveyance). As long as the governments of major countries can be trusted to manage their public debt in a sound way there is really no particular reason to hold gold. That’s of course a very big caveat, because governments can’t be trusted to manage their finances properly, and the reason that the gold price has risen from a few hundred dollars to nearly 2000 dollars an ounce over the last ten years is because of the markets’ lack of confidence in the debt management of major governments.
L.S.: But then also private banks are now interested in gold these days as a more or less zero-risk asset.
D.P.G.: Yes, but I consider that a marginal development at this point. One of the most important issues in the banking industry right now is the availability of sound collateral. The value of very high quality government securities is that you can use them to borrow against it at very low interest rates very flexibly. So the financing value of high quality government securities is an extremely important component of their desirability as an asset. There is now a global shortage of high quality collateral, and the reason is that government debt of many major countries has become compromised by extremely poor economic and financial management. So because there is a shortage of high quality collateral, banks are experimenting with gold as an asset because you can borrow against gold collateral at extremely low interest rates. So it’s beginning to filter into the banking system because of this collateral shortage.
This not just driven by the market, but it’s also driven in part by the regulators. You may be aware that the Bank for International Settlements’ supervisory committees have insisted that banks maintain a much higher degree of liquidity, in other words that a larger portion of their portfolio than in the past should be invested in highly liquid assets. That is from a supervisory standpoint a very reasonable suggestion. Remember that one of the big problems the banks had in 2008 was that they had levered enormous amounts of supposedly high quality assets, which turned out to be completely illiquid in the event of the crisis such as collateralized mortgage obligations with Triple A rating. As you are aware, the rating agencies are being sued by the government of the United States for billions of dollars for allegedly falsifying such ratings.
So with the demand from the regulators that banks maintain essentially a higher liquidity profile, it is physically difficult for them to do so because of the lack of high quality collateral. That’s why banks at the margin are interested in gold. And again, emphasizing the point that to the extent that governments mismanage their finances and the quality and the liquidity of government debt is compromised, gold will be seen as an important alternative. However, I think we are a very long way from a proper restoration of gold in the monetary system.
L.S.: China is buying gold big time.
D.P.G.: Yes, China is buying gold, but from a very low base. China has $3 trillion of foreign exchange reserves. If China were buying gold seriously, the gold price wouldn’t be at $1.600 / 1.700 an ounce, it would be at $5000 an ounce. As far as I can determine – remember it’s a state secret, the Chinese do not tell you what they own – and infer from partial data, the Chinese are buying everything – they are buying raw materials, they are buying technology, they are buying machine factories in Germany (last year, Chinese direct investment in Germany was three times the level of German direct investment in China, which is quite a difference from the past, and there had be some very high-profile acquisitions). From the Chinese standpoint, yes they want to increase their gold reserves, but they also want to increase their portfolio of technologies, they want to increase their access to raw materials, they want to do many different things. Their interest goes far beyond the monetary.
They have been very modest net-sellers of US treasury securities, I think they were down a bit less than $ 200 billion in holding US treasury securities last year, if I remember the numbers correctly. It’s a small but significant amount. I don’t see China engaging in a massive gold buying campaign. Instead I see it as a steady increase, but from an extremely low base. A couple of years ago China’s gold reserves were only 2 or 3 percent of their total reserves, which is extremely small. So it makes sense for them to increase from that little base.
There is another reason for the US dollar to remain an important reserve instrument for some time, and that is Japan. Here is where the politics come in: there has been a great deal of discussion, and I am sure that you are aware of it, about the possible development of an Asian reserve currency, which would perhaps involve a gold anchor. I think that’s idle speculation for a very simple reason: the Asians don’t get along with each other politically. The Japanese and the Chinese are at odds with each other, and as we have just seen today (referring to the Russian fighter incursion into Japanese airspace on February 7) the Japanese and the Russians are at odds with each other as well. If you look at the major economic powers outside of the United States – China, Japan, India, Russia, and after that you have to go to places such as Brazil, which really don’t count for much –, there is no possibility for any significant agreement among them, let alone a monetary agreement.
The Japanese according to reports that we have seen over the last months are expected to increase their reserve holdings of US treasuries by between $400 and $500 billion per year, as they intervene in the market to weaken the yen. Now, there are other ways to weaken the yen, and so the buying of that much US treasuries suggests to me that the Japanese still consider themselves pretty much as part of the American sphere in a monetary as well as in a military sense. Japans Prime Minister Abe has called for an alliance between the United States, Japan and India to contain China. This is a very popular theme among some American strategists as well – you read about it everywhere. So the idea that Japan would shift its reserve position – which is huge – away from the United States and towards some kind of Asian bloc is politically impossible. It’s completely unforeseeable in the existing constellation of world forces. That’s why I say that the emergence of gold as a reserve instrument or actually a gold standard of any kind is extremely unlikely for the foreseeable future – the politics simply aren’t there.
L.S.: However, you support a commodity price rule for monetary policy connected to gold.
D.P.G.: Yes, sure.
L.S.: Could you explain the concept behind that and why you support it, please?
D.P.G.: This is an idea that was advanced by Robert Mundell, but actually it goes all the way back to David Ricardo’s idea of the gold standard. Robert Mundell, of course, is the father of the euro and the father of supply-side economics, he’s a Nobel Prize winner, and he has been the most prominent economist advancing this idea; he has talked about it for roughly the last thirty to forty years. The idea is pretty simple: to create some kind of objective market-based rule which would limit the ability of central banks to create money and to debase their currencies, or on the other hand to act as a break against deflation. In other words: to use market observations of auction prices that reflect expectations of the overall price level in order to correct central bank errors.
There has been an enormous amount of debate for centuries now about what the criterias should be for central bank money creation and how important that is. Mundell’s argument is that the quantity of money is much less important than the way the market responds to central bank increases in high-powered money or in bank reserves and how that affects expectations of the price levels. So central banks should listen much more to the market.
And gold among all the commodities probably gives you the purest signal about future price expectations. There is a very simple reason for that: the amount of gold in stockpiles is many times – 25 to 30 times – annual consumption. So a change in desire to hold gold as an investment is a much more important determinant of the gold price than changes in current mining supply or changes in current consumption of jewelry or industrial applications. If you use copper or platinum or bauxite or other commodities, the stockpiles are extremely low relative to current use. And you also might have a technological change or an economic slump or a big increase of demand which would drastically affect the prices. So it’s much more difficult to interpret price signals from industrial commodities as an indication of expectations about the future price level. Gold gives you much better information. So it certainly has pride of place among all commodities as an indicator of expectations about the price level and as a guide to central bank activity.
That idea of a commodity-based standard which is to create confidence in the market place and to correct for central bank errors is the core of Mundell’s concept. I think it is an extremely good idea and I firmly believe monetary management in general would have done much better if we would have followed Mundell’s view and not the guess work of central bankers.
Certainly errors committed by the Federal Reserve in monetary policy contributed to the development of the financial bubble during the 2000s. During 2003, as you recall, the Federal Reserve eased because they were afraid of deflation – there was a big drop in the bond yield and they saw it as a deflationary signal. At the time my department at Bank of America produced a large body of research, arguing that this was not a deflationary signal, that the Federal Reserve was in error, and the Federal Reserve’s ease was mistaken. Therefore, I can think of a number of instances where the Federal Reserve would have been much better off to watch the gold price rather than bond yields or consumer price indexes or other things that they were watching.
L.S.: Do you consider it worthwhile to follow the gold market?
D.P.G.: Oh, absolutely! Gold gives you extremely important signals. The question that financial analysts should ask is not simply what the market expects, but what is the range of possibilities that the market expects and what probabilities are assigned. In other words, expectations should not be thought of as a point in the future – I think that the stock market is going up by 7.38 percent next year, that’s my expectation. Instead the expectation should be thought as a probability distribution. For example, if you are going off to rob a bank, you have a very screwed distribution – on the one hand you come away with 50.000 euros, on the other hand you get shot dead. If you invest in government bonds there you got a much narrower distribution.
So the willingness of the market to pay for hedges against extreme outcomes – and gold at this point is a hedge against extreme outcomes – is a very important indication of the market’s thinking. One interesting comparison is between gold and inflation tracking securities, like TIPS (Treasury Inflation-Protected Securities) in the United States. There is a very close relationship in the last five years between the gold price and inflation trackers as I have pointed out numerous times in the past in my research for clients. Both of them are hedges against extreme outcome. Right now when you buy into an inflation tracker in the United States, or in fact any of the better quality countries, you have a negative interest rate – that is, you invest a hundred euros at principle, and if nothing unexpected happens in ten years you get 99 euros back. Why would you accept a negative yield? Because if you have other extreme inflation or extreme deflation, TIPS will outperform other bonds and probably other stocks as well. So the fact that gold and TIPS track each other extremely closely is an indication that both of these instruments are hedges against extreme outcomes.
So the gold market is an extremely important signal, but it needs to interpreted carefully. Gold is not a good forecaster of inflation in any reasonable time horizon, say five to ten year time horizon. At this point gold is not a hedge against inflation, but a hedge against a very big change in unexpected inflation, a very big inflation surprise. So again, the gold market is extremely important analytically. I personally own gold as a hedge against extreme outcomes. It’s not really a great deal in my portfolio, but I have a substantial amount of gold as insurance.
L.S.: So I would guess that you don’t think the gold price is a bubble?
D.P.G.: No, absolutely not. The proof that gold is not a bubble is that gold and TIPS track each other so well. If that were true, one would have to say that TIPS is in a bubble, but that would make no sense. I’ve never heard anyone say the TIPS market is a bubble.
L.S.: Since you were once Bank of America’s global head of bond research: is the bond market mispriced?
D.P.G.: I think the Spanish bond market is mispriced. I wouldn’t own Spanish bonds at these levels because I think the Spanish government is covering up the real extent of their banking problems. I think the European Community made a decision to let the Spanish underestimate substantially how severe the problems are, because they want to dampen the perspective of the crisis. But as far as the United States is concerned, I think as long as growth is in the 1 to 2 percent range and you have a very substantial increase in government debt and the prospect of serious increase in inflation due to the American budget problems, the bond market is not necessarily in a bubble at all.
I like to look at American bond yields broken down to two components: TIPS, that is the inflation protected yield, versus the ordinary coupon yield. The difference between the TIPS yields and ordinary coupon treasury yields is typically called “break-even inflation”. The difference between those two yields is the inflation rate that will be required for TIPS and coupons to produce the same total returns. And in the last few weeks as bond yields have gone up, in fact TIPS yields have gone down, they have become more negative, which shows that people are willing to pay more for protection against an extreme outcome, but break-even inflation has gone up, it has gone up more.
So the fact that TIPS have such an enormous support, because yields have gone even more negative, tells me that bonds are still an important portfolio hedge against certain kinds of extreme outcomes. I also see a lot of international demand for US treasuries, particularly by the Japanese. So I don’t think we are going to see huge moves in bond yields. I do think that a large part of the credit market is much too optimistic. I think that the Federal Reserve’s purchases of mortgage backed securities have distorted the market, and so I think the price of risk in the credit market is much too low, I think there is some mispricing there.
L.S.: One final question: usually, debt crises end ultimately in a write-down of the debt. Do you think that we will see in the next few years an international summit where exactly this will happen because it needs to happen?
D.P.G.: Well, the write-down of government debt – that’s conceivable more in some of the European countries, but it is very unlikely. The reason why I think it is unlikely is because if you look at the amount of private wealth available in most European countries compared to government debt, private wealth vastly exceeds government debt. What governments do when they are in trouble to pay back their debt, as in Argentina, is to expropriate private wealth. So what I believe will happen in the extreme case well before you have any default on government debt, say in places like Italy or Spain, you will have some substantial wealth taxes.
In the case of the United States, we will add a lot of inflation. Inflation is a partial default on government debt. For example, let’s say that I lend you a hundred euros for a month, and a month later you come back and give me a hundred dollars. So I say: Well, Lars, what’s that – I gave you a hundred euros and you give me a hundred dollars? And you say: Look, a hundred is a hundred, take it or leave it. This is what governments do to bond holders when they devalue their currencies. A dollar worth euro 1.35 is not the same thing as a dollar worth euro 1.70. But if the United States were to continue a reckless fiscal policy and it lead to the devaluation of the dollar, then in effect you’ll be giving bond holders a different devalued debt repayment. The typical way governments default on their debt is through inflation. And I think that’s a very significant probability, that’s exactly why TIPS are considered so valuable and why people accept negative interest rates, because people are afraid that the government will do precisely that. But a global rescheduling of debt, I just don’t see it as very likely at all.
L.S.: Thank you very much for taking your time, Mr. Goldman!