Although the past week did not seem to show a fair amount of important trading or direction, I think that it was a relevant week nevertheless. Monetary authorities and government have made it very clear, if there ever were any hesitations, that at least in the US the accommodating policies will stay in place for as long as needed. In addition to this, over the weekend, a major hurdle to the collectivization of the US health care infrastructure was removed.
The natural winning choice here seems to be gold. However, over the long term, it doesn’t seem right to me. Call it a hunch. Indeed, the world is struggling to come up with a reserve asset, on the prospect that the USD may fail to work as one. But, does anyone doubt for a moment that liquidity will eventually be drained out of the market? To be honest, I do. The issue is that what we call liquidity today, may only be so at a diminished value tomorrow. Let’s see…
Everything may seem a challenge these days, but Keynes foresaw decades ago the dilemma we currently have in front of us. We, at “A View from the Trenches”, also suggested this approach, in our letter of April 28th (www.sibileau.com/martin/2009/04/28 “A Keynesian Perspective”). In April, I quoted Chapter 13 of the General Theory, writing that:
“…Keynes says something rather ominous: “…if employment increases, prices will rise in a degree partly governed by the shapes of the physical supply functions, and partly by the liability of the wage-unit to rise in terms of money…”. Essentially, the final rise in prices that we may expect will depend on how we address productivity issues today (i.e. physical supply functions…) and how our current politicians reshape the labour market today (i.e. contract negotiations with unions, etc. that determine the liability of the wage-unit to rise in terms of money).
The final sentence is perhaps the most relevant. Keynes wrote that “…when output has increased and prices have risen, the effect of this on liquidity-preference will be to increase the quantity of money necessary to maintain a given rate of interest…”. This strongly suggests that an exit strategy by the Fed may be counterproductive. Inflation may be high enough for us to need today’s increase in the quantity of money, to maintain the rate of interest at the end of this experiment”
The discussion above is more relevant after the events of last week. Strategists worldwide are writing research on how to hedge against upcoming inflation, the initial consequences in the credit markets (spread tightening in 2010 will continue) and the evolution of the global monetary system as the US may be too focused in trying to orchestrate a joint exit program with China only. Thus the degree of productivity increases (= strength of the recovery), which we check every quarter, as earnings are released, becomes critical. Unemployment, which so many an analyst sees as a burden for growth in consumption is, in my view and following Keynes’ comments, a plus. With a 10%+ unemployment rate (i.e. the liability of the wage-unit to rise in terms of money), prices will rise slower than otherwise. Thus, is there a role for gold? Unfortunately, even as this commodity will certainly continue to rise, unless something more fundamental takes place, gold has limited chances of becoming a true reserve asset. But this does not mean, at all, that gold’s chances to outperform in the near term are compromised.
Lastly, as I read the news last week, it seemed to me that we were closing on many questions that we had had since the beginning of the year. Will the Treasury be able to place its debt? Will the Fed indicate a path on rates? Will the US have a collective social health care system? Will there be enough demand for corporate credit? Will we see a clear inflationary reading in the Consumer Price Index? Will we see a clear trend in the reduction of unemployment claims?”
Thus, on this note, I think a comment about Method can be suggested. Thomas Bayes (London, 1701-1761) became posthumously famous thanks to his paper titled “An essay toward solving a problem in the Doctrine of Chances”, published in the Royal Society’s Philosophical Transactions, in 1764. Bayes had elaborated conditional probability, to be able to answer this question: “How can we infer underlying probability from observation”? (refer L. Mlodinow’s “The Drunkard’s Walk”, Ch. 6″).
It is very tempting, as questions become certainty, to infer what will happen in 2010. In the past weeks, I have read a lot of economic and financial research that is nothing else than inferences made on conditional probability (i.e. if the Fed leaves rates unchanged in 2010, what are the chances that investing in corporate credit outperforms investing in equity or gold?) But here’s the trick: In conditional probability, once you identify and quantify your sample space, you have to prune it, to adjust it for the conditions you already know. Can we do this in a global multi-currency world, where the unemployment rate that is assumed to delay consumption growth is not in the country that produces most of the goods sold worlwide? I think the answer is negative. But it is also negative because money is non-neutral, which means that it affects assets prices at different stages in an inflationary process and in different degrees. Therefore, I believe that we are not even able to work with a specific sample space, let alone prune it.