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12/14 Frank Veneroso and Declan Costelloe - Gold Derivatives, Gold Lending, Official Management Of The Gold Price And The Current State of the Gold Market

Capsule Summary

Courtesy of John Brimelow

a paper presented on May 17 this year at the Fifth International Gold Symposium, in Lima, Peru, (jointly authored with his associate Declan Costelloe) Frank said:

"…some, (though not all) of the gold bug conspiracy talk on the internet seems to us to be more or less correct… We conclude…that, since the Long Term Capitol Management crisis in late 1998, the official sector has been managing the price of gold."

"The gold price has rallied from the mid $270’s to just over $310 and has traded in a stable fashion for about 2 months… For the market to not explode amid numerous bullish technical signals presumes strong offsetting selling. Since producers are covering hedges, we must assume this selling emanates from the official sector… Furthermore, the way in which the gold price initially met the psychologically important $300 level with a sharp drop in volatility suggests that such official selling is not due to uncoordinated one off large scale official sales. This would suggest that the gold price is being managed by the official sector."

"From our contacts in the hedge fund industry, we understand that some of the recent buying in the markets for gold futures, gold forwards and gold equities has been spurred by a growing belief that the gold market is being managed by the official sector and that this management will at some point fail…. We believe the official sector appreciates the challenge such thinking by market participants poses for management of the gold price… we would not be surprised by further official statements or actions that might be construed as part of an attempt to manage the gold price. One or more of these statements or actions may be so extreme as to shock the market."

Frank does make an issue in his paper of believing that much of the outstanding short has been taken over by the Central Banks

"the official sector has …quietly taken the gold shorts from private speculators and producers and transferred them to their books. In other words, the official sector intervened to prevent an explosive gold derivative crisis."

How much of the total short has really been transferred, given the "explosive" or "toxic" nature of many of the hedges (arising from hedgers undertaking to balloon their liabilities if gold should rise, in return for short run concessions on matters such as lease rates and margin requirements) is not actually known, either by Frank or the Central Banks. What is clear is that the Central Banks horribly misjudged the sensitivity of the derivative structure when they devised the Washington Accord, so their track record is poor. Given this week’s action we may be about to be enlightened! However, Frank’s Peruvian paper clearly demonstrates that he believes the gold market continues to be subject to Central Bank management.

Gold Derivatives, Gold Lending,
Official Management Of The Gold Price
And The Current State of the Gold Market

By

Frank Veneroso & Declan Costelloe

Fifth International Gold Symposium

Lima, Peru

May 17th, 2002

Part 1

Gold Lending And Official Management Of The Gold Price

Let’s begin with an explanation of gold banking and gold derivatives.

It is a simple, simple idea. Central banks have bars of gold in a vault. It’s their own vault, it’s the Bank of England’s vault, it’s the New York Fed’s vault. It costs them money for insurance - it costs them money for storage--- and gold doesn’t pay any interest. They earn interest on their bills of sovereigns, like US Treasury Bills. They would like to have a return as well on their barren gold, so they take the bars out of the vault and they lend them to a bullion bank. Now the bullion bank owes the central bank gold---physical gold---and pays interest on this loan of perhaps 1%. What do these bullion bankers do with this gold? Does it sit in their vault and cost them storage and insurance? No, they are not going to pay 1% for a gold loan from a central bank and then have a negative spread of 2% because of additional insurance and storage costs on their physical gold. They are intermediaries---they are in the business of making money on financial intermediation. So they take the physical gold and they sell it spot and get cash for it. They put that cash on deposit or purchase a Treasury Bill. Now they have a financial asset---not a real asset---on the asset side of their balance sheet that pays them interest---6% against that 1% interest cost on the gold loan to the central bank. What happened to that physical gold? Well, that physical gold was Central Bank bars and it went to a refinery and that refinery refined it, upgraded it, and poured it into different kinds of bars like kilo bars that go to jewelry factories who then make jewelry out of it. That jewelry gets sold to individuals. That’s where those physical bars have wound up---adorning the women of the world.

Now, this bullion banker is net short gold when he conducts this operation. Remember he borrowed gold and now he has a dollar financial asset. He is making a 5% return on the spread, but he now has a gold price risk. As a banker he is not normally in the business of putting on speculative positions like this. He is an intermediary, so what does he do? For the most part what he does is he hedges his gold price risk. He goes long the forward market to offset his physical short. Now if he goes long in the forward market someone else must go short, because every such contract in the forward market has two sides---a long and a short. In doing this he allows private market participants to go short the forward market. Who are those private participants who go short the forward market? They are producers hedging future production, they are jewelers who are hedging their inventory, and they are speculators who want to go short the gold market because they believe the price will go down and they earn a forward premium or ‘contango’ which happens to be, in this case, roughly equal (though not quite) to the difference between the rate of interest on the dollar asset held by the bullion bank and the rate of interest paid on the gold loans by the bullion bank.

So, basically, in doing this operation the bullion banker has a hedged position on the gold price and he takes a small margin---like a half of one percent---from this intermediation. In doing so, he allows private market participants to go short gold. That’s why we elide the two phrases---going short in the gold market and gold borrowing. The ultimate borrowers in the gold lending operation are these shorts in the gold futures and forward markets.

Now we have a conservative set of gold lending numbers and we have a more aggressive set of such numbers. Our range of estimates implies that somewhere between 10,000 and 16,000 tonnes of the official sector gold position has left those vaults by way of the lending process.

Now why do we think this?

I started out on this crazy voyage with a statement that was made by a man from the Bank of England---Mr. Terry Smeeton---who was in charge of the gold operations of the Bank of England. On something like November 21st or 22nd of 1995 at the 5th Annual Banking Conference in the city of London, he addressed the issue of gold lending. He gave some statistics. He basically said that gold lending had roughly doubled over the last year and a half. Precisely, what he said was that gold loans had more than doubled and gold swaps increased by more than 50%.

But he didn’t give us any absolute numbers. However, he made a similar speech in Australia in March of 1994 and I went back and I checked what he said then. There he said that gold loans were 1500 tonnes based on a recent survey the Bank of England did, but he didn’t make any reference to swaps. I called him up and asked him what the Bank thought the total swaps were in early 1994---a year and half earlier. He said to me he didn’t remember exactly but he thought they were about 400 tonnes. What that meant is that the Bank surveys indicated that roughly 1900 tonnes of official gold had been lent around the beginning of 1994 and 18 months later---around the middle of 1995---the number had roughly doubled to 3700 tonnes, perhaps more. Now that was interesting because 3700 tonnes was a substantially larger figure than the consensus estimate of all those lendings, which at the time was about 2200 tonnes.

I thought this was intriguing and I did some analysis. I went to Mr. Smeeton from time to time under fairly casual circumstances and I asked him to give me an interpretation of his data. What he told me was that the Bank of England had done a survey of the fourteen principal market makers in the City of London and they had reported this data. I said to him, “Well, did that include the Swiss banks for example?” and he said, “No, absolutely not---only the fourteen principal market makers in the City of London.” So I went to these fourteen bankers and I asked them “When the Bank of England came and asked you about this what did you tell them?”

I found out something very interesting. Some of these characters said to me, “I didn’t report anything. I don’t keep a big book in London---most of my book is outside of London. He doesn’t know my loan position.” Some of them said, “Oh, we complied. We gave them our global book, not only what was in London, but everywhere.” From these conversations, I came up with the impression that, for these fourteen bullion bankers, this number was a partial total---it wasn’t a complete total because many had not disclosed their books outside of London.

    Then a bullion banker friend of mine said, “Frank, that’s only the half of it---those fourteen (14) principal market makers in the City of London.” He said, “Take down this list of all the guys who take gold deposits from central banks.” And I took down the list and there were thirty-seven (37) of them. So I took the other twenty-three (23) who were not surveyed, I put them in a list, and I put that list next to the list of the 14 that were surveyed. I went to ten bullion bankers and I asked, “Of these two groups, which are the most important?” Nine out of ten of those bullion bankers said to me that the 23 who were not surveyed were as important or more important in terms of their aggregate position as the 14 that were surveyed. I sat down and I said to myself, this is very interesting. The Bank of England survey showed that only 14 bullion bankers had lent 3700 tonnes and that total was partial. If I grossed up the 14 to their total and I threw in an equivalent total for the 23 that were not surveyed, I came up with some gigantic numbers. Perhaps 9000 or 10,000 tonnes of gold had been lent, based on this Bank of England survey. This was all by inference mind you, but none the less, it was very striking. The total estimated borrowed gold in the official Gold Fields Mineral Services statistics was only on the order of about 2200 tonnes at the time. There was a giant discrepancy (Table 1).

Table 1: Why Official Supply/Demand Exceeds Majority Opinion Estimates
- An Argument from the Supply Side

Total Gold Loans Outstanding

BOE GFMS Difference

December 1993 4,750 1,600 3,150

June 1995 9,250 2,200 7,050

Note: All Quantities in Tonnes

This discrepancy was so large that I tried to be conservative, and, for no good reason, I chopped the 9000 tonnes down to 6000 tonnes because that 6000 tonne figure was already so far removed from the official numbers. In any case, this Bank of England survey implied big, big errors in the consensus supply/demand balances and a hell of a lot more gold lending than anyone thought.

Now look, gold lending began in earnest in the early 1980s. By 1995 it was a process that had been going on for more than ten years. Now, what if there were 6000 tonnes of gold loans---not 2000 tonnes of gold loans as implied by the consensus supply/demand statistics. That means that there had been 4000 tonnes more lending, most of it over the last ten-year period. Gold lending was a small activity during the 1980s. It was a much bigger activity during the 1990s, so obviously it was a business that was occurring on an increasing scale. If the discrepancy was 4000 tonnes over ten to fifteen years, 300 to 400 tonnes a year---well, then it was probably 200 tonnes a year in the 1980s and it was probably nearer 600 tonnes a year by 1995. That meant supply and demand were underestimated by something like 600 tonnes a year.

Now, the Bank of England survey results suggested a yet higher rate of lending over the past two years alone. This fact makes the Bank of England survey data quite perplexing and difficult to interpret. That being the case we thought it was best to spread the final total out more smoothly over many years. In any case, I looked at this data and I said to myself, “How can this be? Is there any corroborating evidence? Low and behold we found corroborating evidence---so now lets go further.

The World Gold Council conducts annual surveys of gold demand for three uses - jewelry, bar, and official coin - in 27 countries in the world. Though this survey is only partial it clearly points to total global gold demands that are many hundreds of tonnes higher than the so called “official” statistics provided by GFMS.
For 1999, the WGC Gold Demand Trends Survey found that gold demand for the uses and countries it surveys was 3,282 tonnes. GFMS surveys end use demand for jewelry only in some countries not surveyed by the WGC. Their estimates of 1998 jewelry demand alone in only seven countries - Greece, Portugal, Spain, the former USSR, Iran, Columbia and Canada - totaled 268 tonnes. In addition, the GFMS estimated that global gold demand for uses not surveyed by the WGC was 458 tonnes in that same year. If we total these three demand items we arrive at the following;

Table 2
Metric Tonnes

1999
2000

WGC gold demand for jewelry, bar and coin in 27 countries 3,282 3,288

GFMS gold jewelry demand in an additional 7 countries ¹⁾ 268 268

GFMS global demand in all other uses (excluding jewelry, bar and coin) 458 458

Incomplete Global Demand Subtotal 4,008 4,014

GFMS Global gold demand 3,985²⁾ 3,956

1) GFMS occasionally reports end use demand. Their survey for 1998 included the estimate used here. There was no comparable estimate in their 1999 report. The WGC reported a large increase in global gold demand in 1999. Based on WGC global demand trends this number is probably conservative

2) GFMS total gold demands exceed this total by 170 tonnes. They attribute these demands to investment in Europe and North America. The text of their report suggests these investment demands correspond to speculative short covering. Therefore, these additional demands would be outside those demands surveyed by the WGC. That this is so is apparent from an analysis of the breakdown by use of gold demands surveyed by the WGC in the countries in Europe and North America which it surveys.

From the above it is clear that the WGC survey plus select additional items from the GFMS survey points to a total that exceeds GFMS’s estimation of all global gold demands. This subtotal still excludes jewelry demand in more than 100 countries. It also still excludes official coin and bar demand in these 100 or more countries as well as the seven additional countries mentioned above. To be sure, these are all smaller countries than the principal countries surveyed by the WGC. Yet, their income, taken in aggregate, is very large and their gold consumption must be considerable. These additional demands would raise any WGC survey based estimate of global gold demand well above the GFMS estimate.

We might add that this disparity between the WGC and GFMS demand surveys has been increasing progressively over time.

In the Gold Book Annual 1998 we compared growth in the estimates of demands for gold of the WGC and GFMS. We calculated that, for the years 1991-1996, the WGC data series showed annual demand growth that averaged 1.6 percentage points per annum more than the GFMS series. Again, if one compares these two data series for the years 1997 to 2001 (Figure 1), there is once again an average annual disparity but in this period it is even greater. This is a very large discrepancy and suggests that one of these two data series is very wrong.

Figure 1:

GFMS Gold Demand v WGC Gold Demand (1997-2001)

If one looks at Eugene Sherman's data on almost 200 years of private non monetary demand data, such gold demands have grown at a 4% to 5% rate for as long as we have data. During this period the “real” price of gold was more or less constant. Global income has probably grown at 3% to 4% per annum over this time period. This implies an “income elasticity of demand” in excess of unity. Gold demand has slowed since 1971 relative to the past. However, this occurred because of the more than threefold increase in the real dollar price of gold from 1971 to the beginning of the decade of the 1990s. Several studies (e.g. David Gulley) show that gold demand has a significant price elasticity. If one adjusts this rate of growth of gold demand for the elasticity of demand in response to gold’s rising real price, it appears that, if anything, the rate of growth of private non-monetary gold demand relative to a constant real gold price actually rose slightly during the 1970s and 1980s. (See chapter six of the Gold Book Annual 1998). The gold industry has had a superior growth trend and can be classified as a durable moderate growth industry. The WGC gold demand data indicates this long-term trend has more or loss persisted into the 1990s. The GFMS data, by contrast, shows roughly a less than 2% rate of increase in global gold demand in the 1990’s despite a significant decline in the real gold price and average annual growth of global income of more than 3%. This implies a drastic decline in the growth of gold demand relative to its past income and price determinants

Obviously, there is a huge disparity in the level and growth in global gold demand implied by the WGC and GFMS data. This is most conspicuous in recent years. GFMS shows almost no growth in global gold demand from 1995 to 2001 despite a very large decline in the real price of gold and more than a 20% increase in global income. As noted above, historical data shows that private non monetary demands for gold have exhibited an income elasticity in excess of unity and a significant price elasticity. The WGC data since 1994 shows some adverse shift in those historical income and price elasticities but it is still basically consistent with history. The GFMS data shows a massive departure from these historical parameters over this five year period. The degree of shift in these parameters implied by the GFMS data strains credibility; the shift implied by the WGC data does not.

The World Gold Council data, then, was quite corroborative, quite significant.

Now, in addition to the above we did a little bit of field research---we have had other people make inquiries with bullion bankers. (We went to other parties to make the inquires, since we feared that, as analysts, these dealers would be less forthcoming with us.) Some of these bankers had left bullion banking, some had been fired and felt disaffected and inclined to speak, some are still employed. In any case, they were willing to talk. Every year we have come upon one or several new reports on bullion bank present and past deposit positions. We have gotten, albeit crude, estimates of gold borrowings from the official sector from probably more than 1/3 of all the bullion banks. We went to bullion dealers and we asked, “Are these guys major bullion bankers, medium bullion bankers, or small scale bullion bankers?” We classified them accordingly and from that we have extrapolated a total amount of gold lending from our sample. That exercise has pointed to exactly the same conclusion as all of our other evidence and inference---i.e. something like 10,000 to 15,000 tonnes of borrowed gold.
Besides the above reasons for believing the official data on gold lending, gold supply and gold demand is flawed, we have many others. Some are less compelling and complex and not worth elucidating. Some are based on our “market intelligence”, so we cannot disclose their nature and details. All we can say is in this regard is that some, (though not all) of the gold bug conspiracy talk on the internet seems to us to be more or less correct.

We conclude that we are quite confident our assessment of gold demand, gold supply and gold lending is correct.

One last issue. We explained earlier that the ultimate borrowers of gold lent by central banks are the shorts in the gold futures and forward market. In our estimation these shorts have now all been covered to some extent. We believe that some of the speculative shorts were covered in late 1998 when problems arose with many of the major hedge funds. More were covered during the gold price spike after the Washington Accord. Speculators, principally managed futures funds, continued to go short on price decline, but are all now very long. Lastly the producers have begun to reduce their shorts.

In the aggregate, then, total shorts in the gold futures and forward markets have been reduced. Does that mean that gold loans in the aggregate have been reduced ? No ! Why ? Because, at current gold price levels, where total fabrication and bar hoarding exceed mine and scrap supply and official sales, it is impossible for the aggregate gold loans to be paid down. When gold is lent, physical gold leaves the official vault and ends up in jewelry to be worn by the women of the world. Fabrication demand and bar hoarding must exceed mine and scrap supply and official sales in order for lent gold to be absorbed. There has been an absorptive constraint on the flow of borrowed gold and it has taken a decade and a half to build the outstanding stock of gold loans. What would it take to repay even a part of these loans. The bars lent by the central banks are no longer bars; they are now jewelry worn by the women of the world. To get bars to return to the central banks, the gold price must rise high enough to lower price elastic physical demand and raise mine and scrap supply and official sales and thereby create a surplus that can be made into such bars. That obviously has not happened. Therefore the gold loans cannot have been paid down, even by a small amount. In fact, according to our supply/demand balances, borrowed gold continues to flow into the market and the gold loan aggregate continues to grow.

We can phrase this in another way. The existence of a positive flow of borrowed gold requires a “deficit” in the gold market. When this happens, the women of the world become the ultimate longs in a market in which speculators and mining companies are the shorts. The shorts do not realize the women of the world are the longs. Nor do the women themselves. What do those longs do when the gold price rises. In aggregate nothing. Some cash in their gold; but others are inclined to value gold more and buy more. So the women of the world, the longs, are not inclined to deliver their gold to the shorts. In effect, gold lending led to an inadvertent corner in the gold market by the women of the world. The shorts didn’t realize this, the bullion banks didn’t realize it, the lending central banks didn’t realize it either. In effect, they jointly acted to create unwittingly a “prison of the shorts”.

But, you may ask, how have the shorts in the futures and forward market, in aggregate, been greatly reduced ? How can that be ? Very simply, the official sector has recognized the existence of this inadvertent corner, this prison of the shorts and it has had to intervene. It has quietly taken the gold shorts from private speculators and producers and transferred them to their books. In other words, the official sector intervened to prevent an explosive gold derivative crisis. We conclude from our argument based on the development of an inadvertent corner in the gold markets, from a “prison of the shorts”, that, since the Long Term Capitol Management crisis in late 1998, the official sector has been managing the price of gold.

Part 2

The Current State Of The Gold Market

The gold price has rallied from the mid $270’s to just over $310 and has traded in a stable fashion for about 2 months. It is our assessment that there has been relative stability in the physical market overall, large scale buying in the New York and Tokyo futures and forward markets and significant covering of hedges by gold mining companies. Taken together, there has been remarkably strong buying overall. For the market to not explode amid numerous bullish technical signals presumes strong offsetting selling. Since producers are covering hedges, we must assume this selling emanates from the official sector.

The Physical Market

There is a great deal of commentary on physical buying of gold by Japanese households. Apparently, a fear for the safety of bank deposits in Japan has created something of a gold rush. The Japanese government lifted deposit insurance on bank deposits at the end of Japan’s March fiscal year. In addition, concerns are mounting among Japanese households about the eventual necessity by the country’s monetary authorities to pursue a deliberate inflation to confiscate Japan’s excessive debt. The combination of these two factors has led some Japanese households to begin to accumulate physical gold.

However, there is fairly limited data substantiating significant physical gold accumulation in Japan. The import data shows only a moderate inflow of physical metal into the country and dealers do not see a large pick up in shipments of refined metal from Western refineries to Japan. The increase in Japanese imports of gold suggests Japanese households are buying more physical gold than in the past, but it has probably been only on the order of 20 tonnes per month for several months.

How significant would such an increase in Japanese demand be for the physical market overall? In our estimation, it would only partially offset losses in Asian demand stemming from the regional recession and a strong dollar. We estimate overall physical demand to be on the order of 5000 tonnes per year. According to World Gold Council survey data, a weakening Indian currency plus a weaker economy had caused a drop in Indian overall fabrication and bar hoarding in the second half of 2001 when gold prices averaged about $275. This demand has always been very price sensitive in the past, and should have fallen further in the first quarter of 2002 because of the rise in the gold price. Altogether this would suggest that price sensitive Far East demand may well have declined in a fashion that offsets the increase in Japanese demand.

For the Pacific Rim economies, the global collapse in high tech spending has caused a recession that is, in aggregate, almost as serious as the regional recession of 1998. To this adverse shock to income we must add the renewed weakness in the currencies of the region. It is often thought that savers in the Asian emerging economies “go to gold” when their currencies weaken. The historical record shows that this is definitely not the case. These savers allocate a certain percentage of their incomes to gold jewelry and bar purchases. When their currencies weaken, the price of gold in those currencies rises and their incomes, denominated in those local currencies, buy fewer ounces, thereby depressing physical gold demand.
    Based on the most recent World Gold Council and Gold fields Mineral Services demand data, it is our view that a global recession and a strong dollar, coupled with a somewhat firmer dollar gold price, has depressed gold fabrication demand and bar hoarding. The pickup in gold demand in Japan only offsets part of this overall softness in global demand. Therefore, we cannot attribute recent strength in the gold price to physical buying.

The Futures and Forward Market

We have data on speculative gold buying on the two principal global futures exchanges: Comex in the U.S. and Tocom in Japan. The OTC forward market is much larger, but we have no data on such activity in this market. We presume it mirrors the visible futures exchanges but that much larger magnitudes are involved.

The Comex data shows that speculators in that market have gone significantly to the long side. They have not taken on record long positions, but their long positions are now close to (but not quite at) the peak levels seen on rallies over the last several years (Figure 2).

Figure 2:

CFTC Commitment of Traders Report

Net Speculator Positions in COMEX Gold Futures, May 1992 - May 2002

In Japan, the combination of a rising gold price and a weak yen has led to a huge rally in the yen price of gold. This, plus concern about the future value of yen bank deposits, has led to large scale buying in the Japanese gold futures market. Recently, the speculative long position on Japan’s gold futures market is close to peak levels reached only three times since the mid 1980’s.

In our opinion, most of the speculators in both the U.S. and Japanese gold futures markets are trend sensitive; they follow price momentum and will sell once the gold price trend reverses. Based on trading patterns that have prevailed in the past, we would expect considerable selling from these market participants if official selling caps the gold price and the gold price trend reverses to the downside.

Producer Hedging

What is probably making this rally significantly different from rallies in the past is the behavior of gold mining companies who hedge their production in the gold futures and forward market. Prior to late 1999, producers typically added to their gold hedges (or shorts) every year. Such hedging often occurred into gold price strength and acted to cap rallies driven by trend following speculators. There has been a series of spectacular corporate financial crises created by large producer hedge positions on gold price rises since mid 1999 (Ashanti, Cambior, Centaur). These examples have dampened prior producer enthusiasm to add to their hedge books on gold price rallies and the aggregate producer hedge book has therefore been stable to declining since then.

From what we can glean from reports emanating from the producer sector, these market participants, taken in the aggregate, began to reduce their outstanding gold forwards sometime last year. Such a move may have been accelerated by the 2001 decline in US interest rates, which now has almost eliminated the contango that producers earn on their forward hedges. It may also reflect a growing belief amongst mining companies that the gold price has been held artificially low by the official sector. The staff of Veneroso Associates talk often with gold mining executives. The skepticism they expressed in the past toward our unconventional views on gold supply/demand has now largely dissipated. This may be due to a growing awareness that the gold market deficit exceeds consensus estimates. They may now believe, as we do, that the gold price will be driven higher by commodity dynamics sooner than the “official” statistical portrayal of the market would expect.

Figure 3:

Producer Hedging for the period 1982 - 2001 (from GFMS - Gold Survey 2002)

Gold Fields Mineral Services estimates that net outstanding producer hedges declined last year by 147 tonnes (Figure 3). Based on anecdotal evidence, this seems somewhat low to us. Other market participants agree that hedge books are being reduced.

We believe that this reduction in producer gold hedges, which constitutes a form of buying in the gold derivatives market, may have intensified into the current gold price rally. The combination of speculator buying on the various global futures and forward markets, plus a reduction in producer hedge books, constitutes cumulative buying pressure in the gold derivatives market that may have no precedent over the last two decades.

The Official Sector

Physical gold demand may have weakened overall because of global recession and a strong dollar, but its overall decline is probably not significant, owing to recent physical buying by savers in Japan. If anything, global mine supply is basically flat. By comparison overall net buying in the futures market is probably huge. Yet the gold price has staged only a modest $35 rally and has now met considerable resistance at the $310 level. We must presume there has been offsetting selling of a comparable magnitude from the official sector. Furthermore, the way in which the gold price initially met the psychologically important $300 level with a sharp drop in volatility suggests that such official selling is not due to uncoordinated one off large scale official sales. This would suggest that the gold price is being managed by the official sector.

When the gold price rose to $300, Bundesbank Council head Ernst Welteke announced that the Bundesbank would sell gold at higher prices in the future. The gold price fell back thereafter. It soon recovered to $300. Welteke repeated his public comments. In the past, a major central bank like the Bundesbank would have avoided making such a controversial statement. To many the timing of Welteke’s statements could be construed as part of an effort by the official sector to “cap” the gold price.

Sometime, in the coming months, we believe that data will be compiled that will show a significant net decline in producer hedging so far this year. Such a decline will not be readily squared with the consensus (GFMS) supply demand framework for the gold market except by assuming large scale unreported official selling. If one postulates large scale speculator buying, which Comex and Tocom data support, the inferred official sector selling will be larger yet.

From our contacts in the hedge fund industry, we understand that some of the recent buying in the markets for gold futures, gold forwards and gold equities has been spurred by a growing belief that the gold market is being managed by the official sector and that this management will at some point fail. Some such speculators believe, probably wrongly for the time being, that buying by Japanese savers will overwhelm official efforts to “control” the price of gold.

In our opinion, when data on a net reduction in outstanding producer hedges becomes available in coming months, the current suspicions regarding official management of the gold price will move closer to becoming convictions. At that point, speculators will recognize that at some point such management will fail. Though they will in all likelihood judge that it can persist for some time, they will be oriented to speculate on the long side of the gold market whenever there surfaces any reason to believe that official management of the price of gold might fail.

We believe the official sector appreciates the challenge such thinking by market participants poses for management of the gold price. Give the timing of Ernst Welteke’s statement on Bundesbank willingness to sell its gold, we would not be surprised by further official statements or actions that might be construed as part of an attempt to manage the gold price. One or more of these statements or actions may be so extreme as to shock the market.

Conclusion

If history is any guide, official selling will “fill the boots” of trend-following speculators in the gold market and the gold price will fall back toward its prior trading range. The global recession and strong dollar, which curb gold jewelry and bar demand, have been facilitating the ability of the official sector to keep the gold price low.

Over time, the forces for a higher gold price will build. Though it may not happen over the short run, in the long run the dollar will fall - and substantially in our view. A dollar decline will lower the prices of gold in countries outside the dollar bloc, which will in turn stimulate price elastic demand.

The fear of dollar weakness may also shift official sector attitudes toward holding gold as a reserve asset relative to the dollar. Many central banks feel uncomfortable with the now higher share of dollars in their official reserves. The huge and ever increasing internal debt of Japan and the growing prospect of a Japanese bailout inflation, a by-product of which will invariably be a weaker yen, are making these same countries uncomfortable with the yen as an alternative reserve asset. Though the euro will be the prime beneficiary of a move by central banks to diversify from dollars, such diversification objectives may make some central bankers less inclined to sell or lend their gold. In fact, some may choose to buy gold. The Chinese central bank has a stated objective of reducing its high reserve holdings of dollars, and it may be noteworthy that they have reported the first rise in central bank gold holdings (in tonnes) in many years. As long as the dollar has remained strong, central banks have felt no pressing need to address their high dollar holdings, but an eventual reversal in the trend in the dollar exchange rate may change that perception.

The outlook for mine supply will also help lift the gold price. Over the last 4 years, mine supply has held up despite low gold prices because there was a pipeline of projects from the 1994-96 period of higher gold prices. That pipeline has now been almost depleted. In addition, mines initially high graded to improve cash flow at low gold prices. High grading increases output over the near term, but ultimately reduces overall life of mine output and brings forward in time depletion dynamics. We may be getting close to this crossover point. In a recent public statement, Wayne Murdy, chairman of Newmont Mining, forecast that mine supply should now decline by 3-4% per annum.

Declining mine supply will tend to put direct upward pressure on the gold price (Figure 4). More importantly, perhaps, the prospect of a decline in mine supply at current low gold prices may change producer sentiment on the gold price outlook and accelerate the move toward a reduction in gold forward sales that has already been underway.

Figure 4:

World Annual and Quarterly Gold Production (From Goldsheet.com)

Predicting private gold investment demand is far more difficult than forecasting gold commodity supply and demand. However, it does appear plausible that speculative and investment demands for gold may increase in coming years. As noted above, we believe that recent Japanese investment demand for physical gold is currently overrated by many. However, it must be kept in mind that, owing to price deflation, yen currency and deposits still provide high real returns and the controversy over the need for a deliberate debt confiscating inflation in Japan has been largely confined to professional circles. If there is eventually such a debt confiscating inflation, the current demand for physical gold in the country may prove to be the trickle that presaged the torrent once the dam broke. A debt confiscating policy of inflation in Japan will not go unnoticed in neighboring Asian economies that have also contracted the “debt disease”. Though the same may never happen in the West, it is possible that, after 2 decades of having been perennial bears, Western futures speculators, seeing events in Japan, may be more inclined to “punt” from the long side in the future.

Lastly, we hear from our friends in the hedge fund community that our views on the gold supply/demand framework are gaining recognition. Our views imply that the official supplies that have been depressing the gold price must abate or end sooner than the consensus expects. It is our guess that we are correct in our views and that evidence will continue to surface to make our views more credible and more widely shared. This will interest more speculators on the long side of the gold market during future rallies. Over time, such speculation may reach a mass critical enough to have a permanent impact on the behavior of all market participants, including those from the official sector.
******

Footnotes for John Brimelow's summary above:

Besides the above reasons for believing the official data on gold lending, gold supply and gold demand is flawed, we have many others. Some are less compelling and complex and not worth elucidating. Some are based on our "market intelligence", so we cannot disclose their nature and details. All we can say is in this regard is that some, (though not all) of the gold bug conspiracy talk on the internet seems to us to be more or less correct

P5

The existence of a positive flow of borrowed gold requires a "deficit" in the gold market. When this happens, the women of the world become the ultimate longs in a market in which speculators and mining companies are the shorts. The shorts do not realize the women of the world are the longs. Nor do the women themselves. What do those longs do when the gold price rises. In aggregate nothing. Some cash in their gold; but others are inclined to value gold more and buy more. So the women of the world, the longs, are not inclined to deliver their gold to the shorts. In effect, gold lending led to an inadvertent corner in the gold market by the women of the world. The shorts didn’t realize this, the bullion banks didn’t realize it, the lending central banks didn’t realize it either. In effect, they jointly acted to create unwittingly a "prison of the shorts".

P5

Very simply, the official sector has recognized the existence of this inadvertent corner, this prison of the shorts and it has had to intervene. It has quietly taken the gold shorts from private speculators and producers and transferred them to their books. In other words, the official sector intervened to prevent an explosive gold derivative crisis. We conclude from our argument based on the development of an inadvertent corner in the gold markets, from a "prison of the shorts", that, since the Long Term Capitol Management crisis in late 1998, the official sector has been managing the price of gold.

P6

The gold price has rallied from the mid $270’s to just over $310 and has traded in a stable fashion for about 2 months. It is our assessment that there has been relative stability in the physical market overall, large scale buying in the New York and Tokyo futures and forward markets and significant covering of hedges by gold mining companies. Taken together, there has been remarkably strong buying overall. For the market to not explode amid numerous bullish technical signals presumes strong offsetting selling. Since producers are covering hedges, we must assume this selling emanates from the official sector.

P6

The staff of Veneroso Associates talk often with gold mining executives. The skepticism they expressed in the past toward our unconventional views on gold supply/demand has now largely dissipated. This may be due to a growing awareness that the gold market deficit exceeds consensus estimates. They may now believe, as we do, that the gold price will be driven higher by commodity dynamics sooner than the "official" statistical portrayal of the market would expect.

P8

Physical gold demand may have weakened overall because of global recession and a strong dollar, but its overall decline is probably not significant, owing to recent physical buying by savers in Japan. If anything, global mine supply is basically flat. By comparison overall net buying in the futures market is probably huge. Yet the gold price has staged only a modest $35 rally and has now met considerable resistance at the $310 level. We must presume there has been offsetting selling of a comparable magnitude from the official sector. Furthermore, the way in which the gold price initially met the psychologically important $300 level with a sharp drop in volatility suggests that such official selling is not due to uncoordinated one off large scale official sales. This would suggest that the gold price is being managed by the official sector.

P9

From our contacts in the hedge fund industry, we understand that some of the recent buying in the markets for gold futures, gold forwards and gold equities has been spurred by a growing belief that the gold market is being managed by the official sector and that this management will at some point fail.

P9

when data on a net reduction in outstanding producer hedges becomes available in coming months, the current suspicions regarding official management of the gold price will move closer to becoming convictions. At that point, speculators will recognize that at some point such management will fail. Though they will in all likelihood judge that it can persist for some time, they will be oriented to speculate on the long side of the gold market whenever there surfaces any reason to believe that official management of the price of gold might fail.

P9

We believe the official sector appreciates the challenge such thinking by market participants poses for management of the gold price. Give the timing of Ernst Welteke’s statement on Bundesbank willingness to sell its gold, we would not be surprised by further official statements or actions that might be construed as part of an attempt to manage the gold price. One or more of these statements or actions may be so extreme as to shock the market.
-END-

12/20 Remarks by Chairman Alan Greenspan Before the Economic Club of New York, New York City December 19, 2002

http://federalreserve.gov/boarddocs/speeches/2002/20021219/default.htm

Remarks by Chairman Alan Greenspan
Before the Economic Club of New York, New York City
December 19, 2002

Issues for Monetary Policy

Although the gold standard could hardly be portrayed as having produced a period of price tranquility, it was the case that the price level in 1929 was not much different, on net, from what it had been in 1800. But, in the two decades following the abandonment of the gold standard in 1933, the consumer price index in the United States nearly doubled. And, in the four decades after that, prices quintupled. Monetary policy, unleashed from the constraint of domestic
gold convertibility, had allowed a persistent overissuance of money. As recently as a decade ago, central bankers, having witnessed more than a half-century of chronic inflation, appeared to confirm that a fiat currency was inherently subject to excess.

But the adverse consequences of excessive money growth for financial stability and economic performance provoked a backlash. Central banks were finally pressed to rein in overissuance of money even at the cost of considerable temporary economic disruption. By 1979, the need for drastic measures had become painfully evident in the United States. The Federal Reserve, under the leadership of Paul Volcker and with the support of both the Carter and the Reagan Administrations, dramatically slowed the growth of money. Initially, the economy fell into recession and inflation receded. However, most important, when activity staged a vigorous recovery, the progress made in reducing inflation was largely preserved. By the end of the 1980s, the inflation climate was being altered dramatically.

The record of the past twenty years appears to underscore the observation that, although pressures for excess issuance of fiat money are chronic, a prudent monetary policy maintained over a protracted period can contain the forces of inflation. With the story of most major economies in the postwar period being the emergence of, and then battle against inflation, concerns about deflation, one of the banes of an earlier century, seldom surfaced. The recent experience of Japan has certainly refocused attention on the possibility that an
unanticipated fall in the general price level would convert the otherwise relatively manageable level of nominal debt held by households and businesses into a corrosive rising level of real debt and real debt service costs. It now appears that we have learned that deflation, as well as inflation, are in the long run monetary phenomena, to extend Milton Friedman's famous dictum.

To be sure, in the short to medium run, many forces are at play that complicate the link between money and prices. The widening globalization of market economies in recent years, for example, is integrating a growing share of previously local capacity into an operationally meaningful world total. That process has, at least for a time, brought substantial new supplies of goods and services to global markets. In addition, the more rapid rate of technological
innovation, so evident in the United States, has boosted the pace at which our productive potential is expanding. These shifts in aggregate supply--whether foreign or domestic in origin--influence the relationship between money and prices. Moreover, the tie between money and prices can be altered by dysfunctional financial intermediation, as we have witnessed in Japan. Thus, recent experience understandably has stimulated policymakers worldwide to
refocus on deflation and its consequences, decades after dismissing it as a possibility so remote that it no longer warranted serious attention.

The meaning of deflation and the characteristics that differentiate it from the more usual experience of inflation are subjects being actively studied inside and outside of central banks. As I testified before the Congress last month, the United States is nowhere close to sliding into a pernicious deflation. Moreover, a major objective of the recent heightened level of scrutiny is to ensure that any latent deflationary pressures are appropriately addressed well before they became a problem.

* * * * *

Central bankers have long believed that price stability is conducive to achieving maximum sustainable growth. Historically, debilitating risk premiums have tended to rise with both expected inflation and deflation, and they have been minimized during conditions of approximate price stability.

Although the U.S. economy has largely escaped any deflation since World War II, there are some well-founded reasons to presume that deflation is more of a threat to economic growth than is inflation. For one, the lower bound on nominal interest rates at zero threatens ever-rising real rates if deflation intensifies. A related consequence is that even if debtors are able to refinance loans at zero nominal interest rates, they may still face high and rising real rates
that cause their balance sheets to deteriorate.

Another concern about deflation resides in labor markets. Some studies have suggested that nominal wages do not easily adjust downward. If lower price inflation is accompanied by lower average wage inflation, then the prevalence of nominal wages being constrained from falling could increase as price inflation moves toward or below zero. In these circumstances, the effective
clearing of labor markets would be inhibited, with the consequence being higher rates of unemployment.

Taken together, these considerations suggest that deflation could well be more damaging than inflation to economic growth. While this asymmetry should not be overlooked, several factors limit its significance. In particular, more rapid advances in productivity can make this asymmetry less severe. Fast growth of productivity, by buoying expectations of future advances of wages and earnings and thus aggregate demand, enables real interest rates to be higher
than would otherwise be the case without restricting economic growth.

Moreover, to the extent that more-rapid growth of productivity shows through to faster gains in nominal wages, there will be fewer instances in which nominal wages will be pressured to fall.

One also should not overstate the difficulties posed for monetary policy by the zero bound on interest rates and nominal wage inflexibility even in the absence of faster productivity growth. The expansion of the monetary base can proceed even if overnight rates are driven to their zero lower bound. The Federal Reserve has authority to purchase Treasury securities of any maturity
and indeed already purchases such securities as part of its procedures to keep the overnight rate at its desired level. This authority could be used to lower interest rates at longer maturities. Such actions have precedent: Between 1942 and 1951, the Federal Reserve put a ceiling on longer-term Treasury yields at
2-1/2 percent. With respect to potential difficulties in labor markets, results from research remain ambiguous on the extent and persistence of downward rigidity in nominal compensation.

Clearly, it would be desirable to avoid deflation. But if deflation were to develop, options for an aggressive monetary policy response are available.

* * * * *

Fortunately, the ability of our economy to weather the many shocks inflicted on it since the spring of 2000 attests to our market system's remarkable resilience. That characteristic is far more evident today than two or three decades ago. There may be numerous causes of this increased resilience.1 Among them, ongoing efforts to liberalize global trade have added flexibility to many aspects of our economy over time. Furthermore, a quarter-century of bipartisan deregulation has significantly reduced inflexibilities in our markets for energy,
transportation, communication, and financial services. And, of course, the dramatic gains in information technology have markedly improved the ability of businesses to address festering economic imbalances before they inflict significant damage. This improved ability has been further facilitated by the increasing willingness of our workers to embrace innovation more generally.

Irrespective of how deflationary forces might influence it, our economy has the benefit of enhanced flexibility, which has, at least to date, allowed us to withstand the potentially destabilizing effects of some substantial negative shocks.

* * * * *

Certainly, lurking in the background of any evaluation of deflation risks is the concern that those forces could be unleashed by a bursting bubble in asset prices. This connection, real or speculative, raises some interesting questions about the most effective approach to the conduct of monetary policy. If the bursting of an asset bubble creates economic dislocation, then preventing bubbles might seem an attractive goal. But whether incipient bubbles can be detected in real time and whether, once detected, they can be defused without
inadvertently precipitating still greater adverse consequences for the economy remain in doubt.

It may be useful, as a first step, to consider both the economic circumstances most likely to impede the development of bubbles and the circumstances most conducive to their formation. Destabilizing macroeconomic policies and poor economic performance are not likely to provide fertile ground for the optimism that usually accompanies surging asset prices.

Ironically, low inflation, economic stability, and low risk premiums may
provide tinder for asset price speculation that could be sparked should technological innovations open up new opportunities for profitable investment. Even in such circumstances, bubble pricing is likely to be inhibited for a company with a history. To be sure, the stock prices of old-line companies do rise somewhat through arbitrage when the market as a whole is propelled higher
by stock prices of cutting-edge technologies. But it is difficult to imagine stock prices of most well-established and seasoned old-line companies surging to wholly unsustainable heights. With some prominent exceptions, their capabilities for future profits have been largely tested and delimited.

The situation is likely different in the case of a new company that employs an innovative technology. Under these circumstances, the dispersion of rationally imagined possible future outcomes could be wide. If forecasts are unfettered by a need for consistency with the past, investors might take off on unwarranted flights of optimism. Moreover, skeptics find it too expensive or too risky to short sell the shares of such a company, especially when its stock price is rising rapidly.

The conditions of extended low inflation and low risk were combined with breakthrough technologies to produce the bubble of recent years. But do such conditions always produce a bubble? It seems improbable that a surge in innovation in the near future would generate a new bubble of substantial proportions. Investors are likely to be sensitive to the need for asset prices to be backed ultimately by an ongoing stream of earnings. Hence, a further necessary condition for the emergence of a bubble is the passage of sufficient
time to erode the traumatic memories of earlier post-bubble experiences.

* * * * *

Most standard macroeconomic models fitted to the experience of recent decades imply that a distortion in valuation ratios induced by a bubble can be offset by adopting a sufficiently restrictive monetary policy. According to such models, a tighter monetary policy, on average, credibly constrains demand and lowers asset prices, all else being equal. These models can also be interpreted to suggest that incremental monetary tightening can gradually deflate stock prices. But that conclusion is a consequence of the model's construction. It is not based on evidence drawn from history. In fact, history indicates that bubbles tend to deflate not gradually and linearly but suddenly, unpredictably, and often violently. In addition, the degree of monetary tightening that would be required to contain or offset a bubble of any substantial dimension appears to be so great as to risk an unacceptable amount of collateral damage to the wider
economy.

The evidence of recent years, as well as the events of the late 1920s, casts doubt on the proposition that bubbles can be defused gradually. As I related this summer at the annual Jackson Hole symposium sponsored by the Kansas City Federal Reserve Bank, "...our experience over the past fifteen years suggests that monetary tightening that deflates stock prices without depressing economic activity has often been associated with subsequent increases in the
level of stock prices....Such data suggest that nothing short of a sharp increase in short-term rates that engenders a significant economic retrenchment is sufficient to check a nascent bubble. The notion that a well-timed incremental tightening could have been calibrated to prevent the late 1990s bubble is almost surely illusion."2

In short, unless a model can be specified to capture the apparent market tendency toward bidding stock prices higher in response to monetary policies aimed at maintaining macroeconomic stability, the accompanying forecasts will belie recent experience. Faced with this uncertainty, the Federal Reserve has focused on policies that would, as I testified before the Congress in 1999, "...mitigate the fallout [of an asset bubble] when it occurs and, hopefully, ease the transition to the next expansion."3 The Federal Open Market Committee chose, as you know, to embark on an aggressive course of monetary easing
two years ago once it became apparent that a variety of forces, including importantly the slump in household wealth that resulted from the decline in stock prices, were restraining inflation pressures and economic activity.

It is too soon to judge the final outcome of the strategy that we adopted. The contractionary impulse from the decline in equity prices appeared to be diminishing around the middle of this year. But then the fallout for stock prices from corporate governance malfeasance, argued by some as having been spawned by the bubble, became more intense. This, in turn, damped capital investment and trimmed inventory plans. More recently, of course, geopolitical risk has risen markedly, further weighing on demand. Though unrelated to the
bubble burst of 2000, it has muddied the evaluation of the post-bubble economy.

If the postmortem of recent monetary policy shows that the results of
addressing the bubble only after it bursts are unsatisfactory, we would be left with less-appealing choices for the future. In that case, finding ways to identify bubbles and to contain their progress would be desirable, though history cautions that prospects for success appear slim.

The difficulties that policymakers and private agents face become especially acute as an economic expansion lengthens. The decline in risk premiums under these circumstances presumably results, in part, from rational appraisals. In an economy in which the business cycle has averaged four years in length over a protracted period, households and businesses would doubtless become more
cautious in the fourth year of a new cycle. But how do they behave when, as for the past two decades, expansions have been long and cyclical downturns have been exceptionally rare? After five or six years of uninterrupted expansion, is it irrational or even unreasonable to assume that expansion would continue for the subsequent six months? Thus, it was disturbing to observe risk seemingly being priced so cheaply in late 1997 when BBB corporate spreads over ten-year Treasuries sunk to only 70 basis points. That spread is
now about 250 basis points, although it has narrowed significantly in recent weeks.

* * * * *

Weaving a monetary policy path through the thickets of bubbles and deflations and their possible aftermath is not something with which modern central bankers have had much experience.

As I noted earlier, it seems ironic that a monetary policy that is successful in inducing stability may inadvertently be sowing the seeds of instability associated with asset bubbles. I trust that the use by the central bank of deliberately inflationary policy as protection against bubbles can be readily dismissed. While the current episode has not yet concluded, it appears that, responding vigorously in a relatively flexible economy to the aftermath of bubbles, as traumatic as that may be, is less inhibiting to long-term growth than
chronic high-inflation monetary policy. Moderate inflation might possibly inhibit bubbles, though at some cost of reduced economic efficiency.

However, I doubt that such policies could be sustained or well-controlled by central banks. Among our realistically limited alternatives, dealing aggressively with the aftermath of a bubble appears the most likely to avert long-term damage to the economy.4

Regardless of history's verdict on a policy that addresses only the aftermath of bubbles, we still need to improve our understanding of the dynamics of bubbles and deflation to contain the latter, if not the former.

* * * * *

Before closing this evening, I would like to take a few minutes to address recent economic developments.

As I pointed out earlier, the U.S. economy exhibited considerable resilience to a series of post-boom shocks. The list is rather impressive: First, a halving of stock prices and household equity wealth; second, a dramatic decline in capital expenditures; third, the tragic events of September 11; fourth, the disturbing evidence of corporate malfeasance; and fifth, the recent escalation of
geopolitical risks. I would scarcely state that our economy was not shaken by these series of shocks, one on top of the other. But after we experienced a mild recession, real GDP grew in excess of 3 percent over the year ending in the third quarter.

The recovery, however, ran into resistance in the summer, apparently as a consequence of a renewed weakening in equity prices, further revelations of corporate malfeasance, and then the heightened geopolitical risks. Concern on our part led the Federal Open Market Committee to reduce its targeted federal funds rate 50 basis points at our early November meeting as some insurance against the possibility that the weakening would gain some footing. Although
our most probable forecast already was that growth would pick up, we judged the cost of the insurance provided by additional easing as exceptionally modest because we viewed the risk of an imminent rise in inflation as remote.

The limited evidence since the November easing has supported our view that the U.S. economy has been working its way through a soft patch. And the patch has certainly been soft. The labor market has remained subdued, as businesses apparently have been reluctant to add to payrolls. The manufacturing sector remains especially damped, and nonresidential construction has trended lower. By all reports, state and local governments continue to struggle with deterioration in their fiscal conditions. Oil prices have recently risen and, not least, the economies of most of our major trading partners have shown little vigor.

Still, low interest rates and rapid advances in productivity have been providing considerable support to economic activity. Those influences have been most evident on consumer spending and new home sales, which have been remarkably firm this year. Motor vehicle sales have been supported by low financing costs, by high levels of customer incentives, and by high rates of vehicle scrappage and multiple car ownership. More broadly, strong growth of
labor productivity, supplemented by reduced tax payments, has provided a boost both to incomes and to spending. Meanwhile, new home sales have been buoyed by low mortgage interest rates as well as favorable demographics.

Cash borrowed in the process of mortgage refinancing, an important supportn for consumer outlays this past year, is bound to contract at some point, as average interest rates on households' total mortgage portfolio converges to interest rates on new mortgages. However, applications for refinancing, while off their peaks, remain high. Moreover, simply processing the backlog of earlier applications will take some time, and this factor alone suggests continued significant refinancing originations and cash-outs into the early months of 2003.

Corporate risk-taking underwent pronounced retrenchment following the traumatic disclosures of corporate malfeasance this summer. Capital appropriations slowed noticeably across a broad spectrum of American industries. Aggressive accounting practices seemingly disappeared virtually overnight. I would not be surprised if further disclosures of questionable practices were to surface in the months ahead, but I would be quite surprised if such practices were introduced after mid-2002.

Since early October, conditions in financial markets have turned less adverse. Stock prices have, on net, moved up, and corporate yield spreads, especially for below-investment-grade debt instruments, have narrowed significantly. Those spreads, nevertheless, remain quite elevated relative to their readings of early 2000. Credit derivative default swaps have improved recently in line with yield spreads. The overall cost of business capital has clearly declined, inducing in recent weeks increased issuance of bonds of all grades and halting
the runoff of commercial paper and business bank loans.

The recent increase in the expansion of business credit may hint at some stirring in capital investment, but it is simply too early to tell. There is evidence that some corporate managers are beginning to tentatively venture out on the risk scale. New orders for capital goods equipment and software, after falling sharply over the preceding two years, have stabilized and in some cases turned up in nominal terms this year--an improvement, to be sure, but not necessarily the beginnings of a vigorous recovery.

In the end, capital investment will be most dependent on the outlook for profits and the resolution of the uncertainties surrounding the business outlook and the geopolitical situation. These considerations at present impose a rather formidable barrier to new investment. Profit margins have been running a little higher this year than last, aided importantly by strong growth in labor productivity. But a lack of pricing power remains evident for most corporations. A more vigorous and broad-based pickup in capital spending will almost surely require further gains in corporate profits and cash flows.

A full enumeration of the caveats surrounding the economic outlook would, as usual, be lengthy. But often-cited concerns about the levels of debt and debt-servicing costs of households and firms appear a bit stretched. The combination of household mortgage and consumer debt as a share of disposable income has moved up to a historically high level. But the upward trend in the series reflects, in part, financial innovations that have increased access to credit markets for many households. These innovations include the development of a deep secondary market for home mortgages, along with the
advent of credit scoring and automated underwriting models that have enhanced the ability of loan officers and credit card companies to identify good credit risks. These innovations lower the risk level of any given amount of debt.

To be sure, the mortgage debt of homeowners relative to their income is high by historical norms. But, as a consequence of low interest rates, the servicing requirement for that debt relative to homeowners' income is roughly in line with the historical average. Moreover, owing to continued large gains in residential real estate values, equity in homes has continued to rise despite very large
debt-financed extractions. Adding in the fixed costs associated with other financial obligations, such as rental payments of tenants, consumer installment credit, and auto leases, the total servicing costs faced by households relative to their income appears somewhat elevated compared with longer-run averages.

But arguably they are not a significant cause for concern.

Some strain from corporate debt burdens became evident as rates of return on capital projects financed with debt fell short of expectations over the past several years. While overall debt has not been paid down, corporations have significantly increased holdings of cash and have reduced their near-term debt obligations by issuing bonds to pay down commercial paper and bank loans.

* * * * *

In early 2000, as financial imbalances and increased risk brought the surge in capital investment to an end, significant profitable opportunities remained to be exploited. One must presume that they still exist and may well have been enlarged by subsequent technological advances. Indeed, one of the most remarkable features of the performance of the U.S. economy over the past year
had been the extraordinary gains in productivity. The increase in output per hour over the year ending in the third-quarter--5-1/2 percent--was the largest increase in several decades. That pace will not likely be sustained, but it suggests that the underlying supports to productivity growth have not yet fully played out. Against that background, any significant fall in the current geopolitical and other risks should noticeably improve capital outlays, the indispensable spur to a path of increased economic growth.

* * * * *

In summary, as we focus on the dangers of bubbles, deflation, and excess capacity, the marked improvement in the degree of flexibility and resilience exhibited by our economy in recent years should afford us considerable comfort for now. Still, economic policymakers are having to grapple with what seems to be a much larger portfolio of problems than that which our predecessors appeared to face a half-century ago. The ever-growing complexity of our global economic and financial system surely plays a role. Moreover, the very technologies that have helped us reap enormous efficiencies have also presented us with new challenges by increasing our interconnectedness.

I venture that future invitees to the Economic Club of New York dinners will not lack interesting problems to address.

Footnotes

A considerable economics literature in recent years has documented a decline in the volatility of real GDP over the past two decades. Some researchers have argued that the decline in volatility is the result of smaller disturbances to the macroeconomy. Others have argued that improved monetary policy should be credited for the reduction. Another line of work points to structural changes that have increased the flexibility of the economy to respond to shocks. In that vein, I have argued that advances in information technology and the cumulative effects of a quarter century of deregulation have
likely played a major role in promoting the increased flexibility of our economy.Of course, these explanations are not mutually exclusive and could, indeed, be interconnected.

2. But to the extent that this resilience reflects increased flexibility of the economy, we should be searching for policies that will further enhance economic flexibility and dismantling policies that contribute to unnecessary rigidity. The more flexible an economy is, the greater is its ability to self-correct to inevitable disturbances, reducing the size and consequences of cyclical imbalances. An implication is that, at any given point in time, the economy is more likely to be producing close to its productive potential. So often, discussion of policies intended to improve macroeconomic performance have
focused solely on traditional monetary and fiscal policies. But structural policies intended to promote flexibility may be an important complement to standard macro policies, and they may be important enough to influence both the cyclical performance and long-run growth potential of the economy. This issue surely deserves examination and debate. Return to text

3.Alan Greenspan, "Economic Volatility," August 30, 2002, at a symposium sponsored by the Federal Reserve Bank of Kansas City in Jackson Hole, Wyoming. Return to text

4. Committee on Banking and Financial Services, U.S. House of
Representatives, July 22, 1999. Return to text

5. Some argue that bubbles can be prevented or defused by financial regulatory initiatives. It is observed that asset bubbles have often been associated with rapid credit expansion, and hence it is claimed that restraining credit growth could quash nascent bubbles. A bubble could conceivably be defused by restrictive credit regulations that stifle economic growth. It is by no means clear, however, that such a regime would be more conducive to wealth creation over time than our current regulatory system. Also of relevance, in a vibrant
financial system, such as exists in the United States, there will always be many avenues available to investors for financing a bubble. Furthermore, many analysts maintain that stocks are priced at the margin by institutions with little or no financing needs. Return to text

"Of all tyrannies, a tyranny exercised for the good of its victims may be the most oppressive. It may be better to live under robber barons than under omnipotent moral busybodies. The robber baron's cruelty may sometimes sleep, his cupidity may at some point be satisfied; but those who torment us for our own good will torment us without end, for they do so with the approval of their own conscience."

CS Lewis