Because of the inverted yield curve, slowing GDP and the recent downturn in the stock market, pundits have been forecasting a Trump recession. But the recession is already here, if we are to consider one single variable - what is called the Dow Gold ratio, which is the Dow Jones Industrial Average divided by the price of gold. This bold statement requires a lengthy explanation of the purpose gold serves.
Gold has been used as money for thousands of years, because its value changes extremely little, if it all: it is the ultimate store of value. When a currency (such as the Venezuelan bolivar) becomes worthless, gold acts as a refuge, and so do other hard assets (such as silver, diamonds, land) which, by definition, cannot be used up quickly (unlike oil).
But this proposition regarding gold's efficacy, a proposition which has been viewed as nothing more than common sense for millennia, is apparently contradicted by the daily fluctuations in the gold price: don't these ups and downs prove that gold is unstable? And if so, how can gold function as mankind's preeminent store of value?
The truth is that ups and downs in the gold price reflect a change in value of a currency in terms of gold, not the other way around. When Roosevelt devalued the US dollar against gold in 1933, the gold price went from $USD20.67 an ounce to $USD35 an ounce: after the devalution, more dollars were needed to pay for the same amount of gold - the dollar had lost value in terms of gold. (Whereas the US dollar before devaluation could buy 1/20th of an ounce, after devaluation, it could buy only 1/35th). Roosevelt had devalued the US dollar against gold by around 75% and had thereby deliberately cheapened the dollar. This was understood by economists at the time, who thought in terms of classical economics, which said that gold is the constant, currency is the variable.
Another example of a US president ordering a devaluation occurred in 1971, when Nixon took America, and the world, off the gold standard for good. The US dollar and other currencies floated and were no longer fixed, and the price of gold rose from $USD35 an ounce all the way up to $USD850 by 1980 - a depreciation of over 2400%.Such an enormous decline in the value of a currency leads to inflation, and that is precisely what happened in the 1970s: other US prices, most notably the price of oil, silver, copper, land and other commodities, followed gold in an upward trajectory.
But prices can travel the other way. When gold fell from $USD850 an ounce to $USD300 in the years 1980-82, other prices followed in train and America (and the world) experienced a sudden, shocking deflation. In a short amount of time, the dollar had appreciated by over 60% against gold in a dramatic change from the monetary policy of the high inflation, weak dollar 1970s; too many US dollars existed in circulation during the Jimmy Carter years, too few in the Reagan (or at least in the first two years of his first term). The classical economists would have called the increase in gold under Nixon, Ford and Carter a devaluation, the decrease under Reagan a revaluation.
The blame for these wild swings in value of the US dollar - which had severe political consequences for the entire world - lies with the central banks, which are in charge of supplying currency, or money. If a central bank prints too much money, the currency will lose value, and the price of gold and other commodities in that currency will rise; conversely, if the bank prints too little, the currency appreciates and prices fall.
To explain the process in more detail. A central bank injects currency into circulation by printing money and using it buy things - usually government bonds. If the Fed prints $US1, spends it on a bond, and that dollar is not demanded, i.e., no-one wants it - then the Fed has supplied $USD1 extra above demand and, as a result, has weakened the currency and increased inflation. The same works in reverse. If the Fed sells a bond for $USD1, the purchaser pays for the bond with $USD1 which is then removed from circulation by the Fed. If that now missing $USD1 was demanded by the market, and cannot be replaced with a substitute, then the currency will strengthen and prices will go down. Deflation results.
A central bank, then, needs to adopt a target when adding or subtracting currency. Three schools of practical economics differ as to what that target should be.
The Keynesian school - which is the dominant one today - argues that interest rates ought to be the target, and one interest rate in particular, the rate on overnight loans between banks (alter this rate and others will follow in sympathy). In the Keynesian model, low interest rates cause people to borrow more and spend more, and this increased borrowing and spending drives economic growth. But seeing as growth is always inflationary, the consequent inflation must be tamed through interest rate hikes, which cause people to save more and spend less. The economy is to be blown up or deflated like a balloon.
The monetarist school garnered a huge following in the 1970s and early 1980s, but has since lost its appeal. The monetarist argument is that the precise number of dollars (or any other currency) in circulation can be measured by an aggregate called the money supply. If this aggregate is continually expanded at a modest level, then economic growth is assured. But like the Keynesians, the monetarists believe that too much growth leads to inflation, which needs to be subdued not by high interest rates but a sharp reduction in the money supply.
The principles of the third school, the classical, are today only upheld by the supply-side economists. They want the central banks in charge of the really big currencies (such as the US dollar, the yen and the euro) to target the gold price; the smaller currencies should then be fixed to the bigger ones. As for interest rates and aggregates such as the money supply, these can be ignored. Contrary to the Keynesian school, the supply-siders opine that interest rates should be set by the market and not by the central bankers.
How, then, would a gold standard work? Suppose that the Fed sets the target of keeping the US dollar at 1/35th of an ounce of gold. If the market price of gold drifts above $USD35 to, say, $USD40, speculators will buy gold from the Fed at $USD35 and sell it on the open market at $USD40, making a $USD5 profit each time. The Fed, in this instance, sees bars of gold flying off its shelves, and so takes action, withdrawing enough US dollars in circulation to bring the market gold price back down to $USD35 an ounce.
Again, the same works in reverse. Suppose that the market price of gold drops to $USD30 an ounce. Speculators buy gold on the open market at $US30 an ounce to sell to the Fed at $USD35, again making a $US5 profit each time. The Fed's stockpile of gold builds up as newly purchased bars of gold begin to line its shelves. But for each transaction with the speculators, the Fed pays in freshly-minted dollars. This new addition of dollars injected into circulation leads to a weakening of the dollar overall, and so the market price of gold floats back up to $US35.
The gold standard mechanism works with a beautiful, admirable simplicity. So why was it abandoned? Nixon took America off gold because he wanted to devalue the currency and increase the supply of dollars in circulation. The gold standard stands in the way of the latter and imposes a harsh discipline. In 1971, Nixon had come under the sway of Keynesian and monetarist advisers who wanted to break that discipline and depreciate the dollar - after all, inflation brings about economic growth, and won't a depreciated currency make America's exports cheaper and more attractive? The gold standard was holding America back.
Seeing as the US dollar stood at the heart of the post-war international monetary system, a floating US dollar would lead to floating foreign currencies as well: under Bretton Woods, the deutschmark, pound, yen, lire, franc and other currencies were all fixed to the US dollar and so were as 'good as gold'. After the US left gold and depreciated its dollar, other countries floated their currencies and depreciated in tandem. The euro was devised in response to the global inflationary crisis of the 1970s.
II. The Decline of the Dow
Where does the stock market come into this? Rightly considered, the Dow Jones represents the value of America's capital stock, the worth of America's biggest companies. Any money invested in an enterprise should be seen as gamble - the rewards of capitalism arise through taking risks - and if we were to gather up all the gambler's chips at America's most elite casino and put them all into a pile, and then take one random average sample from that pile, we would have the Dow Jones Industrial Average. And how are we to assess the worth of that handful of chips? By dividing it by the dollar price of gold. This is the Dow Gold Ratio.
We read here, in the caption above the Macro Trends Dow Gold chart:
Dow to Gold Ratio - 100 Year Historical Chart
This interactive chart tracks the ratio of the Dow Jones Industrial Average to the price of gold. The number tells you how many ounces of gold it would take to buy the Dow on any given month. Previous cycle lows have been 1.94 ounces in February of 1933 and 1.29 ounces in January of 1980.
So, as we can see, the Dow hit record lows in 1933 and 1980. It hit record highs in August 1929 (18 ounces), January 1966 (27 ounces) and August 1999 (42 ounces!) - all very good years to be an American.
How does Trump's record compare? The Dow sagged after 9/11 but was still high throughout Bush 45's first term, hovering around 25 ounces. But the Dow began to decline midway through Bush's second term, and after the financial crisis of 2008-09, the Dow bottomed at around 6 ounces during August 2011 and took a long time to recover. In the month Trump was elected, we see a big spike. Rapid growth ensued and the Trump boom was underway.
But all has not been smooth sailing for Trump. Under his watch, the Dow peaked at 22 ounces in September 2018 and has been dropping ever since. The last three months of 2018 saw the Dow take a severe battering, and the present downward turn is even worse.
As to why, the reasons are threefold:
Interest rate hikes. The Fed hiked rates multiple times throughout the Trump presidency but left them flat in the Obama years. A paranoid might say that the Fed is out to get Trump:
While it is the case that interest rates are still extremely low, each interest rate hike functions as a tax hike and hurts the Dow each time. This effect is compounded by the Dow's fragility after years of Bush 45 and Obama.
Tariff hikes. The market are reacting adversely towards Trump's trade war with China. On this, little remains to be said - many pundits have covered it already.
The increase in the gold price. Supply-side economist John Tamny wrote back in June:
All of this matters because President Trump’s calls for dollar weakness have picked up in the past week. While a dollar purchased 1/1200th of an ounce of gold when the 45th president entered office, it now purchases 1/1439th. The dollar is weaker, it’s weakening, and by extension the tax on investment without which there is no growth is rising.
The US dollar has lost even more ground since Tamny's article, the gold price having climbed to over $USD1500 an ounce.
In an article written at the beginning of August, Tamny gives an update:
Yesterday’s selloff presumably reflects investor worry about the dollar, and where Trump is taking his trade war. The dollar is rapidly falling, and as the Nixon, Carter and Bush presidencies should remind us, a falling currency always correlates with slow growth since devaluation is a tax. Tariffs limit the ability of the world’s best companies (that would be American companies) to sell around the world. Economics isn’t very complicated.
President Trump should realize this, or his advisers should help him to realize this. He’s wisely staked his presidency on a healthy economy and stock market. Good for him. Every president should. The problem is that tariffs and devaluation never correlate with a good economy, and by extension never boost stock markets.
III. Recommendations
What should Trump do to arrest the Dow's slide? A supply-side economist would recommend three courses of action.
The first is that Trump should get rid of his éminence grise, trade adviser Peter Navarro, the man who provided the intellectual foundations for the levying of the trade sanctions against China. After dumping Navarro, Trump should call for a ceasefire in the trade war with China (and Europe). This prospect seems unlikely, as protectionism, one of the constants of Trump's political career, forms one of the cornerstones of Trumpianism. But as the markets continue to deteriorate, Trump may at some point be forced to face reality.
The second is that the Fed should abandon interest-rate targeting and go back to gold price targeting, and aim at keeping the dollar's value in terms of gold steady - at maybe $USD1500 an ounce. Again, this is extremely unlikely, as economists, central bankers, academics, the media, would all put up tremendous resistance to a return to gold and fixity.
The third is that Trump could cut taxes - again. In the 2016 campaign, he ran on a platform (designed by supply-side economists Stephen Moore and Larry Kudlow) of reducing income tax rates to two brackets of 15 and 25%. After taking office, Trump did manage to slash income and corporate tax rates, as well as rates for small businesses, but the top rate of income tax (37%) still stands far above the top rate of company tax (21%). By bringing the top rate of income tax down to 25%, Trump will achieve near parity. But does this scenario seem likely? Trump could run on such a platform in 2020, but at present, there is no indication he will.
In the interim before 2020, he could - as some of his advisors are urging - index the capital gains tax to inflation by executive order, thereby bypassing a hostile Congress and indifferent Senate, and such a measure would produce beneficial effects, one of them being a market rally, so the supply-siders argue.
The recent crisis has revealed a tension in the Trump administration between the supply-siders and the protectionists - a tension which was there from the beginning of Trump's 2016 campaign. The supply-siders advocate 'hard money', that is, a strong currency and no devaluations, whereas the protectionists - or more accurately, the mercantilists - advocate 'soft money', that is, a weak currency and devaluations when need be. Even before he ran for the presidency, Trump had been biased towards soft money; after all, the thesis of the soft money advocates - that a weak currency boosts exports, fixes the trade deficit and creates jobs for American workers - resonates with the protectionist-obsessed Trump, who views trade as a zero-sum game (that is, in order for one trading partner to benefit, the other must lose). From the outset of his 2016 campaign for the presidency, the supply-siders knew that Trump subscribed to mercantilist notions, but made the calculation that a President Trump would deliver on tax cuts and could be dissuaded from pursuing a trade war against China and Mexico - in other words, they banked on supply-side Trump winning out over protectionist Trump, closing their eyes to the historical fact that the latter was stronger than the former. But now that truth - regarding Trump's fealty to mercantilism and 'soft money' - has become too obvious to ignore.
