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U.S. POLITICS, ECONOMIC POLICY, AND THE FUTURE PRICE OF GOLD

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Gold thrives on political and economic uncertainty . . . and we've got plenty of that now that the Republican Party has seized control of the House of Representatives and narrowed the Democratic majority in the Senate.  What's more, the U.S. Federal Reserve, America's central bank, is adding to the uncertain political and economic landscape as it embarks on another large dose of monetary stimulus.

Without a doubt, the new arithmetic on Capitol Hill -- along with the Fed's recent policy shift -- reinforces the bullish case for gold and raises my confidence that gold prices will rise to $2000 an ounce, then $3000, and possibly higher peaks over the next few years.

Irreconcilable Differences

There's plenty of rhetoric from some Congressional leaders and the Obama Administration about "working together" to solve America's economic problems.  But, in the end, irreconcilable philosophic differences on the role of government suggest that the ship of state will remain rudderless -- at least with respect to fiscal policy -- until the next federal elections in two year.

Not only will the new Republican majority in the House confront a liberal Administration, but there could also be a nasty struggle for control within the Republican Party between its now-more-powerful conservative wing and party moderates . . . and within the conservative wing between the traditionalists and the unconventional Tea Party bloc that has now won a seat at the head table.

Republican leadership will demand across-the-board tax cuts, reduced Federal spending, and rolling back the recently enacted health-care program.  It's hard to imagine liberal Democrats will swallow the Republican medicine.  More likely, we face more gridlock and more acrimony on Capitol Hill -- in short, a dysfunctional government that is incapable of dealing effectively with America's serious economic problems.

Three Fiscal Indicators

Tax Policy: One of the early indicators of future fiscal policy will be the decision taken to extend or let expire the Bush-era tax cuts that run through the end of this calendar year -- or just possibly accept some sensible compromise that would extend the cuts another year or two for all but the wealthiest few percent of tax payers.

Rather than pursue what some consider appropriate counter-cyclical fiscal policy, failure to extend the Bush tax cuts will raise taxes at just the wrong time, taking money and spending power out of the household and small-business sectors.

Others argue the expiration of the Bush-era tax cuts are just the right medicine to reign in our outsized Federal budget deficit and borrowing requirement, a first step toward restoring confidence in the U.S. dollar both at home and overseas -- but fiscal restraint at this juncture could easily backfire, slowing or even reversing the hoped-for economic recovery.

In any event, neither course -- raising taxes enough to achieve a quick and significant reduction in the Federal budget deficit, nor cutting taxes enough to greatly stimulate a sluggish economy -- is politically feasible.

How this controversial fiscal-policy issue unfolds, and it's long-term effect on the health of our economy, will be one of the big issues affecting gold, the dollar, and other world financial markets in the weeks ahead and, possibly, for years to come.

The Debt Ceiling: Political analysts and economists are also wondering how Congress will deal with the national debt ceiling that now prohibits Federal borrowing above the current legal limit of $14.3 trillion.  Unless Congress votes to raise this ceiling, the Treasury's borrowing authority will expire early next year.

In the past, Congress perfunctorily increased the ceiling each time Federal borrowing approached its legal limit.  Now, however, a handful of incoming anti-debt, anti-government Tea Party legislators, led by libertarian Republican Senator-Elect Rand Paul, could stall Congressional action to raise the legal limit.

Without the authority to borrow, the Federal government cannot function.  Public spending on even the most essential programs and services would grind to a quick halt.  The Treasury would be forced to default on maturing debt -- much of which is held by foreign central banks -- and we could find ourselves in a global financial crisis of massive proportions with the dollar sinking fast and gold moving sharply higher.

State & Local Bailouts: Another important -- but less-discussed -- fiscal policy issue that may soon capture more attention on Capitol Hill and in the financial press is the increasing insolvency of many state and local government entities across the nation.  With the new, more conservative, majority in the House of Representatives the hoped-for bailouts from Washington may not be forthcoming.  Many states operating in the red (including California, Texas, New York, Michigan, and others) must balance their budgets -- meaning further belt-tightening, service cuts, more lay offs of public employees (including teachers, policy, firefighters, and office workers), and higher local taxes, all of which will be a further drag on the national economy.

The Fed to the Rescue

With the Obama Administration and a more conservative Congress at loggerheads, it is likely that America's central bank, led by Federal Reserve Board Chairman Ben Bernanke, will be the only agency capable of acting forcefully in the face of a continuing recession-like economic performance characterized by persistently high unemployment.

But all the Fed can do is print more money -- what economists and financial journalists call "quantitative easing" or simply "QE."  The Fed accomplishes this magic trick by purchasing securities, usually Treasury notes or bonds, in the open market or directly from the United States Treasury.

In addition to injecting more liquidity into the financial system, the Fed's purchase of securities lowers medium- and long-term interest rates.  It is hoped that lower rates will encourage additional private-sector borrowing -- borrowing to finance new productive investment as well as borrowing to refinance existing loans (including home mortgages) at lower interest rates and reduced carrying costs.

Quantitative easing also depresses the U.S. dollar exchange rate as excess dollar liquidity in the United States seeks higher rates of return abroad.  Dollar devaluation against the currencies of those countries running big trade surpluses with the United States will improve our international competitiveness, support American exports, restrict our imports, benefit domestic business activity and create more jobs.  Dollar devaluation is typically associated with gold-price appreciation -- and this is yet another factor supporting our bullish outlook for the yellow metal.

The Fed began its policy of quantitative easing with a "shock and awe" spree of monetary creation, purchasing $1.725 trillion in U.S. Treasury, other Federal agency, and Fannie Mae/Freddie Mac mortgage-backed securities. That program, often referred to as QE1, ran from December 2008 to March 2010 -- and was an important bullish factor propelling gold prices higher during the period.

Now, the Fed is embarking on a second tranche of quantitative easing.  Last week, following its early November policy meeting, the Fed announced its intention to purchase another $600 billion more in Treasury securities before the end of next year's second quarter.

In the absence of sensible fiscal-policy alternatives, Fed Chairman Ben Bernanke has chosen, in my view, the least-bad policy path by adopting more aggressive monetary stimulus at this time. Without more action now, the economy would very likely sink further, new job creation would slow further, and unemployment would surely rise.

Underpinning my very bullish gold-price is the expectation that persistent recession-like conditions, especially unacceptably high unemployment, and a continuing fiscal-policy logjam in Washington will force the Fed to adopt still-more stimulative monetary policies for at least another couple of years -- policies that sooner or later will be reflected higher U.S. consumer-price inflation, U.S. dollar depreciation, and significantly higher gold prices.

No Quick Fix

All of us want to see policies that will quickly right the economy, rev up business activity, and put the unemployed back to work.  But, unfortunately, a quick fix is not possible.

Few recognize that America's recent economic problems are structural and were decades in the making, a consequence of excessive household and government spending that was bankrolled by consumer, mortgage, and public-sector borrowing and insufficient productive investment.

America spent, not on updating our national infrastructure or developing 21st century industries or training students and the workforce for the jobs of tomorrow.  Instead, we became a nation of shopaholics, buying things we didn't need with money many of us didn't really have, while our government spent excessively on the cost of empire and on social programs that were of admirable intention but no one wanted to pay for.

Countercyclical monetary and fiscal policies cannot fix these structural problems.  To thrive again, we must reduce our outstanding public-sector and private-sector debt -- measured as a percentage of gross domestic product or national income.  Contrary to popular belief, higher inflation could be part of the solution.

Inflation Intentions

Although the Fed is officially targeting a small rise in consumer price inflation, I believe Chairman Bernanke is well aware of the much greater inflationary potential arising from the program of quantitative easing.

Printing more money may raise the hackles of sound-money advocates and surely won't be appreciated by foreign central banks and others holding U.S. dollar debt -- but higher domestic inflation and a depreciation of the dollar against the currencies of countries running persistent current account surpluses makes sense and may be the least painful road back toward prosperity.

Inflation erodes the real value (or purchasing power) of outstanding debt and lowers the ratio of total debt outstanding relative to nominal gross domestic product or national income.  Once our debt-to-income ratios are restored to "normal" or "healthy" levels, sustainable private-sector and public-sector spending can get the American economy moving again.

Some will argue that inflation is an unfair "invisible tax" on our creditors . . . and this is certainly true -- but so is the lack of employment opportunities for most of our unemployed and the loss of wealth suffered by most American households.

The stagflation of the 1970s -- a period of sluggish economic growth and high unemployment -- demonstrates that high inflation and a falling dollar can occur even with low rates of capacity utilization and high rates of unemployment, what economists euphemistically call economic slack.

Just as the decade of stagflation gave way to economic renewal during the 1980s, higher inflation in the next few years could ultimately give way to renewed economic strength.

Wise economic policies -- although unlikely given our wide domestic political divides -- could lessen the pain and accelerate the return to economic health.  But, whatever policy path we find ourselves on, the United States faces difficult times that will be reflecting in a continuing long-term appreciation in gold.