The liquidity trap – gold

Storm clouds do not seem to want to go away. They have formed turbulence over the financial markets and the resultant depression just does not want to move. Growth momentum is slowing, credit ratings of governments are under increasing pressure – downwards – interest rates are as close to zero as possible in almost all developed countries and equity markets have, since July, taken a significant knock downwards.

What is going on or who is going to save the world if things turn out to be uglier than we currently believe? In our present economic environment, with interest rates as zero, with fiscal belt tightening at the top of the agenda, and yet no end in sight of more bad news, what is to prevent markets from sliding even further as things get worse?

It is looking increasingly likely that the markets are pointing towards a liquidity trap. Ask the Japanese, they know all about it after their years of experience over the last decade. Let us see what a liquidity trap actually means when traditional monetary policy is unable to stimulate the economy either through lowering of interest rates or increasing money supply (printing anyone?) Liquidity traps typically occur when expectation of adverse events make persons with liquidity unwilling to invest and take up even calculated investment risk. It is a situation where the central banks find it difficult with all their armour of fiscal weaponry to improve the environment through monetary policy. Even though there is money supply around which to date does not cost much, this alone does not mean that credit demand will pick up automatically. There needs to be a willingness to commit this liquidity rather than save it for another day.

Look at Japan once again. Where money supply has increased threefold, inflation has gone down while nominal GDP has barely moved. In our own scenario, individuals’ appetite for risk has diminished completely. Individuals seek only a very safe haven for their money. Also as they are averse to spend more than is necessary, they would be saving much more than usual.

The banks are also being very much more cautious and thus the banks’ liquidity is in the current scenario being built up by this extra savings but they too are not placing this liquidity back with the market as their lending policy becomes more and more cautious. Hence more liquidity, less spending, less investment equals the liquidity trap. Trapped with no place to go.

All pressure now lies with the central banks and if they are not able to get it right and deliver, then more quantitative easing might have to be made. But is this the answer? Also if they do get it wrong or if one country manages to pop up yet another bunny out of a hat full of bad news. Then what? Exciting?

And how has gold been behaving amid all this turbulence? Gold prices have been as wild as the market and at one stage recently gold was up by nearly 100 US$ per day, to a record of just over $1,900. That’s pretty close to the $2,000 level – before staging a downturn to the $1,700 level where it is today. (See box.)

Accelerating so quickly to this new record high took many by surprise but this shooting star movement could not be sustained and a period of consolidation at present levels would strengthen and build up stronger foundations for an assault on the $ 2,000 mark.

Gold together with the Swiss franc are considered as a safe haven of choice during these debt ridden uncertain times and that is the way it is expected to stay amidst these times of such economic turbulence.

This article is the objective and independent opinion of the author. The information contained in the article is based on public information. Curmi and Partners Ltd. is a member of the Malta Stock Exchange, and is licensed by the MFSA to conduct investment services business.

Mr Curmi is a director at Curmi & Partners Ltd.