Why gold and stock markets will continue lower. April 19, 2013 - 10:01am | Peter Leahy at Sovereign Leadership Group We are living in an economic and political environment where governments, central banks and finance ministers are busily exploiting every tool available to try to spark life into dormant economies. Some countries, including the UK, are pulling two sets of levers that are having opposite effects. An example of this questionable practice is the current policy of printing money – known in financial markets as quantitative easing – at the same time government expenditure is being slashed. QE is a trick we picked up from Japan. The process is simple enough. The government issues debt – known as gilts or bonds – and simultaneously buys them back from the debt market with money freshly printed for the purpose. We are living in an economic and political environment where governments, central banks and finance ministers are busily exploiting every tool available to try to spark life into dormant economies. Some countries, including the UK, are pulling two sets of levers that are having opposite effects. An example of this questionable practice is the current policy of printing money – known in financial markets as quantitative easing – at the same time government expenditure is being slashed. QE is a trick we picked up from Japan. The process is simple enough. The government issues debt – known as gilts or bonds – and simultaneously buys them back from the debt market with money freshly printed for the purpose. Any GCSE economics student will know this should eventually see more money finding its way into our wallets and purses – and with this extra cash being spent on goods and services, our economy should grow as a result. An inevitable consequence though is a rise in prices. The disastrous effects of Germany’s hyperinflation of the 1930s emphasises the importance of properly managing the risk inherent in this approach. Jumping forward 80 years, at first glance it appears as if QE is working its magic. Consumer price inflation is holding steady at 2.8 per cent - and both the Bank of England and the bond market expect the figure to exceed three percent later this year. But the worrying news is that these rises are a symptom not of emergent recovery but of higher import costs as the pound falls in value. Mark Carney, the Bank of England governor designate, is widely seen to be a devotee of Japan’s plan to rejuvenate its ailing economy by doubling the supply of money within the country. Sterling’s recent slide from $1.65 towards $1.50 since his appointment was announced is a reflection of the expectations widely held by currency traders. An important link needs to be reinforced. Inflation describes the reduction in the real value of money while devaluation is about the fall in the value of money vis-à-vis other currencies – so both are about reduction in the value of money. Hence, inflation reduces the real value of government debt as well as being a symptom of economic renaissance. It is therefore relatively desirable to heavily indebted governments, while deflation would be a nightmare. In this context it’s worth examining how QE has fared in Japan and elsewhere. The Bank of Japan first deployed QE in March 2001 – and while it may have staved of the worst of a slump, it certainly hasn’t sparked either inflation or kick started the once all-conquering Japanese economy back into action. Since the start of the credit crisis six years ago, QE has been extensively deployed in the Eurozone, the USA and here in the UK (where the government’s QE spend amounts to £375 billion). Yet despite governments frantically printing fresh euros, pounds and dollars, increasing opinion is that QE hasn’t successfully reignited economic growth. Indeed last year Alan Greenspan, the former chairman of the US Federal Reserve noted that QE had 'very little impact on the economy'. One of Britain’s foremost economists, Michael Nevin, went further and blamed the practice for actually depressing economic activity. He explained that 'QE failed to stimulate recovery in the UK and instead prolonged the recession between 2009 and 2012 as it caused a collapse in... the rate at which money circulates around the economy. This happened because QE drove down gilt yields and annuity rates and forced pensioners, savers and companies to hoard cash to counter the negative impact of QE on their investment income'. The reason QE has failed is that the recipients – financial institutions – have simply recycled the money back into investment markets and gold. This in turn has led to a contradictory situation where stock markets have recently reached record highs while the world’s key economies continue to stagnate. It’s only when you manage to step back and evaluate what’s happening, that you appreciate just how laughably perverse the situation has become. Fortunately there is now a realisation that QE isn’t working and that in fact it never has. It’s been an abject failure, aside from artificially inflating stock, bond and precious metal prices. So far this year gold has lost nearly a quarter of its value while the price of Brent Crude oil is down 16 per cent. Instead of an environment of steady economic growth – driven by the positive impact of QE –the very real risk we now face is deflation. Gold was never really a safe haven from inflation, but in the context of deflationary risk has clearly become a bubble of Dutch Tulip proportions. Peter Leahy is managing director of Sovereign Leadership Group