GR-NEAM

Gold has a long and varied history in economics and finance. Otherwise sensible people lose rationality and logic when conversation turns to the subject, with some rising to passionate romance, and others to apoplexy. It elicits neither for us, which allows us an attempt at a reasoned view. That is more important today than usual, because there is a message in gold's price behavior, and it is not an encouraging one. That message is that not only are rates of return low at the moment, but they may remain there for some time.

The enthusiastic response of the capital markets to the Federal Reserve's announcement of the third quantitative easing program is, of course, just what they intended. It recalls the even more ebullient response to the ECB's Long Term Refinancing Operation announcement late last year.

The world is relying upon its central banks to work wonders. Having made a mess of their balance sheets, households and governments are faced with the long and unpleasant task of reducing indebtedness. The infinite supply of money in a paper money system is the obvious solution. The question is whether, with very liberal exercise of that privilege, there is some limit to its use.

The insolvency of Lehman Brothers was a fault line in financial history. The failure of the U.S. government to act as lender of last resort in Lehmans insolvency was a deflationary shock unlike anything in decades. Now, in Europe, there is a growing risk of a second large deflationary shock in just five years, if Germany were to disavow contingent liability for deeper Eurozone union. The result is that there is a developing craze for safety underway.

It is almost four years since the Lehman bankruptcy. In the periods of economic contraction that were typical of the postwar period, the clouds would be parting by now. Income growth would have resumed and necessary balance sheet repair would be more or less complete. By any standard, the current episode is a balance sheet recession of historic proportion. Previous downturns were initiated by central bank rate increases, which occurred this time as well.

The economist Hyman Minsky held that capitalist economies are inherently unstable because investments are financed with debt, and the financial markets pricing of debt is volatile. Economies are prone to booms and busts as the cost of financing falls too far, or rises too much, revealing poor investment decisions. This has always been obvious to observers of business cycles, of which Minsky was one. Too many of his colleagues in economics ignore this, which we have found puzzling.

There was a time when governments were held to account for the long-term consequences of their financial habits. Those days appear to be long gone, of course, to policymakers frenzied at the political urgency of producing rising employment. But there must be a price to pay for thumbing our noses at lessons previously learned. We look here at just how far government husbandry of the financial system has strayed over time, and how important the consequences are likely to be in years to come.

The escalating frenzy for yield may in fact prolong the trying process of deleveraging by tacitly supporting bad investment decisions, and underpricing of risk. The relentless destruction of private capital in real terms is policymakers' answer to reducing leverage in nominal terms. If central banks err in the direction of ease, as the Fed will signal if it ignores the Taylor Rule for a time, poor long-term investments are likely to do well for a transitory period. The eventual reckoning can be suppressed, but only for a time.

The tides of financial returns ebb and flow, and for the moment, they are flowing. Since the financial crisis of 2008-2009, the deflationary forces of excessive indebtedness prevail for a while, and then are beaten back by the determination of popularly elected governments to reflate. The financial markets no longer reward skill, so much as they react to the relative strength of governments will to offset contraction.

American house prices are approaching a bottom.In certain cases, they are already there. For the better part of the last years we have watched the improving economics of rental cash flow with interest, as monthly rents have risen rapidly while purchase prices have languished. The Fed issued a paper in early January reviewing conditions in the U.S. housing market for the purpose of imploring Congress to make structural changes that would remove barriers to a more rapid recovery.For the Feds pump priming to work, the pump must be capable of functioning properly, they said essentially.

The developed world is riskier than it was, and should be valued accordingly. That is a dour conclusion, but avoiding it does not mean that one can outrun it. Perceptions of what makes risky assets attractively valued need to be adjusted for the context. Valuation levels that were attractive when the world was less indebted are attractive only at lower levels since valuations have not yet anticipated eventual inflation. Those that will do the best are those that benefit from inflation and the negative real interest rates that result, since ultimately that is the choice governments will make