Fiscal Deficits GDP and the Gold Price

It is widely thought that if the direction of deficits spending is upward, the price of gold will go upward.

That has only been partially true.  It certainly was the case in the 1970s.  But it was not so true in the 1980s and 1990s.  So, why if the deficit was rising, didn’t the gold price rise?

Gold prices peaked in 1980 then wandered in a bear market wilderness for almost 20 years even though deficits rose under Ronald Reagan, George Bush senior, and Bill Clinton.  This was likely caused by the fact that economic growth was good under these Presidents. With Clinton in the White House and Newt Gingrich as Speaker of the House, the Clinton years actually saw economic growth with modest budget surpluses.

The relationship that does seem to work consistently is that of deficits in relation to GDP.  If government deficits rise faster than the economy, the gold price does too.

GDP is an accepted measure of total output of the economy.

Thus, if fiscal deficits are rising, but not much faster than the economy is growing, it is not always good for the gold price.  But if deficits are growing much faster than the economy is growing, or deficits are growing while the economy is actually shrinking (which happens to be the case right now), that has been a powerful positive factor for gold.

Is that the case today?  Yes, definitely.

Notice the shaded areas representing recession.  In a modern welfare state, government spending always accelerates as people fall into the “social safety” net.  The perverse accounting of a recession goes like this:  rising social expenditures because of recession and falling revenue because of economic contraction results in higher deficits as a percent of GDP.

It is also worth noting that recessions are by the nature (credit crisis, scramble for cash) deflationary.  Yet gold prices have in the past done well immediately during and after recessions, as long as deficits as a percent of GDP are rising.  The relationship of deficits to GDP is the key metric.

The blue line are deficits as a percentage of GDP.  The red line is the gold price.  When the blue line is rising, fiscal deficits are a lower percentage of GDP.  When the blue line is falling, fiscal deficits are a higher percentage (shown as a negative) to GDP.

Note the gold price does well when deficits are rising as a percent of GDP (blue line falling).  Deficits can be rising, but if they are rising slower than GDP, gold has suffered.

That is 52 years of history.  What about today? We rolled into this current crisis with GDP in 2019 of $21.4 trillion, and a projected annual fiscal deficit of just under $1 Trillion. Thus, fiscal deficits were about 4.6 % of GDP.

With recent legislation such as the CARES ACT to fight the coronavirus pandemic, deficits could balloon to $3.7 trillion (an estimate by the brokerage house Morgan Stanley) and GDP might contract by 20% or more.  That would cause the ratio of fiscal deficits to GDP to soar to almost 25% of GDP, versus the previous 5%.  That is almost a six-fold increase.

Not only do we think this is possible, it may be worse than that.  Many observers feel the recently passed “stimulus” is simply the opening salvo of more spending to come.  Already there are hints of possibly another $2 trillion in infrastructure spending.  If we see something like that, the annual fiscal deficit could be $5 trillion or more.

The other variable (GDP) is also hard to know for sure, but the longer the economy is shutdown by health professionals, the lower the GDP number.  And even if they let up on the economy in another month or so, we have entered into this recession with serious overvaluations in many markets and with excessive debt.  Even under the best of circumstances, it will take time for output to recover to pre-crash levels.

Consumers will be so frightened by this most recent experience, and their savings so devastated, it will be quite a while before they start going into debt to buy cars, second homes, and long vacations.

Truthfully, no one has any idea of what GDP might do.  If it is a V shaped recovery, GDP might fall only 10-15%, and start to recover by the end of the year.  A more elongated U-shaped recovery, might see a sharper drop of 20-25%, and an even longer workout phase taking years.

With every major economy in the world being shut down by politicians (except Sweden and Iceland) following computer models, only time will tell if the epidemiologists got their calculations right.  They might have flattened the curve for mortality but for certain they have flattened the global economy.  A difficult trade off, to be sure.

The world has never seen such a government forced coordinated global recession.  We are seeing something quite new to the modern era. Don’t expect output to come roaring back that fast. High deficits are likely to persist for years.  We couldn’t come close to a balanced budget even in recent good times. The aging of Baby Boomers, and entitlement spending, will go on, with or without the coronavirus.

Whatever the two variables turn out to be, it seems very clear that in term of direction, that deficits will be rising much faster that output, and hence deficits as a percentage of GDP will be rising.

In the past, that has always indicated higher gold prices.

Charts courtesy of FRED, the data base for the Federal Reserve Bank of St. Louis. Data is derived from sources believed reliable but investment results cannot be guaranteed.