Russia, Speculation and Gold

1. Russia, Speculation and Gold Econ 114, Dr. Tom Porter

2. Sanctions Sanctions are a market level activity designed to affect political ends through an economic effect. Limit exports and imports of the target country Used for political/diplomatic objectives Puts pressure on a country Has been used in multiple occasions Cuba (political) Iran (political and nuclear weapons related objectives) North Korea (nuclear) 0

3. Russian Sanctions Limits a country’s ability to trade Exports and imports fall. no impact on Net Exports or aggregate demand Fewer and more expensive imports: Indirect impact on consumption Impact on production costs Lower export income Resources are used in less efficient ways Lowers output, consumption and investment 0

4. Sanctions – Production Possibilities Frontier With trade restrictions, the gains from trade are reduced. The consumption point at A is no longer possible. The significance depends on how far point A is outside of the PPF and how successful the restrictions are in preventing trade. Sector Y A Y0 Y1 B Sector X X1 X0

5. Russian Sanctions Sector Y: Consumables Russia’s key exports are natural gas&oil. Trade is primarily with the rest of Europe – exporting energy and importing other manufactured goods. The significance or sanctions still depends on how far point A is outside of the PPF and how successful the restrictions are in preventing trade. A Y0 Y1 B Sector X: Natural Gas X1 X0

6. Sanctions The success of sanctions depends on how important trade is for production or consumption. Cuba – continued to trade with the USSR, Caribbean and South American countries following US sanctions on the communist regime. The underlying productivity of Cuba and the USSR is poor, so sanctions were part of the overall impact. Iran – annoying, but not a major impact. Iran is still able to sell oil. North Korea – fundamentally flawed economy. The trade war during the 1930s had greater impacts. 0

7. Russian Economy Russia has very poor economic fundamentals. Sanctions will have potentially significant effects given these poor productive fundamentals. Sanctions will also have an effect on its trading partners in the rest of Europe who depend on Russia’s oil & gas. Russia’s exports are Europe’s imports. Russia is facing economic decline – for example, in 2007 Russia’s energy giant, Gazprom, was predicted to be worth $1 trillion by 2014. It is only worth $90 billion. If Russia is facing decline, then Europe will not want to be seen as causing this decline and will back off. 0

8. Russian Economy Russia has very poor economic fundamentals. Russian Oligarchs – the industrial structure is dominated by a small number of large producers (some companies are public and some are privatewith political protection). The structure has similarities with many developing economies – including the US, Europe and Mexico at different times in their economic histories. The rapid rise of a number of companies (oligopolies) is beneficial to an extent. Once these organizations interfere with other company successes, then these oligopolies are impeding productive investments in the economy. 0

9. European Economy Europe has weak economic fundamentals. Russia’s economic performance will affect Europe. Many European financial institutions are over extended: high lending relative to capital and reserves extremely high government borrowing (Greece, Spain) are exposed to Russian risk (too much lending in Russia) Russian economic decline will effect European growth and will affect Canada/US as well. Trade is good for long-term growth, facilitating productive and efficient uses of resources. However, short-term decline often spreads through trade relationships. 0

10. Market Responses to Risk There are many sources of risk and uncertainty in European economies. Many people know this and are managing their risk, lowering their expectationsand lowering productive investment. Europe is using monetary policy to stimulate investment – short-run improvement in lending. Monetary policy cannot fix fundamental issues (long-term problems associated with productive investment). Monetary policy encourages speculation. 0

11. Market Fundamentals Prices always vary from economic fundamentals (long-term productivity). Distinguishing short and long-term effects is difficult: General versus Relative Prices Actual versus Expected Prices Market prices can vary from fundamentals for long periods of time. Markets eventually adjust to align short-term information with economic fundamentals. Monetary Policy attempts to increase investment using short-term positive price signals. 0

12. Market Fundamentals Short-term positive signals increase investment in: Good investments (productive investments) Poor investments (seemingly productive investments) Speculation If the short-term signals have varied very far from fundamentals, then: Poor investments and speculation grow relative to productive investments, and Correcting expectations becomes more dramatic. Stock market crash of 1929 (leveraged borrowing) Financial crisis of 2008 (sub-prime loans and monetary policy) 0

13. Speculation Speculation is not good or bad. It is the act of buying low and selling high. It has always occurred in the history of the world. Speculation is Valuable when it creates liquidity in financial markets. Smart speculations leads to small corrections that improve expectations. Speculation is Dangerousbecause it allows asset prices to deviate from fundamentals for extended periods of time. 0

14. Speculation Leverage is borrowing of money for investment. We do this with houses and real investments We do this for savings (financial investment) If I borrow $9,000 using $1,000 as leverage, then I can make a $10,000 financial investment. A 5% return ($500) on the overall investment means a 50% return (minus borrowing costs) on the initial savings. If borrowing costs are 1% (that is $90 on $9,000), then the total return is $410 (or 41%). If the leverage ratio is larger, then the return on the original funds is larger as well. The maximum loss is $10,000 or 1,000%! 0

15. Speculation Leverage and speculation allow for higher returns and lower risk flexible mortgages, credit cards, student loans, stock and bond markets Speculation and leverage allows short-term deviations from long-term fundamentals The longer and the greater the deviation, then the greater the correction (5%) or crash (25%+). Central banks mitigate over-leveraging by maintaining higher interest rates and regulation. Current extremely low interest rates adds to leveraging and speculation. 0

16. Gold Market risk and uncertainty increases the price of gold Government risk and uncertainty increases the price of gold (and bitcoin) Buyers are looking to mitigate or diversify risks: Crimea Alternatives to market speculation (stock prices) Printing of money (monetary policy) Sovereign debt (government debt) 0

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20. Gold – as an Asset Bonds, Real Estate, other Physical Assets: Price is based on supply and demand There are no costs of production, so demand dominates market dynamics Future expectations drive demand Optimism tends to drive markets and lead to speculation based on speculation In general, asset prices: rise along with the general price level (hedge against inflation) fall with interest rates (opportunity cost) 0

21. Gold – as a Financial Investment Two sources of financial return: Income as interest or dividends, or Growth as in the appreciation of assets Investment Income – based on real activity Growth and Appreciation Returns from trading Trading based on growth in asset value (general prices), or Trading based on fluctuations in asset value (relative prices) Buy low, sell high over time The potential for financial returns depends on changing conditions or changing expectations about market conditions 0

22. Gold – as a Commodities Commodities are often traded as though these are financial assets. Three broad categories: Valuable These have an intrinsic value such as silver or gold Industrial These are valuable because of their use in production Copper, silver, rare earth minerals, oil&gas Perishable Grains, livestock Firms trade in commodities and futures markets to mitigate risks from future price shocks 0

23. Gold Gold is: an asset, a commodity and money (because its high intrinsic value has made it the preferred medium of exchange and store of value in all of history). In order to successfully trade gold, all we need to do is to understand the nature of these demands. Government history with the gold standard: http://www.econlib.org/library/Enc/GoldStandard.html 0

24. Final Thoughts People: will try to improve their condition (trade) are creative, and will always try to find ways to manage the future People are creative, innovative and will continue to raise productivity for the purpose of: health, wealth and well-being 0