Gold is hotter than ever. You can’t turn on the TV these days without seeing a gold commercial. Several well known hedge fund managers have leveraged up positions in gold while John Paulson even went so far as to start his own gold hedge fund. As an asset class gold has outperformed just about everything over the last 10 year period. It’s been an impressive run. But is it all justified? Bear with me for a bit while I take a long-term macro look at gold as an asset class….
After having experienced deflation through much of 2008 and the beginning of 2009 the economy began to reflate as the government eased monetary and fiscal policy. Asset prices began to stabilize and bank balance sheets were suddenly flush with cash as the government provided stimulus. The inflationistas immediately began crying wolf. All of this extra cash was certain to cause inflation. And that meant one thing: buy gold and short dollars. Right?
All was not what it seemed, however. Underneath the surface, there was no real reflation – only continuing signs of deflation or at best, benign inflation. Asset prices surged as money flowed out of low risk assets (for which investors were no longer rewarded) and into high risk assets. But there was a continuing problem lurking beneath the surface – debt de-leveraging. While asset prices have improved the liability side of the ledger remains in tatters in the U.S. economy and around the world. De-leveraging continues and demand for more credit remains subdued. Yet, the price of gold rallied. I believe a large portion of the move is based on the misconception of gold as an asset class.
When analyzing the price of gold it’s important to understand that gold prices do not move like most other commodities. It has certain built-in unquantifiable characteristics that drive price. The price of gold is actually a function of four things: 1) its replacement potential for the U.S. dollar; 2) the future rate of inflation, 3) Sentiment – generally fear based and 4) true supply and demand. Let’s take a look at each.
Nouriel Roubini recently quoted Keynes in describing the gold standard as a “barbarous relic”. Ignoring the fact that the gold standard has failed repeatedly, there is still a hefty premium built into the price of gold because it is viewed as a currency – currently an alternative to the dollar. It has served as a reliable currency for thousands of years and continues to be seen as an alternative to fiat currencies. Going forward, I think this is a dying belief which has led to considerable confusion in the current economic environment.
The fact of the matter is, the fiat currency system is here to stay (or at least some form of it). The odds of reverting back to a purely gold based system is next to zero in my opinion. The truth is, the gold standard as a currency system is a barbarous relic. It is a currency system that worked well in the old world economy, but simply does not have the flexibility to meet the demands of the growing global economy. The global economy has become too complex and too intertwined to be constrained by the gold standard. The fiat currency system is a product of economic evolution and the growing demands and strains of international trade. Famous examples of the break-down of the gold standard and its inflexibility to meet trade demands include the UK in 1931 and the U.S. government’s destruction of the gold linked currency system under the Bretton Woods agreement.
Gold investors generally make the false argument that the gold standard somehow stabilizes prices (as if the price of gold is stable) or will restrain governments from excess spending, but the truth is, under sound stewardship, the fiat currency system provides all the benefits of the gold standard and all the flexibility that the gold standard didn’t contribute. In addition, the gold standard had a tendency to cause severe strains on countries due to trade imbalances and the inability to provide flexibility to countries with trade deficits. The argument that inflation, instability, corruption and mal-investment cannot occur under the gold standard is historically false.
If we were to alter our currency system it is most likely that we would move to a currency basket of some form, a global currency or move to a commodity basket – of which gold would likely be a component. Realistically, however, the odds of moving back to the gold standard (or even a commodity basket) are next to nothing. Nonetheless, gold investors remain hopeful of a currency collapse and a rewinding of our economic evolution. Don’t count on it. The current monetary system provides sovereign issuers of currency with enormous power over their currency and they are unlikely to relinquish this power into the hands of gold producers or an international currency (or bank) any time soon.
The popular idea of hyperinflation is one of the primary arguments in favor of gold. Of course, as we’ve already discussed, this is inherently flawed because the likelihood of reverting back to a gold based monetary system is virtually nil so anyone hiding gold bars under their bed is unlikely to find themselves trading them back and forth at the local Wal-Mart any time soon. Regardless, speculation, corruption and mal-investment will occur in any currency system that allows such things to persist. If these inefficiencies are allowed to persist they can lead to inflation and economic ruin. The favorite arguments used by inflationistas are the Weimar Republic and Zimbabwe, however, any true historian understands that the United States is not even remotely comparable to these corrupt and inefficient economies. The comparisons are completely illogical. See here for more. This is not to imply that inflation cannot occur in the modern currency system, but under sound stewardship the fiat currency system is no more potentially destructive than a gold standard (where sound stewardship remains a necessity).
Of course, there is nothing in a gold standard that keeps a country from becoming a poor steward of the currency. In fact, the restrictions of the gold standard have resulted in more government defaults than any flexible exchange rate fiat currency. The argument that 99% of all fiat currencies have failed is simply an outright falsehood. Fiat currencies restricted by the gold standard or pegged to another currency have failed repeatedly. That is not the system in which we reside today. It’s important to understand that the currency system in which we reside is vastly different from the pre-Nixon Shock currency system in which currencies did not freely float and currencies were convertible. As I described last week, a sovereign issuer of currency with no foreign denominated debt cannot go bankrupt in a floating exchange rate system unless it effectively decides to. Inflation is another story altogether, but we’ll touch on this further.
The gold standard and single currency systems have all ended in demise for similar reasons. There are several flaws in single currency systems, however, two are most notable:
- They are inflexible
- They impose inherent constraints
- They are susceptible to corruption
The inherent inflexibility and inherent weaknesses imposed on particular trade partners within the currency system is always apparent in single currency systems. As I’ve previously noted:
“the gold standard had a tendency to cause severe strains on countries due to trade imbalances and the inability to provide flexibility to countries with trade deficits.”
The move off the gold standard and convertible currency systems has generally been due to the inherent restraints imposed by such systems. For instance, trade deficit nations are at an inherent weakness when attempting to respond to recession because the trade imbalance results in rising unemployment and falling output and prices – an inherently deflationary environment. With your own currency this imbalance would naturally offset over time, but under a single currency system there is no opportunity for the floating exchange system to reach balance. This is just one very simple example of the types of inherent restrictions a single currency system imposes on a nation, but it’s particularly pertinent as we see this exact event unfolding in Greece – where the single currency system is destroying the country and handcuffing the government from properly defending their economy and thus providing for their citizens. Instead, they are risking default (a risk which does not exist within a sovereign issuing floating exchange system) and forcing their citizens into recession all so the surplus nation of Germany can enjoy price stability and continued high exports. Such a system is wondrous during the boom, but it can be catastrophic during the bust.
The other critical flaw within the Euro system (and the gold standard) is a very human one and not necessarily unique to single currency systems. In Europe, it is the unwillingness to accept political failure which ultimately results in a form of political corruption and manipulation in a misguided attempt to right previous wrongs. In his “Money: Whence it came, where it went”, John K. Galbraith described this flaw:
“It had also a notable flaw. That was in asking, in an age of growing nationalism with a growing tendency to hold governments responsible for economic performance, that both nationalistic instinct and domestic economic management be subordinated to an impersonal, international mechanism, one capable of inflicting considerable hardship and distress. It was a flaw that supporters of gold did not accept. They saw any reluctance of governments as inhering in the lack of moral fibre of politicians – a lack that led them to try to ameliorate the strains that gold imposed. That the morality of politicians is difficult to alter in the short run was not recognized.”
When the world was constrained by the gold standard it very much resembled modern Europe. It was a world of many countries with multiple governments, multiples, economies, differing needs and no monetary sovereignty. What happens in such a world is that you experience severe trade strains. With no floating exchange rate a government can do little to influence its trade balances. What results is severe imbalances. In the case of Europe, you have the periphery nations all suffering through high trade deficits. The core nations are experiencing surpluses. In order to offset the current account deficit the periphery nations were required to become high deficit spenders. This is sustainable for so long. And the results are now clear. The profligacy of the periphery has come back to haunt them as asset prices fall and economies contract. With no floating exchange rate there is no way for these nations to combat this problem. They must either suffer depression or hope that the core nations will bail them out. That’s no way to live and any government that allows a nation to be involved in such a currency system should be truly ashamed of itself. The same things used to occur under the gold standard. But as the single currency imposed it natural strain on the world countries wised up and rejected it.
Most of the hyperinflationists or gold investors I know are worried that the Fed’s printing press (or button pressing if you will) will ultimately result in inflation. This is not entirely correct. As I have previously explained, when you pour an iced tea packet into a pitcher of water you don’t automatically get iced tea. You have to stir it in. Our banking system is much the same. There is no demand for credit as of now and therefore there is no expansion in the amount of actual money in the system. Because the private sector is busy repairing their balance sheets aggregate demand remains historically low. Therefore, the hyperinflation argument remains bunk. The latest readings on wage inflation, demand for credit, etc all point to continued de-leveraging and low demand for credit, and in our banking system that means inflation is not yet a concern. For a more detailed explanation of the deflationary risks please see here.
In terms of sentiment there is an inherent premium built into gold because it is viewed as a safehaven currency. This opinion is generally sold to the public by investors who genuinely believe the world is going to end or that the modern economic system will ultimately fail as the dollar crumbles. These people genuinely believe that the entire global economy will collapse one day and we will all be sitting around trading our gold bars back and forth. This is pure and simple fear mongering. This is not to imply that the U.S. dollar can’t fail or that the fiat currency system will always exist in its current form, but the idea of reverting back to a time when we carry gold in our pockets in order to purchase goods is simply ludicrous. “Barbarous” as some might call it. The truth of the matter is that the fiat currency system is simply an evolutionary step in our economic progress. Those who latch onto the days of the gold standard simply don’t understand how fiat currency works in the current floating exchange rate system. If you want to believe the global economy will one day collapse that is just fine, but should that scenario actually pan out the last of your concerns will be which local market is accepting gold in exchange for food. The man with the most lead will be the man with the most food in that scenario.
Where gold does contain real value is as an actual commodity. I don’t believe that gold has no intrinsic value as many gold haters believe. I believe it has intrinsic value in the same way that diamonds have intrinsic value. I just don’t believe gold should have any intrinsic value as a currency. None. From a purely supply and demand perspective the gold market actually looks fairly constructive. Nouriel Roubini pointed to several reasons why gold is not necessarily a bad investment:
“the global supply of gold—both existing and newly produced—is limited, and demand is rising faster than supply over the medium term. The recovery of the global economy has started a revival of retail gold demand especially in India. Central banks looking to diversify their portfolios account for further demand—see for instance, the recent increase in gold holdings by emerging market central banks. Most of the increase in demand comes from private investors using gold as a hedge against low probability tail risks of high inflation and another near depression caused by a double dip recession. Inflation risk and the risk of a double-dip are both low, suggesting lower gold prices, but increasingly investors want to hedge against such risks early on. And given the inelastic supply of gold, it only takes a small shift in the portfolios of central banks and private investors to boost increase the price of gold significantly.”
Passport Capital recently laid out the bull case as well:
- Demand in India and China is surging and demographic and wealth trends should bolster prices.
- Demand from central banks has undergone an important shift in recent years in response to the credit crisis.
- Mined supply peaked in 2001.
- The ability of above-ground gold stocks to satisfy demand is undergoing structural change, and markets may be overestimating their ability to satisfy an increase in demand at current prices.
One might conclude that I think gold is a terrible investment after reading this. That couldn’t be farther from the truth. I simply believe gold is a misunderstood asset (particularly as an alternative to the dollar). I know that the overwhelming majority of investors see value in gold and therefore it is ignorant to ignore its potential as an asset. The modern fiat currency system is still largely misunderstood and very young. It will take time for investors to learn to trust it and fully understand its benefits.
Of course, these misconceptions are likely to persist for years if not decades and ignoring the beliefs of a huge amount of the investment world is no different than the fundamental analyst who ignores the millions of chartists in the world. The belief is there therefore the price action is there. I believe there are good reasons to hold gold in ones portfolio, but those reasons should be purely based on the underlying laws of supply and demand at work as they pertain to gold’s value as a commodity. The idea that we will one day revert back to the gold standard is simply not pragmatic in my opinion. If I were a betting man (and I am) and if I had to bet my lead on it I would bet that the idea of gold as a currency will be almost entirely extinct in 500 years. But that doesn’t necessarily mean the price of gold won’t be much much higher.
In conclusion, I continue to fail to grasp the rationale for gold as an “investment”. While fear rules the day today, human ingenuity is likely to outperform unproductive assets over the long-term. Additionally, with little to no inflation the inflation hedge argument remains bunk. As for sentiment and the collapse of the modern economy, well, I don’t think gold will be the thing you really want to own in that world. It is not gold we will all be clamoring for, but lead and God save you if you don’t have something to load that lead into because those gold bricks are mighty hard to throw at someone….The main takeaway from this discussion is that we should not seek to collect bars of metal in our basements. We should seek to become more innovative, more virtuous and generally better. And if you cannot achieve that on your own you should seek to invest in human ingenuity through the genius of others. Collecting bars of metal is not the best way to achieve this….
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