GOLD ON HOLD

GOLD ON HOLD
Peter T Treadway, PhD
Historical Analytics LLC
www.thedismaloptimist.com

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“The 19th century experienced monetary stability, and all the economically advanced countries clung faithfully to the gold standard; in the 20th century they have gone off gold one after the other, and their respective currencies have undergone ‘inflation’, ‘deflation’, ‘stabilization’, and ‘falling exchange rates’.”

-Pierre Vilar, A History of Gold and Money 1450-1920, (1969) p17.

“Gold, unlike all paper-based assets, is no one’s liability. It therefore has a near-unique ‘safe haven’ quality since its value cannot be eroded by any decline in the creditworthiness of its issuer.”

-Roy W Jastram and Jill Leyland, The Golden Constant, p 239.

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View from the Souk

This Dismal Optimist was written from Dubai. One might question the sanity of visiting Dubai in July where temperatures during the day can run 108F/42C degrees. But for someone with an intellectual interest in gold, a visit to the traditional Dubai Gold Souk makes up for minor inconveniences such as heatstroke or dehydration. Fortunately the Dubai Souk stays open until late at night when the temperature can drop to a “chilly” 100 F/38 C. The Souk consists of hundreds of small shops, many run by Indians and offering all kinds of gold and precious stone jewelry, from simple bracelets to elaborately filigreed gold necklaces, designed for Arabian and Indian tastes.

According to World Gold Council (WGC) statistics, in 1Q2010 Indians were the leading buyers of gold jewelry with the Chinese and the Middle Easterners occupying the second and third positions. Indians and Middle Easterners traditionally buy gold jewelry as an alternative investment to financial products in their own countries which either haven’t been available or not considered reliable. They often serve as gifts at weddings and religious festivals. According to the WGC, in 1Q2010 jewelry consumption constituted 62% of total identifiable demand for gold. Total ETF demand by contrast was less than one percent although that number was abnormally low as compared with 17.9% in 2009. The point is that jewelry consumption in recent years has constituted more than fifty percent of the world demand for gold. Having adjusted to the higher gold prices, any big drops in the world gold price will likely be viewed as buying opportunity by these traditional non-Western buyers who in recent years have been gaining in overall wealth. Reflecting its role as an investment product, gold jewelry is generally predominantly priced by weight and caratage and not so much by the beauty of design.

India does not produce much gold and the bulk of Indian gold is imported. As an aside, Dubai’s role as the major supplier of gold to India can be viewed as a “triumph” of Nehruvian socialism which banned the import of gold upon Indian independence in 1947. This ban was not relaxed until 1991. Dubai’s traditional expertise in smuggling worked to solidify its role as supplier of gold into India.

Long Term You Have to Like Gold

On a long term basis there is no alternative but to be bullish on gold. There are several reasons for this. The first and most important is that, since the final breakdown of the Bretton Woods quasi-gold standard in 1971, inflation and inflation related bubbles and busts have been the norm. The world is on a fiat money, dollar standard which has an inflation and bubble/bust bias. A fundamental cause of the 2008 global financial crisis and global real estate bubble/bust lies with the current defective international monetary system. The nineteenth century gold standard provided an automatic adjustment system among countries and an anonymous discipline that prevented countries from inflating their currencies. The current fiat money dollar system does not have an automatic adjustment mechanism – witness the build-up of Chinese dollar reserves – and allows governments especially the United States to engage in inflationary monetary excesses.

Second, the country whose currency is the basis for the current dollar standard—the United States – faces severe long term fiscal problems as reflected in projected Federal and state deficits. The US is currently following a “what me worry” irresponsible fiscal policy combined with a “helicopter” quantitative easing monetary policy. The temptation will be very strong for the United States to “devalue” its way out of its dollar denominated debt by printing money. This will have severe consequences for the entire world so long as it is on the current dollar standard.

Third, there is a “shortage” of gold at current prices should gold in whole or in part be restored to a significant role in the international monetary system. The gold price would have to rise dramatically for there to be “enough” gold. How this restoration would occur is another matter. Ideas have been floated for various gold backed international currencies. The US government certainly would be opposed as it is the major beneficiary of the current system which is based on its currency. China could be a big loser as well since it has chosen to lend trillions in US dollars to the US. However, China’s position on the creation of such a currency is unclear. For China, getting rid of the dollar based global finance system may be worth the short term cost.

Near Term Gold Could Weaken – But Not Too Much

There are two reasons why investors might choose to buy gold and nations might want to use gold to replace the current dollar standard. The first would be that significant US inflation is expected. That would mean that the dollar as a store of value would lose its attraction. But as I argued last time, the US is in the deflationary phase of its current real estate bust cycle. The US consumer is deleveraging as are consumers in other areas notably Europe. Demand from Europe is likely to be weak and China’s economy seems to be slowing. Talk of a double dip for the US economy is in the air. The inflation numbers for the US for the next year or two are likely to remain low if not negative. Plus investors have the example of Japan which has experienced deflation off and on for twenty years despite expansive fiscal and monetary policies. So near term investors may not fear a loss in the dollar’s value due to inflation and may not have an immediate need to rush into gold.

Second, investors might want to buy gold if they were concerned that the US financial system were collapsing. That was the case during the early very deflationary part of the Great Depression when investors pulled money out of collapsing banks and bought gold. (Until President Roosevelt made owning gold illegal in 1933). But the danger of that happening now is past. The worst is over. The various rescue programs such as TARP, however bad they may be in terms of fairness, moral hazard and resource allocation, prevented a collapse of the US financial system. Of course if you believe another near term potential collapse of the US financial system is on the way, then buy gold now.

So the bottom line is that near term without dollar inflation an immediate prospect and with the US financial system no longer on the verge of collapse, Western investors may not feel compelled to run out and buy gold.

To repeat, my view is that longer term the US fiscal problems and monetary quantitative easing will be highly detrimental to the dollar. In that environment gold will soar and alternative gold based currencies may emerge. But not yet. In fact, were the outcome of midterm US elections to be viewed as a major victory for fiscal conservatism, gold could decline and the stock market would get a boost in the second half of this year despite lackluster economic numbers. Perhaps that would be the time to buy gold. After the midterm elections.

There is one caveat to this however which may serve to limit any significant downward pressure on gold prices. Deflation may be a problem for the US, Europe and Japan. But inflation is currently the outlook for India. Inflation seems to be the current problem in China although there is some evidence of a China real estate bubble peaking. As discussed above, Indian and Chinese investors are major buyers for physical gold including jewelry. Moreover the Indian and Chinese governments have been acquiring gold over the last year.

If the Gold Standard Was So Great, Why Did the World Get Rid of It?

The reasons for the abandonment of what was a very successful monetary system up until 1914 are complex. But I will give four: (The “bible” on this subject is Barry Eichengreen’s Golden Fetters.)

First, the classic gold standard was dropped at the outbreak of World War I by all the combatants except the US. All the major countries including the US began to print fiat money with wild abandon to finance the war. The expectation was that, like the British in 1821 after the Napoleonic Wars, that all countries would rejoin the gold standard. But that turned out to be easier said than done. Germany and the losing powers experienced hyperinflation and in 1925 the UK got back on the gold standard at the prewar exchange rate, a decision now generally regarded as a deflationary mistake.

Second, WWI was extremely disruptive from an economic point of view. The Austria-Hungarian Empire was replaced by a host of unstable countries roped off by tariffs and currency restrictions, the Ottoman Empire similarly disappeared, Russia fell to Communism, Great Britain – the former core country under the classic gold standard—was broke and Germany was saddled with punitive war debts. The US, after the war the world’s most important economy, refused to take on a leadership role as it would later do after World War II. Significant global agricultural capacity that was developed during the war to feed the warring nations made the 1920s one of global overcapacity in agriculture. No international monetary system would have functioned well in that environment.

Third, the advent of modern central banking subverted the workings of the less rigorous gold-exchange standard that was put in place after the war. Under the gold-exchange standard, countries held as reserves either gold or currencies of countries that were convertible into gold. So a lot depended on the gold coverage and credit worthiness of the reserve currency countries. David Hume’s price-specie flow model is considered the best explanation of how the classic gold standard was supposed to work. Under that model, gold flowed out of countries that ran trade deficits thus contracting their monetary bases. The monetary bases of the countries in surplus would expand as gold flowed in. Only gold made up the monetary bases. Thus there was a self-correcting mechanism and no worries about the credit worthiness of reserve currency countries. Deficit countries would contract and surplus countries expand until equilibrium was reached. But the Federal Reserve, created in 1913, sterilized the inflow of gold into the US in the 1920s by effecting offsetting contractions of the monetary base by selling government debt which would not have been possible under Hume’s model. Thus the deficit European countries could not adjust.

Fourth, the granting of universal suffrage in many countries during the war made it impossible for governments to allow the anonymous workings of the gold standard to determine monetary policy. As they do today, electorates want action from their governments whether or not it is rational or in their best long term interest.

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Peter T Treadway also serves as Chief Economist, CT RISKS, Hong Kong