Gold – Don’t Get Carried Away



“We will answer their demand for a gold standard by saying to them: You shall not press down upon the brow of labor this crown of thorns, you shall not crucify mankind upon a cross of gold.”

-William Jennings Bryant



“No gold-digging for me… I take diamonds! We may be off the gold standard someday.”

-Mae West



Time to Take Another Look

Gold has been flat to correcting for almost a year after hitting a spot price high of about $1875 per ounce in August 2011. Gold bugs pride themselves at being able to take the pain of occasional corrections which inevitably come along the path of a long march upward for gold. But I think this correction has lasted long enough to require some reevaluation of the basic thesis. I have been a proponent of buying gold. I still am but perhaps I see more near term downside risk.

Below I examine three ways to look at gold. Only one of them yields an unequivocal “BUY”.

Three Ways to Value Gold

There are three ways to look at gold. The first is simply as an inflation hedge. In this view, gold is sort of an index of commodity prices. Here gold may be ahead of itself. For example since the gold link was terminated in 1971, the CPI inflation index has risen 567% percent. From its $35 per ounce official 1971 price, gold has moved up roughly 4600 %. While the choice of beginning price is somewhat arbitrary in this calculation since the official price in 1971 was below market, the likelihood is that on a pure inflation basis gold is currently overvalued. Moreover, in a period of near term debt deflation in the advanced Western countries and Chinese slowdown as we are now in, gold as a commodity is likely to decline in price.

No question if hyperinflation is on the horizon, gold will rally. But not yet. Deflation, or at least a lack of significant inflation, is our near term future.

Comparisons with the past for gold can be misleading. When gold was the center of the monetary order, it was the anchor, the constant. Of course gold held its value. Today it performs no such role. In periods of financial stress when in theory people should be buying gold, they are sellers as they need liquidity. In periods of global expansion, gold becomes an attractive outlet for excess global liquidity. Many people argue that quantitative easing is releasing high powered money into the system which will then chase gold. I don’t see it that way. I think the high powered money created is just sitting in the central banks as excess reserves. Debt deflation is a powerful force.

A second way to look at gold is an attractive alternative asset and store of value for central banks and investors in a time of loss of confidence in the dollar and the euro. Under this view gold might play some role in a new international monetary system or as the basis for one of several future alternative currencies. A lot has been written about this. Some central banks are now buying some gold. Under this view, gold presumably would have a higher value than under the first view but it is hard to come up with some kind of valuation formula for this. Moreover, all of this, while it makes for interesting intellectual discussions, is somewhat “mushy” as an investment thesis.

Despite what many believe is illogical, the dollar today is strong and amazingly the euro holds together. So long as the dollar stays strong and the euro stays together, gold will not be the refuge that its supporters believe it should be. An actual breakup of the euro could cause a rush into gold as an alternative. That would be bullish for gold. But I do not think the euro will break up. Yes longer term the ECB’s money printing will be inflationary and the entire European approach of wealth transfers from Germany is a mistake. But for now it’s deflation as Europe careens into a recession.

The third way to view gold is to assume the classic gold standard will be revived. In that case there would be a huge shortage of gold at current prices. Depending on what kind of gold standard would be adapted (for example full or partial backing for checking and currencies), a great deal more gold would be required. Since the supply of physical gold is highly inelastic, the only way to increase the supply of gold in monetary terms would be to increase its price by several multiples of where it is today. Most serious gold bugs implicitly assume a gold standard restoration. They are anticipating a monetary cataclysm to force this change. I would answer, maybe someday but not yet.

But remember the classical gold standard’s intellectual basis was an economic model by David Hume (1711-1776) called the price-specie flow model. In this model, gold flowed from country to country bringing countries with trade surpluses and deficits into equilibrium. Countries with a trade surplus would experience an inflow of gold and an expansion of the money supply resulting in a higher price level and a reduction of the trade surplus. The reverse would happen with countries experiencing a trade deficit. Hume’s model had no specific role for central banks and indeed in his time most countries didn’t have a central bank. Later the model was amended to allow for central banks who were supposed to act in a counter cyclical manner, raising interest rates when a country was in trade deficit and lowering them in times of surplus.

The gold standard doesn’t work if central banks can create high powered money out of thin air in addition to holding gold. If central banks have this power and they can sterilize gold inflows and outflows the gold standard won’t equilibrate anything. Frankly, it seems unlikely central banks will give up this power to create high powered money. They will not give up their power over monetary policy to an anonymous metal. Nobody needs a phony gold standard and that’s what it would be if central banks still had money creation powers. Government demand management is considered a divinely appointed duty by modern economists, central bankers, politicians and indeed electorates. They are not going to let go of that in favor of a force, i.e. gold, that they cannot control.

So I have concluded buying gold in hopes of a restoration of a pure gold standard seems like a long shot. The gold standard would be wonderful but it’s not likely to happen. Unlike William Jennings Bryant’s recommendations quoted above, Ron Paul’s suggestions will never be enacted. The fatal attraction of populism makes it unlikely that democracies will ever allow a return to the classic gold standard. The gold standard would say “no” where elected politicians always say “yes”. I am torn between my fundamental view that the historically successful gold standard could be restored successfully vs. the unlikeliness that such an event would ever happen.

Keep in mind that David Hume’s price-specie flow model is not an investment scheme. It is an economic system with gold at the center. Hume wasn’t a gold bug in the sense the term is used today. He wasn’t urging his followers to go out and buy gold to get rich. The classical gold standard is not a get rich scheme. But restoration of this system will in theory bring about a major one time capital gain for gold holders. If the system is not restored, no capital gain.

Beware of Governments

The more gold goes up in price and the more people are seriously considering giving gold a renewed monetary role, the greater risk of confiscation and/or punitive tax treatment of gold by governments whose monetary monopoly is threatened. Never forget Franklin D Roosevelt’s 1933 Executive Order 6102. This forbade the hoarding of gold coin, gold bullion, and gold certificates within the continental United States, thus criminalizing monetary gold by any individual, partnership or corporation. Ironically Roosevelt made it illegal to own gold about the same time it was made legal to drink liquor. The majority of the country was more pleased by this latter action than displeased by the former.

Note the government of India – desperate for money any way it could get it — recently doubled the import duty on gold. After huge protest and a 21 day strike by jewelers, most of this tax increase was rolled back. OK the government of India is not exactly a model of good governance. But the message is clear. Gold can be an easy target for governments. One justification governments give when they institute measures to discourage their citizens from holding gold is that they want to redirect funds into “productive assets.” That’s what the Indian government said.

What could be more productive for citizens than an asset like gold, which provides a store of value for their own savings? Doesn’t that fill a consumer need as much as a computer or a bag of potato chips? Providing a store of value is something government-issued depreciating fiat money generally does poorly or not at all.

Source: The Dismal Optimist


Peter T Treadway, PhD
Historical Analytics LLC
305 761 4718
852 94091186
July 1, 2011

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