Gold's Not the Best Investment in Inflationary Times 33 comments
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Previously we talked about why it’s important to own “things” (i.e. commodities, stocks, homes) for the long run, especially since the government is willing to dramatically increase the supply of money (making existing money worth less, and assets worth more). Basically the government is potentially going to create a lot of inflation at some point down the line. So the question that is always asked is, if we are heading into an inflationary environment shouldn’t we buy gold?
There are two reasons people buy gold - as an investment or for jewellery (there is a small percentage used for industrial applications as well, but for our purposes let’s ignore that). I have to imagine that jewellery sales are declining, or at least gold jewellery sales, as silver is currently a more attractive option (it’s in style and 1/80th the price). So anyone investing in gold today is making a bet that either a) the economies of the world get materially better (and jewellery demand picks up as people start spending more on luxuries) or b) because there are inflation concerns (money will be worth less, therefore gold is worth more).
If you’re investing in gold because you think the economy will get better and jewellery demand will increase (even at gold’s current high price, relative to everything else) then, simply put, you’re crazy. If the economy recovers (and with it jewellery demand), and that is the bet you are willing to take, then there are thousands of better investments than gold.
Since I don’t really think anyone is that crazy, then the only rational reason people are investing in gold today is the safe haven trade. That is, gold is viewed as a safe haven against inflation. I’m going to lump the collapse of capitalism into “inflation”, meaning the extreme gold bugs who see the US dollar becoming effectively worthless (not worth less) and the world ending, are effectively making an inflation trade. An extreme one, but an inflation trade none the less. As an aside, why do gold bugs put US dollar price targets on gold? The ones that think the US dollar is going to collapse and gold will go to $5,000/oz are effectively saying that they would trade their gold for US dollars at some price. If the US dollar is worthless, it's worthless - why trade your gold for something that is worthless?
Ignoring the extreme case, the argument, going forward, is effectively that the Fed has created such an enormous supply of US dollars that when people get around to spending them the inflation will be massive. So if you want to protect against inflation you buy gold, since it is perceived to have significant value and that value relative to dollars will be more significant in the future. Of course that logic is somewhat circular.
Imagine we lived in Perfect and there were 1,000 citizens each with $1,000 dollars. The price of gold is $850/oz in Perfect and the price of a basket of other goods is $850 and their main index trades at 850. The government of Perfect decides that the citizens need more cash so they give everyone $1,000 more. In Perfect the price of gold would go up to $1,700/oz, the basket to $1,700, and the index to 1,700. You can still only change 1 ounce of gold for 1 basket of goods or 1 unit of the index. You are only better off having purchased gold as an investment if your alternative was only to leave it in cash. That is, if you are faced with the choice of money in the bank or investing in gold, then the choice is clear in an inflationary environment… invest in gold. In Perfect the price of gold would increase at the rate of inflation.
The last year, however, has taught us that we do not live in Perfect. We live in Far From Perfect, the land where perception is reality. The perception, as it relates to gold, is that we are entering an inflationary period that is going to send the price of gold skyrocketing. So the price of gold has held in relatively well (compared to any other ‘asset’ class) and that is the current reality. The true reality is that inflation CANNOT exist without increased economic activity. That is, you can increase the money supply all you want, but if people don’t spend it then there won’t be inflation. Inflation occurs when people get into bidding wars for goods and services. If we have increased economic activity then, as I said before, there are thousands of better investments than gold.
I’m not saying gold won’t increase in price in 2009. I’m just saying everything else will probably increase more.
From the team at Magna Partners, we wish you a happy, healthy, and prosperous New Year!
Stock position: None.
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This article has 33 comments:
However: The author says you have to have a pickup in economic activity to have inflation because if an expanded money supply doesn't circulate, then there is no inflation.
But, let us say you grow the money supply by 50% and it DOES circulate. However, the money is now only worth 1/1.5 =0.67 times as much.
So even if all the new money circulates, economic activity remains FLAT in terms of dollars adjusted for monetary inflation.
So does that not imply that you can indeed have inflation WITHOUT an increase in economic activity?
It would be interesting to see whether there is a flaw in this logic. If anyone can see one please speak up.
If economic activity does indeed need to increase in parallel with monetary growth for price inflation to occur, then oil should be a darn good investment.
Nevertheless, I still have considerable $ in gold stocks. One thing about it, small gold exploration and development companies are dirt cheap right now and I would expect they will go up 5% for every 1% that gold goes up. So even if gold bullion is a laggard compared to other hard assets as the author predicts, I believe my stocks should do well.
A couple suggestions for anyone interested: Eastmain Resources, Metanor Resources, and Sabina Silver.
Words, even prettily structured ones, without the discipline of analysis are .... rhetoric.
oh yeah? what was the real growth in Yugoslavia, Argentina or Russia during their hyperinflationary bouts?
What is being discussed above is velocity of money. Once borrowing begins again in ernest, then velocity picks up, which I belive, is how you get price inflation (as opposed to pure monetary inflation).
If what you are saying is true, then you would be saying that Post-War Germany had to have had "increased economic activity" for their inflation to become so rampant that a loaf of bread cost a wheelbarrow full of paper money. The same is true for the US both during and after the Revolution.
Neither of which is what I would consider calling "increased economic activity."
So tell me, why what the hell was with those recessions in the 70s while we had "runaway inflation"?
Not true. Suppose all economic activity in Far From Perfect collapses except for base necessities: Food, water, shelter, etc.
If an the money supply is inflated bidding wars could break out for some items due to differing personal 'requirements' for any one necessity. Since nothing is more important to a person than the necessities, prices on these items would rise dramatically unless there is a glut of everything 'needed'.
Economic activity may collapse, yet prices increase with lower volume of exchanging going on.
Another possibility is that the trust of the general public in the value of the money may be destroyed once they figure out that it is being created with reckless abandon (think Zimbabwe). In this scenario, people will pay outrageously high prices simply to get rid of the money and own a tangible asset (ANY tangible asset) because they know that tomorrow that asset will be worth something, but they aren't sure the money will be.
Workers in Weimar Germany were paid twice daily and then rushed to buy anything just to get rid of the depreciating money. They knew you could always trade silverware, nails, or candlesticks for something, but they couldn't be sure the money they got paid would buy anything tomorrow.
On a side note, your Perfect world does have one flaw. If it were truly "Perfect" there wouldn't be any need for a government nor for the government's money. People would trade for a commodity based money like gold, as people have done for thousands of years.
Paper money comes and goes, as history shows again and again, but gold endures.
Not to mention the hoarding of Gold by China, Russia, and the GCC right now. the world is ready to give up on Fiat..Gold will reach it's fair value as a monetary metal and inflation will send it higher.
Don't let the Dollar rally Fool you..the world is ready for monetary change.
Buy Gold and Silver unless of course you want to leave your capital open to Fed Assasination. In a Country where the failures are givien money to survive and the survivors are taxed to failure...I'll hang on to my Metal.
Why gold? Gold does not rust or corrode and lasts millenium.
I am not a gold bug, it's just human nature that set gold up as a reservoir for wealth. When the system normalizes, gold will go back down. So you sell gold and buy stocks at th gold top/stock bottom. Just another trade.
also, there is no argument for the third rationale for purchasing Gold: 3) as a refuge in a bad economy sans inflation. Gold held its value in 08 WITHOUT inflation and WITH hedge fund selling and WITH a resurgent Dollar. Pretty durable.
I'm not a Gold Bull, and I'm not calling a de-coupling of Gold from Inflation, but it seems that an argument for Gold as a refuge WITH or WITHOUT inflation can be made.
Inflation can definitely exist in the absence of increased economic activity. Ancient Romans discovered this during their empire's decline. Successive Emperors debased their coinage while Roman society degraded to lower standards of material well-being. We may learn the same lesson.
it is the very definition of weath.
one day all currecnies will be measured in grams per $ (or euro, etc).
and the measuring stick will be gold $5 or $5k per ounce.
gold $5000 /oz in 2012-2014 or so.
On Jan 06 04:52 PM bcgator wrote:
> Do you realize the hit your credibility takes when you can't even
> spell the word "jewelry" correctly? It's not spelled "jewellery".
> Just another sad example of why our collective education system ranks
> somewhere between that of Jamaica and Equitorrial Guinnea.
On Jan 06 04:52 PM bcgator wrote:
> Do you realize the hit your credibility takes when you can't even
> spell the word "jewelry" correctly? It's not spelled "jewellery".
> Just another sad example of why our collective education system ranks
> somewhere between that of Jamaica and Equitorrial Guinnea.
seekingalpha.com/artic...
If you believe that the government has understated inflation for years, then the performance of gold vs. inflation is even worse than the article shows.
The price of gold doesn't represent current inflation. It represents inflationary expectations at the time - that is, what people expect inflation to be in 2-3 years, not what it actually is today. When people expect high inflation in the future, regardless of current inflation, the logical thing to do is buy gold. When inflationary expectations are 2-3%, as they were during most of the 80's and 90's, gold reverts back to its jewelry and industrial value - around $300/oz. Any premium above that amount roughly represents the expectation of future inflation.
For gold to go up in the future, people's expectations of what inflation will be in 2-3 years will have to be higher in the future than they are today and by buying gold, you are speculating on that increase. At, say, $850, I estimate that there is a $550 premium on top of gold's jewelry value that reflects expectations of future inflation. Your buy or sell decision should be based on whether you think the expectation is too low or high. But how do we translate gold's price into an inflationary expectation in percentage terms?
Historically, gold has approached $1,000/oz when inflationary expectations approached 10% and fell to $250-300 when inflationary expectations fell to 2.5-3%. Thus we can create a very rough model where gold's price = inflation expectation percentage * 100. Based on this model, gold markets are predicting about 8.5% inflation in 2011-2012. $850 = x * 100.
However, for gold's price to be higher in 2011-2012, the expectation at that time for inflation in the 2014-2015 timeframe will have to be higher than 8.5%. If the fed constrains money supply and raises interest rates to double digit levels like they did in the early 80's, expectations for future inflation could easily fall to 3% again, even during a time of 8.5% actual inflation.
In such a scenario, gold could hit $300 again. On the other hand, if foreign lenders fled US debt, the government rant the presses to finance itself, and 50% hyperinflation expectations resulted, gold could hit $5,000.
I can't advocate a specific scenario - too speculative for me - but hopefully this evidence-based model helps explain the gold market and improve whatever decision you make.
Raise rates and we default, keep rates low and we'll have masssive Inflation in the future.
That is my thinking exactly.
We can not raise rates to Volcker's 20% levels to prevent inflation without risking default........
so we must get mass inflation.
The adjusted monetary base has doubled in the last few months. That is the money measurement that correlates best with inflation. Please remember that there is a 6-12 month lag between changes in the AMB or other money supply measurements and price increases. Inflation by DEFINITION is an increase in the money supply. Price inflation lags that money supply increase.
I do not see the alternative unless the Fed requires banks to increase their reserve holdings to higher than their current levels, which is possible but it would then throttle lending and business activity.
Alternatively, the Fed could issue Federal Bills, Notes and Bonds as suggested in a trial balloon recently. This would allow the Federal Reserve to pay high interest rates, soak up excess dollars, and compete with the Treasury's Bills, Notes and Bonds. This would be OK because the Fed would buy the government debt at low interest rates (keeping US government interest payments low) but the Fed would pay everyone else high rates. This would be blatantly inflationary long term but if they took advantage of the lag time it might work short term.
In any case, buy some gold. You are going to need it. This is NOT going to end well with a $50 trillion world GDP and $1.3 quadrillion worth of world debt obligations. The popping bubble is going to be a might loud. We ain't heard anything yet!
While I understand the approach and reasoning behind your approach, I would have to say that basing your model on two measured points (1979 and now) might yield a model that was somewhat less than robust given that the monetary base has made a step increase of nearly 50% in the past few months.
I imagine if you looked at the price of gold in $Zimbabwe prior to Mugabe's massive print and spend efforts you could construct a similar model that would never, ever predict that the price of an ounce of gold in $Zimbabwe would have a dozen or more zeros to the left of the decimal point. Yet it does now.
Thus far, the one thing that is retarding any surge of inflation due to the increased monetary base is that 90% of that growth is in bank reserves, which the banks aren't lending yet, but which everyone is begging them to start lending in order to promote economic recovery.
If and when they DO start lending (fractional reserve multiples of) those extra reserves into circulation, then your model will likely be of little value.
As much as I hate to say it, this time it's different. Very much different. Current circumstances aren't anything like past circumstances in regards to the monetary system.
The assumptions underlying your model do not hold very well in today's environment, and where they are still holding, there are great forces ready to be released which will overwhelm them.
STAGdeFLATION!!
I guess this is because M2 and M3 are collapsing.
Question:
So what happens when these measures of money supply are going down AND M1 and the adjusted monetary base (ABM) are going up?
Answer:
Interesting times.
Way too interesting for me.
So I will buy some more gold until the "experts" sort this out.
Or better yet the market does.
On Jan 06 04:52 PM bcgator wrote:
> Do you realize the hit your credibility takes when you can't even
> spell the word "jewelry" correctly? It's not spelled "jewellery".
> Just another sad example of why our collective education system ranks
> somewhere between that of Jamaica and Equitorrial Guinnea.
Smartypants, I was going to point out the same thing you did about Weimar Germany. Hyperinflation occurred in large part because workers stopped working (to protest the invasion by France and Belgium into Germany's biggest industrial region) but the German government paid workers anyway. Money supply grew but was chasing after fewer goods and services.
The value of a nation's currency depends on the amount of currency relative to the economic output of that nation. Yes, velocity matters too.
So what is happening in the US now? Let's see. There is rapidly growing unemployment --> less economic output, just like Weimar. On the money supply side, we have record low interest rates and money printed to bailout financial institutions and automakers.
But money needs to be in the hands of the general populace to have the velocity to produce inflation? States will be given massive bailouts from the federal government and these will all be contingent upon extending unemployment benefits (extending the duration and extending benefits to out-of-work part-time workers).
To me, this all spells inflation. I acknowledge that the money supply may be shrinking overall due to deleveraging and velocity may be in decline due to increased saving. But the key is that economic output is declining even more rapidly so, relative to economic output, the money supply is actually growing.
On Jan 06 04:52 PM bcgator wrote:
> Just another sad example of why our collective education system ranks
> somewhere between that of Jamaica and Equitorrial Guinnea.
Hey Genius:
In Jamaica we spell it "equatorial" not Equitorrial.
On Jan 06 04:52 PM bcgator wrote:
> Do you realize the hit your credibility takes when you can't even
> spell the word "jewelry" correctly? It's not spelled "jewellery".
> Just another sad example of why our collective education system ranks
> somewhere between that of Jamaica and Equitorrial Guinnea.