Is Gold a Good Investment During the Credit Crunch?

It could not have escaped your attention that the financial sector is undergoing a crisis of confidence just now as the sub-prime loan debacle continues to ripple out to what was once thought as impervious sectors of the banking world.

Having watched the spectacle of bank runs, bank failures (i.e. takeovers), a falling housing market, increased cost of credit, emergency Fed loans and banks trying to boost capital through rights issues, investors are naturally concerned that even their deposit accounts are under threat. Well so far I am not aware of any major loss of funds by depositors as the Federal Reserve steps in to stabilize the cash flow of vulnerable banks and guarantee the deposits of customers via the FDIC scheme.

That has not stopped gold being recommended as an alternative safe haven to cash as predictions are made that the total write-offs may yet exceed $1 trillion. So is gold a good investment during a credit crunch? How does the price of gold behave during a panic in the financial markets? Let us look at the historical data to come to some conclusions.

First of all, I want to look at the LIBOR rate. This important set of numbers tracks the rate of interest at which banks are prepared to lend to each other. Wikipedia puts it succinctly:

The London Interbank Offered Rate (or LIBOR) is a daily reference rate based on the interest rates at which banks offer to lend unsecured funds to other banks in the London wholesale money market (or interbank market).

The LIBOR consists of various currencies and loan durations to provide a data set that measures the confidence banks have with each other. During financially stable times this rate should not be far from the Federal Funds rate (the rate at which the Fed lends to banks) but in times such as now, the spread widens as banks place a higher premium on lending out money due to uncertainties over the credit worthiness of the bank receiving the loan. It is the spread for 3 month US Dollar rates from 1971 to 2008 that we plot below. To reduce volatility in the display, I have plotted it as a 30 day average to show the general trend in this measurement.

You will also see the daily price of gold superimposed in green on the chart to give an idea as to how the two may be correlated. Now note that a spread close to zero is ideally what one wants to see. However, there have been periods of wild swings where the spread has gone as high as 3% and dropped as low as 1% below the Fed rate. The price of gold meantime seems to have plotted a course which by and large is not highly correlated to the LIBOR spread.

Note in the early 1970s how the spread dropped but gold actually rose during the same time period and again when gold blew off to its record high in 1980, the spread was actually less than it had been a few years earlier. The conclusion is that gold was being more influenced by other factors (inflation and the real rate of interest I would suggest).

As we progress in the disinflationary period of the 1980s and 1990s we do tend to notice a degree of correlation between the LIBOR-FFR spread and the price of gold though it is not highly correlated. Moreover, the steep rise in gold in recent years despite the spread being no higher than anything in the prior twenty years leads one to conclude that confidence between banks is not a major factor driving the price of gold. In fact, if we zoom in on the LIBOR spread and the price of gold in this last tumultuous banking year, we get a clearer picture.

We can see here how the LIBOR spread bumped along happily at 0.10 before things exploded with the closure of Bear Stearns’ (BSC) sub-prime hedge funds in August 2007. The panic took off again in March when Stearns was taken over by JP Morgan (JPM). The spread reflects the headline stories but gold is not quite reacting in a sympathetic manner. When the spread took off in August, so did gold, but gold kept on going once the spread settled down to normal levels. Yet when the major news of the Bear Stearns bankruptcy broke (that’s what it was even if they did not file for it), gold headed south and has stayed south ever since despite the spread rising again to new highs for this crisis.

So the matter is at best inconclusive as regards gold and bank failures, but what can we learn from other periods of bank troubles? The two other periods were the Savings and Loans Crisis of the late 1980s and the bank runs of the 1930s. Considering the latter first, over 4,000 banks alone failed in 1933 with a combined loss of nearly $4 billion in the money of that time. That run on the banks led depositors to withdraw their money in gold coin.

However, it was not the case that people exchanged their money for gold because gold was money back then. A single $20 coin contained nearly one ounce of gold and it was perfectly legal to exchange paper dollars for gold dollars. During this period the price of gold did not budge a cent because the price was fixed at $20.67 per ounce by the US government. The price was finally raised to $33.11 an ounce in April 1933 but that was only after nearly all gold coin had been confiscated by the Roosevelt administration. As a footnote, the FDIC insurance company was set up after this to guarantee deposits of an insolvent bank and all our miserable depositors received 85% of their money back (albeit many months later).

A better picture is gained during the S&L crisis when the price of gold was left to float freely and not be set by government decree. The bankruptcy of hundreds of savings and loans companies between 1986 and 1995 threatened the savings of millions of depositors as shown in the table below. In total, $394 billion had to be rescued by the government’s FSLIC and RTC agencies (parallel institutions to the FDIC). In today’s money this amount would be roughly equivalent to an astounding $886 billion. In other words, the S&L crisis was of almost equal proportion to the current sub-prime debacle. How did gold react to this similar crisis?

The crisis reached its peak both in terms of dollars under threat and number of failed companies in 1989. A look at the long term chart above shows that gold in no way spiked during that period. In fact, gold was halfway through a decline starting from 1987 to 1993. One could argue there was a mini-spike in 1989 but it only constituted a rally within a larger downtrend. The graph below confirms this and plots the S&L insolvencies and asset losses against the average price of gold for each year. Notice how gold (yellow line) actually peaked a year before the height of the S&L panic; evidently people were not fleeing to gold during that troublesome period.

In fact, in theory gold should not be expected to track such events. The main reason is because bank failures are essentially deflationary events because money is destroyed. If the government steps in to guarantee deposits, it is essentially a zero sum game as far as inflation-deflation is concerned. Yes, I know some argue that gold goes up in a deflation but note that gold could not even stay up during the milder disinflation of the 1980s and 1990s.

No, there is only one main reason why people should hold gold and that is inflation. We have it and it is here to stay for a long time. That is why the price of gold is going up and I submit that this has a lot more to do with the price of gold than any number of bank worries we have seen.

Comments

[bluesmoke]

Good article. I own a lot of gold via stocks, etf's & mutual funds mostly as a defensive play against inflation. Since no country honors the "gold standard" there is no true yardstick to measure its value by. On the other hand, oil and commodities such as corn, etc, can be measured to a finer degree through supply and demand, as they are actually consumed.

[Jerlad]

Please see this excellent article from Hard Assets Investor:
seekingalpha.com/artic...
The chart "Correlation? What Correlation?" shows that oil and gold are 80% correlated. USO and GLD are currently my best holdings. So Roland Watson, "How Long Will Inflation Last?" should be your follow-up article. I wait for it with anticipation.

[steveballmer]

YES!

[fxtrader07]

inflation here to stay? hm. what about deflation caused by the massive deleveraging, imploding home prices and a virtual squeezing out of all non-oil items?

[Vlada Kynsky]

See great technical analysis video for gold price. www.ino.com/info/227/C...

[Hugh]

Gold is bedrock. Gold is something solid to stand on, like a big rock in a fast moving river. Regardless of inflation or deflation, war or civil unrest, gold is ultimately the favored store of value.

This is it boys. This is how Gold rolls. Read the above paragraph again and forget all of the charts.

[MoralHazards Amok]

Inflation! You hit the nail on the head.

Gold will continue to be a good investment as long as the central bank keeps inflating the M3 money supply at over 16%, making gold an attractive safe heaven from the Fed’s destruction of our fiat money supply. Inflating the money supply above that of GDP is the ONLY real cause of inflation, btw.

Ok, how long will this continue you may ask?

A long time. The central bank, which is made up of human beings acting in their own interests, will inflate the money supply (M3) as long as they can get away with it, probably for at least 2 or 3 more years. This inflation pushes the credit crunch and employment problems out to the next administration and also greatly benefits the shadow banking system, which was the real objective of inflation in the first place.

Two or Three years, are you kidding? But I thought that inflation was caused by unanchored expectations, and increasing wage demands, (you say)?

No, that’s what Uncle Ben and the old Keynesian and Phillip’s curve crowd wants you to believe but in fact those people were thoroughly discredited back in the 70s. Unfortunately, we have that same crowd running the money show now making the same terribly policy blunders today that were made in the mid-70s with the same results, and just like the 70s, inflation AND unemployment will continue and get much worse. Obama’s team also holds the same discredited loose money views, so don’t expect any changes there if he wins.

Wait just a second! Won’t demand destruction, deleveraging, and a sour economy put the breaks on inflation???

No. That’s what the old Keynesian Phillip’s curve crowd told us back in the 70s too, and look how that turned out. Back then unemployment was over 10%, the economy had negative growth, and yet still inflation was at double digits and spiraling ever higher. High unemployment and a tanking economy did NOTHING to stop inflation because in the real world inflation is nothing less than a reckless increase in the money supply.

The day gold is no longer a good investment is the day when the Fed gets serous about controlling the money supply and I don’t see that happening anytime in the foreseeable future, because Greenspan, Ben, and the rest of the Phillip’s curve crown is still is in charge. Stay long on gold till otherwise.

[mark mchugh]

Damn it! I was hoping for a one word article when I clicked on this link. Good comments, Moral Hazards Amok.

[yuman]

This article is half finished. It discredited two myths about gold prices: interest rate spread and bank failures with historical data. So we learned that there no correlation between gold that those factors.
But the article jumps to another myth without proof: "there is only one main reason why people should hold gold and that is inflation. "
Isn't it a simple data gathering and presentation to superimpose inflation data, CPI/PPI or M2 over gold prices?
Has anyone seen or constructed such a chart to establish the gold/inflation relationship? Without the data, we are running the risk of buying another myth.

[lep]

This is a good historical article, which unfortunately selects e.g. the LIBOR 30-day MA and then shows how gold correlates with it. Thus, the intent is similar to a research question such as: how does gold correlate with the 30-day MA for LIBOR? Well, it looks like it doesn't. Now, how about going back to the drawing board and getting moving averages for say 100 sector indices, and in fact, start lagging the data, and while you're at it use something other than visual correlation. In research, especially statistics, we don't write articles about things that don't correlate -- so find something that correlates with gold, and then come back. (besides, wouldn't your boss kick you out of his/her office for writing something like this?).

[phinsuntanning]

when the economy collapses, gold collapses, you cant eat gold,

[wearmanyhats]

Can't eat gold? Maybe literally. Inflation is an easy answer to why people should hold gold. But in truth, if the economy collapses, gold becomes essential. Anyone who knows anything about money will trade at least food for pure gold and silver. That's why you always hold at least some in your portfolio. Pure gold and silver was the only thing that bought any kind of food after WWII and in the South after and during parts of the Civil War. THAT'S why people must hold precious metals.

[Nazbuster]

There's another issue this time: a risk of the US$ collapsing. If the govt starts printing $ to "solve" our various crises, you can kiss the $ goodbye... and the COST of gold in US$ will skyrocket.


On Jul 15 05:09 AM phinsuntanni ng wrote:

> when the economy collapses, gold collapses, you cant eat gold,

[Richardinbellingham]

I'm the Resourceful Bear, and I say: "Interest rate inflation, producer price inflation, and consumer product price inflation is on the way and that is a gold thriller, and a stock and bond killer".