How Gold Investment Hurts The Economy And Becomes A Self-Fulfilling Prophecy

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Includes: GLD
by: Seth Walters

One of the most hyped investments out there is gold, with silver, platinum, and sometimes palladium coming in behind as distant cousins. To be quite honest, I much prefer investing in things that I have to go learn about a little bit and that every website on the Internet is not flashing ads at me telling me to buy. Perhaps I am naive, but it makes me feel a little more that I am not simply following the herd and buying into a massive bubble. In this article, I will make the argument that commodity fetishism, or the desire to possess physical commodities as an investment, harms the real economy and slows real economic growth. As such, responsible investors should avoid the practice (aside from the fact that the precious metals are all trading at giant bubble valuations). For convenience's sake, you will see me refer to precious metals in general as "The Shiny Bubble" throughout this article. This is because they are shiny, and because they are trading at enormous bubble valuations.

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source: indexmundi.com

What drove this chart way, way up? Was it strong earnings? Expectation of strong earnings? Hyperinflation? No. It was a change in sentiment, that created a rush of people eager to chase the momentum of The Shiny Bubble. Value, real value that creates progress and makes people's lives better - that sort of thing lasts. Sentiment can and will be gone with a breeze.

To begin with, I would like to consider the basic economic utility of any investment. Most investors think that the purpose of an investment is to make them money. But functioning human societies do not reward behavior that does not help that society. In general, laws are passed to prevent this kind of thing from happening. Well, how does investing help society? This is really pretty simple. When you invest in a company's stock, that is fundamentally a financing activity for that company. You get a stake in the company, and the company gets money to buy things. Buying bonds does much the same thing but with lower risk and lower reward for you. Now, in that very act of buying things ... whatever the company is buying (as long as someone made it in some way)... the company creates jobs. Because someone had to make the things the company is buying, and for someone to make the things to sell, that person had to be employed. Thus, purchasing an equity stake in a company - any company - inherently stimulates the economy. If you manage to purchase a stake of a good strong company that has good earnings and good management and grows, then your initial purchase has a large knock on effect that keeps stimulating the economy as it grows. This is one of the fundamental reasons why investment bankers are paid large salaries, because keeping the markets efficient is an economic good in and of itself, and that is what they are supposed to do.

But, what if instead of investing in stocks or bonds you purchase ounces of gold or another precious metal? What if you buy into The Shiny Bubble? I will argue that this has four counterproductive effects to the world economy, all of which are bad and some of which reinforce the reasons you bought the bubble in the first place.

1) The first effect of sinking investment capital into gold is that it is killed dead. It is no longer available to go about fulfilling the needs and wants of the human race. It sits there in a safe, shiny and frozen. Because this capital is not participating in the economy, the economy cannot grow as fast. It is wasted and stagnant. Thus, if enough people can be persuaded to sink their money into gold, and the real economy stagnates partly as a result of this, then the gold will start to look like a better and better investment. The more investors that buy into The Shiny Bubble, the smarter and smarter they look, and the more and more anemic the economy gets. How big is the world's gold bubble now? Around $9 trillion. That's a huge chunk of the world's assets, relatively speaking. If that was flowing into productive economic investment and into buying things, the economy would be far, far healthier. This is nearly 10% of the world's net assets, so we can imagine that putting all this money into the world economy would cause 10% world GDP growth. And with a kickstart like that, the world economy would likely be healthy for some time.

2) The second counterproductive effect of massive commodity investment is that artificial investor support of the gold price creates fundamental and very bad economic inefficiencies. For example, hundreds of billions of market cap in gold mining companies has been created. Newmont Mining (NYSE:NEM), Goldcorp (NYSE:GG), and Barrick Gold (NYSE:ABX) alone have more than $100 billion in market cap between them, and there are a lot of gold companies out there. In addition, billions of extra market cap has been created in companies that supply the mining industry. The problem is that all this money is not going towards anything useful. It is not going towards making anyone's life easier or better or more productive. It is ensuring that gold investors can have a tiny bit more shiny stuff in their safes to look at once in a while. And in the end, when the gold bubble collapses, as all bubbles must, this malinvestment will wreck whole industries. The gold mining industry will be devastated and struggle to survive. Many companies may go bankrupt, or at least see their stock prices plunge to tiny valuations and production go way down. Companies that supply the mining industry such as Caterpillar (NYSE:CAT) will reel from the double whammy of loss of demand from the gold mining companies and the sudden proliferation of a whole bunch of slightly used dozers on the market that other miners can now buy.

3) Everything that requires gold or other precious metals for its manufacture becomes more expensive because of the artificial and fetishist demand for it. This includes jewelry, consumer electronics, tooth fillings, catalytic converters, and a lot of other products. This adds up to consumers having to spend much more money to get a hold of these things, which lowers demand for them somewhat (hurting manufacturers), and prevents people from buying as much stuff in general, hurting both the economy and their standard of living. All so a few can hold the shiny bubble in their safes.

4) The final effect is that by having money frozen in the shiny bubble, precious metals investors cause deflation by lowering the velocity of money. This causes the government sector to pursue an inflationary policy of deficit spending and quantitative easing to fight the deflation. When the gold bubble collapses, the money now tied up in gold (at least, what investors manage to get out in time) will cause inflation even before the Fed tries to unwind its balance sheet. Ironically, the bigger the gold bubble gets, the bigger the eventual inflation it will cause, inflation that it was supposed to hedge against.

In summary, there are at least 4 very good reasons why investment in gold is a terrible behavior that hurts the real economy. The little economic activity that gold hoarding encourages is almost entirely malinvestment. The redeployment of money held in gold into the real economy could help cause a powerful economic recovery by reversing the 4 negative effects. The shiny bubble also creates short opportunities, notably in gold and silver. They say that the markets can remain irrational longer than you can remain solvent, and perhaps that is true. Even so, the Jan 2014 $150 puts against SPDR Gold Trust (GLD) look awfully cheap, at under $7. All bubbles represent malinvestment, and therefore hurt the economy, but as I have explained, precious metals investment hurts the economy even more than an equity bubble. All bubbles eventually pop as well. The $9 trillion gold bubble has created some impressive shorting opportunities, with the most direct effects being had in the metal and mining companies, and knock on effects being seen in mining suppliers. While no one can predict the market, with gold up about 6X and inflation only up about 1.33X since 2001, I believe that it is only a matter of time before this bubble comes crashing down, with all the attendant consequences, most of which will actually be very good for the economy.

Finally, there is a small element of a real bull case for gold, which should be mentioned in the interest of objectivity. The world's population has increased since 2001 by about 15%. However, the amount of gold in the world has also increased by about the same amount, from what I can tell. Despite this, as cultures such as India that very highly value gold jewelry continue to grow in wealth and population, their demand for gold should continue to grow. I don't believe this is nearly enough to explain the current gold price, but I will allow that gold may have a fair value of $500 or even $600 an ounce in 2012, factoring in inflation and some increased demand. And regardless of how bullish or bearish the case for gold is based on actual human use, I would argue that having $9 trillion dollars invested in these assets is still a terribly uneconomic activity.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. While I am not planning to initiate short positions in the next 72 hours, I am strongly contemplating taking a short position sometime in the next several months to a year.

Disclaimer: This article is for information purposes and your consideration only. If you choose to act on this investment thesis, it should only be after careful due diligence on your part. I believe that the arguments I have made are valid, and that gold and precious metals investment is not only a bubble, but actively destructive with respect to the real economy for the reasons I mentioned. If you have counterarguments or other points you would like to offer, I will welcome the discussion. With the advertising and passion and fear that floats around about gold, I am sure that this article will provoke some spirited discussion.