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Oh, to be a Goldbug

|Includes: FirstFed Financial Corp. (FED), GOLD

   As gold has increased in price over the last few years it has become more mainstream than at any time in recent memory.  All the attention has led to questions like: "what is driving gold's price increases", "is gold in a bubble" as well as the most important "will (can) it continue to increase".  In this note I will attempt to elaborate on the reasons for the move as well as shed some light on where gold is going.  I should note that this analysis is based (as much as I am able) on the "Austrian" framework so for background information I'll point you in that direction.

   At its core the fundamental reason for the run-up is a change in the valuation method for gold.  Since the close of the gold exchange window gold has been valued according to its Subjective Use Value (SUV).  This value is based on its ability to function as an ingredient in further stages production, dentistry, etc.  It was - like all other inputs - a derived demand based on the value imputed from the satisfaction its final consumption good imparted.  This is the exact same valuation method by which coal, iron, and wood receive their prices.

   The recent rise in gold is not even close to being explained by an increase in the value of its final consumption good.  The only reasonable explanation is that an additional layer of value has been added - that of Subjective Exchange Value.  This has caused gold to receive a premium based on its ability to be exchanged for any other good in the economy.  Essentially it has begun the process of transitioning to money.  The addition of SEV means that in the value scale of any individual, when compared to the satisfaction resulting from any combination of goods, gold now occupies a rank befitting its ability to be exchanged in the future.

   This process is far from complete though - proven easily by the fact that we are still talking about the price of gold in terms of Dollars.  The endgame will be when we start talking about the Dollar as a piece of colored paper worth .0024oz or a car being worth 11oz (amazing how small that seems).  It has not yet reached that critical mass of people necessary for it to really obtain an SEV.  So we have to ask:  What will it take to convert the medium of exchange from Dollars to gold?

  The acceptance of gold as a medium of exchange is more a matter of the Dollar's loss of value and ability to serve as money than any inherent increase in gold.  This happens when the general public perceives - via a continuing declining trend in the regression of the Objective Exchange Value - that the value of the monetary unit will continue to fall due to a deliberate policy and that prices of goods in terms of the Dollar will continue to rise.  When this occurs the public is unable to economically calculate through time and as such; the monetary unit is sold for any good thought to serve the exchange function better.  After this happens there is no hope for the monetary system as given and a re-set following the lines of Menger's Regression Theorem will occur, resulting in the establishment of a new medium of exchange.

  Since the Federal Reserve controls the issuance of new money, and given that a general rise in prices can only occur through an increase in the money supply, it follows that the Fed is directly responsible for controlling the trend in OEV for the USD.  Currently the money supply has already been increased to the tune of some ~$2 trillion.  The issue becomes when and where will the price increases of goods and services show up and will it be enough to cause the "man on the street" to consider the increases a deliberate action.  In the absence of further easing and direct money printing I say no, as the price increases will come and will work their way through the economy but will then stop.  As I have stated before I do not believe the Fed has the ability or desire to institute more easing and the recent inflation numbers will not allow them to.
  So the case for gold is a definite negative in terms of price measured in dollars.  As it loses its SEV and returns to valuation on SUV there should be a relatively large decline in price.  however, as governments have never truly been able to constrain their spending and avoid the temptation to inflate away the debts incurred, I believe a position in physical gold is a good hedge against political whims.

  On the whole, the best way to implement this trade will be a long physical position and a short gold price position.  As gold declines additions to your physical stock will come at increasingly lower Dollar prices.  This allows more physical accumulation while the short paper position help to offset losses on the physical piece and potentially enabling additional accumulation.  Viewed in another light this is basically a play on an increasing premium for physical over paper.