Part One: A New Phase to the Gold Market
Gold began a secular rally at the beginning of this century coincident with the primary top in the financial markets driven by the mania of internet stock investing. That mania attracted capital from around the globe into the United States, setting the dollar’s value at a high that is unlikely to be seen again for some time, if ever. Consequently, the financial media has mostly attributed the overall rally in the yellow metal and its daily ups and downs to dollar weakness vis-à-vis other developed nation currencies. Traders have followed suit, betting on this correlation.
But at the start of 2010 the dollar looks oversold. Technical trading indicators, exchange rate parity, and a building crisis within the eurozone have coalesced to cause participants in the gold market to pause, fearful of having the dollar move against them. The large mass of money supposedly protected by risk modeling and ever mindful of correlations has also begun to unwind its bets and even consider going in the opposite direction.
The Contrafactual Case
From the peak of the internet bubble in 2000 to the advent of the financial meltdown in 2008, the broad money supply (M3) roughly doubled, from $7 trillion to $14 trillion. The odd thing about the doubling of the broad money supply in the seven years leading up to the crisis is that it caused inflation of less than three percent annually.
Some assert cleverly that the consumer price index (NYSEARCA:CPI) understates inflation by several percentage points at least. But a close look at the methodology suggests that simply applying a delta between actual and reported inflation measurable many years ago to today’s statistic may not be valid. Synthetically imputed homeownership costs may have been repressed when the market was booming and extrapolated rental cost was linearly extrapolated. But with real estate markets teetering on a collapse, anyone could find a cheaper place to live or do business if they could get out of their mortgage or lease. When bureaucrats trend line these expenses for today’s CPI, they might even overstate inflation.
Moreover, no one can really know what the inflation rate actually is for you or for me. For WalMart shoppers, the purchasing power of the dollar increased. For buyers of new homes, it collapsed until about 2007. For those who dine at McDonalds, prices remained under control. Now there is a $1 value meal – mimicking the deals available decades ago when fast food was a category killer.
One has to wonder about the contrafactual case. What would have happened if the Fed had held broad money growth to the low single digits? Consumer prices would have fallen considerably, maybe by as much as five percent annually. Why? Because the six billion of the world’s population who live meagerly desire to exchange their labor for maybe $2 per hour, and they dwarf the roughly 700 million who earn a median income in the mid-five figures in Europe and North America by a factor of nine-to-one.
Inopia Nommorun or Nommorun Caritas?
As explained in my recent book, Endless Money (John Wiley & Sons, 2010) in U.S. history there is a pattern of long waves where demand for money balances – or in the opposite, credit – rise and then fall. It is likely we have begun a stage when we prefer accumulating money over credit, but it is being forestalled by big government spending and borrowing. The pattern of the Fed injecting money into the banking industry’s reserve base getting consumed by the money multiplier working in reverse will continue, where heavily leveraged asset holders hit propped up bids and use the proceeds to reduce debt. Actually, the phenomenon is common to empires whose treasury or central bank manufactured new money abundantly. The Romans, with their prolific silver mines and conquests, had phrases for each: Inopia nommorum described times when credit expansion pushed up the value of assets relative to coins; nommorun caritas was when those holding money could buy cheaply.
No one can be completely sure, and that is what makes markets so fascinating. Respondents to the inflation-deflation poll running on the ConservativeEconomist.com show 55% think more inflation is in store, but 35% believe deflation will surface by year-end. Never in the memory of current participants has the investment community entertained such sharply divergent macroeconomic opinions.
The prediction of hyperinflation runs counter to observations of past panics described in Endless Money and in my articles published on www.ConservativeEconomist.com and on the www.mises.org web sites. After an up-cycle of using credit to chase asset prices, which can last for a generation or two, heavy indebtedness eventually overwhelms deliberate attempts by policymakers to maintain high prices achieved through debt fueled speculation. Only preposterous money production (such as in eighteenth century France or the Weimar Republic) could counteract this tendency.
But while that scenario is possible, it rests on the flimsy assumption that stimulus beneficiaries would behave differently than players enjoying the Fed’s monetary injections in the capital markets today. In 2009 the pet banks of the Fed used freshly minted reserve notes to arbitrage what was once a yawning gap between a risk-free rate applied to the cost of funds and yields provided in credit securities, or to earn the “carry trade” available between that same nearly free cost of funds and long-term or foreign securities of comparatively higher yield.
However, when the party switched into high gear on Wall Street, Main Street sobered up and drove home early, repaying debt with asset sales attested to by the excess of $1 trillion of broad money supply destruction that has occurred since the crisis began – this being the difference between a $1.3 trillion expansion in the Fed’s balance sheet and broad money growth of only about $300 billion. Moreover, the prodigious production of GAAP liabilities is not cash flow. Rather, these are promises to remit money at a later date, which does not require refunding.
Of course, not everyone in America participated in amassing the $40 trillion of private debt mostly produced in recent times. Some had foresight, and others had windfalls from careers on Wall Street. These wise souls were mostly seniors who saved for their golden years, often having hit the bid on their homes and having moved into a small retirement space requiring less effort to maintain.
The great classical economist, David Ricardo, observed that if holders of money felt that a substantial quantity of assets was held in weak hands, they would anticipate lower prices and be inclined to stockpile money rather than expend it on assets or consumption. They might also hoard if they were uncertain about their job or prospects for insolvency.
Banks recycled deposits into real estate investments. Therefore, the deposits of electronic Federal Reserve notes in banks have a value that is ultimately linked to this collateral, especially since actual money is not at these banks – only a promise to remit it once mortgages are repaid. Because income governs the ability to honor promises made, so too would taxes be difficult to collect to subsidize the banking system. Thus, in an unraveling of a credit bubble, gold would be vastly preferred over electronic deposits. Does the hoarder care if there is no inflation? If the money isn’t physically there in the bank, then it’s simply academic whether its purchasing power could be inflated away, or if its value disappeared because it was already gone to begin with.
Once the global nature of the currency problem becomes evident, the age-old use for gold could become apparent. It has utility for steering clear of a meltdown in the value of deposits backed by real estate lending, especially if taxation might not be adequate to repay public debt or prop up banks. When one side of the scale is light with “just” $1 trillion or so of quantitative easing and the other is heavy with $50 trillion of private and public debt and another $50 to $100 trillion of entitlement promises, a massive air-drop of paper might be called forth that could be inflationary. But not long ago a $1 trillion intervention was thought to be shocking, and our sensibilities tell us adding another $1 trillion might be doubly so.
The Next Phase: A Surprise?
If indeed markets are beginning to fixate on a new set of underlying drivers, gold may still show strength. But the story would need to morph completely and enter a third phase, one which is not dollar-centric and recognizes the failings of all centrally administered currencies, a profane thought that is unmentionable inside the four walls of any institution deemed too big to fail. At the start of 2010, most financial market actors who have sold gold fear a dollar rally, or they are not buying because inflation is weak. That gold would be a refuge when leverage unwinds would surprise the public and most financial market participants, because it is an abstraction and a long shot presently. Or they simply don’t think leverage will unwind, because markets are healing. Trained to think in terms of permanent Fed-stimulated monetary expansion, a world wherein demand for money rises and desire for investments and speculations falls is absurd. Thus, a surprise is possible, even though the arrival of such a condition was telegraphed in 2008.
In Part II of “For Whom the Gold Bell Tolls,” William Baker writes of the history of monetary and fiscal interventions, the global nature of currency depreciation, and how gold’s unique attributes may prove alluring in that context.
An unabridged version of the entire essay is available on the Conservative Economist web site.
Disclosures: Long and short equities. Long gold, gold derivatives, and gold equities.
Disclosure: Long and short equities. Long gold, gold derivatives, and gold equities.