Gold has attracted some attention recently as it pushes into record territory. Many don't know what to make of it. Some say it's in a bubble phase, some say it's just getting started. Here's an attempt at articulating the various viewpoints on this decidedly difficult valuation dilemma.
1) The Gold-bug adherent
SA has its legion of gold-bugs, many of whom have ideas that resemble Revelations in the Bible. The line of thinking essentially boils down to something beyond a government default on fiat, ending up with the break-down of civilization as we know it. Bunkers in hard-to-reach places are the perennial favorite of this kind of citizen, of course along with your glittering stash of gold.
While I am bullish on gold, I find this scenario hard to swallow, and believe it ultimately represents a set of circumstances unnecessary for gold to reach new heights in the future. Personally, I would think that guns, food, and potable water would be in much higher demand than gold in the gold bug’s wet-dream scenario, along with possibly a hand-cranked radio and the like. What is interesting about these alternatives to gold during Armageddon is that I believe one can extrapolate these alternatives onto the global political realm and get some realistic scenarios worth planning for. More on this later.
2) The Gold-is-worthless subscriber
SA also has its share of people in the opposite camp - those that believe that the use of gold for non-industrial/consumer purposes has no place in modern society. I used to subscribe to this camp as well, and would refer to Buffett as my justification (from Wikipedia):
"It gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. "
"Stocks are probably still the best of all the poor alternatives in an era of inflation — at least they are if you buy in at appropriate prices"
I used to subscribe to this line of thinking, not really caring much about what would happen if the dollar lost integrity. It's a seductive point; place faith in business, let your money - gold or otherwise - work for you, succeed in your endeavors, reap the rewards. It’s all about hard work, and perhaps ironically, this is precisely what China is doing with its capital. It's one half of the picture, and I do believe it stands on solid ground in any era.
However, there is another half, along with a question that remains unanswered. What is the utility of gold? It obviously has little to no use in business or industry. But, still, for some strange reason, central banks in the developed world own more than 20% of all of the gold ever mined. Why? What utility is there in doing so?
3) The Gold-is-money scenario
Before we answer that question, some background:
In the not-too-distant past, China utilized 20% of its enormous surplus to stimulate its economy. It worked - it's widely recognized as the economy that will lead the world out of recession, having done so first. What about us? Haven't we also initiated some sort of stimulus?
Yes and no...what we've done is to dig a deeper hole in the hopes that in the future, we'll be able to easily climb out of it. It's akin to someone recently unemployed taking a large cash advance out on their credit card, or perhaps making a large withdrawal out of retirement funds, in the hopes of finding employment in the future when the economy looks brighter. While this may work on an individual level, this type of logic suffers from a fallacy of composition - the very reason why our economy is in a funk is precisely because we as a nation are approaching dangerous levels of debt - we've collectively taken on larger and larger amounts of debt in the hopes that the future will be brighter, without really considering whether short term 'shocks' may unravel our collective balance sheet. We've collectively overestimated the extent to which we can borrow (thanks to the rating agencies), and this by itself may prove to be more dangerous than all other factors combined to our future well-being.
Yet...the question remains...what about OUR reserves? Do we have a surplus? Someone looking at the federal budget and debt would laugh at such a question - of course we don't have a surplus. But is that the right answer? Enter gold.
Despite our own stimulus, we haven't done anything like what China did. China dipped into its reserves, which were easily quantifiable in dollars and euros, and picked its economy up from the doldrums of recession. It spent money it had on a project they deemed would be a good investment.
Our reserves are valued in gold - more importantly, gold that does not trade in the 'free market'. This gold is equivalent to the trillions China holds as its currency reserves. This gold is money – this is the utility of gold. When WE run into problems, we will NOT be spending dollars we don't have, euros or RMB or yen to dig ourselves out - we will be using gold. Why? How? To answer these questions, we will have to see how gold operates in the grander scheme of things.
The Razor's Edge
Let's return to the gold-bug adherent. Anarchy and terror reign; no one is certain of anything. The next meal is always on your mind, and no one knows whether or not your next day may be your last if someone were to raid your abode, armed to the teeth. You better hope you have plenty of ammo, and plenty of protection for your stores of food.
I read a book by renowned political scientist John Mearsheimer a while back - 'The Tragedy of Great Power Politics', and found the unconventional viewpoint to be quite an eye-opener. Recently, I added two and two together, and realized that Mearsheimer's view of international politics is exactly the same as the gold-bug's view of armageddon - anarchy reigns, no one is certain of anything, a surprise attack may occur at any moment due to imperfect information from 'that other guy' (in this case, 'that other country'). Mearsheimer proceeds to add up all able-bodied men in scenario after scenario over the past 200-300 years to come to the conclusion that the only way a government can adequately secure its borders is by eliminating all of 'them' and establishing hegemony. Paranoid yes, but his research was substantive. I’m not doing it justice by condensing his work into 100 words or less.
What this means in today's world is that politics trumps economics - a couple days of warfare can destroy decades of development. We now have a threat to our world-wide hegemony in China, one that is quite different from Russia. We are sabre-rattling again, not quite in the same fashion as in the Cold War, but the intent is quite similar - we will not tolerate a challenge to our power. One can assume that China will reciprocate this stance, much like how Russia did during the Cold War. We will use whatever measures deemed appropriate to regain our advantage, as will they.
What advantage have we lost? An economic advantage, mainly due to what is perceived as a mis-pricing of the Chinese economy (who are we to say what the price of the Chinese economy should be, but I digress). They're stealing jobs and building wealth, wealth that should belong to us. Eventually, their robust economy may translate into a military threat - this must stop. Enter gold.
Our reserves are not market-priced – they are government assets and are subject to government edict. IMHO we can set the price of this gold to whatever price we feel we can enforce. This price can be anything due to our military dominance – also consider that all of Europe and their militaries will be our enthusiastic partners in this gold revaluation - but what should the price be? An extreme (but logically sound) viewpoint would price our gold reserves to such an extent as to have our reserves equal the same percentage of GDP as China's current reserves are as a percentage of their GDP – this would undo the effects (but not the cause!) of all of that vile currency manipulation we so love to accuse the Chinese of doing. Their reserves are at 50% of GDP, meaning that our 8000 tons of gold will attain a value, net our debt, of 50% of our GDP, i.e. around $7tn. Given that our debt is $8-13tn, this would value 8000 tons of gold (around 257,200,000 ounces) at anywhere from $15-20trn, or around $58,000-$78,000 an ounce. Just to have our gold reserves wipe our debt slate clean would price it at half this amount, for about a 2000% rise from current prices.
Clearly the chances of this happening are miniscule - it would run counter to everything we believe to have the government dictate prices to this kind of extent. But, it can happen if we are desperate enough, and more importantly, if the Chinese do not plan for such, it just might happen. Case in point - what are the consequences of such a pronounced revaluation of the dollar? The Chinese will probably respond in kind and devalue their currency, along with every other economy in the world. This would essentially wipe out the potency of their surplus, and the precariousness of our debt. It would affect commodity prices to a huge extent, which is fine by us because we own most of the world's commodities, either through outright ownership or 'partnerships' like the Sauds. It would NOT affect current inflows and outflows, as China is making their wealth the old-fashioned way - hard work. This will have serious consequences since, ceteris paribus, we will then be paying the Chinese in gold for our excess consumption, and at the $80,000 per ounce scenario, we’d be paying them a little bit more than 1% of our total gold supply per annum – about $250bn. It would be closer to 15% per annum if gold was at $5,000 per ounce – totally unsustainable. At today’s prices, our gold reserves would barely last us one year. Still, the shock of the revaluation would favor us considerably, regardless of whether or not we actually engineer a longer term ‘flow’ fix.
How would China defend against such a scenario? It will accumulate as much gold as it can possibly get away with without triggering a bubble. By doing so, it limits the damage to its surplus that would happen in the case that both Europe and America debase precipitously. That seems to be exactly what is happening currently. China is now the world’s largest producer of gold even though their reserves are insignificant. It is not exporting any of it.
What about other commodities? Gold is unique in that it has little industrial usage, and considering central bank holdings, supply and demand would generally be much more attuned to geopolitical considerations rather than industrial usage – this is what pundits are referring to when they use the placid term ‘safe haven’. We have every reason to price the commodities China needs and we own as expensive as possible for the Chinese – this is the definition of good business and sound economics. So, the upward trend in commodity prices that we’ve seen over the past 10 years will probably continue, but they will probably not precisely mirror gold – this applies to industrial commodities like silver and platinum as well.
1) We live, and have always lived, in a world of uncertainty.
2) Our reserves – our economic lifeline in an uncertain world - are ‘price-less’ – there is currently no reliable mechanism available to value our reserves.
3) We have yet to dip into our reserves – if we do, we have every reason to value them as high as possible. Our military dominance will assure that the price will be high indeed.
4) Our reserves alone will solve nothing long term – they will merely provide the ultimate ‘quick fix’ to our current economic troubles by erasing both our debt and the surplus of our prime competitor, China.
5) China currently has no adequate defense against this. The mere act of them mounting a defense will be extremely bullish for gold.
Some additional questions:
Why would we need to revalue the dollar? Can’t we just let the economy hum along once it recovers so that we naturally pay off the debt?
Given the size of our debt, and the fact that our deficit all but guarantees that 5-10 years from now it will be substantially larger, we will have to plan significant outlays simply for interest payments – outlays that may begin to dwarf our military spending, for one. This will occur when rates are only at 4-5%, to say nothing about remedies for potential double-digit inflation, which may cripple our economy just because of interest payments. The size of our debt, along with what may one day be much higher interest rates, all but guarantee that the dollar will be debased.
Why gold? Why not oil?
Gold is a ‘pure play’ on this debt/surplus scenario with China. Oil may end up being more significant to global trading patterns, and would possibly affect ‘flow’. You have to remember that China is essentially the world’s manufacturing center due to cheap labor and efficient infrastructure. The cost advantages gained from manufacturing in China would be negated if oil prices, and hence the cost of transportation, begin to eclipse the cost savings from cheap labor. So gold and oil would solve different aspects of this imbalance of trade. High oil prices would be much more crippling to the global economy than either a gold revaluation or a trade war, IMHO. I haven’t thought about how high oil prices will have to be in order to cause such a scenario to occur.
The main strike against oil involves its industrial usage – as important as it may be in the global economy, it is not immune to demand shocks, such as a prolonged economic malaise.
Why do you think the US has a world-wide hegemony? We share the world with various powers, and their economies in aggregate are much larger than our own.
This line of thinking refers back to Mearsheimer’s work. On the surface, our borders are the contiguous 48 states, Alaska, Hawaii, and some small territories. However, if you consider that armies are what constitute national borders, our reach is far greater. We have bases in England, Germany, Greece, Turkey, Saudi Arabia, Afghanistan, Iraq, Japan and Korea. We have alliances with India/Pakistan, Australia. Draw a line and connect the dots and you will end up defining a border in Eurasia that essentially leaves out two, maybe three countries – Iran, Russia, and China, maybe SE Asia. If not for these countries, we would indeed have something resembling a world-wide hegemony, based upon military presence. Mearsheimer’s theory about the drive for hegemony goes a long way towards explaining why we still have such a pronounced military presence overseas after the Cold War – we will relent only when someone else forces us to do so.
You seem to agree with Buffett’s viewpoint on gold – so why are you bullish on gold and not stocks?
This is a really good question, one that I have not fully fleshed out. I consider gold and commodities to be no-brainer beneficiaries in the event of significant inflation, much more than TIPS or other instruments that protect against inflation. Stocks I also recognize as a form of protection, but I have to acknowledge the possibility of a real trade war and its affects on corporate earnings. I also think America’s reputation abroad will suffer greatly in the developing world once the debasement scenario comes to pass – this will deflate corporate earnings abroad.
Another bit of uncertainty deals with the American economy. I think that stocks are priced for a far rosier scenario in America than is warranted. Based on future earnings, they seem adequately prices, but based on prior earnings, I am willing to wait for a significant dip before buying most names on my radar screen.
Bottom line, most S&P companies are dependent upon international markets for their growth. Given our current problems, I see this being a potential liability going forward particularly for US companies with substantial operations outside of the West. Gold is affected by none of this.
Why do you see Europe as having such an accommodative stance to what seems like extreme policy from the US?
Europe’s economic situation is currently deemed as being almost identical in type to ours, but worse in severity. In aggregate, their central banks also own more gold than we do, so they would possibly be even more enthusiastic about a gold revaluation, especially since it will be largely enforced by our military and not theirs.
Why are you so negative on the dollar?
I think the retort to someone asking the above question would be “why are you so negative on gold?” Nixon released us from the gold standard not because of the superiority of a fiat money system, but because our gold supply was dwindling. Fiat as it stands today was a defensive maneuver, seen as a necessary but inferior alternative to what was policy before, i.e. the gold standard. It would follow that one day gold would be deemed as currency once again, as has been the case for most of history.
Comments and constructive criticism are welcome. This is more a thought-piece than any sort of dogmatic attempt at professional journalism, so I’d like to encourage a lively debate.
Disclosure: Long LEAPS at various price points on GLD, long TIP, commodities stocks, high-technology stocks