Here’s a thought—that tiny handful of investors and analysts warning how Fed policy risks hyper-inflation are in fact doing the central bank’s work.

The Fed wants you to believe hyperinflation is looming. Or at least, it should want that, if doubling its balance-sheet – purchasing and lending against investment junk – is going to work the wonders that modern central-bank theory says it can. And the Fed certainly wants you to believe it will stop at nothing to avoid deflation (”whatever means necessary” as the chairman put it back in 2002).

So anyone touting the hyperinflation risk in public is playing the shill, a decoy – seemingly unconnected – proclaiming the miracle powers of Dr.Ben Bernanke’s snake oil to CNBC anchors at every chance.

In fact, they’re doing the Fed’s work better than the Federal Reserve itself. Really.

“The major danger with a zero lower bound for the interest rate,” said Swedish policy-wonk Lars Svensson (also a Princeton colleague of the Fed chief and his credit-bubble associate Paul Krugman) in a speech earlier this year, “is that inflation expectations will be too low and even negative, and that the real interest rate will thus become too high.”

With it so far? Slashing interest rates to the very minimum of 0% suggests inflation has vanished, at least in the central bank’s eyes. But that, in turn, reduces the rate of inflation expected by consumers, investors and business. Central banks are credible forecasters, you see. At least in central-bank eyes. So in Svensson’s philosophy, the zero-rate solution to falling inflation proves self-fulfilling as people hoard cash and sit tight in bonds.

“It is thus necessary to…to counteract expectations of falling inflation, and preferably to create expectations of higher inflation,” Svensson went on. But “as Paul Krugman put it” says the Riksbank’s deputy governor, “How will the central bank ‘credibly promise to be irresponsible’…?

Heaven knows the Fed’s trying. (So’s Krugman, to no one’s surprise.) But while it’s embraced credible recklessness, the Fed’s stop short of French kissing it.

Why so coy…?

“We have a very serious recession, we have a 9.4% unemployment rate,” said San Fran Fed governor Janet Yellen in a speech in California on Tuesday. “If we were not at zero, we would be lowering the funds rate…We should want to do more.”

Just how much further would the Fed go – all the way to hyperinflation perhaps? Racing to first base, “The vigorous policy actions of the Fed and other central banks, combined with sizable fiscal stimulus here and abroad, have sent a clear message that deflation won’t be tolerated,” Yellen said.

“Based on measures of inflation expectations,” she went on, an apparently reading straight from Svensson, “the public appears confident that the Fed will adopt policies that will maintain a low, positive rate of inflation. Evidently, the credibility that the Fed and other central banks have built over the past few decades in bringing inflation down has spilled over into a belief that we won’t allow inflation to get too low either.”

Steady on, cheeky! Second base next, and “A glance at history shows that many countries with massive structural deficits and without an independent central bank turned to the printing press to pay off their debts,” Yellen continued.

Straight to third then, and “That’s a recipe for high inflation and, in some cases, hyperinflation.”

Gulp, almost home! But then, somewhere between third and fourth base, the Fed’s gone shy and rebuttoned its blouse. Because “I don’t believe the United States faces that threat,” Yellen said, showing the come-on to be just one big tease.

“Looking back in history, runaway fiscal deficits have often been accompanied by high inflation,” she explained in Tuesday’s speech in the bankrupt state of California. “But, since World War II, such a relationship has only held in developing countries. In countries with advanced financial systems and histories of low inflation, no such connection is found.”

Oh man, what a let down! Who’s gonna put out hyperinflation if not the Fed…?

“In order to make up for the collapse of credit, we are effectively creating money,” said George Soros, the legendary if only occasionally accurate hedge funder, at a Washington forum in March. “If and when credit is restarted, you would then have an incredibly swollen monetary base, which, if it were leveraged, you would have an explosion of inflation.”

The trouble comes, as Lars Svensson guessed back in January, with that “if and when”. Because it opens the door to the idea that a central bank might opt instead to withdraw all this new money after the deflation panic has ended. And that in itself is enough to make creating it useless. Pointing to Japan’s five-year experiment with ‘Quantitative Easing’ between March 2001 and March 2006, said Svensson, boosting the monetary base by some 70% failed to “noticeably affect expectations of inflation and the future price level.

“For example, the Yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.”

Sure, the Bank of Japan’s trillions did triple Japanese Gold Prices. But even with gold refusing to drop back against the Dollar right now, eagle-eyed readers will note that, quite apart from the urgent debate in Europe, the US authorities are at pains to deny they need an ‘exit plan’ any time soon. White House advisor Christina Romer made that much plain in last week’s Economist magazine, blaming the double-dip depression of 1937 on “an unfortunate, and largely inadvertent, switch to contractionary fiscal and monetary policy.” Yellen said it again Tuesday.

So Team Bernanke have got the right idea – at least on Planet Svensson – if not the right level of irresponsibility just yet. Slip a little vodka into their juice though, and they might start talking up inflation like Alan Greenspan, Bernanke’s predecessor and the Maestro himself, writing last week in the Financial Times. He tried to spook everyone out of cash and into the stores by warning of a decade of inflation ahead!

“A pending avalanche of government debt is about to be unloaded on world financial markets,” Sir Alan of Greenspan warned sagely, almost visibly winking from behind those enormous spectacles. “The need to finance very large fiscal deficits during the coming years could lead to political pressure on central banks to print money to buy much of the newly issued debt.”

Or given enough sauce to get really loose, the Fed might even get crazy like Asia-based doomster Dr.Marc Faber. (He’s been known to enjoy the odd cocktail or two.) Stop warning on hyperinflation. Just come out and say it instead.

“I am 100% sure that the US will go into hyperinflation,” as Faber told Bloomberg in late May, and again on June 29th. “The US central bank has structured and introduced policies without considering exponential credit growth and its consequences,” added the Gloom, Boom & Doom author in an interview with the Korea Times on Wednesday.

See what I mean about being a shill? It’s like he’s on the payroll…

“The United States will not raise interest rates for many years to come because it needs to pay off its huge debts,” he went on, recommending inflation-friendly assets such as equities and Gold Bullion. “In turn, too much money in the economy will raise costs of everything, including healthcare and education, giving rise to hyperinflation.”

There, now that’s the way to do it! Greenspan and Faber on song, while the Bernanke Fed tip-toes around stating its aim:

Spark inflation and leave it to burn. Because putting it out worsened both the Great Depression and Japan’s “lost decade” – the one that started two decades ago and hasn’t yet ended. Everyone who’s anyone in monetary theory knows that.

And if they claim otherwise, maybe they’re the ones kidding.

Regards,
Adrian Ash
BullionVault

July 6, 2009

This article was originally featured on Whiskey and Gunpowder

Faber and Greenspan: Shills for Fed Snake Oil

-Jude Wanniski, former Reagan advisor, April 1982

So does the price of gold rise or fall in a deflation?

Hint: It’s a trick question, already tripping up plenty of would-be advisors. Because gold must fall during deflation, since it rose during the ’70s inflation. Right?

“Gold prices, in real inflation-adjusted terms, unsurprisingly tended to increase during inflationary times,” nods one commentator, writing in London but posted at the Business Times in Singapore. “Its purchasing power tended to sag during depressions and deflation.”

The source for this claim? Besides syllogism (”The ’70s gave us inflation and a gold bull market; ergo, the opposite must be bad for gold…”) it was apparently Roy Jastram’s The Golden Constant, that dusty study of gold’s enduring stability across the very, very long run by the end of which we will all be deader than Austrian disco hits.

First published by Wiley in 1977, The Golden Constant has just been updated by Jill Leyland, former chief economist at the World Gold Council, for Edward Elgar Publishing. I’ve not seen the re-issue yet (not at £72 a pop! Some $120). But unless Jill’s scrapped Jastram’s research entirely and written a wholly new monograph, the conclusions should in fact be precisely the opposite.

Gold, like silver, gained in purchasing power during deflation but lost out to inflation. The only things to rise during commodity-price inflations were commodity prices and social unrest.

Three centuries of data are hard to ignore, but it seems they can be misread – not least when skim-reading for a quick book review. (If you care for the big picture, Jastram’s charts are available free at the Golden Sextant.) Those three centuries of data can also prove a real bore to analysts without a library pass, as Jastram apparently makes for “a very dense read” says a recent Seeking Alpha post. And all those numbers can also mislead the unwary if the key point’s neglected:

Gold, like silver, rose in value during deflations when it was still used as money. It lost out to inflation back when that role applied, too. But since the end of WWII, we’ve not suffered the first and only endured the second…and gold has risen sharply in purchasing power as the supply of what we’ve come to call “money” has swelled by an order of magnitude or twenty.

Meantime – and not coincidentally – gold ceased being money beyond offering a store of value (and free from default risk, as well). Little wonder that inflation really took off after the limits to money-supply growth set by the post-war Bretton Woods deal were cut by the Nixon White House at the start of the ’70s.

And we all know where that little trick got us…

“What the press and policymakers are calling ‘disinflation’ is simply deflation, the deterioration of the monetary standard characterized by falling prices,” wrote Jude Wanniski, former Wall Street Journal editor and advisor to Ronald Reagan, in 1982 – slap bang in the middle of what he’d come to call the “Volcker Deflation” in honor of the tall, cigar-wielding inflation-fighting Fed chairman.

Volcker took US rates to double-digits and left them there, wringing inflation out of the system and squashing the gold price—then (as now) a key marker for the stable value (or not) of money.

“There is a confusion because commodity prices [in 1982] are falling even as the cost of living continues to rise. [But] the price of gold, the ‘commodity money par excellence’ is the surest proxy for all prices, goods and bonds…[and] the recession that threatens to become depression could also swiftly turn into a major bull market if the Fed arrests the gold-price decline at $300, signaling an end to continued deflation and the monetarist policies that have guided the open-market desk.”

Fast forward the best part of three decades, and here we are again, trying to heat-treat the mutant spawn of a new “monetarist experiment” that’s also broken out of the lab and started to munch bystanders on the corner of Wall Street and Main.

Wanniski’s point back then was that, to prevent the end of the world, the gold price should be forced higher, making dollar devaluation explicit and pumping cash into the economy that could then be lent and spent to unwind that “deterioration of the monetary standard characterized by falling prices.” And only an idiot would pick a fight with Wanniski’s terms of reference.

So please – if you’ll glance at that chart of gold both sinking and rising as deflation failed to hit during the ’80s. Then hold my jacket a second…

Gold is no longer money, not as a means of exchange. Anyone who tells you it should be forgets that the Pound, Dollar, Yen and Euro have yet to expire. Whereas gold has signally failed in that role, not being used to make payment anywhere in the world today. The gold-money survival rate is zero, and so are the chances of a near-term return to any kind of gold-backed currency. (What do you think politicians and central-bank chiefs read for fun if not Brad DeLong and Barry Eichengreen?)

Absent the money-supply limits which the gold standard imposed on the world, people rightly guess that double-digit inflation would prove rocket-fuel for the bull market in gold. Yet the purchasing power of gold nearly doubled during the Great Depression, and it’s risen four-fold during this decade’s low consumer-price inflation as well.

Why? Because both those periods of low price-inflation saw the money-issuing authorities devalue the currency, first with explicit reference to gold but now without daring to name it. Roosevelt in the mid-30s slashed the dollar’s gold content by 40%; the Greenspan/Bernanke Fed devalued the Dollar again to sidestep a DotCom Depression, keeping real interest rates at less than zero, between 2002-2005.

The maestro’s apprentice applied the same trick in the back-half of 2008, but so far to no avail. And now even the European Central Bank is pumping out money – a near half-trillion euros today alone – in a bid to revive bank lending, swamp the currency markets, and pull Germany out of its first flirt with deflation since the 1930s.

Just such a devaluation – and again, absent any stated reference to gold – was attempted by the Bank of Japan a little less than a decade ago.

Indeed, Japan is the only developed nation since the end of the gold standard to have suffered an extended deflation in prices. So far, at least. Germany and Switzerland look set to try for a re-wind, and unless the dollar can outpace the euro’s descent, we might yet see truly sub-zero inflation in the United States, too.

But whatever that should mean for gold prices, all other things being equal, just doesn’t matter. Because the gold price will not get a chance. All other things are not equal, and the policy solution – rank devaluation – can only make gold more appealing to investors and savers, whether the “monetarist experiment” of TARP, quantitative easing or a half-trillion euros proves successful or not.

Japan’s slump into deflation coincided with the Bank of Japan’s “zero interest rate policy” (ZIRP) at the start of this decade. It also saw the gold price worldwide hit rock-bottom and turn higher, a move that analysts (including us) have typically linked to US monetary moves and investment cash looking for safety as the Dotcom Bubble exploded.

But zero-rate money from the world’s second-largest economy shouldn’t be ignored. And today, zero-rate money is all the developed world has to offer – a trick that might not beat deflation, but might just spur a whole new rush into gold.

Regards,
Adrian Ash
BullionVault

June 29, 2009

This article was originally featured on Whiskey and Gunpowder

Gold and Deflation: A Trick Question

TIME WAS that central banks targeted and fretted about keeping their currency stable against the Dollar.

But as the Dollar-led inflation of 1950-1980 destroyed the value of bonds and savings worldwide – and then destroyed equities, as well as any sober hope of business and hiring plans – policy-makers tried to target instead the volume of cash flowing around their domestic economy.

Monetarism in turn fell apart as first the mid-80s “super Dollar” and then globalized deregulation of finance pulled the various “M” aggregates down, up and finally out of the window. “We didn’t abandon the aggregates,” says one practitioner in Steven Solomon’s 1995 book The Confidence Game; “they abandoned us.”

Central banks already had a new hope at hand, however. But now that theory – inflation targeting – is falling apart after almost 20 years of apparent success. And so the monetarists are back, in practice if not in policy statements.

What else do you think “quantitative easing” aims to achieve if not easier quantities of cash flowing from banks to business and households? And how can inflation targeting – whether explicit as in the UK, or generally guessed to be the chief aim, as in the United States – possibly survive this crisis given the failure of policy-makers to either hit target or reduce volatility?

It’s not simply the impact of monetary policy on consumer inflation which has gone “off message” in 2009.

Extending their remit – and now hoping also to control longer-term interest rates as well as overnight money rates in the “open” market – central banks are signally failing to cap either the yield or volatility of long-term government bonds. The 10-year US Treasury bond, formerly the financial world’s modern “Gold Standard” equivalent – has never offered such wide-swinging returns.

Most disastrous for policy wonks pulling this lever and pushing that button, you have to go back to the Great Depression – when central banks still nailed exchange rates and the volume of money to a tightly supplied quantum of Gold Bullion bars – to find uncertainty about quite where the cost of living will stand running this great, this fast. The month-on-month rate of change in US consumer prices has been three times as vicious since December as the CPI’s previous six-decade average. Here in the UK, consumer-price inflation has now overshot the official 2.0% target for 20 months running, even as the previous measure of living expenses – the Retail Price Index – has sunk below zero.

“We didn’t abandon the inflation target,” the Bank of England will no doubt declare. “It abandoned us…”

Thing is – and as with any social experiment, such as the London Gold Pool’s attempt to cap the price of gold in Dollars at $35 an ounce, finally abandoned in March 1968 – trying to observe as well as influence the “out-turn” of inflation means neither task is done very well, if at all.

Promising to buy and sell gold in the “open” market at a fixed price lower than private traders would bid, the Gold Pool only invited fresh pressure on their fast-shrinking stockpiles. Defending that $35 price – itself arbitrarily set by President Roosevelt at a series of jovial breakfast meetings three decades before – showed the absurdity of any particular fixed value for gold in a world awash with money.

Now in 2009, and slashing rates towards zero to try and force savers out of cash and boost new mortgage debt, the Bank of England has itself caused those sub-zero readings on the Retail Price data – the very opposite of what it set out to do. Because those numbers include mortgage-interest payments each month. Whereas the Bank’s mandated target of 2.0% is pegged against the mortgage-less Consumer Price index. And on the logic of that measure alone, not least with oil prices about to start pushing higher on the year-on-year figure as the spike of July ‘08 fades from the series, interest rates should in fact now stand higher, rather than encouraging yet further hikes in the cost of living.

What to do? At this pace, we’ll all join the Swiss in quietly setting targets for foreign exchange rates and ranges, hoping to side-step deflation at the expense of our neighbors’ overseas exports. Already in March this year, the Bank of England’s Spencer Dale cheered the fact that “the marked depreciation in Sterling should support demand, both at home and abroad, for domestically produced output.” But that exchange-rate gain was swiftly undone as the Pound then raced back towards $1.65 to the Dollar, knocking 18% off the Gold Price in Sterling and widening the UK’s trade deficit to £7.0bn in April from March’s eight-year low of £6.5bn.

How to escape this policy nightmare? Besides yet more volatility, we guess here at BullionVault that only one thing is certain. Central bankers scrabbling around for a new “Hey! This might work” policy to square the circle of full employment with low, stable inflation are guaranteed not to apply a fixed limit on the absolute volume of cash, as set by some implicit if not official Gold Standard.

Sure, if policy-makers, politicians and the rest of us would only abandon the hope of costless inflation, then yes – a Gold Standard might well appeal. But the promise of above-average wealth for everyone makes yawning debt a necessity, and that makes a commodity-linked supply of money untenable. And anyone who tells you otherwise needs to review not only the one policy lesson taken away by every economic advisor who’s studied the Great Depression, but also how unstable the “stability” of precious-metal standards proved in practice beforehand.

Digging deep in the archives three decades ago, Professor Roy W.Jastram of the University of California at Berkeley found that – while relatively constant across broad sweeps of history – holding gold even amid a Gold Standard didn’t do much to smooth short-term volatility in prices.

As the table above shows, taken from Jastram’s analysis of “the English experience” across 366 years, neither silver or gold overcame shorter-term shocks to the cost of living, typically driven upwards by war. Indeed, the post-Gold Standard inflation of the 20th century proved the only exception. Precious metals rose ahead of the cost of living, gaining real value as the value of money diminished and commodities leapt. Whereas until the end of first the Silver, then bi-metallic and finally Gold Standard in the mid-1930s, it was deflation which boosted the real purchasing power of precious metals – then, unlike now, hard cash you could take to the shops and exchange at the bank.

Quite what this means for central bankers now seeking the next number to chase in their monthly meetings, we neither know nor care. But for private investors seeking a little stability in their own savings and wealth, the one certainty remains vicious, violent changes in value, no matter what digit on what metric is chosen.

Regards,
Adrian Ash
BullionVault

June 19, 2009

This article was originally featured on Whiskey and Gunpowder

Inflation and Random Numbers, Part II: Return of the Monetarists

– James Warburg of the banking dynasty, resigning as President Roosevelt’s monetary advisor, 1933

Want to know where the price of gold, oil, the S&P, Euro or overseas stock markets are heading?

Pick a number, any number. Go on, choose whatever number you like! Because that’s how policy-makers and their advisors would like to set the common denominator of asset prices: the value of money.

“When I calibrate my favorite version of the Taylor rule using the most recent data,” says Greg Mankiw, professor of economics at Harvard and chairman of Dubya Bush’s “I get a target for the nominal federal funds rate of about negative 1%.”

Actually, “as long as expected inflation is still positive…that means an even more negative target for the real interest rate. And given the forecasts of inflation and unemployment, we are likely to get further into the negative region in the months to come.”

Yes, you read right. As Dr.Marc Faber of the Gloom, Boom & Doom Report has been howling since Mankiw published his “Economic View: Time to Go Negative” in the NY Times back in April, the professor “seems to have great sympathy for the outright expropriation of savers.”  Negative real rates of interest – returns paid to cash depositors that lag the rate of consumer-price inflation, thereby devaluing bank savings in terms of purchasing power – are currently best maintained in Zimbabwe, notes Faber. And Mankiw is such a man of the future, sent back in time to guide us with the wisdom of ages yet to pass, that pension savers in the United States might hope their retirement runs out before the Fed acts on his hindsight and drags us all into Robert Mugabe’s brave new world.

Ignoring the fact that the real Fed Funds rate was negative for 34 of the 38 months between Aug. 2002 and Oct. ‘05 – a feat topped only by the 40 months of negative real rates between Sept. 1974 and Jan. ‘78 – “The idea of negative interest rates may strike some people as absurd,” writes Mankiw.

“But remember this: Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace…”

Early mathematicians also gave the world geometry, algebra, Pi, elevation surveying and pneumatics. But those old, dead people with their fear of surds…They know nothing! NOTHING! as class monitor Jim Cramer would no doubt scream if invited to comment. And closer still, even within living memory, “When you look at the [Fed's] mistakes of the 1920s and 1930s, they were clearly amateurish,” as Mankiw told the WSJ in Feb. 2000.

“It’s hard to imagine that happening again – we understand the business cycle better.”

“[In May 2001] I wrote a paper on monetary policy in the 1990s,” the über-enlightened Mankiw blogs on. “I estimated the following simple formula for setting the federal funds rate:

“Federal funds rate = 8.5 + (1.4 x (Core inflation - Unemployment))

“The parameters in this formula were chosen to offer the best fit for data from the 1990s,” explained Mankiw after solving his equation 8 years ago. Yes again, you read that right. His “favorite” monetary-policy rate for any given pair of inflation and jobless data is spat out by taking the one from the other, multiplying the result by 1.4 and then adding that result to eight-point-five.

Not because those figures of 1.4 and 8.5 represent some immutable law of the universe. They’re now stuck in the mold of, say, the ratio of a circle’s circumference to its diameter always equaling 22/7…or the weight of fine gold (its specific gravity) being 19.3 that of an equal volume of water. No, Mankiw instead built his theorem upon the achievements of “miracle worker” Alan Greenspan (to quote the professor), head of the Fed when inflation – as well as unemployment – trended down towards 40-year lows.

Inflation is always and everywhere a monetary phenomenon; so any change in the rate of inflation must come due to changes in monetary policy. Unemployment is also influenced “over a period of at least two or three years by central-bank actions,” Mankiw asserts. Hence the numbers – not quite any numbers – squeezed out of Mankiw’s solution to the Maestro’s 40-year records in US macros-stability and growth.

One-point-four, eight-point-five. Keep them in mind. They might mean something important. Not least a whole new surge in commodity and especially gold prices as savers flee the warm, welcoming  arms of US commercial banks – now being recapitalized by lending cash at pre-crisis prices but giving depositors next-to-nothing in return.

“I’m advocating 6% inflation for at least a couple of years,” says Mankiw’s Harvard colleague – and former IMF chief economist – Kenneth Rogoff. At current interest rates, “It would ameliorate the debt bomb” by taking real rates to their very lowest in history and leaving them there. Or rather, it would make the debt bomb sound like a fire-cracker against the exploding oil refinery of re-shrunken savings rates, impossible investment decisions, and collapsing Treasury bonds.

“There’s trillions of dollars of debt, in mortgage debt, consumer debt, government debt,” Rogoff notes sagely. Yet somehow, he thinks, soaking the lenders will mean avoiding “a long period of slow growth.”

Remember: This tomfoolery might sound absurd right now, but in Harvard’s bright smiley future, it could indeed become commonplace – and US cash savers lived with precisely this outcome between 2002 and 2005.

Now this “thinking” represents the blue-sky academic and professional chin-stroking amidst which the Federal Reserve claims it will start raising rates and withdrawing “excess liquidity” just as soon as Consumer Price inflation ticks higher.

Like Jim Cramer says, they really do know nothing.

Regards,
Adrian Ash

June 18, 2009

This article was originally featured on Whiskey and Gunpowder

Inflation and Random Numbers, Part I

“FEAR, Mr. Bond, takes gold out of circulation and hoards it against the evil day,” as 007 learns from a Bank of England officer in Ian Fleming’s Goldfinger (1959).

So “in a period of history when every tomorrow may be the evil day, it is fair to say that a fat proportion of the gold dug out of one corner of the earth is at once buried again in another corner.”

Evil-day gold buying really motored since the credit collapse began in August 2007. Soaking up investment dollars worldwide, in fact, new allocations to the metal – whether trust fund or owned outright – swelled by 38% during the first quarter of 2009 compared with total demand between Jan. and March 2008, according to marketing-group the World Gold Council (WGC).

Within that figure, what the GFMS consultancy (who supply the WGC with its data) calls “identifiable investment” leapt 248% compared to Q1 ‘08. And gold ETFs made the headlines once more, sucking in “another quarterly record” as new inflows required 465 tonnes of metal to back them, thus dwarfing the previous record of 149 tonnes set in the third quarter of last year.

That doesn’t mean the world’s investors are now all in, however. According to the World Gold Council’s Marcus Grubb last month (using we-don’t-know-which data), current gold investment allocation stands at less than 0.6% of total global wealth.

It makes a nice pie chart, and it offers a useful snapshot of different asset classes vs. each other. But we also think the idea’s worth refining. Because this estimate both over-states liquid assets in toto and under-estimates the stock of gold available to investment flows – whether retail or wholesale.

First, note the scope for double-counting between pension, mutual and insurance funds. I’m not saying the WGC’s data trips up on that error, but you can see how likely it seems given the end-allocation categories applied. For instance, “hedge funds” are stripped out separately (as are REITs and private-equity), even though institutional allocations via funds-of-funds will be counted elsewhere under the broader “funds” title.

Similarly, but more pertinent, the outstanding quantity of “gold – investment stocks” underplays the true volume of metal held as a store of wealth. Simply counting the “investment” volume excludes fully 84% of the above-ground supply, as another chart from the WGC’s presentation shows.

Why not also include “official sector” gold hoards? Sovereign wealth funds and FX reserves were included on the other side of the ledger, after all.

More crucially still, why not include jewelry? Trying to split out the volume of trinkets held for aesthetics alone might feel easy enough to a Western analyst just back from window-shopping at Mappin & Webb. But across south-east Asia, and most particularly in India – typically the world’s No.1 destination for physical gold each year – large, chunky necklaces and bracelets make for “investment jewelry”, acting as a store of wealth in the absence of any formal banking network.

Still, the point is well made, we believe. Gold remains but a slither of investable wealth – albeit a fast-growing slither as the value of other assets has dropped.

“Gold [has] been deprecated and reduced as a financial asset,” as Jeffrey Christian of the CPM consultancy put it earlier this year. “In 1968 gold may have represented 4.5% to 5.0% of the world’s wealth…By the 1990s it was down to 0.2% of the world’s wealth. Not that gold was falling in value so much as the other wealth – stocks, bonds, paper assets, government bonds, corporate bonds, bank deposits – were exploding once the tie to gold was severed.

“In 2006 gold represented 0.2% of world wealth. At the end of 2007, it was about 0.4%. Depending on what you think about wealth destruction in 2008, it may have been 0.6%.”

That figure just about matches the WGC’s estimate of 0.7% (perhaps they used the same inputs and excluded the same volumes of central-bank and jewelry gold?). It also contrasts with our own Estimate of Gold as a Proportion of Investable Wealth at nearer 2.7% by the close of 2008.

Either way, gold is fast-attracting attention – both from nay-sayers, retail investors and new die-hard bulls amongst the professional institutions. Regulatory filings show legendary hedge-fund manager John Paulson took his position in the SPDR Gold ETF to 30% of his portfolio during the first quarter of 2009. Paulson & Co. now owns 8.7% of that paper – as well as significant chunks of the Gold Miners ETF (GDX), Kinross Gold (KGC), Gold Fields (GFI) and AngloGold Ashanti (AU) – if not any actual bullion itself.

Does that in itself make gold a buy? Of course not. But compared to the evil days of 1930s depression – or the fearful inflationary panic of the late 1970s – the world’s wealth remains very under-invested in metal right now.

Regards,
Adrian Ash
BullionVault

May 21, 2009

This article was originally featured on Whiskey and Gunpowder

The World Gold Council Wrong About Gold

It’s common knowledge that gold bullion proved the most reliable wealth-store during the vicious inflation of the late 1970s. Yet almost un-noticed, gold has once again been the best-performing asset bar none this decade, too.

Gold has dominated the 21st century so far, in fact – something which will look plain to future investors, although only a handful appreciate it today.

Whether gold can now extend or repeat this performance, of course, is less clear. But “People rightly buy gold when they fear inflation ahead,” as William Rees-Mogg, a keen historian of gold, puts it. And just as during the Great Depression of the 1930s, many people now fear inflation, sparked by the very threat of deflation driving government interventions and central-bank money creation.

That’s why global demand for gold jumped throughout 2008, rising 26% on the GFMS consultancy’s data, just as the US, British and Swiss central banks moved to begin quantitative easing – a.k.a. printing money.

Gold prices had already trebled and more against the world’s major currencies, gaining an average 14% per annum in Sterling terms since the start of 2000.

Yet gold still remains a “fringe” asset class for most funds and advisors. High-margin offers and outright scams are starting to trap the unwary, while good information about how to buy, own and trade the metal remains scarce. Quite how much of your wealth you allocate to this “ultimate insurance” is something to decide for yourself. But buying and selling gold can now be much simpler and safer than during gold’s last multi-year run. It should be dramatically cheaper as well.

The Story So Far

The spark for this decade’s bull market in gold? It came from the huge central-bank gold sales of the late 1990s. Because whatever Gordon Brown sells, a few bloody-minded investors agreed, must be worth buying. It wasn’t just the UK Treasury, however.

Gold sales by those central banks about to join the Euro reached such levels, they signed a deal (the so-called Washington Agreement) to cap annual sales and limit uncertainty on the open-market price. (Renewed in 2004, the Central Bank Gold Agreement expires in September this year. Annual sales undershot the 500-tonne ceiling by one-third or more in both 2007 and 2008. The Agreement may be rolled over to accommodate the sale of 400 tonnes by the International Monetary Fund (IMF), first proposed in February 2008.)

At the same time, in the mid- to late-90s, the Financial Times and Economist both declared “the death of gold”, tempting a similar fate to the famous “death of equities” cover published by BusinessWeek just before the US stock market began its two-decade bull market of the 1980s and ’90s. The Dot.Com Crash that followed between 2000 and 2003 led a growing number of people to seek out alternative wealth stores. Whilst institutional funds overwhelmingly chose fixed-income bonds, a growing number of private investors began to buy gold, especially as the central bank fix – led by the Bank of Japan and US Federal Reserve – was to encourage a tide of cheap credit into all asset markets via (then) record-low interest rates of just 1.0%.

This flood of money washed into house prices, debt investments and emerging stock markets, and it also pushed gold higher thanks to two key events:

1. Leveraged speculation

Financed by the prime brokerage departments of the big investment banks, hedge funds the world over piled into gold derivatives as interest rates fell behind inflation in the middle of this decade. Between 2004 and 2008, they doubled the outstanding volume of US futures and options contracts, for instance, helping gold prices to double as well.

2. Exchange-traded gold funds (gold ETFs)

As early as 1999, research for mine-industry marketing group the World Gold Council (WGC) showed that very large investment portfolios could have made better returns with reduced risk if they had included a four to seven per cent allocation to gold, even during the gold bear market of the previous two decades. Many retirement and mutual funds, however, were blocked under the terms of their deeds from owning physical property, especially in the United States, and derivatives were seen as too risky.

How could these large institutions gain exposure to gold prices? The WGC responded by sponsoring a series of funds that hold physical gold bullion in trust, securitising it for shareholders and thus tracking the gold price. First launched in Australia in 2003, and soon followed by South Africa, the UK and then the United States, these exchange-traded gold funds (gold ETFs) can be traded only during stock market hours. They charge 0.40% per year for storage (typically at HSBC’s bank vaults in London), reducing the gold backing each share down to 98.3% and below of the nominal value.

Already surging by 30% in 2009 to a total valuation of $38 billion, gold ETFs are clearly attracting significant new allocations from mainstream pension and mutual funds. Yet the metal remains “institutionally under-owned” according to James Montier, London strategist for Societe Generale. Pointing to conflicting signals about whether the global economy now faces inflation or deflation, Montier recommends gold as “insurance” against both outcomes. Because while “gold is the one currency that can’t be debased” by inflationary policy, “a significant prolonged deflation would see what’s left of our financial system likely to collapse. Holding a money substitute isn’t such a bad idea against this cataclysmic outcome.”

A Case of Mistaken Identity

Several big-name hedge fund managers have also taken sizeable positions in gold so far this year, including John Paulson of Paulson & Co. (who bet against sub-prime mortgages in 2007) and David Einhorn of Greenlight Capital (who bet against Lehman Brothers’ stock while publicising its 40-to-1 leverage). But the broader universe of hedge-fund investors, however, has been pulling in the other direction, reducing their exposure to gold amid the collapse of Bear Stearns, Merrill Lynch and then Lehman Brothers. Gold futures and options were sold off alongside crude oil, emerging markets and non-Dollar currencies as hedge funds were forced to unwind their leveraged positions, first by their investment-bank brokers raising the level of margin calls and rolling costs, before withdrawing credit entirely, but also by their clients withdrawing funds and demanding redemptions.

Call it “mistaken identity”, as John Hathaway of Tocqueville Asset Management has said. Because while the boom in gold derivatives required credit that was both cheap and freely available, physical gold in contrast only grew more attractive as the banking crisis wore on.

No one’s obligation and no one’s liability, gold owned outright is quite literally the opposite of debt, giving you the same tangible security as owning real estate free of a mortgage, but instantly priced in a 24-hour international market with deep liquidity. London’s gold bullion market, still the centre of professional gold-dealing worldwide, turns over $60 billion per day, and this wholesale dealing in physical gold would be the least likely market to lose liquidity in a true financial crisis. That’s why, largely as a result of the crisis in the credit markets, a small but growing number of high-net worth individuals have already begun investing heavily in physical metal.

Rush to Physical Gold

By March 2008, the very earliest gold buyers had seen its price move from $250 above $1,000 an ounce, making newspaper headlines alongside the collapse of Northern Rock, Countrywide and Bear Stearns. Come July of last year, a sharp drop in price from the all-time dollar-high then drove many existing physical gold owners, especially coin buyers, to accumulate more gold as the world economy slowed and financial markets went into a tailspin. The leading metals refineries, however, weren’t expecting a rush until the usual autumn-time spree, typically driven by India’s usual post-harvest surge of gold buying at Diwali. (Rural India has no formal banking system, so “investment” gold jewellery acts as a hard-money savings account for many millions of people, making India the world’s No.1 consumer market.)

Last summer’s sudden jump in gold-coin demand also caught the world’s largest mints napping as well, and so their clients, especially coin shops in Germany, the UK and United States, hit a genuine shortage of gold coins and bars. The upshot today is that gold-coin supplies remain tight the world over, pushing the average premium charged above professional “spot” market prices by US retail dealers up from five to ten per cent and more – even for the most heavily-minted coins such as the South Africa Krugerrand. (The Rand Refinery has issued well over 50 million gold Krugers since launching in 1969. So there’s little rarity value compared to the plain “lump” of gold you can buy in large bar form.) German-based Heraeus says furnaces worldwide are still booked solid to try and catch up. But with stock-market investors still bruised after the crash of 2008, demand from new buyers only continues to grow, thanks not least to “the biggest interest-rate cuts in history…an unprecedented fiscal expansion,” as Gordon Brown put it at the recent G20 summit in London.

Injecting $5 trillion into the world economy between them by 2010, the world’s leading economies are receiving “more money than ever before,” said Brown. These historic doses of cash, plus the money creation of quantitative easing, lead many new and existing gold buyers to feel that “price falls should be seen as buying opportunities,” say London professional dealers Mitsui, “given the impact of global spending programs on long-term inflation.”

The plan, remember, is to reflate the economy – and asset prices – by weakening the value of money. That’s what central banks mean by “fighting deflation”. The concern amongst gold investors, however, is that reflation will tip into inflation long before global spending programs and central-bank money creation face any genuine attempts to cap, curb or reduce them.

The last decade of gold prices might then prove only a prelude to the price gains ahead.

Regards,
Adrian Ash
BullionVault

May 18, 2009

This article was originally featured on Whiskey and Gunpowder

Gold: The Best Insurance Against Inflation and Deflation

Even the UK’s small, tightly packed mainland, floating off the edge of Europe, includes disparate and distinct real-estate markets. Glasgow is as different from London as Cornwall from Cheshire. But in the main (and the mania), and with a peak of 185,000 new dwellings under construction in 2006, the broad sweep of house-price inflation…followed by an inevitable slump lasting six years or so…tends to apply across the nation.

In the United States, in contrast, new housing starts at the peak of what pundits, economists and investment bankers clearly felt was a coast-to-coast boom in 2006 approached 1.63 million amid a total housing market of 128 million units spread across 3.5 million square miles.

By necessity, that makes the idea of an “average” home price more slippery. But let’s not let such quibbles clog up our spreadsheet! Not after math PhDs, applied to mortgage-backed zeroes, clicked and dragged the answer “AAA” whenever asked. And not before we contend with the data itself.

This first chart’s solid enough, thanks to the certainty with which the Census Bureau dispenses its data.

It shows the median price of new US housing, at sale, divided by the ounce-price of gold, monthly average. And as you can see, new housing has swung wildly – measured in ounces – over the last 45 years. Quite clearly, one made a better home for investment than the other over distinct periods, as the mid-way price of new homes (half the market paid less, the other half more) was rocked and rolled by booms, bubbles and busts in both bricks and bars.

Second up, existing homes bought on the secondary market – and the same picture, but only on an annualized basis (and with the National Association of Realtors thrown in as a source) for the Census Bureau’s less lengthy, less detailed data.

You can see, between the two charts, how new housing during this last real-estate boom (2000-2006 in nominal prices) began and topped out much sooner when priced in terms of gold. New units also reached further above existing-home prices too, peaking at $243,000 in 2006 – then 550 ounces of metal – or some 10% higher than the secondary market.

Perhaps that extra cash paid for new homes’ expanding foot-print. But it’s also worth noting, turning aside from Gold Investment for a moment, that new US home prices this decade also saw the mean outstripping the median as never before. The gap between average and mid-point prices, in fact, gaped from one-fifth or less (1975-1999) to as wide as 30% during the summer of 2006. Which might show, we guess, a growing number of super-priced units way up at the top-end of the market…bought and paid for, perhaps, with bonuses skimmed off mortgage-backed bonds sold against the sub-median half.

Finally, the money shot…

True long-run figures for housing, like the concept of “average” itself, are more sketchy than Mel Gibson after a night on the sauce.

We’ve used Robert Shiller’s invaluable numbers, of course, but they only come as an index, itself built from five sources stretching back to 1890. Rolling those numbers back from today’s current average ($175,000 according to the NAR) only throws up big gaps with the Census Bureau prices collated and published every 10 years starting with 1940. It also puts the price of US housing above $4,000 in 1900 – and in 1900 dollars, too – when average wages were just $2 per day.

Okay, so home-buying was yet to meet democracy through that great 20th century liberator, the securitized mortgage loan. And yes, two-thirds of US homes had yet to gain running water, let alone electricity. But as in the UK data, Gold Bullion regained its Great Depression value in housing as the Great Inflation of the 1970s peaked out, suggesting (to us, at least) that its utility as a store of value was little diminished by new bath fittings and copper wiring.

The broad sweep – smoothed out to fix those anomalies which our quick desk-bound research, a mere 5,000 miles from the Library of Congress throws up – remains as broad and as sweeping as either gold bulls or bears might hope to spy.

From here, the bottom in housing may still be to come, at least priced in gold. Broad-sweeping investors are invited to draw their own conclusions.

Regards,
Adrian Ash
BullionVault

May 6, 2009

This article was originally featured on Whiskey and Gunpowder

U.S. House Prices in Gold

Remember the great hope for Hope Now…?

“Let’s not harp on about the costs, absurdities or risks of governments meddling in real-estate bubbles when they burst,” wrote BullionVault as the Bush administration pushed the initiative front-and-center in Dec. 2007.

“This is about hope. Hope now. Let’s worry about tomorrow some other time.”

Too bad tomorrow’s turned up, but with 917,000 homes foreclosed since then regardless. A further 1.3 million foreclosures are now in progress according to Hope Now’s own data, with nearly one-in-twenty of all US mortgages standing 60 days late or more on debt service.

Some 8.3 million mortgages risk being drowned by negative equity, too. So even if the lender moves to foreclose, the asset won’t cover the debt – if they can find a buyer at all – making the net loss of wealth truly systemic for America’s banks.

Which is kinda where all this began, only the other way round.

“Mortgage performance steadily declined each month in 2008,” says Hope Now in its full-year data. “One in 10 loans was delinquent in some way by December,” despite Hope Now itself helping modify and refinance almost a quarter-million loans that month. It helped modify and refinance a quarter-million loans yet again in January. By then, however, US real estate had lost $2.4 trillion of its value year-on-year, reckons First American CoreLogic.

Puff! It was gone, just like that. Which kinda makes you wonder where it all came from in the first place.

“There is broad agreement that until we begin to stem the tide of foreclosures, you will not get an end to the current crisis,” says Barney Frank, Democrat chair of the House Financial Services Committee, pointing to the, ummm, foreclosure crisis.

Put another way, “The remedy for [today's] deflationary delevering and mini-depression is simple and almost axiomatic,” as Bill Gross, head of the Californian bond giant, wrote last month:

“Stop the decline in asset prices.”

Such a happy truism; stop prices falling, and you’ll stop pricing falling. But how to achieve it? Maybe Gross doesn’t quite mean what he says. Not as simply as he says it, at least. Not without trimming his (occasional) moustache into a neat little paintbrush. You know, more like that highly-strung German chap who stole Charlie Chaplin’s look (minus the hat and cane) in the 1930s.

But that word “delevering” – it throws up the real problem sparked by declining asset prices: the gap between what they’re now worth, and how much money was borrowed to buy them.

“One in five US homeowners with mortgages owe more to their lenders than their properties are worth,” First American CoreLogic goes on, as quoted by Reuters, “and the rate will increase as housing values drop in states that have so far avoided the worst of the crisis.” That army of drowning, not waving debtors now threatens to swell by one-quarter if home prices slip only 5% further from here, as well.

Negative equity, of course, doesn’t in itself force default. It’s inability to pay, most often sparked by loss of income, which forces late payments. But negative equity makes the problem systemic. Because it gears up the net loss and spreads it from debtor to lender, levering the pain of foreclosure from the hurt of the home-loser to the net lending loss suffered by banks.

Lenders end up out of pocket – and so too might their lenders in turn – even if they can sell the house reclaimed to settle the mortgage. All of which, as we say, just replays the merry-go-round spiral of soaring house values and E-Z credit in reverse.

“Making Home Affordable will offer assistance to as many as 7 to 9 million homeowners,” said the Treasury on Wednesday. (Note the friendly, if all-too pessimistic, use of the singular “home”). Yes, the new commander-in-chief is leading a fresh charge against house-price deflation and the still-surging surge in foreclosures.

Once more, with feeling!

“The Home Affordable Refinance program will be available to 4 to 5 million homeowners [who] would be unable to refinance because their homes have lost value,” the Treasury went on, “pushing their current loan-to-value ratios above 80%…

“The Home Affordable Modification program will help up to 3 to 4 million at-risk homeowners avoid foreclosure by reducing monthly mortgage payments.”

Now throw on top the one million mortgagees expected to declare themselves bankrupt when Obama’s “cram down” bill wins the day in Senate (which it will), and up to 10 million American home-buyers look set to refinance or re-modify their loans, just 15 months after Dubya Bush and Hank Paulson swore blind that refinancing and re-modifying would stem the depression in housing.

Might it work this time round instead? Given that the cram-down act will enable federal judges to extend mortgage terms, slash the interest rates agreed with lenders, and cut the outstanding debt owed by insolvent homeowners, and you might expect the flood of foreclosures to slow. Destroying 1,000 years of contract law should achieve nothing less, you might hope. And that might stop home-prices tumbling. Right?

“Throughout 2008, the re-default rate ranged between 30% and 40%,” explains Hope Now, defining such recidivist shame as “any mortgage that is 90 or more days delinquent or in foreclosure 6 months after the date it was first modified.”

One-third of bad loans turned bad once again, in other words, even after the lender cut the debtor some slack. So perhaps the new hope for housing should just cut straight past the chase and go to the credits. Y’know, the bit where the state seizes outstanding home-loans entirely, and re-modifies their terms to give houses away free to what once were called “the buyers”.

Any house first bought for “no money down” should become a no money home, a free gift to the debtor. How’s that for putting a floor under prices!

“More householders than ever own their homes,” said the Census Bureau in 2001. Way up at 66.2%, however, that record ratio wasn’t high enough either for government or the finance industry. Hence the non-stop shilling by President Bush of home-ownership as a way to defeat racism, poverty, Bin Laden, you name it.

The number of owner-occupied homes had in fact swelled by nearly one-fifth in the previous 10 years. And since the 1990s marked prosperity (and even a shrinking fiscal deficit!) as interest rates ticked lower, runaway growth in home ownership was surely been an unalloyed good. Only an anti-American fanatic would think otherwise, you’ll agree.

But smothering fresh chunks of California, Nevada and Florida in hard-top failed to concrete over the basic facts of economics, however. Because where demand finds itself sated, but supply continues to build, over-capacity follows and prices start to fall back. And even before the housing recession became a depression, excess capacity was building fast in the US housing supply. The rate of occupation slipped from 87.5% to 86.4% between 2005 and 2007, while the total number of units crept higher to 128.2 million on the Census Bureau’s latest data.

Trying to stall or reverse this cold fact will clearly take more money – and more stupidity – than even the Bush administration could throw at the task. Such as, say, via fascism or hyper-inflation. Put a floor below prices, beneath which it’s illegal to sell; or allow house prices (if not the S&P too) to slide only in real inflation-adjusted terms, printing money to inflate the cost of living while nominal realty prices hold steady.

That would allow the slide in real asset values to continue, even as nominal prices stay flat or fall. Because short of socializing all houses and so taking their value to zero – a trick tried to sad effect across Eastern Europe c.1917 to 1991 – this tinkering and tweaking is just fighting a trend that cannot be stopped.

In this credit deflation, where the nominal price of all things is shrinking, that which inflated the most should now shrink the fastest. Both its share of total economic value and its absolute pricing are working to reverse their misallocation over the last decade and more.

And double the inflationary trouble means double deflation once the bubble has burst – as the financial services industry is only just finding out as well.

Regards,
Adrian Ash
BullionVault

March 9, 2009

This article was originally featured on Whiskey and Gunpowder

Hope Now: Pretending People Can Keep Their Homes

The 1970s didn’t just curse the world with cheap German wine and the Bay City Rollers.

That decade gave us soaring inflation, too.

Gold’s stellar run up to $850 per ounce, rising more than 24 times over, also came in the ’70s. So gold, therefore, must deliver its strongest returns when the cost of living shoots higher. Right?

Wrong. “In the long run, stocks have thrashed gold as great long-term hedges against inflation,” says Jeremy Siegel, professor of finance at Wharton University, Pennsylvania. What’s more, the eight-year bull run in gold prices so far this decade has come against the lowest average consumer-price inflation since the early 1960s.

In short, the common opinion of gold as first and foremost a defense from inflation is wildly amiss. Just look at the last 30 years.

Consumer prices in the United States, even on Washington’s data, have pretty much trebled since 1980. But starting at what was then an all-time high of $850 per ounce, gold simply failed to keep pace. In fact, it dropped half of its purchasing power (monthly data) over that time.

At its lowest point, back in 2001, gold’s loss of purchasing power for US investors reached beyond 85%. The broad S&P index, on the other hand, stood more than eleven times higher, even as the Tech Crash pushed US equities into a nosedive.

Sure, things have reversed a little since then. But not enough to reverse the cold fact of gold’s losses during the long inflation of the late 20th century. How can we square it with gold’s huge returns amid the inflationary ’70s?

“Well,” you might guess, “perhaps gold only responds to rapid inflation – the nasty kind we got 30 years ago, rather than the ‘mild’ case our money has suffered ever since?”

But again, you’d be wrong – or very close to it. Between 1980 and ‘81, consumer price inflation in the US destroyed 17 cents of the Dollar’s purchasing power, a severe depreciation by any reckoning. Yet the Dollar price of gold dropped 40% during that same period. Longer term over the 1980s and ’90s – a truly horrific period of sustained inflation, then averaging 4.6% per year and vicious by any historical comparison – the real value of gold sank by more than four-fifths.

Look further back – even to when physical gold stored in government vaults underpinned the Dollar, just as it underpinned all major currencies – and you’ll find that gold almost always made a poor hedge against rising prices. In the mid-70s, Professor Roy Jastram at the University of California at Berkeley found that gold failed to keep pace with the cost of living during seven inflations in Britain across more than three centuries. In the United States, Jastram spied six inflationary periods between 1808 and 1976. On average, they saw the purchasing power of gold fall by more than one-fifth!

Only the final period in Jastram’s study – beginning in 1951 – saw the metal gain value, and it continued to gain purchasing power for the next 30 years. By the end of 1980, the average annual price of gold had risen more than 17 times over. But right from that top it was downhill for the next twenty years.

How come?

What changed at the start of the ’80s? Two things in short order, which were entirely connected.

First, Paul Volcker – the famously tall cigar-loving chairman of the US Federal Reserve – raised Dollar interest rates to nearly 20%. So secondly, and as a direct result, the rate of inflation sank from that record peace-time spike above 14%.

Volcker’s strong medicine took nearly two years to slow the rate of inflation. But it killed the gold price almost instantly. Before Volcker hiked rates – and before he and his successors gained ample room to cut them year after year – “There was a kind of great speculative pressure,” as Volcker since said. The Fed noted how “speculative activity” in the gold market was spilling into other commodities. One official at the US Treasury called the gold rush “a symptom of growing concern about world-wide inflation.”

So yes, people piled into gold as double-digit inflation and collapsing bond prices destroyed their savings at the end of ’70s. And yes, it took a record return paid to cash for the devaluation of money to slow down, allowing a cautious return to risk assets like corporate debt, listed equities and new private ventures – assets whose long-term appeal rests on stable costs and expenses, rather than a speculative guess at how the central bank might set its interest rates from one month to the next.

But now, in contrast, Britain stands on the brink, the United States will likely confirm it on Friday, and Japan’s pretty much there – yet again – suffering the horrors of inflation’s bleak evil twin, deflation.

How come gold just keeps hitting new record highs?

Before the 20th century, short periods of falling prices were as common as scurvy, and just as harmless for the long-term value of money and assets. Indeed, deflation is a good thing, for savers at least. Provided their savings institutions stay solvent. And provided their cost of living actually goes down faster than the value of the assets they’ve saved. Which is not what’s happening today. And that brings gold’s other key feature – the one investors should note if they buy it as a tightly supplied metal that shot higher in price when inflationary panic struck in the late ’70s.

Because fact is, gold also offers a deep, liquid market (if held in its internationally tradable form of large wholesale bars) with no risk of counter-party default (if owned outright, rather than through a trust or a fund or a similar financial structure).

In our debt-deprived world today – where the outstanding value of what retirees and savers are owed is deflating much faster than costs – it’s this attraction of gold…it’s “off risk” advantage…which is fast-gaining appeal amongst large funds and private investors alike.

Inflation and deflation – both a crisis in money – both also force business and growth to give up. What remains, paying zero and promising nothing, is the need to simply store wealth and savings for a better future, whenever it shows.

Regards,
Adrian Ash
BullionVault

February 20, 2009

This article was originally featured on Whiskey and Gunpowder

Gold Amid Inflation and Deflation

“The twilight of gold appeared to have arrived,” wrote Niall Ferguson – now a Harvard professor, then an Oxford scholar – of the metal’s 20-year bear market at the end of the last century.

“Gold has a future of course,” he added, “but mainly as jewelry.” And it’s a common enough long-term view of the metal, repeated every so often by economists, historians, columnists and analysts.

“The stuff has a historical place in the money market,” as one New Zealand advisor put it in a note to her clients in 2003.

“But gold’s just that – historical.” So historical, in fact, it deserves to be scorned – along with human sacrifice, living in mud huts and VHS tapes – as primitive, brutish, uncivilized.

“Was it not I,” asked John Maynard Keynes, man of the moment when the world’s financial system needed re-booting in 1945, “who wrote that ‘Gold is a barbarous relic’…?”

Man of the moment once more today, Keynes was hardly first to disdain the metal as money, however – even if he was part of the Bretton Woods’ team which replaced it with US dollars. Printed at will, the Dollar would prove so much more flexible, more available than tightly-supplied gold. Amid the Great Depression of the late 1920s and ’30s, Keynes called for Great Britain and then the rest of the world to stop redeeming its paper notes for gold coins or bullion. The supply of money and credit could then start flowing freely once more, boosting demand for goods and services and sparking an inflation in prices that would make the value of outstanding debts evaporate. Yet the scheme was nothing new. More than two centuries earlier, John Law – another visionary economist – had proposed and attempted the very same thing.

A world-famous gambler, convicted murderer and exiled Scot, Law gave the world its first modern bubble and bust. His grand system – first proposed in his book, Money & Trade Considered (1705) – sought to revoke state bankruptcy by replacing gold money with arable land, paper notes, stock-market shares, future tax revenues, the Mississippi Delta…anything but more metal.

“It is in the interests of the King and his people to guarantee bank money and to abolish gold specie,” wrote Law as he applied his theory to France’s very real financial crisis. Giving monetary power to, say, the stock of his Mississippi trading company, would “diminish the value of gold by taking away its usage as money.”

But those dumb Frenchmen! Whenever they took profits by selling Mississippi stock as it doubled, trebled and rose 10-fold, they “thought they might turn it into heaps of gold and silver, which they call realizing,” spat Law.

Couldn’t they see?

“The lands of France are worth more than all the gold which still lies hid in the mines of Peru,” Law declared. “The stocks [of his Mississippi venture] actually surpassed in value all the gold and silver which will ever be in the kingdom.”

Yet still the French crowded out of his stock and into gold as the bubble burst in 1720. Come May, John Law banned the use of monetary metal altogether on pain of fines, imprisonment and even death – stealing a march on US president F.D.Roosevelt by some 213 years.

Make no mistake; Law would have been right to price Mississippi stock far above money…if only his Compagnie de l’Occident had held any real value at all. Instead, it owned a million miles of disease-ridden swamp, plus a sick colony of ex-beggars and thieves lost in Louisiana. Whereas gold offered then just what it offers today: very little of productive value, but a time-honored bolt hole when nothing else pays.

Gold’s only value, you see, comes in owning it – whether for adornment, to escape the risk of counter-party default, or as a defense from inflation. Any other class of financial asset, provided it offers a yield, income or growth, should win out over gold. Just so long as they it keeps delivering that yield, income or growth. Because gold, a raw lump of metal, will pay nothing and do nothing besides holding its value across the very longest of long terms.

How long is the long term? “It is said that an ounce of gold bought 350 loaves of bread in the time of Nebuchadnezzar, king of Babylon, who died in 562 BC,” wrote Stephen Harmston – then an economist at Bannock Consulting – for the World Gold Council (WGC) just when Niall Ferguson was condemning gold as mere frippery ten years ago.

“The same ounce of gold,” Harmston went on in his study, gold as a store of value,”still buys approximately 350 loaves of bread today.” Which seems an odd swap to us, unless you’re very hungry indeed. But “across 2,500 years, gold has in other words retained its purchasing power, relative to bread at least.”

Crucially for long-term investors – especially for those with 2,500 years to wait – “Gold has had a real rate of return of zero,” as Harmston observed. Meaning it doesn’t beat or lag inflation or deflation. Not across the very long run, that period in which “we’re all dead” as John Maynard Keynes, himself now very dead for six decades, once said.

To get this straight, it bears repeating. Gold is NOT the ultimate inflation hedge, not compared with dividend-paying, growth-dependent stock investments. Not unless you keep your entire savings tied up in gold bullion in, hedging your very existence against a loss (or gain) in the value of money. And not unless you get to exist for an awfully long time to come as well.

Across the slightly-less long run – say, a mere one-and-a-half centuries, rather than two-and-a-half millennia – the inflation-adjusted value of gold remains well below where it started on average.

The value placed on gold when the Bank of England set the international gold standard in motion in 1844 has rarely been seen since. And on the historical view (and gold is “just that – historical” as our Kiwi advisor noted above) it’s in fact slipped by 15%, slowly declining before turning decisively lower throughout the 20th century.

Why would the world (the best proxy for which, we guess at Bullion Vault, is the well-attested British experience) put progressively less value on gold amid the murder and mayhem…bubbles and busts…of the last 100 years? Why did gold lose purchasing power – and then continue to lose value – both during and then for a long while after total war swept Europe, Africa, Asia and the Pacific? Surely such death and destruction should force gold to a premium?

The fact is, however, that the 20th century also brought fresh competitors for investment wealth…competitors rapidly offered to every class of investor as the Second World War receded and then the “Big Bang” of deregulation began under the Thatcher and Reagan administrations.

Yes, it may seem heretical (if not blindingly obvious, depending on where you start), but like charcoal and shire horses, steam trains and gas lamps, the 20th century subjected gold to a sharp loss of relative utility and thus value. Gold’s only use comes in its ownership, remember; so its value as a store of wealth necessarily depends on the supply of alternative holdings. And the 20th century brought a flood of competition for that role.

The upshot today, almost a decade after Gordon Brown’ infamous gold sales marked not the high-point of anti-gold sentiment but also the very nadir of its 20-year slump? Free from default risk and inflating supply, gold suddenly looks very attractive to fund managers, investment advisors and private individuals who only a few years ago mocked the idea that metal might be worth owning.

Sure, the time may soon come when gold’s one single use is matched and bettered again, beaten by other, more productive investments. But until then – and as gold’s current price action suggests – what else will you hold as stock earnings tumble, bonds are over-supplied and threaten default, and the value of money itself is forced ever-deeper into genuine crisis?

Regards,
Adrian Ash
BullionVault

February 13, 2009

This article was originally featured on Whiskey and Gunpowder

The Long-Run Value of Gold, Part III