By Tyler Durden | 23 March 2010
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Digging In
Some would say the time to sell is now. Gold just isn't the misunderstood, widely shunned asset it was a few years ago. Isn't the gold bull market now long in the tooth, with better opportunities to be found elsewhere? I can understand this view. Had you bought stocks at the bottom of the bear market in 1974 and held them for ten years you'd have seen them go from being hated to being loved.
And as the number of mutual funds exploded you could have plausibly argued that since stocks were no longer the deeply contrarian plays they'd been, they should be sold. But you'd have missed spectacular gains over the next 15 years because the social contrarian indicators said nothing as to how favourable underlying conditions were for risk assets.
And even as insolvency is now a universal fact of life, the outcome, as Ebullio found out the hard way, is still either/or— with both hyperinflation and deflation likely (with a dash of stagflation thrown in for good measure).
Though developed market governments are insolvent by any reasonable definition, it's far from inevitable that this insolvency will precipitate an extreme inflationary event— it's just that it might. And although I've wondered aloud if Ben Bernanke is in fact the reincarnation of Rudolf von Havenstein— the tragic president of the German Reichsbank who presided over the Weimar Hyperinflation (speculative evidence presented below)— I don't think he actually is; it's just that he, and other central bankers, might be more alike than they think.
Gold, like all other commodities, is inherently speculative. Unlike well chosen stocks which you buy to hold to take advantage of their wealth-compounding properties, you only ever buy commodities to sell later. With this in mind, when should you sell gold?
The Age Old Question— Is Gold A Currency?
Willem Buiter called "Gold— a 6000 year bubble?" —ft.com. The late and great Peter Bernstein subtitled his book about gold "the History of an Obsession". But much as I admire these two great minds, such loaded phraseology implies there to be something irrational about owning gold and I think that's just plain wrong. The fact is that there is a fundamental need for a reliable medium of exchange. Early civilisations used pebbles or shells. Prisoners and others have used cigarettes.
Having a medium of exchange makes life far easier than in a barter economy and societies have always organised themselves around the best monetary standard they could find. Until industrialisation of the paper printing process, that happened to be gold, which is small, malleable, portable and with no tendency to naturally waste away or oxidize (ie, it is relatively indestructable— unlike paper money, it won't even burn). Crucially, it's also exists in relatively limited amount and this particular characteristic (in combination with the others) can be very useful in environments characterised by monetary mischief.
I view it primarily as insurance against such environments. It's a lump of metal with no cash flows and no earnings power. In a very real sense it's not intrinsically worth anything. If you buy it, you're forgoing dividend or interest income and the gradual accumulation over time of intrinsic value since a lump of cold, industrially near useless metal can offer none of these things. That forgone accumulation of wealth is like the insurance premium paid for a policy which will pay out in the event of an extreme inflation event.
Is there anything else which will do that? Some argue that equities hedge against inflation because they are a claim on real assets, but most of the great bear market troughs of the 20th century occurred during inflationary periods. A more obvious inflation hedge is inflation linked bonds, but governments can default on these too [[or cheat on the inflation 'measures': normxxx]].
More exotic insurance products like 'sovereign' CDSs, inflation caps, long-dated swaptions or upside yield curve volatility all have their intuitive merits. But they all come with counterparty risk. Physical gold doesn't. Indeed, during that "6000 year gold bubble" no one has defaulted on gold. It is the one insurance policy which will pay out when you really need it to.
There is nothing mystical about gold and I don't consider myself a gold bug. In fact, I'm not sure I'd even classify gold as an "investment" in the strictest sense of the word. Well chosen equities (not indices) will act as wealth-compounding machines and are likely to make many times the initial outlay in real terms over time.
These are "investments" because so long as the economics of each business remains firm, you don't want to sell. As they say in the textbooks, you "buy to hold". But gold isn't like that. Like all commodities, it's intrinsically speculative because you only buy it to sell it in the future.
There has never been a more appropriate time to be long gold than now, when every developed country is either insolvent or on the brink, and desperately applying band aids to mask the fact. The reason I own gold is because I'm worried about the long-term solvency of developed market governments. I know that Milton Friedman popularised the idea that inflation is "always and everywhere a monetary phenomenon" but if you look back through time at inflationary crises— from ancient Rome, to Ming China, to revolutionary France and America or to Weimar Germany— you'll find that uncontrolled inflations are caused by overleveraged governments which resorted to debasing/printing money as the easiest way to avoid explicit default (whereas inflation is merely an implicit default).
It's all very well for economists to point out that the cure for runaway inflation is simply a contraction of the money supply. It's just that when you look at inflationary episodes you find that such monetary contractions have very rarely been politically viable courses of action. Economists, we find, generally don't understand this because (like most specialists) economists look down on all other disciplines, such as history, which might teach it to them.
But most historians understand that while the economic laws might hold in the long run, in the short run the political beast must be fed. I wrote about the Weimar Hyperinflation a few weeks ago and showed, for example, that Rudolf von Havenstein (Reichsbank president) was terrified of pursuing such a monetary contraction because he was so fearful of the social consequences that rising unemployment and falling output would elicit [[and which came to pass anyways, but only after the hyperinflation had long passed, taking with it the middle class and setting the stage for Adolph Hitler: normxxx]]. But the agonizing dilemma he faced, identical in principle if not in magnitude to that faced by policy makers today, is as old as money itself.
In the 3rd century AD, as the Roman Empire became too large and unwieldy, its borders were consolidated and the great imperial expansion was halted. Though necessary, this consolidation posed problems. While the Empire was in growth mode, driven by military conquest which strengthened public finances, the army more than paid for itself.
Indeed, it was an asset on the national balance sheet. But when that territorial growth was halted, a hole was created in the budget since, while the army was still needed to defend the borders, it was no longer self-funding because there was no territorial expansion [[with its share of loot and plunder: normxxx]]. Roman emperors discovered that contracting expenditure to fit with new lower revenues was a difficult feat to pull off.
So rather than contract military spending, public works or public entertainment— long-term necessities which were painful in the short run— they opted to buy time by using successive currency debasements. (What the declining Roman empire was doing then is precisely what Ben Bernanke and all central bankers are doing now.) Ultimately, this would culminate in the world's first, of many, fiscally driven inflation crises (see charts below).
Click Here, or on the image, to see a larger, undistorted image.
1800 years ago, the fiscal sobriety so clearly needed in the long run was subordinated to the short-run requirement to buy time. They succumbed to the age-old short-term temptation to debase the currency, hoping that no one would notice. Paring overstretched government balance sheets has never been easy. As the Romans should have done in the third century, developed market governments today will [eventually] have to come clean with their citizens that— since keeping the welfare promises they've made over the years will bankrupt us all— those promises are going to have to be "restructured": government expenditures will have to be substantially reduced and services cut.
Click Here, or on the image, to see a larger, undistorted image.
Alas, the sugar substitute of denial, especially when faced with mid-term elections, is easier to swallow than the bitter pill of cutting back to live within one's means. Governments aren't ready to swallow the bitter pill at the moment (the chart above shows just how painful the required measures could be). Indeed, the pressing fear among policy makers today remains that the sugar, ie, "stimulus", might be removed too soon.
In the UK, policy makers refuse to "risk the recovery we've fought so hard for" to quote PM Gordon Brown. In the US, lawmakers have just expanded the most inefficient health care system on the planet (according to Peter Peterson —ft.com there are five times as many CT scans per head in the US as there are in Germany, and five times as many coronary bypasses as in France). It has been promised that the increase will be deficit-neutral (which I doubt) but even if it is, current period deficits aren't the correct way to look at health and pension obligations which should be examined on an actuarial basis. (And, if expanding the program is so difficult, wait until they try contracting it!) [[That's really not so hard. They just cut the resources and subsidies, and the quality of health care goes down, but most especially for those with the rare conditions, so hardly anyone notices.: normxxx]]
But they will have to face up to these problems one day, because they must. And the good news is that there are precedents for policy makers adopting the policy of short-term pain for longterm gain. In the UK in the 1970s, for example, the country grew tired of lurching from one crisis to the next, of militant trade unions and of high inflation. Eventually, they elected Margaret Thatcher who promised to control inflation and smash the unions even if the short-term pain would be severe. She did, and it was.
But the rest (despite 364 economists petitioning her that such drastic measures threatened social stability— see How 364 Economists Got It Totally Wrong— Telegraph) is history. The key point to bear in mind is that she was elected with a mandate for short-term pain which hadn't existed five years earlier. The political winds had changed.
Ireland, in the process of swallowing bitter fiscal medicine today, offers a similar example. I've been over there a couple of times in the last few months and it's heartbreaking. Its economy has contracted by nearly 10% since the peak of the credit bubble and my friends in Dublin tell me that, unofficially, house prices are down 60-70% from their peak. Unemployment has spiked to around 15%.
The striking thing about being there, though, is that while no one is happy about them, and there have been strikes in protest at the distribution of the pain (which, in passing seems to be a feature of the political climate during such crises), on the whole there seems to be an understanding that such measures are unavoidable. These draconian fiscal policies wouldn't have been possible five years ago. But the political winds have changed.
Click Here, or on the image, to see a larger, undistorted image.
The reason why gold has been so popular lately is the combination of all the factors that make the mixture explosive, with just the ignition catalyst missing. That catalyst— government crises. And look no further than Europe to see what happens when an entire continent is on the verge of collapse as a flawed monetary and socio-economic experiment not only disintegrates, but takes down the bulk of the constituent countries with it.
What causes the political winds to change? A government crisis. In 2008, Ireland came very close to going the way of Iceland. They had their crisis. And historians today still refer to the "inflation fatigue" in Britain at the end of the 1970s. This was our crisis. So what we learn from these experiences and others like them is that a fiscal crisis is required to force a majority acceptance of the painful necessity of downsizing an overleveraged, grotesquely expanded government.
The political winds in countries with central banks are a long way from blowing in the direction of fiscal rectitude. And while it's true that more people are at least talking about it, talk is cheap and no one is yet close to walking the walk. Such steps remain politically unpopular because we haven't had that crisis yet. But given the clear unsustainability of government financial trends and the explosive path government leverage is on, a government funding crisis is unavoidable. Iceland, Ireland, Dubai and Greece are merely the first claps of thunder in what is going to be a long, world-wide emergency. [[If we are lucky, figure another eight to twelve years.: normxxx]]
Eventually, there will be a crisis of such magnitude that the political winds change direction, and become blustering gales forcing us onto the course of fiscal sustainability. Until it does, the temptation to inflate will remain, as will economists with spurious mathematical rationalisations as to why such inflation will make everything OK (witness the IMF's recent recommendation that inflation targets be raised to 4%: IMF Tells Bankers to Rethink Inflation —WSJ). Until it does, the outlook will remain favorable for gold. But eventually, majority opinion will accept the painful contractionary medicine because it will have to. That will be the time to sell gold.
In closing, we would like to add that one should also not ignore the technical pressures on the gold market, with price suppression by the Fed and JP Morgan proven beyond a doubt. Should a full blown government crisis develop and price supression break down, watch what happens when the rush to cover those massive gold shorts ensues. Indeed, the time to sell gold is not now, nor any time in the foreseeable future. The time to buy, however, will depend on fluctuating levels. A push by the central banks to break the gold support level that results in a slide back into the triple digit range will be as sure a buy signal as any.
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Normxxx
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