Why Gold?

why-gold

“Since the financial crisis began, Gold grudgingly began to form a part of the investment landscape and gradually began finding a role back in investors’ portfolios. But as we complete more than 5 years from arguably the “depth” of the financial crisis, it is remarkable that the debate about the utility of Gold as an investment still remains an open one in the mainstream press. Indeed, we believe the temporary success of Central Banks in levitating asset prices with some signs of an economic revival in the US has encouraged main stream investors to discount the role of Gold in portfolios and we would argue abandon the precious metal.

As grudgingly as it began to find a place in investor’s portfolios; it today comprises a still miniscule portion of total global assets and mainstream investors and “sell side” broker firms that were tripping over themselves in calling for higher targets on the way up have been very happy to call for lower and lower targets on the way down.

As adherents of the Austrian School of Economics we have a bias and a preference towards “commodity” money. But events of the last few years should prove beyond a doubt that Central Bankers (on the PhD standard as Jim Grant calls it) cannot be trusted to run a monetary system with a fixed & stable emission of money as Milton Freidman and the monetarists thought they could. As adherents to the Austrian School our investments in Gold will prosper or wilt in the future, on the validity of the tenets of the Austrian School. We are prepared to take that chance.

Ludwig von Mises, the doyenne of the Austrian School, famously said “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.”

The first alternative course of the sentence implies deflation and the second course implies hyperinflation.
In that sentence Mises starkly lays out the denouement that Western economies find themselves in today as a result of the credit boom that Central Banks fostered from 1995 onwards.

In that sentence Mises lays out the choices that face today’s Central Banker’s (and the Government Fiscal authorities)- will they voluntarily abandon encouraging further credit expansion or do they continue to “kick the can” down the road; risking a total catastrophe of the currency system. Neither Central Bankers nor investors know how far the road runs but run out it surely will.

So far at least, Central Bankers and Governments have chosen the latter path and willingly embrace, to us, the risk of a total catastrophe of the currency system. While we are not sure they will continue to embrace this course for ever; as protection against either course, we choose Gold.
There are several reasons for our choice of Gold in either a deflationary or inflationary/hyper-inflationary environment:

    1. In 3000 years of history, Gold has been the “people’s” choice as the instrument best serving the function of “money” in voluntary exchange. Governments only adopted Gold and then adapted it as their form of “money” as it enjoyed widespread acceptance and support. In fact civilizations that adopted gold and kept a fixed and unvarying amount of Gold prospered. Throughout history there have been several episodes of Governments abandoning Gold as the centerpiece of their “money”, most often during wars. Almost always they had to tether themselves back to Gold (or sometimes Silver) in order to stabilize or prevent a collapse of the economy and the monetary system, invariably at far higher exchange rates than when they went off- to prevent deflation and to anchor the value of the liabilities to a stable unit-lest the value of liabilities collapse.
  • The monetary system we have today is not the result of any grand, intelligent design but a system that has come about by a series of accidents and a result of lurching from one expedient “solution” to the next that culminated in August 14th 1971 when Richard Nixon broke the link between the US$ and Gold. Nixon abandoned the gold exchange standard in order to protect the loss of US Gold reserves to Europe (read France). The Gold Exchange Standard itself which came about after WW II was the result of the US finding itself the holder of 90% of official Gold Reserves. That was the result of confiscation of private gold holdings held by US citizens in 1932 in order to bolster the monetary reserves of the Government and thereby stabilize the US banking system. The abandonment of the Gold Exchange Standard in 1971 unleashed a virulent inflation that was only brought down in the early 1980’s after putting Western economies through stratospheric unemployment and record interest rates. The system was stabilized after 10 years of stagflation, severe economic hardship and even then all it managed was no “real “net growth in credit. The current episode of an all “fiat-money” system has thus been continuing for 43 years. This has been the longest episode that we are aware of bar one- an episode for 43 years in China during their on again and off again 200 year experiment with paper money (at that time Silver was the commodity money).

 

  • Gold is the only “monetary” asset that is not another entities liability. Every other form of “monetary” asset-what Austrians call “fiduciary media”- is effectively some other entities liability. The checking account is the bank’s liability, backed by reserves at the Central Bank. The reserves at the Central Bank are the CB’s liability backed by US Treasury Bonds (and now increasingly some junkier assets) and the US Treasury Bonds is the US Governments liability backed by – the taxing power of the Government! The US taxpayer has willy-nilly become the ultimate guarantor of all the fiat money in issuance! In a consolidation of bank liabilities except for Gold there is no other monetary asset. The only monetary asset that can conceivably back US Treasury Liabilities in extremis is the Gold purported to be held by the US Treasury. We say purported because the Fed and the Treasury have resolutely refused to allow any independent audit of their gold holdings. At today’s price of Gold this monetary asset is supposed to be worth some USD 250 billion to USD 300 billion and theoretically backs USD 3 Trillion (and counting) of foreign Central Bank holdings of US T-Bonds, and USD 4 Trillion or so of the US Federal Reserve holdings. We therefore have a “debt based” monetary system. The illogic of this arrangement in our current monetary system is patent when we reflect that the greater the emission and issuance of debt the more “wealthy” we are!

 

So if the logic of holding Gold as insurance against extreme economic scenarios -both deflation and/or inflation/hyper-inflation- holds well and has happened in almost all historic periods that we are aware of, what is the % of investable assets that is reasonable to hold?

Again drawing from history the answer has been surprisingly consistent- 10% of assets.

The reason is, in any deflationary episode other assets: equity, corporate debt obligations (and we would argue even the Government obligations in the future) and real estate- decline by 90% or so in nominal terms. Gold has usually held its nominal value, at least ultimately. Ergo a 10% position will allow one to restore the asset position at least in terms of its command over equivalent assets at the end of such a deflationary episode in relative terms. Incidentally, there have been 5 previous episodes of deflation since 1600 (since when we have accurate records of financial history). Each of these 5 episodes was the result of a prior credit boom not dissimilar to ours, and the propagation of “novel” banking nostrums and “elastic money”. Let me recount them: South Sea Bubble (UK), Mississippi Bubble (France), 1810-20 (UK), 1873-1895 (US), 1929-39 (US/Global), Japan (1990 to current). This is the sixth or seventh episode depending on how one counts. Each one the previous episodes ended in deflation, high “real” interest rates, a high “real” price of Gold and a boom for Gold producers and their equity securities.

Conversely, in rapid inflationary or hyper-inflationary environments, Gold has become the asset of choice and risen by 10 x’s on a relative basis, again allowing one to maintain the asset purchasing power of a portfolio that incorporates at least 10% in Gold as a whole. But if truth be told in our opinion, inflation does not benefit Gold per se. It is only the prospect of a recalibration to a far higher price of Gold to the increasing extent of the liabilities (‘fiduciary media’) that is ultimately required to prevent severe deflation that benefits Gold.

Our own belief is that in today’s globalized economy, footloose capital flows will ultimately not allow Central Banks the freedom to go all the way down the hyper-inflationary route, and that well before we reach that juncture, monetary arrangements will be changed so that logic of bringing the Gold Standard or some such variation, back into Global Monetary arrangements becomes a reality. Maybe the creditor countries will insist on it. Maybe it will happen as a result of being at the brink of a systemic collapse. We cannot guess what nature or shape that would ultimately take, but if the world is to avoid going through a severe deflationary episode the only way it can be done, we believe, is to re-price these un-repayable debts and liabilities by maintaining the nominal values of these liabilities by inflating the price of the only monetary asset that is no one else’s liability-and that is Gold.

Whichever way one looks at it, that price is going to be a whole lot higher than the price we see today. In fact something dramatic need not be done. Governments/Central Bank’s could merely announce that they stand ready to buy Gold at a certain price, to build their reserves and the market will do the rest by finding the right price that will ensure that the banking system is properly liquefied with adequate “real” reserves. A reverse process to what happened in the late 1960’s that led to the abandonment of the Gold Exchange Standard when Central Bankers tried to defend the fixed parity price of Gold at US $ 35 despite the issuance of liabilities far in excess of that. But what we cannot be sure of is when Governments, Central Bankers, the IMF, BIS, et al will see all this as obviously as we see it-that they have the magic bullet that they seek to turn back the tide of the deflationary forces- by bringing back the Gold standard and validate all the inflation that they have already engendered. Let us just say, so far we have been severely disappointed by their perspicacity!

So if we are convinced about the confluence of these events happening, sometime in the future, say certainly within the next decade; can we make any near term predictions about the price of Gold. Alas we have to reply with an emphatic no!

Using and being limited by the various methodologies that we use, it seems to us that there is still the possibility that Gold can trade lower in nominal terms, perhaps down to $1,100 or so, but we are reasonably convinced that in either eventuality of a severe deflation or inflation, Gold is mispriced relative to what it will finally settle at. For anyone contemplating purchasing gold for the first time in this period of high relative prices, we would recommend a dollar cost averaging program. Say a certain % per month or per quarter as appropriate.

We continue to view Gold’s role primarily as insurance in protecting the purchasing power of assets and retaining the command over goods & services in any extreme economic environment including in the event of a systemic banking and financial crisis. Grant Williams used the phrase “unsurance” to describe Gold’s roles as a protection for the time when market participants become unsure about the central banks ability to keep their confidence game going.

So far we have come close twice in recent memory -1998 and 2008. Both times a systemic collapse was avoided by extreme measures but no real “solution”-only more of the same (issuance of “fiduciary media”) and the substitution of private debt for public debt and in far larger quantities than has ever been experienced in financial history. Both times the policy of driving asset prices higher to engender a “feel good” wealth effect have been seen as a substitute to real economic growth built on thrift, savings, investment and higher productivity. By lowering the prospective returns on assets are far lower than the required historic returns is ultimately a self-defeating exercise and when asset markets turn down belying the expectations of a euphoric public, they are prone to panic as they all realize their folly at once.

But where do Governments in any case,get the wherewithal to back the issuance of this public debt….it is only through their taxing power and the ability to tax every citizen. And if they choose to do that are there no consequences to the economy?

Can a systemic collapse be avoided again? Who knows? But for those that feel there is a chance, even a slim chance that the road that the Government authorities are ‘kicking the can’ down will END sometime, we would suggest holding a combination of Physical Gold (with the possibility of access in extremis) and very select Gold related equity securities as insurance. Of Course we fully expect that Governments will do the right thing eventually, mankind will progress, but the transition to the “right way” may well be very rocky indeed and in the meantime we hold Gold-as insurance and as “unsurance”.

Prashant  K Trivedi, CFA

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