Saturday, September 12, 2009
Like a battering ram in a medieval siege, gold keeps hammering away at the gate. For the third time in less than twelve months, the yellow metal is once again crashing into the $1,000 per ounce level. As of press time, it looks like gold will close above that level today and will set a new record in the process. Even if the breach is fleeting, who can doubt that it will mount another assault soon? In the meantime, there is no shortage of market analysts who are not buying gold while questioning the motives of those who are. Although they offer a variety of strained reasons, they nearly all agree that it has nothing to do with inflation, which is nearly universally considered dead and buried. As a self-confessed gold bug, I can assure all that inflation is the only reason I buy gold. And recently, I’m buying a lot.
When individuals choose to accumulate savings in the form of gold rather than interest-bearing paper deposits in government-insured accounts, there is only one reason for doing so: they fear that the interest will not be enough to compensate for their expected loss of purchasing power through inflation. This fear reflects both current inflation and the expectation for future inflation. While there are those who buy gold to speculate on its appreciation, the underlying factor that drives that appreciation in the first place will always be inflation. If governments were not creating inflation, there would be little investment advantage to owning gold.
Some believe that gold investors are primarily motivated by fear. It is often assumed that gold is the one asset class that holds its value when all other asset classes are falling due to market uncertainty. But this explanation brings us right back to inflation. When economies move into recession, there is always political pressure for governments to intervene. Their one tool is the printing press.
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When governments act to prop up sagging markets, or bail out investors or depositors of failed institutions, they create inflation (print money) to pay for it. This, in effect, transfers capital from prudent investors to speculators. At the same time, it pulls the rug out from under the safest vehicles of traditional investment – bonds and cash. It becomes hard for investors to protect their principal, much less grow their wealth. Some turn to gold, with its historically guaranteed ‘floor’ against losses, and others start making ever riskier investments to try to ‘beat’ the inflation rate.
Gold’s appeal as an asset of choice during times of political uncertainty, particularly during wartime, is again a function of its being a hedge against inflation. Wars are always expensive. They are also often unpopular, which makes paying for them through tax increases politically dangerous. As a result, they are almost always financed through the ‘secret tax’ of inflation. For a nation that loses a war, or suffers revolution or systemic civil conflict, there is always the chance that its currency could become worthless. While this may not be the kind of inflation that we read about in the business section, it is the ultimate form of the monetary malady – whereby a currency loses all of its purchasing power.
Whenever the price of gold rises sharply, I always take it as an early warning sign that inflation expectations are rising. If those expectations are not met, its price will fall. If the market is correct, gold will maintain its gains. And if the inflation continues to intensify, so too will gold’s rise. Most analysts, however, simply look at the dubious CPI to determine the presence of inflation and inflation expectations. They perennially forget that prices are a lagging indicator and only a symptom of inflation, and may in fact not be rising at the moment when inflation kicks into high gear.
The anti-gold camp takes their greatest solace from the bond market, where things have been eerily quiet. They maintain that since bond yields have not risen much, inflation must not be a problem, and so the gold bugs are simply paranoid. The bond market, they tell us, is populated by ‘vigilantes’ who sound a bugle call at the first whiff of inflation. But this argument ignores the fact that central bankers themselves are the biggest bond buyers and are in effect ‘vigilantes-in-chief.’ Their outsized participation in the market has led to gross distortions. When the Fed or another central bank buys treasuries, real returns are not considered. Purchases are made for political reasons rather than investment merit, which renders meaningless the signals current bond prices are sending.
The gold-bashers also believe that reduced consumer demand due to unemployment will keep inflation pressures at bay for the foreseeable future. However, inflation will ultimately act to reduce the supply of goods much faster than unemployment reduces demand for goods, sending prices up despite lower demand. The stagflation of the 1970s is an example of such an outcome.
The bottom line is that gold is continuing its long-term bull run, and those who dismiss the message behind its rise do so at their own financial peril. When it comes to inflation, gold is the canary in the economic coal mine. Just as unseen toxins kill the canary before the miners succumb to the fumes, a spike in gold is a harbinger of reckless monetary devaluation. Our leading commentators think that since they can’t see or smell the gas, all those canaries (gold prices, commodity prices) must be dying of natural causes. Good luck to them when the toxins flood the mine.
This article was posted: Saturday, September 12, 2009 at 4:58 am