The gold sell-off

In our previous post discussing Cyprus, we noted that governments in general have three choices when they run up debts beyond what their income can support.

One option, of course, is to increase their income.  Governments can try to raise income by raising tax rates or, a far better option, by encouraging economic growth which will lead to greater tax revenues even if tax rates stay the same or go lower.

A second option for governments is to borrow further.  Governments do this by selling bonds.  If they do too much of this, however, it can cause their borrowing rates to go up and their credit rating to go down.  

A third option is to print more money in order to pay for their expenses.  Because a big part of those expenses are interest payments on their debt, this option is also known as "monetizing the debt."  It is  also known as inflating the currency.

One of the consequences of inflating the currency is that it takes more dollars to buy the same amount of the same thing, and one of the places this effect can be most easily seen is in the number of dollars it takes to buy a fixed amount of gold.  Since a gold bar of equal weight and equal purity made in 1970 is no better and no worse than a bar of the same weight and purity made today, the difference in the price of the same gold bar in 1970 and today is primarily a function of the inflation of the currency. 

When governments inflate a currency, the price of gold and other commodities go up in relation to that currency.  When people expect a lot more inflating activity in the future, many of them will start to buy gold or other commodities in the anticipation of the rise in commodity prices.

Gold has been on a nearly unbroken bull run since 2001, but since the publication of the previous post on Cyprus something very significant took place in the gold market: the price of gold, which had been settling slowly after reaching all-time highs in August of 2011, plunged 25% during the week of April 8th through April 12th, and then continued to plummet on Monday, April 15th with a drop of over 9% in a single day -- the biggest one-day drop in thirty years.  The price of gold ended last week just above $1400 per ounce, down more than 25% from the high of $1,900 reached in August, 2011.

Does this drop signal the end of something, or is it just a big head-fake in a landscape that has not changed?  Arguments that nothing has fundamentally changed and that the reasons for buying gold remain intact are well summarized in this article entitled "Gold Down: What Now?" by Frank Seuss, published in the Daily Bell.  In that article, the author argues that: 
Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so. The recovery story is really just that: a story. All the reasons to buy and hold gold as a medium- to long-term crisis hedge and for portfolio diversification are fully intact. The only difference is that now, or in the next few weeks, we can buy at a much better and more reasonable price.
In other words, he believes that the economic recovery is a "myth, a word he uses earlier in the article.  While this article does not give the authors reason for calling the economic recovery a myth, many who are in that camp argue that any growth the economy has experienced since the crisis of 2008-2009 has been the product of easy money from central bankers and stimulus spending from central governments.  Those in this camp note that such policies inevitably lead to more inflating, which will inevitably push up the prices of commodities including gold.  Some in that camp also believe that the situation could get so dire that it could lead to an outright collapse, in which case fiat currencies would become worthless while tangible stores of value such as gold would not.

Although we adamantly oppose inflating the currency, we believe the arguments of those in the "myth" camp are mistaken.  

One of the primary problems with the argument is the idea that the economic recovery is all a product of emergency government spending and central bank easing.  We believe this view gives far too much credence to the healthful powers of government spending and easy money.  In fact, we believe government spending and excessively easy money are harmful, not helpful, and that the recovery has taken place in spite of such actions, not because of them.  We suspect that without such obstacles, the recovery would have been much stronger over the past four to five years.

Secondly, there may have been some other factors at work fueling gold's spectacular 12-year bull run than simply fears of inflation and speculation of more government spending and monetary expansion, although those certainly contributed.  In this important blog post entitled "Gold is re-linking to commodities," published last Monday April 15, retired economist Scott Grannis argues that the surge in the demand for gold corresponded to a decade of explosive growth in China, which caused China to increase their foreign exchange reserves at a rapid pace.  

Holding foreign currency exposes a country to foreign exchange market risk, and a common move is to use those reserves to buy commodities, including oil and gold.  In his posts on this subject, Scott Grannis presents some excellent charts showing a very strong correlation between the increase in China's foreign currency reserves and the steep climb in the price of gold, beginning around the year 2001.  He explains: "This came to an end in early 2011, as net capital inflows to China approached zero, and shortly thereafter gold peaked.  Both forex (foreign exchange) purchases and the price of gold increased by many orders of magnitude over roughly the same period."

These arguments contradict the idea that "Fundamentally, all of the reasons that made gold an ever more attractive asset over the past years are still fully in place, and increasingly so," as those in the camp of the "recovery myth" believe.  

Trying to predict the next move in the price of any commodity is extremely difficult, and we believe that doing so correctly year-in and year-out for long periods of time is next to impossible.  We have always argued that it is much wiser to invest capital in businesses which can be analyzed based on their business plan and management team than to speculate on the ups and downs of commodities, including gold.

The indisputable history of governments with fiat currencies over time is to inflate those currencies.  The question is how investors should protect themselves against such depredations.  While ownership of gold is a well-known strategy in this regard, speculating on the price of gold is fraught with peril, especially because the price of gold can be influenced by numerous factors, some of which are unknown to the general public.  We believe this is a very important subject for our readers to understand.