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The question most often asked of gold
bulls is, “At what price will you take your profits?” It is a
question that betrays a lack of understanding about why anyone should own
gold. Nevertheless, the simple answer must be, “When paper money stops
losing its value”. This response should alert anyone who asks this
question to the idea that owning fiat cash is the speculative position, not
ownership of precious metals.
This
sums up the problem. Instead of gold, people commonly think of paper money as
the only medium of exchange and as a store of value; cash is after all their
unit of account. They see the gold price rising when they should be seeing
the value of paper money falling. Because cash is everyone’s unit
of account it is wrongly seen as the ultimate risk-free asset. This is also
the fund manager’s approach to investment: his investment returns are
calculated in paper money, so he cannot account for a superior class of
asset. He is also taught to spread investment risk across a range of
inferior asset classes to enhance returns. Therefore the investment manager
wrongly assumes that precious metals is one of those inferior asset classes.
All modern investment management works on these assumptions.
This
helps explains why managed portfolios today have very little exposure to
precious metals, but there are other reasons. Investment funds in total have
grown rapidly since the 1970s on the back of money and credit creation.
This monetary expansion has fuelled both new funds for investment as well as
asset prices generally, while gold and related investments became
unfashionable in gold’s twenty year bear market between 1980 and 2000.
The combination of these two factors reduced precious metals exposure in
managed portfolios to very low levels. Gold was therefore ignored as an
asset class when modern portfolio theory evolved in the 1990s, and is simply
not considered by the current generation of fund managers.
Consequently,
investment funds of all types invest in bond markets, stock markets, property
assets, securitisations, foreign currencies and to a minor extent general
commodities. From time to time they may have had temporary and
speculative exposure to precious metals, but very few fund managers actually
understand that gold is the ultimate hedge against cash losing its
value. After all, if you account in paper money, paper money has to be
the risk-free position. The understanding that cash is not risk free is left
to private individuals not misinformed by modern portfolio practice.
The
world-wide accumulation of hoarded wealth in the form of gold and silver
ingots, coins and jewellery has been growing at an accelerating rate over the
last thirty years. This has compromised the central banks who were actively
suppressing the price: the result is that large amounts of gold and silver
have passed from governments to private individuals. None of this can be
properly captured in the statistics, partly because the central banks
involved refuse to provide accurate information about their sales, swaps and
leases, and partly because the individuals that hoard precious metals do so
secretly, and are therefore beyond the scope of meaningful statistics.
The
reason these individuals hoard precious metals is the basic hypothesis of
this article: they will dishoard gold when paper money stops losing its
value. We should therefore consider the extent and speed of this
loss. In 1973 there were US$1,120 of demand deposits plus cash currency
for every ounce of gold owned by the US government[i]. Today, including excess reserves
held at the Fed and the $600bn to be printed over the next seven months, the
figure stands at $26,512[ii].
In 1973 there were twelve times as many dollars as there was gold at the
market price, compared with nearly 20 times today, so paper dollars are more
overvalued in gold terms today than at the time when the gold price was only
$100.
The
quantity of paper money will continue to grow as the world wrestles with its
problems. As every day passes, one’s worst fears of yesterday
materialise. Governments, driven by social pressures rather than
dispassionate economics, are forced into ever-increasing financial rescues;
but by far the biggest problem facing them is the seeming inevitability of a
full-scale banking collapse.
That
is what has the panjandrums of Euroland in a panic over Ireland. We are told
by the Bank for International Settlements that total Irish debt to foreign investors
stands at $791bn, the substantial majority of which is owed by the banking
sector. Ireland on its own might not derail European banks, but the domino
effect of the spreading problem most probably will.
This
obviously cannot be allowed to happen. Forget the rights and wrongs of
“too big to fail”: politicians and therefore central banks have
no option but to intervene. But what can they do? They cannot fund a
rescue with taxes, and they are already borrowing as much as the bond markets
can stand. There is only the nuclear option left, however it is dressed
up: shore up the system by printing as much money as it takes. Printing money
is simply the way governments buy time.
This
analysis may turn out to be unfortunately right, or hopefully wrong; but it
is more right today than it was last month and also progressively so for the
months before that. The rising interest in precious metals is entirely
consistent with the growing likelihood that the printing of fiat currencies
will continue to accelerate in order to buy off default. While the
translation of monetary inflation into price inflation is rarely an even
result, we know from both economics and the experience of history that the
two are linked as cause and effect respectively. So we can conclude that
paper money will continue to lose its value for the foreseeable future.
But
accelerating price inflation does not just affect cash as an asset class.
Bonds, which are commonly the largest component of a conventional portfolio,
will lose value faster than cash. Equities will be lucky to keep up with cash
values while bond yields rise and the adverse effects of accelerating
inflation result in recession. Property will be hit by rising bond yields and
rent increases that can only lag inflation. Only commodities, which are a
minor asset class for portfolios, can be reasonably expected to outperform
cash. Furthermore, equities and property are commonly used as collateral
against the very high levels of borrowings in the private sector, which ties
their prices to interest rates, and therefore to cash. Furthermore
history confirms that gold and silver are easily the best performers in times
of rising inflation[iii].
So
in the middle of today’s banking and economic crisis, those
unfortunates who have delegated the management of their investments to
professional fund managers have only bought for themselves the illusion of
financial security. They are almost entirely exposed to cash and assets
that are dependant on cash itself, because they own negligible amounts of
gold and related investments. This means that systemically, portfolios have
become totally dependent on the stability of fiat currencies.
This
makes gold and silver, not cash, the ultimate risk-free investment class.
Paper money may be the medium of exchange and the unit of account, but in
these increasingly uncertain times gold and silver are the safest stores of
value and will continue to be hoarded, irrespective of price, for as long as
these uncertain times continue.
So if anyone asks you when
you might take your profits in gold and silver, smile sweetly and just say,
“When paper money stops losing its value”.
[i] See table “Gold
backing for 26 major currencies” (page 216 of “You can profit
from a monetary crisis” by Harry Browne, published by Macmillan in
1974).
[ii] Today’s instantly accessible
cash is $6.934 trillion, comprised of deposits held in domestic offices less
time deposits of $4.323 trillion, plus non-interest bearing deposits held in
foreign offices at $71 bn, figures provided by the FDIC. To these are added
currency in circulation of $974bn and excess reserves at the Fed of $966bn,
figures obtained from the Fed, together with the QE2 figure of $600bn. Gold
held by the Fed is listed at 8,133.5 tonnes.
[iii] See the German experience 1918 to
1923.
Alasdair McLeod
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