Dow down slightly yesterday. The FTSE was flat.
Oil
falling further below $100. And gold still going up.
What is most interesting is the movement in the
price
of gold. It seems to be heading up again – almost no matter what
else is happening.
So, let’s look at what might be going on.
If investors sensed a recovery, they would expect banks to lend
more freely, people to shop more freely and prices to rise.
This would raise consumer prices; the price of gold should go up.
But if the market sees growth and inflation ahead, why is oil
slipping? And why is the
Baltic
Dry Index – which measures shipping prices – at a 25-year low? And
how come last month’s US employment figures were disappointing? And why
aren’t stock market prices going up?
Most important, if the economy is really recovering, why is the
ten-year note yielding only 1.82%? And what about the long bond?
Shouldn’t it be trading at a yield higher than 3%?
And how come house prices fell over the last year, and the last
month?
And how come incomes are falling?
Or, to look at it from the opposite point of view, how is it
possible for a real recovery to take root in the hard, barren soil of
falling house prices and slipping consumer earnings?
But if the economy is not improving, then there should be no
increase in inflation and no pressure on the price of gold, right?
Maybe investors don’t anticipate a recovery at all. Maybe they’re
buying gold because they see the economy getting worse, not better. We
associate a rise in the price of gold with inflation. But gold is much
more versatile than we think. It protects your wealth when paper money
loses its value. It also protects your wealth when paper money gains in
value. It protects you when you are right and when you are wrong.
How so?
During the Great Depression, for example, the price of gold rose
against dollars even though the prices of food, clothing and other
consumer items, as well as the prices of investment assets were falling
in dollar terms. Why? Because money gains value – relative to things –
in a depression. Gold is money. It is the best money. It is the only
money that has stood the test of time.
Besides, there is more going on. In a financial crisis or a
depression, investors begin to doubt that their counterparties will make
good. Banks fail. Investors go broke. You own a mortgage, and then you
discover that the homeowner has left town and the house has lost half
its value. You own a note, and then you discover than the payer is
bankrupt; your note is worthless. You own shares in a company; and then
the company goes out of business.
When you are in a de-leveraging phase, you discover that many of
the assets of the previous credit bubble are not assets at all. And
while you’re waiting to find out, the best thing to have in your safe is
gold.
As uncertainty rises; so does the price of gold.
The price of gold also rises when the return on other assets
declines. At 1.82%, the real return on a 10-year T-note is negative.
Consumer prices are rising faster. So, the reward for lending to the
government is less than zero.
Normally, holding gold costs you money. You give up the return
you could get from ‘risk free’ investments (Treasury debt). Now, you
give up the risk from reward-free investments.
Gold goes nowhere. It produces no yield. It pays no dividends. It
makes no profits. You can’t live in it. You can’t drive it. You can’t
hang it on your wall and admire it.
But when the return on Treasury debt is negative, what do you
give up by owning gold? You give up a loss!
You also give up the risk of a much bigger loss. The Fed is bound
and determined to bring up the inflation rate. Ben Bernanke has
suggested that he might set the inflation target higher than 2%. He has
announced that he will keep the Fed’s key lending rate near zero for the
next three years. He has hinted that he is ready to print more money –
QEIII – if conditions warrant.
Holding gold protects you from Bernanke’s success. For if he
succeeds in raising the rate of inflation, gold will surely soar. And
there is substantial risk – bordering on certainty – that he will be no
better at creating moderately more inflation than he has been at
creating moderately more GDP growth.
It is quite possible that he will overshoot.
Normally, inflation is a feature of the banking system. The
system takes the Fed’s monetary grubstake and parlays it into the
nation’s money supply. Banks magnify the money supply by lending... and
thereby create more demand, which raises prices. They do this by making
loans to people who then spend the money.
This sort of inflation is controllable, by raising interest rates
and tightening banking credit rules. But there’s another form of
inflation. The kind that starts with an 'h'.
Hyperinflation happens when the banking system breaks down.
People lose faith in the money itself and the people who control it.
Foreign dollar holders may worry that the Fed is printing too much
money. It may even be good economic news that causes them distress; they
may anticipate higher inflation rates, and a sell-off of the dollar,
which would lower the value of their dollar reserves. They may figure
that they are better off diversifying into yuan or gold.
Then, when other investors and householders see the dollar
falling... they get panicky too. Pretty soon, people are digging around
in drawers, bank accounts and mattresses looking for dollars – just so
they can get rid of them.
That is when dollars hit the hyperinflationary fan. Our old
friend Michael Checkan tells what it was like in Argentina in the late
‘80s:
“Imagine a $2.00 gallon of milk spiking to $775.40 within a year –
like in Argentina, 1988.”
