Is it always a good time to own gold?
Absolutely not. A portfolio in the S&P 500 or Treasuries in 1973 has returned a much higher rate than gold bought that year — even if gold raced ahead up ’til 1980, and is racing ahead again now. We know that throughout history gold has sustained its purchasing power, and fiat currency has lost its purchasing power. But we also know that stocks have grown their purchasing power.
But gold continues to rise — so what makes gold different right now? Well, from a technical perspective, America and the West are in a secular bear market:
But a technical perspective doesn’t really give enough political and economic background to explain why we are where we are.
In my view, it is a combination of things.
We are at a unique moment in history:
- Bailout economy; ever since the failure of Long Term Capital Management (a hedge fund) in 1998, governments in the West have felt increasingly happy to declare parts of the economy infrastructural and bail them out if they fall into trouble. Simply, that just isn’t capitalism, and it means that zombie banks that have failed can blunder and bumble on parasitising the taxpayer while giving back zero growth, and zero new jobs. Zombies fill holes in the economy that would otherwise be filled by new smaller higher-growth companies and industries that tend to create more employment.
- Industrial Revolutions and the Information Age; more technology means more automation, which means more cost-saving layoffs, which means less jobs, which means less consumption, which means less demand. The information revolution has created the circumstances for soaring corporate profits, and stagnant real incomes and employment. Stagnating labour forces lose skills, strength and productivity, sapping the national productive capacity. This was a situation predicted by Marx and Engels following earlier industrial revolutions. What staved off communist revolution? All of that wealth eventually trickled down through the economic food chain.
- Globalisation; a global economy means job migration to the centres of high population that can offer the lowest wages. This means less employment in the West, creating similar problems to those of industrial revolutions. Eventually, capital also migrates to the productive centres — which is why both China and Arabia have built up humungous dollar hoards, why China has such a high national savings rate, and why America has such a low one.
- Higher Global Population; more people means more demand for goods and services and resources, which means higher prices, which generally means less disposable income for individuals and households, less saving, and less investment.
We have been through many similar social, technological, agricultural, organisational and financial transformations before, and have usually come out of them quite well. Global wars, famines, droughts, etc, have been shrugged off by new eras of growth, confounding the cynics. But this time the system is not only poorly prepared. It is extremely entrenched, and a lot of powerful people have a lot to lose from sweeping change. Why?
- Western Political Turmoil ; the Eurozone is a failed and incoherent monetary union. America’s Congress struggles to agree on a budget. Governments’ attempts to interfere in markets and picks winners are often costly and ineffective.
- The Free Lunch Mentality; America took advantage of the hard work, productivity and resources of the rest of the world through possessing the global reserve currency that it could freely print and distribute in return for goods, services, resources, etc. Subsequently it became the world’s consumer, enjoying huge quantities of foreign oil and goods in exchange for nothing but paper and treasuries. Its factories, domestic supply chains and industrial labour force became surplus to requirements, and subsequently deteriorated.
Worse, there are specific structural problems with the Western and international financial systems that are effectively constraining any future prospects of new organic growth:
- Deleveraging Trap; the West continued consuming and consuming through massive debt acquisition. Western consumers remortgaged their homes to buy cars and boats and televisions that they often neither needed nor could afford once the house-price bubble burst. After the bubble burst, private spending has been depressed by deleveraging — something Japanese individuals and business have been doing for the past 20 years — while governments have misguidedly attempted austerity measures. This has depressed growth.
- Counterparty risk; institutions created a multi-quadrillion dollar huge web of bets and counter bets so sprawling and complex that a single bank or institutional failure like Lehman can lead to a tidal wave of defaults so massive as to suck the entire system into a black hole.
I believe that in order to restore growth, what the system needs, and what it is driving toward is restructuring. This can either be accomplished intentionally through explicit haircuts or defaults, through high inflation, through a slow painful private deleveraging process or through strong organic growth.
I don’t know how debt reduction will take place. It could be three months or years away, or it could be another grinding, unemployed and depressed ten years, full of false dawns. Certainly that is what has happened to Japan since its stock market and real estate bubbles burst twenty years ago. Maybe the West will perform better than Japan in the deleveraging trap — maybe new technological innovations like cheap decentralised solar energy will provide the necessary organic growth to overcome the debt problem. Or maybe not.
Until the private debt load is significantly reduced, it will act as a huge weight tying down economic growth, tying down employment, and structurally weakening both the financial system and society. High debt loads require low interest rates to sustain — which with a little inflation means negative real interest rates. Gold has traditionally done very well in low real rate environments.
Once the deleveraging trap has been left behind, it will be the time to ditch gold and plough all of that purchasing power into productive assets: industrial stocks, real estate, farm land, inventory, and labour force.
And gold will once again settle into significantly under-performing stocks.
azizonomics 
Global reset, and then what? Do you think any methods will be in place to avoid going down this path again? Do you think gold will play a role in said methods? Or you see it just as a temporary (0-10-…? years) hedge?
It’s not a hedge. It’s my main investment — just like treasuries are the main investment right now for the big funds. But I will be selling my gold and silver once we get the collapse and we get to DJIA:AU 1:1
I believe China will attempt to institute a gold-backed yuan as the international reserve currency (in fact this is almost out in the open after the Huntsman cable). This will continue to spur Chinese buying which will also drive up the price. And once the gold yuan is in place, it is definitely the time to get out of gold (store of value) and into industrials and productive assets (generators of value).
It is quite possible America may attempt to institute a new gold-backed dollar to try and compete with the yuan. That could mean terrible news for gold investors in America: confiscation at (something like) $3,000 an ounce, and then a new currency where gold is immediately revalued to $9,000 an ounce. Marc Faber is right. Spread your gold around jurisdictions.
Currency war are funny things. Right now nations are scrambling to make their currencies weaker. Lemmings… But in the aftermath of an oil shock, the exact reverse would true: countries would want to get as much oil/gas/resources for their currency as they can.
In the new battle for global currency status Germany, Switzerland, Italy and France might get together to relaunch the Euro as the Geldmark.
Why do you see the gold yuan as a signal to get out of gold? Wouldn’t that somehow validate the idea that it’s real money triggering further demand for gold? Or maybe you’re just saying that it’s a signal the governments may begin to confiscate it?
Andrei: vinon is correct about China but it actually goes further than that. The main issue is that after this economic storm is over, the crippling debt has been (at least partially) erased (by hyperinflation or default) we will revert to the long-term historical norm of productive assets being a superior producer of wealth to hoarding gold. I wouldn’t expect gold to significantly fall — just to do what it did during the 80s and remain relatively constant both in price and in purchasing power.
I try to remember that gold is not really going up — the other assets are being devalued. That is why I believe gold is a strong asset to hold at present — because it is holding its value in the face of everything else being ripped apart by leverage, by debt, by poorly functioning systems, by mismanagement, by fear, and by global change.
andrei: i think once china manage to persuade the world to use yuan as the main currency (where that time yuan is back with gold ), they will want the gold to be constant not fluctuate so much or surpress gold value , like how the america have been surpressing gold value so that everyone will be paying attention to usd currency rather then gold.
(correctme if i am wrong azizo.).
azizo: you say confiscation of gold in america? i bought gold in the form of etf(paper gold ) will that be affected if my etf is from america. ? and you mention about investing gold jurisdictionally do u mean buying from diferent country ? or the type of gold investing eg: etf , physical gold ?
Gold confiscation has happened in many jurisdictions in the past, including the United States under Executive Order 6102.
ETFs are effectively derivatives. If you do not have a specific claim to a physical/material asset you are effectively holding a derivative which is subject to counterparty risk
From Seeking Alpha:
Physical is good. If you do not want to store your own gold look at a website like BullionVault: they have allocated physical gold in vaults in multiple jurisdictions, including the United Kingdom and Switzerland that you can withdraw any time. I would hold a moderate amount in as many jurisdictions (I hear Australia is good, but Switzerland is probably the best) as possible to hedge against wars/calamities/confiscations/frauds.
Wouldn’t a gold-backed yuan completely destroy China’s exports? If China really tries to back its currency with gold the exchange rate for USD/CNY would soar to something like 3:1 or even 1:1…
Export arbitrage (like most forms of arbitrage) is heavily overrated. Pricing isn’t that sticky. Companies adapt their pricing schemes to reflect FX much quicker than a lot of macro thinkers seem to believe.
Where China can gain an arbitrage advantage is with a significantly stronger currency: they want to vacuum up all the oil and resources they need to continue their great Confucio-Maoist-Capitalist experiment.
I’m getting a bit ahead of the curve here, but the real question isn’t whether they can afford a stronger currency (practically every deep-field analyst I’ve spoken to suggests they ultimately want to either float the yuan or peg it to gold and that this dollar peg is something of a gambit) but whether or not they can actually sustain the great experiment. Will too much central planning create a dramatic misallocation of capital that totally undermines their model? Will the peasants rise and drag the Maoists into the dust? Certainly given their FX reserves it seems highly unlikely that Chanos is right and that this housing bubble will kill them. But is a steady stream of state-led construction and development really the answer for China in the 21st Century?
I guess we’ll get to find out.
There will certainly be a moment when the Chinese demanding more freedom and democracy. It will be a matter of time when China switches into free market capitalism then – I think it would offer even greater potential for the country ultimately. The real provlem there
is the possibility of state breakdown by minor nationals such as Tibet and Uigur, I expect.
“I believe that in order to restore growth and start a new economic cycle, what the system needs, and what it is driving toward is a great reset — the washing away of debt, (and the destabilising and dangerous web of derivatives). This will either be accomplished through debt cancellation, or (much more likely) through high or even hyper-inflation.”
What you are saying is that the people who run and benefit from the system are or have already run out of options, they will destroy their system through hyperinflation or default. I doubt if any of them will allow a debt cancellation or forgiveness as they want their ‘pound of flesh’. So they are willing to destroy their cash cow through hyper inflation and lose their own wealth and power, they have too much to lose. Are they really out of all other options?
Debt-funded spending (gov’t, institutional and consumer) isn’t digging us out of the hole. It’s making the hole deeper. The weight of interconnected fragilising debt (and the perennial derivatives counter-party risk black hole) is sucking the global economic system and the people of the world down into a depression. Deleveraging is cold and painful. Hyperinflation and managed default are two routes out. They sound pretty messy, but not as messy as that other great “global stimulus” that so often raises its ugly head in times of crises:
Global conflict.
Pingback: Krugman on Why the Eurozone is in Big Trouble « azizonomics
Pingback: The Economist: “Time to be Afraid” (Unless We Print a Lot More Money) « azizonomics
Pingback: The Economist: “Be Afraid” (Unless We Print a Lot More Money) « azizonomics
Pingback: Paper vs Gold « azizonomics