Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 3rd June, 2010.
There are two articles in the 31st May edition of Barrons magazine that point to a much higher gold price over the years ahead. The first of these articles is an interview with Ray Dalio entitled "Set Aside Fears of Inflation -- Just For Now".
Ray Dalio is the chief investment officer for Bridgwater Associates, a firm that manages about $75B on behalf of governments, central banks, pension funds and endowments, so his opinions carry some weight. His views are decidedly gold-bullish, not because he is bullish on gold but because he unequivocally concurs with the Keynesian (read: wrongheaded) policies implemented by governments and central banks in response to the financial crisis. Specifically, coming through loud and clear in the article is Dalio's belief that central banks can help the economy by creating money out of nothing (counterfeiting). For example, he says:
"There is a lot of criticism about saving financial institutions and running a big budget deficit, but if the government didn't do those things we would be in a terrible situation. It will be impossible to stimulate that way in the future because politically it is untenable. That's a risk because, between now and 2012, the economy will probably go down again, and it will be important for monetary policy and fiscal policy to be able to be stimulative, and for the Federal Reserve to be able to purchase assets again."
"The English also have way too much debt, but they have [an advantage over the euro zone in that they have] an independent currency and can print money and avert a debt crisis. Debtors with no ability to print money are the ones in trouble."
Moreover, near the end of the article he dispenses with the idea that the large-scale printing of money will lead to an "inflation" problem, as follows:
"The depreciation of the major currencies and the printing of money will not cause a significant general level of inflation anytime soon.
The printing of money will offset the deflation that is coming from the weak demand for goods and services due to weak credit growth. For example, in March of 1933 the U.S. printed a whole lot of money, and that had the effect of converting deflation into modest inflation, but not a high rate of inflation.... My point is, in developed countries there is too much of most things at the moment, and that's creating a deflationary environment. There is too much manufacturing capacity. There is too much labor. There is too much housing stock. As Europe's economy weakens and its debt crisis worsens, the printing of money does not mean that it will produce an accelerating inflation because simultaneously there is also less being purchased, and the surpluses are already causing deflationary pressures. That is why, contrary to almost everybody's belief, I believe the bonds in countries that can print money will be good investments."
To summarise Dalio's view: Central bank money creation will put a floor under the economy, and as far as the general price level is concerned it really doesn't matter how much new money is created as long as there is an output gap.
If highly respected and influential money managers such as Ray Dalio believe that monetary inflation is the way to go then we are a long way from the point where the political tide shifts against attempts to 'inflate away the debt'. This suggests that there will be a lot more inflation in the future and that a much higher gold price lies in store.
The second of the two Barrons articles is entitled "Gold: The Ultimate Fiat Currency". This article makes the correct point that people tend to chase performance, which results in investments becoming extremely popular after they cease to offer any value. Unfortunately, that's the only correct point in an article riddled with misunderstandings and logical errors. We'll only deal with a few of the errors/misunderstandings.
Richard Wiggins, the article's author, argues that gold has become too popular, the implication being that it is now over-owned and therefore at risk of experiencing a large price decline. We agree that gold is a lot more popular today than it was five years ago, but very few members of the investing public currently have significant exposure to gold. To quote Marc Faber:
"Let me shed some light on...[the argument that gold is over-owned]. Every year I attend numerous investment seminars, corporate meetings, and conferences. I frequently ask who among the audience owns some gold. Usually a maximum of between 3% and 5% of the participants own some gold or other precious metals. ...In fact, given all the money printing that is going on around the world I was rather shocked that when I attended recently five different conferences and group meetings with investors I consider to be "sophisticated", prudent, and "intelligent", hardly anyone among them owned any physical gold or silver (usually among 200 people maybe 3 people)."
After wrongly asserting that gold is "over-owned", Wiggins continues:
"The big argument for gold is that all of the money that the Federal Reserve is printing -- 18 years of easy money -- will come back to haunt us at some time when inflation comes roaring back. Yet if today's investors are worried about U.S. inflation, they can go out and sell T-bonds, or buy the euro or another currency and earn interest while they're doing it. Investors afraid of 1970s-style inflation also should be buying Treasury inflation-protected securities."
We agree that a short position in T-Bonds should do well over the next few years, but there are four reasons why a short T-Bond position is not a good substitute for an investment in gold bullion. First, a short position in anything should never be considered an investment. Second, you only need to look at what happened over the past decade to realise that declining confidence in government-controlled money can be accompanied by positive returns for both gold and T-Bonds. Third, by monetising T-Bonds the Fed could ensure that the government bond market failed to reflect the "inflation" threat for an inconveniently long time (inconvenient, that is, for anyone attempting to protect themselves from "inflation" via a T-Bond short position). Fourth, mathematics favours 'longs' over 'shorts', in that the maximum potential gain on a non-leveraged short position is 100% whereas the maximum potential gain on a non-leveraged long position is unlimited.
Regarding the idea that inflation-fearing investors should buy inflation-protected securities, we'll simply note that these securities only protect against the effects of inflation that the government admits to.
Regarding the idea that investors buy the euro as a hedge against US$ inflation: He can't be serious!
The article ends as follows:
"Only 15% of gold is used as a monetary metal; the rest of it is used as a commercial metal, and that use, particularly as a corrosion-resistant electrical conductor for semiconductors, is declining. Regrettably, it is a soft, semi-useless metal with very few industrial applications.
Gold is just another fiat currency. The only reason gold is valuable is that we believe it is valuable. Ultimately, this gold bubble ends in tears. When and how far gold's price will decline is anyone's guess, but a smart bet is "sooner rather than later.""
He may as well have held up a sign that reads:
"I am totally clueless about gold supply and demand, and I don't know the meaning of the term "fiat currency". Also, it has never occurred to me that the only reason ANYTHING is valuable is because we believe it is valuable."
In conclusion, the first of the above-mentioned Barrons articles is gold-bullish because it reflects a belief that a lot more monetary inflation will be needed to support the economy in the future, while the second is gold-bullish because it reflects gross misunderstandings of gold, money, and what a real "gold bubble" would look like. Such misunderstandings are usually prevalent in the early or middle stages of bull markets, but never near the ends of bull markets. When we get to the stage where the gold bull market is almost complete, almost everyone will understand why the price is rising.
We aren't offering a free trial subscription at this time, but free samples of our work (excerpts from our regular commentaries) can be viewed at: http://www.speculative-investor.com/new/freesamples.html.