In the face of growing fears of a renewed global plunge into economic depression and a climate of low apparent price inflation, investors might expect commodities and precious metals to be falling in price. Instead, gold continues to hover around a relatively high $1,640 an ounce and silver at $29. At the same time, central banks - including those of the ever more important China, Russia and India - continue aggressively to buy gold.
At a time when very complex financial instruments allow for the seemingly effective hedging of all manner of risks, why should precious metals, which ostensibly involve considerable downside risk, continue to be attractive? Simply, investors in precious metals see traditional risk management instruments as too dependent upon the challenged financial markets that they fail to represent true and ultimate insurance.
The 2008 financial crisis was rooted in a property bubble, but was magnified when reckless risks were often passed on to unknowing, conservative third-parties. This was accomplished by means of increasingly sophisticated and deceptive financial instruments. When the unthinkable happened and property prices turned down, the highly interconnected Western financial world was awash with toxic assets and so-called hedge instruments, including derivatives. At one stage, total financial collapse threatened, so governments stepped in to absorb these toxic assets or pass them off to more solvent banks.
To most observers, the threat was averted. To others, it was merely hidden in banks, central banks, and national treasuries. The result is that massive, latent deleveraging continues to threaten Western economics and cast doubt on all categories of paper assets. Among other consequences, this has raised the prospect of a dismantling of the euro, the world's second currency. And yet another round of political and central bank interventions have been taken to avert this outcome.
Despite its posturing, Germany wants the EU to survive as the domestic market for its exports. As long as Germany sees the euro as vital to EU survival, she will support the continuation of the status quo, even if it is necessary to support prostrate economies like Greece. But even Germany's treasury could become overwhelmed attempting to finance and support all the PIIGS (Portugal, Ireland, Italy, Greece and Spain) in its pasture.
At each stage of the operation to paper over the growing threat of national insolvency, the actions taken by regulators, financial companies, central banks, and governments become not only increasingly desperate, but also expose the systemically vulnerable global financial system to unforeseen shocks. Sensing this, more players turn to precious metals as an escape.
Looking at the current international financial shoring up operations is like looking at an old, massive dam which has suffered structural damage from earthquakes. Unwilling or unable to rebuild the dam, politicians have been content to pour cement over the cracks. Not only is this unsound engineering, but it also hides the real cracks from plain sight. As such, no one knows from where or when the next potentially fatal fissure will come.
Right now, all eyes remain trained on Europe. If Germany were to overplay its hand within the eurozone, the common currency could collapse. That would throw the $600 trillion derivative market into panic, threatening the viability of most of the Western world's prime banks, commercial enterprises, and even governments.
Judged by recent experience, it would likely lead initially to a surge in the US dollar as investors sought perceived 'safety.' Indeed, foreigners now own some $6 trillion, or almost 40 percent of the US Treasury's debt. However, with Treasury debt now at 102 percent of GDP, the United States has joined Portugal, Italy, Ireland, Iceland, Greece, and Japan in the ignominious club of nations with debts larger than their annual production. Should this fact start to worry overseas holders (let alone domestic owners) of Treasury debt, a collapse of the US dollar could follow. The undertow of a sinking dollar could drag down a massive web of closely interrelated and sophisticated hedging securities and vehicles. Indeed, a mass of financial assets previously perceived as 'uncorrelated' would appear suddenly to be correlated all too closely in collapse. A sudden absence of bid prices, even for prime securities, would devastate paper fortunes across the West.
However, those who hold precious metals as a hedge should escape the worst of the fray. If the last decade is any indication, keeping in mind that past performance is no guarantee of future results, gold is still regarded as a true safe haven - its appeal growing as other paper reserve options are exhausted. In the event of a Western collapse, not only gold and silver, but all commodities will still be in demand across the developing world - itself insulated from Western foibles by its high domestic savings and tremendous productive capacity.
The current high prices of precious metals, in the face of possibly deep economic recession, indicate that the prospect of a sudden and catastrophic financial collapse is very real. Indeed, as long as politicians continue to ignore the real implications of the uncertainty they are creating, gold and silver should continue to set new nominal highs.
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