Gold bugs will be vindicated

2012-MAY-12

In recent weeks, while the eurozone has suffered escalating levels of systemic stress in government bond markets and its banking system, the gold price has fallen under $1,600. One would have thought that – but for the occasional fat-finger trade – gold would rise in all this instability, not fall. Putting aside short-term considerations, the simple reason has to be that the investment establishment, which has bought into the bond market bubble, does not believe that gold is any longer an alternative to paper money.

We can understand why they think this. Though the Keynesian vs Austrian economic debate is attracting increasing attention, financial services companies recruit economists who have been trained in the traditions of Keynes and Friedman. They are thus immersed in economic disciplines that assume gold is old-fashioned and has no meaningful place in a modern economy. While they might accept that gold has an historical attraction for some investors, they see it as a “risk-on” investment. This is jargon for something you buy when you want to take risks, the opposite of gold’s traditional role.

For further proof, you need look no further than the average level of portfolio exposure, which across the global investment management industry is said to average less than one per cent. This is certainly not compatible with the level of risk in today’s markets, with many nations on the edge of bankruptcy. The result is that flaky gold bulls are experiencing the discomfort of rising panic.

Let us go back to fundamentals. The Keynesians and Friedmanites are oblivious to the debt trap faced by all major currencies. Central banks are printing money to fund government deficits at the lowest possible interest cost. The inevitable consequence of printing money is price inflation, and price inflation always leads to higher interest rates. Higher interest rates exacerbate budget deficits.

You cannot put it more simply than that. The alternative is to stop printing the money and jack up interest rates, but in that event at the head of the insolvency queue is government itself, so this can be ruled out as a deliberate policy. That is what a debt trap is all about: whichever way you turn, there is only one outcome: bankruptcy.

When a government goes bust, its paper is valueless: not just its bonds, but its fiat currency as well. On the surface it is different in euroland, because the nation states do not issue their own currency. On this basis the demise of the euro is an event one step removed from the bankruptcy of individual nation states. The relationship with the other major fiat currencies is direct.

The destruction of fiat currencies themselves is becoming more likely by the day. Meanwhile, the weakness of “risk-on” gold has led to a serious mispricing in the market. This has happened because the financial community, sucked into the bond market bubble, has not even begun to discount the debt threat to government paper from sovereign bankruptcies.

When this mispricing is inevitably resolved, it is unlikely to be gradual. It will be so swift that those old-fashioned enough to own gold for insurance purposes will have the protection they sought. Those that fall for modern neo-classical economics will learn a very sudden lesson about what gold is actually for.