Vivek Kaul
An old theory about bull markets is that every bull market has a theory behind it. This was true about the bull market in gold which started in 2002 and ran for almost ten years till late 2011. The price of gold during this period went up from around $280 per ounce (one troy ounce equals 31.1 grams) in January 2002 to around $1895 per ounce in September 2011.
The gold bull market had essentially two theories driving it, at different points of time. Between 2002 and September 2008, gold rallied because there was the fear of the American financial system collapsing, as the American citizens went piling on debt to buy new homes, only to sell them after a short period of time.
The American financial system came close to collapse. And some time later it was revealed that Europe was heading towards a similar and a bigger mess. Central banks around the world tried to stem the rot by printing truck loads of money. This money was first used to save the various financial institutions and banks which were on the verge of collapse.
After the governments had managed to save the financial institutions from collapsing, the next lot of money printing was carried out to revive their respective economies. The hope was that by pumping more and more money into the economy, the governments would be able to ensure that there was ample money supply in the economy.
This would ensure low interest rates, leading to people borrowing and spending more, and banks lending more. This spending would lead to people buying more homes, automobiles, consumer goods and so on, helping businesses make more money and thus help revive the overall economy. Low interest rates would also help people to re-finance their homes loans, leading to lower equated monthly instalments(EMIs). The money thus saved would be spend on other things and thus add to economic growth.
The danger here was that all this excess money floating around could chase the same number of goods and services, and lead to very high inflation, as had happened in the past. To hedge against this risk, investors started moving their money into gold.
The investment in gold comes with the belief that gold retains its purchasing power over long periods of time. As Nick Barisheff President and CEO of Bullion Management Group Inc and the author of$10,000 Gold: Why Golds Inevitable Rise Is the Investor’s Safe Haventold Firstpost in a recent interview “It took 66 ounces of gold to buy a compact car in 1971. Today it would take about 10 ounces. We can see the same ratio with houses…Today you can buy 3 average size houses for the same amount of gold you would have needed to buy 1 house in 1971 even though the prices of houses have risen significantly in dollar terms since then. That’s how gold serves as a hedge against inflation and maintains its purchasing power.”
With investors buying gold to hedge the risk of high inflation, the price of the yellow metal went up from $780 per ounce in mid September 2008 to around $1895 per ounce in early September 2011, which meant an absolute return of 143% over a three year period.
The price of gold has fallen since September 2011, and as I write this it quotes at around $1410 per ounce. With this fall, we now have a new theory being bandied around. And its now being said that gold rallied all these years on a misunderstanding.
As per this new theory, those investing in gold have got it all wrong. The fundamental argument about investing in gold is that excess money printing leads to high inflation and to hedge against that inflation investors buy god. But this time around the argument doesn’t really hold, we are now being told. This is because the world is in the midst of a balance sheet recession.
The term balance sheet recession has been coined by the Japanese economist Richard Koo. He feels the situation in the United States and almost all of Europe is very similar to as it was in Japan when the stock market bubble as well as the real estate bubble burst in 1990.
In a balance sheet recession a large portion of the individuals who had taken on loans to be a part of a bubble (real estate in case of America as well as Europe and real estate as well stock market in case of Japan), start saving more to repay their loans. When this happens they are not spending as much as they were in the past. This means incomes of businesses come down, which slows down economic growth as well.
Governments try to revive this economic growth by printing and pumping more money into the economy. This is done in the hope that interest rates will remain low, and encourage people to borrow and spend more. This spending will in turn create economic growth. The trouble is that people are in the saving mode and no mood to borrow and spend.
This also means that all this money that has been printed continues to remain in the vaults of banks. And when that happens, the situation where more and more money chases the same amount of goods and services, leading to higher prices and inflation, doesn’t really come around.
And when there is no high inflation there is no point in buying an asset as useless as gold is.
Hence, there is a fundamental flaw in the reason why people have been buying gold. This is one of the new bear market theories in gold, being bandied around.
There are multiple problems with this approach. First and foremost, the theory has come around only after the price of gold has fallen. Over and above that governments all around the world have been printing money in the hope of maintaining low interest rates and people borrowing and spending more. They have also been printing money in the hope of creating some inflation. When prices are rising or are expected to rise, there is a greater chance of people getting out in the market and buying stuff, so that they don’t have to pay more in the days and months to come.
But this hasn’t really worked because there is a balance sheet recession on. Central banks and governments have tried to solve this by printing even more money. But inflation hasn’t shown up in the official numbers as yet.
As Jeff Nielson, Editor of www.bullionbullscanada.com puts it “The premise is that you can print infinite quantities of paper; but as long as you hive-off that money-printing from the “broader economy” there (supposedly) will be no inflationary impact.”
So governments can print all the money that they want but there will be no inflation, as long as the money is lying in bank vaults. The question is that if money is to lie in banks vaults only and not lent out, then why print it in the first place?
Also, just because people are not borrowing doesn’t mean all the money being printed is not being put to use. As Nielson explains “What is meant by hiving-off this money-printing? Giving every penny to bankers, and letting them gamble with it in their (private, unregulated) derivatives casino, or hold government bonds for the interest arbitrage.”
So bankers and financial institutions are borrowing this money at close to 0% interest rates and speculating in different kinds of investments and markets around the world. This also explains to a large extent why stock markets around the world have been doing stupendously well, even though the global economy has been stagnating. It has also led to bankers and financial institutions buying government bonds, and thus helping governments borrow money at close to 0% interest rate. All this obviously isn’t reflected in the official inflation numbers.
The other trouble is the way in which official inflation numbers are calculated. The consumer price index which measures inflation is looked at as a definitive measure by economists. But there are problems with the way it is constructed. As a recent report titled Gold Investor: Risk Management and Capital Preservation released by the World Gold Council points out “The weights that different goods and services have in the aforementioned indices do not always correspond to what a household may experience. For example, tuition has been one of the fastest growing expenses for US households but represents only 3% of CPI (consumer price index). In practice, tuition costs correspond to more than 10% of the annual income even for upper-middle American households – and a higher percentage of their consumption.”
An August 2012 World Bank report said between June 2012 to July 2012, corn and wheat prices had risen by 25%. While soybean prices had increased by 17%. During this period inflation in the United States was close to 0%. This led Nielson to quip that “total inflation was supposedly at absolute-zero among the obese U.S. population. Did nobody eat that month…?”
Famed investor Jim Rogers summarised this best in an interview when he said “if you shop in the U.S., you know that there is inflation – whether it’s taxis or tolls or insurance or education or entertainment or food. I mean, the price of everything is going up. It’s only the U.S. Government that says prices aren’t going up…Go and try to buy something. Go see that there is inflation in the U.S. just as there is everywhere else.”
Then there are also methodological changes that have been made to the consumer price index and the way it measures inflation over the years, which in practice do not always reflect the full erosion of the purchasing power of money. If inflation in the United States was still measured as it was in the 1980s, it would be now close to 10% instead of the official 2%.
So yes there is a lot of inflation, it is just that it is not showing up in the government numbers (This link gives a detailed argument). Nielson makes another fundamental point. He says “For me the perversity of the mainstream media acknowledging all the money-printing but refusing to acknowledge currency-dilution is even more fundamental. All of these people are reporting on markets. If a company dilutes its share structure through excessive printing of shares; all of these same analysts would immediately recommend fleeing that company because of “dilution.””
But the same analysts don’t do that when governments print money. “Fiat currencies(i.e. Paper money) are literally nothing but the equivalent of “shares” in our overall economy. Yet when our currencies are diluted (through exponentially increasing money-printing) the concept of “dilution” is — supposedly — impossible for any of these analysts to comprehend,” says Nielson.
As economist Milton Friedman (who was no gold bug) wrote in Money Mischief – Episodes in Monetary History: “Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”
To conclude, its worth remembering that just because money printing by government hasn’t produced official inflation till date, doesn’t mean that there will be no high inflation in the time to come. We simply don’t know. And that is something worth remembering.
(The article originally appeared on www.firstpost.com on June 4, 2013)
(Vivek Kaul is a writer. He tweets @kaul_vivek)