Gold: An Unreliable Inflation Hedge?

``Gold has two interesting properties. It is cherished and it is indestructible. It is never cast away and it never diminishes, except by outright loss. It can be melted down, but it never changes its chemistry or weight in the process. Its price has been remarkably similar for centuries at a time. Its purchasing power in the middle of the twentieth century was very nearly the same as in the midst of the seventeenth century." James Grant quotes Roy Jastram

Since Gold has recently racked up a new historical high in nominal terms, I’d like to dwell on some objections made by several experts.

Gold’s fantastic 4.6% surge over the week to close at a record $1,049.4 seems quite distant yet from its real (inflation adjusted) highs of $2,264 using BLS.gov data, when considering its 1980 high at around $850. In other words, the high of $2,264 reflects on the 1980 purchasing power of the US dollar.

To add, if we consider today’s price levels compared to that when the former US President Nixon shut the quasi Bretton Wood gold window standard in August 1971, current gold prices would only translate to $196.84 in 1971 terms. Extrapolating the previous record high of $850 in 1980 applied to 1971 price levels, we would arrive at $4,529.85.

In short, based on the US Bureau of Labor Statistic’s inflation calculator, current prices of gold would still be very much heavily discounted against current rate of US inflation (in monetary terms).

Importantly, this has yet to factor in the prospects from current policy actions which will eventually lead to more inflation over time.

This would also suggest that there could be immense room for growth in gold prices, if only to reflect on current and future inflation rates.

Predictable Trend: Paper Money Eventually Returns To Zero

The mainstream have been obsessed with their highly presumptive models-capacity utilization, unemployment, wages etc…, all of whom views money as neutral [or where they see money as constant with marginal additions of money as having no effect on prices] and sees inflation as merely expressed in rising prices of goods or services more than a political phenomenon of monetary expansion. Hence, they have all vastly underestimated the impact of inflationary policies.

And this dogmatic fanaticism, which serves as justification for more inflationary policy measures, will risks tilting of inflation towards the extremes.

Moreover, the reality is that the market is far larger than government’s repeated tomfoolery over their constituents, where over the long term, Gold has always maintained its purchasing power against the Fiat currencies which has been imposed on modern society as legal tender (see figure 1).

Figure 1: American Institute For Economic Research: Gold vis-à-vis Currencies of Developed Economies

According to the AIER, ``Apparently many people today believe that all of that is behind us now, that inflating has been curtailed, and that any “embezzlement” of savings currently taking place is something that America’s “forgotten citizens” can live with.

``Anyone inclined to believe this view could benefit from a short course in human history: it is an inescapable fact that throughout known history, there has never, we repeat never, been a fiat currency that over an extended period of time has retained its purchasing power. All irredeemable currencies have in time become worthless, and (except for collectors’ items or rarities) all paper currencies are today worth less than when they were first issued.” (bold emphasis mine)

In the chart above, paper money from developed countries calculated or plotted in terms of US purchasing power has been, over the long run, in a steep decline. François Marie Arouet (1694-1778) prominently known in his pen name as “Voltaire” rightly observed that ``Paper money eventually returns to its intrinsic value -- zero."

This erosion of purchasing power would even have a far worse track record for developing economies. For instance, Brazil already had 7 defunct currencies which makes today’s real the 8^th over its history. This holds true for Argentina whose Peso is the 6^th currency.

So if there is any market or economic trend that is “predictable” or “stable”, it is that paper currencies are all headed for zero, if not extinction. And like most of the modern currencies before today’s extant currencies, demonetized currencies had been mainly due to hyperinflation or war.

But no trend moves in a straight line. And this holds true even for modern fiat paper currencies. Again from the AIER, ``the upswings in some currencies’ U.S. purchasing power between 1985 and 1988 and since 2002 indicate a relative “weakening” of the U.S. dollar against those currencies during that time rather than actual increases in purchasing power in the countries of issue. Moreover, the occasional short-term upturns cannot disguise the longterm erosion of purchasing power of each currency. The historical record is that the world’s major paper currencies, in terms of what they will purchase, today are worth only from about 1/1000th to 1/4th of what they were worth in 1913. By contrast, and despite short-term fluctuations, the purchasing power of gold is above what it was in 1913.” (bold highlight mine)

So gold does track inflation over the long term, but where we depart from the view held by some experts is on the suggestion that gold underperforms other hard assets in an inflationary period because of taxes.

While it is true that volatility from market forces could bring gold to periodical price pendulum swings that may overshoot and or undershoot, due to myriad temporal factors (such as governments’ intervening in the markets), this could serve as windows of opportunity for outperformance.

In other words, if we can “time” gold’s secular bullmarket cycle then we can outperform other benchmarks.

Besides, if today’s prospective economic environment would somewhat shadow the stagflation era of the 70s, then gold and oil would likely be topnotch performers as before.

However from our perspective, in boxing vernacular, the 70s looks likely to be the undercard (prologue) to the main event.

Globalization And The Triffin Dilemma

Some analysts, mostly from the “deflationist” camp, have further downplayed the role of gold as hedge to inflation.

The gist of the argument: During the 80s to the new millennium, as money printing by the US Federal Reserve soared and where the purchasing power of the US dollar has continually eroded, gold hasn’t successfully served its traditional role of “inflation hedge” and has miserably lagged inflation. (see figure 2)

Figure 2: Economagic: Gold As Poor Inflation Hedge?

As you can see gold as signified by the CRB precious metal index (in red), has been in a bear market and has stagnated following its peak in 1980 and has only bottomed out in 1998.

Whereas monetary aggregate US M2 (in green) which has steadily been accelerating upwards, has been reflected in the declining purchasing power of the US dollar (in blue).

Where gold should have reflected on inflation, it hasn’t. Hence, to the deflation camp, the appearance of ‘poor’ correlation has been construed as basis to conclude that inflation and gold have a tenuous link. Although reasons for these haven’t been given.

We have one word answer to refute this claim: globalization.

To understand today’s globalization process we need to begin with the fundamentals of globalization’s fundamental link, the US dollar as the world’s global reserve currency.

The basic function of an international reserve currency is to play the role of providing the medium of exchange not only to the local economy but to the international economy.

This means that the US dollar will have to be issued by the US Federal Reserve in excess of local requirements in order to cater to the needs of international trade or exchange.

Thereby, the basic way to provide liquidity to global economies or to finance international trade is to buy more stuff (import) than sell abroad (export).

Hence, the concept of providing liquidity to fund global trade is the main function of the international currency reserve. Alternatively, this means that the US will have to continually incur deficits with its trading partners by having an overvalued or “strong dollar” policy for as long as the US dollar remains as the principal currency reserve.

And as international trade grows, the US will have to account for larger trade deficits in order to fund or finance these transactions. At the obverse side, trading partners of the US will accumulate US dollar as reserves.

If the imbalances from the said deficits begin to undermine the US dollar exchange value, then the trade deficits will shrink or stabilize to which may jeopardize the role of the international reserve. This is known as the Triffin Dilemma.

Practically all the specifications of the currency reserve conditions as provided for by Yale University Robert Triffin have lived up to his model.

This had been vividly manifested mostly in late 2008, when the US banking system seized up and consequently triggered a collapse in global trade and precipitated the sharp narrowing of the US current account.

The ferocity of the ensuing volatility rippled throughout the global markets- stocks, commodities, bonds, real estate and others virtually crashed. On the other hand, the US dollar spiked as the banking woes triggered a liquidity squeeze while US sovereign bonds rallied hard.

Yet, importantly, the 2008 meltdown likewise manifested a geopolitical response: shrill outcries to replace the US dollar as the reserve currency status by several key emerging market economies!

So as the US dollar liquidity was drained from the near collapse of the US banking system, markets violently responded, and in the aftermath, several political leaders brashly agitated for a new monetary order. This effectively vindicates the Triffin ‘foreign currency reserve dynamics’ Dilemma.

The point is that most of mainstream arguments superficially focus on the current account imbalances, which subsequently pins the blame on currency policies of ex-US trading partners while mostly weasel over the fundamental role of the US dollar as reserve currency and the attendant internal policies that brought upon the crisis.

To wit, one must be reminded that 14 nations have dollarized or have used or adapted the US dollar as their local currency and some 23 countries have been pegged to the US dollar, according to wikipedia.org.

The implication of the US dollar standard is that, in contrast to the fantasies of mainstream, there is no possible rebalancing of the global current account primarily because the current monetary platform does not accommodate for this, as the recent experience have shown.

For as long as foreign transactions are quoted, paid and settled in US dollars, then the nature of these imbalances will have to continue.

And the only way for a rebalancing to occur would be to replace the US dollar standard, not with another fiat money, with no automatic adjustment mechanism from which ultimately will meet the same destiny, such as much ballyhooed IMF’s SDR, but one with a commodity backed currency.

However, replacing the US dollar standard for the purpose of merely mounting a monetary coup d'état against the US won’t likely occur for political and military reasons.

From our perspective the only way for the US dollar to lose its monetary hegemon is via the same path of where most currencies meet their end; a massive inflation, or at worst, hyperinflation.

Globalization Soaked Up US Inflation

The other point pertinent to gold is that the inflationary measures undertaken by the US Federal Reserve during the 1980-2006 came amidst where Deng Xiao Peng declared his celebrated catchphrase “To Get Rich Is Glorious” and thus opened China to the global economy in 1979.

This was followed by the open door policies or economic liberation reforms of India in 1991 and the collapse of the Berlin Wall (1989-1990) which paved way for the deepening of globalization trends.

As global economies opened up, the supply of goods and services, labor and migration flows, financial intermediation and capital flows became more deeply integrated and thereby produced a far larger output (see figure 3) than the monetary policies engaged by the US central bank.

Figure 3: World Trade Organization: World Export and Global Trade

Global Exports sharply accelerated during the 1990s, which underpinned almost the same degree of expansion in Global GDP per capita.

So increased global trade meant more US dollar financing, as manifested by the burgeoning trade deficits, yet the increased output from the world resulted to higher productivity and thus generally growth deflation or “disinflation”. Ergo, lower gold and commodity prices.

According to the World Trade Organization (2008 World Trade Report),

``A key driver of globalization has been economic policy, which resulted in deregulation and the reduction or elimination of restrictions on international trade and financial transactions. Currencies became convertible and balance-of-payments restrictions were relaxed. In effect, for many years after the end of WWII it was currency and payments restrictions rather than tariffs that limited trade the most. The birth of the Eurodollar market was a major step towards increasing the availability of international liquidity and promoting cross-border transactions in western Europe. Beginning in the 1970s, many governments deregulated major service industries such as transport and telecommunications. Deregulation involved a range of actions, from removal, reduction and simplification of government restrictions, to privatization of state-owned enterprises and to liberalization of these industries so as to increase competition.

``In the case of trade, liberalization was pursued multilaterally through successive GATT negotiations. Increasingly, bilateral and regional trade agreements became an important aspect of (preferential) trade liberalization as well. But many countries undertook trade reforms unilaterally. In the case of developing countries, their early commercial policies had an inward-looking focus. Industrialization through import substitution was the favoured route to economic development. The subsequent shift away from import substitution may be owed partly to the success of a number of Asian newly-industrializing countries that adopted an export-led growth strategy, but also partly to the debt crisis in the early 1980s, which exposed the limitations of inward-looking policies.”

In other words, the deepening globalization trends allowed more citizens of the world to increase wealth generation.

As for the Americans, by financing global trade, they were graced with more selection of goods and services at far more affordable prices.

In addition, US dollar accumulations of emerging or developing nations were recycled back to finance US deficits because the US had deeper and more sophisticated markets, aside from domestic policies aimed at anchoring directly or indirectly to the US dollar by several key developing economies for market share purposes.

More proof of globalization’s absorption of the US dollar…

Figure 4: WTO: Financial Flows to Developing Countries

The explosive growth from Foreign Direct Investments (FDI) in developing countries had been manifested in the mid 90s but slowed during the dot.com bust. Nevertheless, FDI’s to developing nations in the early 90s served as a staging point for the spectacular surges.

To add, worker remittances also had a near parabolic ascent over the same period, operating under the globalization dynamics.

Overall, the early phase of globalization, where emerging economies with vast economies of scale integrated with developed economies, resulted to intensive increases in economic efficiencies.

This virtually accommodated the expansionary policies by the US Federal Reserve which resulted to lower gold and commodity prices.

Thus, gold prices had been muted then as “disinflation” from productivity generated growth dominated the global arena. But nevertheless in contrast to the allegation, gold hasn’t been stripped of its role as an inflation hedge.

Are Bond Yields Implying Deflation?

Many analysts from the deflation camp have also been harping on the brewing inconsistencies between the performances of US sovereign markets relative to global stock markets and commodity markets.

They say that since US sovereign instruments have been rallying along with global stocks and commodities, one of the two groups must be wrong.

For them rallying US bonds signified fear or flight to safety from the specter of deflation, whereas rallying stocks and commodities implied the opposite -economic growth, and thus, inflation.

Further they allege that such divergences favor bond investors more than stock market investors because the former is more “reliable” or “credible” or “sophisticated” or “intelligent”.

Because they mostly adhere to the model of Japan’s ‘lost’ decade or the Great Depression as an outcome for the economic environment, they emphasize on the impotency of global central banks or government actions on the predicament of intractable debt which burdens consumers and the banking system of the US and parts of Europe.

We have lengthily argued against these in Investment Is Now A Gamble On Politics. For us both Japan and the Great Depression are unworthy models of comparison.

Today’s landscape is far more globalized than during the early days and that globalization has somewhat coordinated global central bank actions which could lead to the possibility of more traction from largely synchronized policies.

Nonetheless recent actions in the bond markets appear to “validate” rather than contradict our inflation risks outlook.

Figure 5: stockchart.com: US Treasury Yields Spike!

Across the yield curve, US treasuries have dramatically spiked last week!

While almost every market today have been politicized, as the visible hands of government seems ubiquitous, there is no market as deeply and directly involved with US government as the US sovereign and agency bond markets.

The reason for this is that the balance sheets of the US banking system have been stuffed with sundry assets of different quality, most of them are rubbish. Hence government directly intervenes in these markets to avoid major bank failures by buttressing the banking sector, in order to generate systemic liquidity, to help banks recover profitably from trading on spreads, and hopefully to reanimate the largely impaired credit system.

Similarly, policymakers attempt to control real estate prices from seeking its natural levels or from going lower by acquiring mortgage assets.

As Assistant Professor Philipp Bagus recently wrote, ``The financial crisis was caused by solvency problems that led to a liquidity constraint. Central banks tried to fight this by increasing the availability of liquidity and buying or loaning against the same bad assets that caused the solvency problems. If central banks sell those assets again or stop accepting them as collateral, the same solvency problems will reemerge, along with the preexisting liquidity issues. Paradoxically, by buying and accepting bad assets, the central banks did not fix the solvency problem: they merely delayed the inevitable. The bad loans did not turn "good" by changing hands or being accepted as collateral by central banks. Hence, the problem remains and exit strategies can only be successful if the quality of these assets changes or their quality is acknowledged and banks are recapitalized accordingly.”

In short, by levitating markets the US Federal Reserve hopes that risk appetite would radically improve for the Fed’s position, so as it would be able to unload or dispense of the bad assets accrued within the system.

Unfortunately, the Fed seems stuck with monetizing government debts in the face of additional pressures in the economy.

As we earlier pointed out, the US Federal Reserve is supposed to end its Quantitative Easing (QE) program on its self imposed quota on purchases of $300 billion worth of US treasuries. However, it also declared to extend a significant part of the program in order to complete its purchases on $1.25 trillion worth US mortgages.

Figure 6: Federal Reserve of Cleveland: Federal Reserve Purchases

But data from the Federal Reserve of Cleveland shows otherwise (figure 6).

The blue arrow pointing to the red ellipse shows that the US Federal Reserve has been buying in excess of the $300 billion quota for third time. This means that these purchases were not accidental but deliberate. The Fed has acquired about $2.631 billion above its goals.

Meanwhile, the black arrow also shows of the purchases of mortgage securities by the Fed under the present QE program which is slated to end in early 2010.

In the Fed balance sheet watch, the Wall Street Journal sees the same developments,

``The Fed expanded its purchases of Treasurys and agency debt, though its holdings of mortgage-backed securities declined for the second straight week. The Fed started a program in March to ramp up such acquisitions in order to keep long-term interest rates low. The central bank announced in August that it will be buying more Treasurys through the end of October, and said last month that it will be buying MBS into 2010.”

Perhaps one of the reasons behind the recent spike across the yield curve in US sovereign securities could be imputed to the market interpretations of the FED as ending its support on US sovereign papers. This eclipses the a strong economic growth revival in its economy.

But a surge in sovereign yields could affect mortgage rates and could put renewed pressure on housing and commercial real estate (CME) prices. And a disorderly surge in treasury yields could also ripple to other markets.

One must be reminded that the inflationary policies acts like a pyramiding mechanism which requires more and more accelerated amount of inflation in order to support specifically targeted prices in an unsustainable system propped by artificial stilts.

As Credit Bubble Bulletin’s Doug Noland rightly observed, ``Our policymakers have much less flexibility in the new financial and economic landscape. Both fiscal and monetary measures have lost potency. Trillions of dollars of deficits, zero interest rates and a $2 Trillion Fed balance sheet today get less system response than hundreds of billions and a few percent would have achieved previously. This hurts the dollar.”

Hence, reading through the bond markets when they are directly manipulated by governments would represent as serious misdiagnosis. That’s because these markets have effectively been politically choked which doesn’t reflect on market prices. Eventually imbalances accruing from these will implode.

Moreover, we should expect the US Federal Reserves to continue with its QE programs, regardless of the self imposed quota, simply because the guiding economic ideology, the recent triumphalism, biases derived from research (e.g. anti-deflation tools: printing press, zero interest rates) and importantly, political pressures from the banking industry and/or the political leadership have all converged to incentivize the chief policymakers to take on the risks of an “inflation” route.

Lastly, fighting the FED looks myopic.

US Fed Chair Ben Bernanke looks dead set at taking on the “nuclear option” of jumpstarting the US economy by sparking inflation via devaluation.

This clearly is in his guidebook. As Mr. Bernanke pointed out in his 2001 ‘Helicopter’ speech, ``Although a policy of intervening to affect the exchange value of the dollar is nowhere on the horizon today, it's worth noting that there have been times when exchange rate policy has been an effective weapon against deflation.” (emphasis added)

Importantly all of the prescribed weapons from Mr. Bernanke’s diagnosis against a deflationary outcome, patterned after the Great Depression, seem in place:

1) avoiding mass failures of the banking system. This by taking equity stakes in key financial institutions, aside from exercising diverse roles as the lender, market maker, buyer and investor of last resort via different alphabet soup of programs,

2) adopt zero policy rates,

3) apply an extended period for zero policy rates,

4) run large fiscal deficits

5) seek to further consolidate and expand the powers of the Fed and lastly,

6) use the printing press through QE programs

All these seem potent enough to ensure for the US dollar to massively devalue.

However, the problem is that the US dollar in the 1930s had been anchored to gold.

Today, the US dollar has essentially replaced the function of gold as the world’s anchor currency.

And global governments may not tolerate the US to unilaterally devalue at their expense. And as we pointed in King Canute Effect: Lagging Peso A Consequence Of Central Bank Intervention, as Asian Central Banks including the Philippines have tacitly embarked on interventions in the currency markets to stem the rise of the national currencies.

Ultimately, all these collective policies to “reflate” the system risks, not deflation, but hyperinflation.

As J. Kyle Bass of Hayman Advisors LP fittingly wrote,

``Western democracies, communistic capitalists, and Japanese deflationists are concurrently engaging in what may be the largest, global financial experiment in history. Everywhere you turn, governments are running enormous fiscal deficits financed by printing money. The greatest risk of these policies is that the quantitative easing will persist until the value of the currency equals the actual cost of printing the currency (which is just slightly above zero). There have been 28 episodes of hyperinflation of national economies in the 20th century, with 20 occurring after 1980. Peter Bernholz (Professor Emeritus of Economics in the Center for Economics and Business (WWZ) at the University of Basel, Switzerland) has spent his career examining the intertwined worlds of politics and economics with special attention given to money. In his most recent book, Monetary Regimes and Inflation: History, Economic and Political Relationships, Bernholz analyzes the 12 largest episodes of hyperinflations - all of which were caused by financing huge public budget deficits through money creation. His conclusion: the tipping point for hyperinflation occurs when the government's deficit exceed 40% of its expenditures.” (bold highlights mine)

Hence, the thrust to devalue the US dollar enhances the risks of accelerated inflation which may eventually tip the financial and economic scale towards our critical-‘Mises moment’.

And this translates to massively higher gold prices not only on inflation concerns but at the risks of a global currency crisis.

I’ll end this quote with a repeat reminder from Mr. Ludwig von Mises on stoking perpetual booms, ``The boom can last only as long as the credit expansion progresses at an ever-accelerated pace. The boom comes to an end as soon as additional quantities of fiduciary media are no longer thrown upon the loan market. But it could not last forever even if inflation and credit expansion were to go on endlessly. It would then encounter the barriers which prevent the boundless expansion of circulation credit. It would lead to the crack-up boom and the breakdown of the whole monetary system”