Gold is Insurance Against Money Printing and Credit Expansion by Governments

* Gold – over the last couple of days I read a few articles in support of gold, and against gold. The common denominator of the bullish articles seemed to focus on the idea that gold’s rise over the last 6 years, is only half as much as the rally in asset categories which are regarded as bubbles, such as the tech stocks leading up to 2000, theNikkei stock market up to 1989, and a few others. Another bullish article on CNBC.com, admonished the Asian central banks because of the low amount of gold these banks hold as part of their currency reserves, and speculated on what would happen if these banks move a modest, say 10%, of their reserves into gold. The bears have so far been wrong, and cite gold’s many fold increase over the past few years as evidence that it is done rising. The bearish case also cites the numerous ads on TV, encouraging people to invest ingold coins. A bearish article in Barrons over the weekend called gold the ultimate ‘fiat’ currency. Obviously, the author does not know what the definition of ‘fiat’ is. In case you are wondering, ‘fiat’ refers to the ability to governments to create money at will, without it being convertible into coins or ‘specie’, such as gold. 


Clearly the debate can cut many ways. In a nutshell, gold is an insurance policy against money printing and rapid credit expansion by the governments of the world, who are coming under increasing pressure to support the debt inflated financial systems they have fostered. In fact, I would say that the bulk of the financial crisis centers on the easy credit extended to many parties, ranging from sovereign governments who cannot repay their debts without receiving a steady supply of new debt, to sub-prime home-owners, and banks who have subsequently used their easy credit to purchase loans which will never be repaid to them. The entire system is built upon the premise that the loans will be repaid. Unfortunately, this will not be possible unless governments print more money to make good on these debts.


A topic which I have covered in the past needs to be repeated: Currency printed and shipped from the developed countries, think the euro and the dollar, is flowing to the developing countries. And the developing countries, which are export based manufacturing economies, are using the currency they receive to purchase commodities which are the building blocks for their economies. The developing countries are also accumulating currency at a rapid pace, and in the case of China, has used their foreign currency reservesto issue more of their own, local currency. While a sinking and de-leveraging housing market will mute the US government’s CPI reading, rest assured that the currency we ship overseas is created a boom in the growth of the Chinese Yuan, and domestic Chinese inflation is a tell-tale sign that easy monetary policy in the US is causing inflation in China.


The net of these developments, is that the developing countries have plenty of currency around to continue to purchase the commodities which fuel their economies. As I stated in yesterday’s blog, the world is going from a place where 16% of the population consumed 90% of what the world produced. The other 84% of the population, the developing world, is now picking up their pace of consumption, and they will continue to exert their influence on commodity prices, regardless of what happens to the western economies. As the depression in the western world takes hold, the short term impact will be to pull commodity prices down, and in my opinion, when this happens, it will create a great opportunity to buy into commodity based resources and related equities.


Within the Chinese economy, inflation is exerting itself in the real estate markets (+12% year over year), and to a lesser extent in other aspects of the aggregate Chinese economy (+5% year over year). These are not trivial rises in inflation, yet it is what China seems to be okay with as their normal. In turn, local inflation will cause the value of the Yuan to sink relative to foreign currencies. That concept would work if the Chinese government allowed their currency to freely float. Relative to the dollar, if China allows the local prices of various items to rise, then, on a purchasing parity basis, the Chinese currency will become rich to the euro and the dollar. When I was inBeijing in November of 2008, a nice 2 bedroom apartment in a high rise development about 10-15 miles from downtown, was valued at $200,000 to $300,000. While this is just one anecdotal data point, my point is that in a country which has a very low average annual wage (the urban average was $7,600 in 2009), real estate does not seem like any bargain. To someone from New York City, this might seem like a bargain, but to the average local, you need a ‘western’ job at a western pay scale to afford to own real estate in Beijing. Nonetheless, the point is that all the excess dollars which the US has printed, and distributed via our trade deficit, are floating around the developing world, and fueling their demand for commodities. 


The US Federal Reserve Bank is oblivious to what is going on in China, and if you asked them, I would think that they would admonish China for printing so much local currency, which is ultimately the source of local inflation. Because dollars are not easily convertible to Yuan in a free flowing capital market environment, the creation of local currency is strictly up to the Chinese government. To their credit, China will claim that their large foreign currency reserves are the backing for the local currency. With $2.6 trillion of these reserves, China can afford to purchase imports, notably commodities, at will.


There was a report this morning which I heard on CNBC, in which various developing country central banks stated their continuing faith in the Euro. It is funny that on Bloomberg this morning, there was a statement by Iran that they were going to move their $45 billion stash of foreign currency reserves from the euro to the dollar. Nonetheless, it is remarkable that the developing Asian countries have miniscule portions of their foreign currency reserves in the form of gold. When will these countries wake up and smell the printing presses? My guess is that they will take notice when the Fed prints another trillion of currency. That’s when the fun for gold investors will really begin.


And with that thought, I return to one of my original premises, that gold has been used as a medium for foreign governments to settle their debts over the course of millennium. For stretches of time, governments ignore gold, as there are times when the discipline of the gold standard is too restrictive for a particular countries interest. The history of money is full of examples where countries go on and off the gold standard, always returning at a more convenient point in time. And so it was with the US, which in 1971, took itself off the gold standard. 


The trend of individual investors to purchase gold in record quantities, as is evidenced today can be thought of the last gasp of a bubble, except for the fact that on average, most people own no gold, and those who do, only own a token amount. The next time you are at a cocktail party, or with friends, ask how many own gold. I think you will see how under-invested people are in this alternative to currency. Will gold, which has held value throughout the history of modern man (5,000+ years), all of a sudden become obsolete? I would argue that the current trend has a long way to go, despite the obnoxious commercials we see on TV.