Recent headlines proclaim yet-a-new record high price for gold. Another mentions a new high for home foreclosures and a record for repossessions. While those who have “invested” in gold are cheering the former headline, they should be paying attention to the latter and getting off the gold train before it derails.
The problem is the assumption of hyperinflation. All the late-night gold hawkers scare the viewers with horror stories of Zimbabwe-like levels of hyperinflation, and how the US Dollar is doomed and why the “smart money” and the “experts” are investing in gold.
Now , before we get into the specifics of why they are wrong, let’s first address the idea of gold as an investment. Gold is a commodity- like oil, pork bellies, or corn. Commodities sell on futures contracts—a promise to buy a certain amount of something at a future price. This is why you hear things on AM radio (catering to farmers) like “June soy beans down a quarter, July lean hogs up an eighth” for example. Buyers not only bid on future production of a given month, but they also trade with each other to try and improve their positions. Let’s say it’s May and you make a deal with a corn grower to pay $5.07 per bushel in September. Meanwhile, it turns out that there was a major disease infestation and the September harvest looks like it will be very poor. Other buyers for that September corn are now willing to pay the grower $7/bushel. You could sell your contract to them for $6.50—they save money, you turn an instant profit and have no risk anymore because you don’t have to wait on the harvest results, you converted your position to cash. This is essentially how all commodities markets work (Chicago’s mercantile exchange is the Wall Street of Commodities, and that’s where the famous “we should have a Tea Party” rant by Rick Santelli gave the current movement it’s name).
This is *not* investing in a traditional sense. You are not putting capital into an operation with an expectation that the operation will CREATE value. No, you are saying that the current price is less than it should be. This is *speculation*, not investing. Commodities are not investments! They are speculation—always. Whether oil, cotton, hay, beef, corn, soy, or whatever—they are not investments.
Contrast that with real investment where a person thinks a company is will increase in intrinsic value, not just in price. Price is intrinsic value expressed through dollars. Dollars go up and down in strength, and price along with it. Intrinsic value is a nebulous concept, but it’s the value of the company apart from the value of the dollars used to express it.
So when a person “invests” in gold, they are not investing at all, they are speculating that the current price is too low, that it will be going up as the market realizes how underpriced gold really is. There’s no belief that gold will increase in intrinsic worth. A bar of gold always has the same capability to be made into different products. Rather, it’s the belief that the dollars used to express the price of gold will radically change (not the gold itself).
So speculating in gold is invariably a speculation that inflation will occur, and to an extreme degree.
So any discussion of Gold has to be a discussion of inflation, or quite simply, what is a dollar worth? Right now, a dollar is worth different things in different measures: 1/1300th of an ounce of gold, 1/3rd of a gallon of gasoline, one entire crappy plastic toy from the dollar store, etc.
But on a larger level, the value of a dollar follows basic supply and demand. If there’s more than adequate supply for the demand, the value will go down. If there’s not enough supply for the demand, then the value goes up.
On the “demand” side of things, you can usefully lump all those sources together as essentially the size of the American economy. If the economy shrinks with the same number of dollars in circulation, then your dollar is a slice of a smaller pie, worth less than before (inflation). If the economy grows radically with no change in the number of dollars, then your piece is of a bigger pie, and it’s worth more (deflation).
So the gold speculators look at the current US economic mess, the astronomical US Gov’t deficits and conclude that the supply of dollars will drown the economy, as the Fed fires up the printing presses and mints a couple trillion dollars more in cash.
But is that the only source of money? NO!
Now I will explain to you why the FED is fighting its hardest to prevent DEFLATION and how it may be losing that war. When/if deflation comes, the price of gold will collapse massively.
Cash isn’t the only source of money. The FED keeps tabs on all currency in circulation (and can tightly control that), but they cannot control the money supply—they can only influence it. WHY?
Because money in circulation is “created” from thin air. Let’s say you walk into a bank with $10 cash and want to deposit it. The bank can turn around and loan someone else $100 based on the $10 cash you deposited. So that person’s loan would be the $10 you deposited, plus $90 created from thin air. The $100 loan is backed by only $10 in real cash. This is called “fractional reserve lending” and it means that any bank generally has available 1/10th of its nominal value in hard assets.
When banks fail and houses go into foreclosure, the amount of “funny” money in circulation collapses as the loans get liquidated for pennies on the dollar.
The FED influences the amount of “funny money” by creating incentives to borrow—low interest rates. But they cannot MAKE people borrow. Borrowing is the activity that pulls money from the Fed vaults and into circulation. It is the activity that increases the money supply (through our loan example). Conversely, bad loans or failed banks decrease the money supply.
You can see now that the Fed printing more money will not put that money in circulation. Only borrowing and other economic activity does that. That’s why even though the Fed created over a Trillion dollars cash in Feb 2009, we have not seen a whiff of inflation at all. So, while the Fed can quickly pull money OUT of circulation (like pulling on a rope), it cannot PUSH it into circulation (like pushing on a rope).
The Fed has “pushed on the rope” as hard as it possibly can. It has cut its main interest rate to ZERO. Essentially they are offering to PAY banks to borrow money! Home mortgages are available in the three percent range, yet sales are slacking. Car sales are at their lowest since 1983 despite historically low rates on loans.
So while the Fed has tons of cash in the vault, the supply of money in circulation keeps shrinking and shrinking. There’s nothing more that can be done to fight deflation. They are doing everything possible to CREATE inflation—yet it’s STILL not happening!
So even though there’s no current inflation, and hasn’t been since Sept 2008 or so, the price of gold keeps inching higher. Based on what? It’s based on the fear of future inflation, primarily. It has created a high demand for gold as a hedge against risk. (much the way oil speculators bid up crude in early 2008 to astronomical prices).
But there’s no way that future inflation can get bad enough to justify the current price of gold. For one, the collapse of an economy (which as we outlined earlier SHOULD be inflationary --too many dollars representing too little value), ends up being Deflationary because of how it shrinks the money supply.
Increasing the money supply takes a lot of economic activity, and it takes time. The economic activity isn’t happening now because Congress is jerking around the America with all kinds of uncertainty. So people are hunkered down, waiting to see what’s going to a happen. They will believe things are OK slowly—only when unemployment comes down, homes are not foreclosing at record rates, and banks are being newly opened rather than closed down.
When the economic activity happens, it will happen slowly enough that the Fed will be able to withdraw money from circulation enough to keep inflation in check.
The real fear remains deflation, because so many things are pointing that direction. Foreclosures shrink money supply and you get deflation. Bank failures? Deflation. Unemployment? Deflation. Federal indebtedness at some point will cause higher interest rates—and higher interest rates push towards deflation (that’s why the Fed LOWERS rates to fight deflation).
So it’s not just contrarian to resist the temptation to jump on the golden bandwagon. Those who buy gold NOW are depending on others being even more fearful than they are. The overwhelmingly likely outcome is that those who now “invest” in gold will either lose a little or lose big, depending on how long they stay in it. Gold most likely will never be below $400/oz again (but it could—high prices are a strong incentive to produce and increase supply—what happens when the demand collapses?). However, it’s almost certainly not hitting $2k anytime soon.
