A Discussion on Money and Gold with a Reader

 

Goldbug man

“Find the trend whose premise is false,” says George Soros, “and bet against it.”

Gold bugs seem schizoprenic. Gold prices are manipulated downward; buy more gold!  I think the recent fall in gold has to do with increasing recessionary conditions and "disinflation". But when people realize that real money (financial reserves) can not be replaced by credit and debt then the price decline will reverse.

Imagine you are a major holder of new Lexus cars. Imagine you are in financial trouble. The market for Lexus cars anticipates the upcoming supply. Prices of drop. OK… but are Lexus the same as gold?

Imagine that, instead of Lexus cars, you held cash — a big wad of cash in your vault. Then, in financial trouble, you need get out your cash and use it to pay your creditors. Does the market for cash go down? Does the value of your cash decline because people know you will have to give it to someone else?

The premise is false. Real cash does not become less valuable when people find themselves in financial difficulty; it becomes more valuable. The demand for cash goes up, not down.

But wait. Today’s bills are payable in paper cash…not gold. Debtors must raise paper cash by selling their gold for paper. It’s paper they need… not real money.

Our current system runs on irredeemable, fiat, paper money. People spend it. People borrow it. Now people need more of it to pay their bills. So they sell their valuables — namely, gold — to get more paper money. The Gold price in dollars goes down, while central banks print up more paper money — just to make sure there’s plenty to go around.

One day people will stop worrying about the quantity of the paper and begin worrying about the quality of it.  I am saying gold is commodity money–real money with no liabilities (promise of acceptance).  But I haven’t proven anything, I am putting down thoughts. Next week I will need to prove why I believe that idea has merit. Our goal is to improve our understanding of reality.

I will need to define my terms and prove my premises to debate the reader who provided his thoughts on gold.

First, What is inflation? 

The reader in his comments below says inflation is rising consumer prices.

I define inflation as  any increase in the economy’s supply of money not consisting of an increase in the stock of the money (gold) metal.

Money is a commodity serving as a medium for exchanges, and–because there has been a recent prior history of exchanges–money can serve as a store of value for future exchanges.

Here is another description: Inflation is tn extension of the nominal quantity of any medium of exchange beyond the quantity that would have been produced on the free market. This definition corresponds to the way inflation had been understood until WWII. The 1941 Funk and Wagnalls Dictionary defined inflation as an “expansion of extension beyond natural or proper limits or so as to exceed normal or just value, specifically over issue of currency.”

A free market  is social cooperation conditioned by the respect of private property rights,” Therefore the meaning of inflation is that it extends the nominal money supply through a violation of property rights.  In this sense, inflation can also be called a forcible way of increasing the money supply (by fractional reserve banking, by monetization of government debt, by counterfeiting, by forgery, etc.) as distinct from the “natural” production of money through mining and minting.

The difference is vast and important. Friedrich A. Hayek stated that his chief objection against monetarist theory is that it pays attention only to the effects of changes in the quantity of money on the general price level and not to the effects on the structure of relative prices. In consequence, it tends to disregard what seems to me the most harmful effects of inflation: the misdirection of resources it causes and the unemployment which ultimately results from it.

 

So next week I will lay out my premises and show why the distinction is important. A debate without definition and/or agreement of terms is like having a contest to nail jello to a wall.

Pop Quiz: If the FED wanted to increase the velocity of money what could it do? Hint, the effect would be immediate. Why do you think the FED is not doing that? Where are the errors in this report: HIM2013Q1NP

A Reader Discusses Gold

I was a bull on gold for years, but switched bearish during the mania of summer 2011 and have been bearish ever since.  I don't think anybody can argue that central banks are flooding the world with money.  Everyone knows this is occurring and laments about it, and professional investors keep pushing gold.  You'd be hard pressed to find a big name manager who doesn't like gold.

The problem is that gold doesn't actually protect you from anything - unless everyone else thinks
it does.When Greece imploded back in 2010, almost all assets went down except gold and the
US dollar.

People thought that gold was a safe haven, and therefore it was a safe haven.  Now, the situation is 
almost the exact opposite.Gold bulls have gotten everything they wanted in terms of bullish gold
fundamentals, yet the price keeps going down.

The problem is that gold is purely a psychological asset, and it's only worth what
the next guy is willing to pay for it.  With most senior miners cash cost well south of
$1000/oz, gold is clearly more expensive than pure marginal cost analysis would suggest. 
That premium is the amount that people are willing to pay for "protection" against inflation,
the collapse of fiat currencies, or whatever other event they think they are being shielded from. 
But that premium is now falling because investors realize that other assets protect them
from these events much better.
If concerned about inflation, I would much rather own multifamily real estate than gold.  
Rents reset every year, so they should be well-indexed to inflation, and real estate is traditionally
favored in inflationary times.  Moreover, real estate produces substantial current yield, something
that gold does not.
If worried about sociopolitical unrest, the US dollar or US treasuries are a much better alternative
than gold.  The US dollar is being debased at a much lower rate than other competing currencies
(i.e. GBP or JPY, and likely soon EUR), and remains the world reserve currency, making it an
attractive safe haven.  US treasuries also produce yield, and I believe are unlikely to fall much in
value over the next few years because inflation will need an increase in the velocity of money, 
which will take much more time.
I also agree with you that the stock market is fundamentally overvalued (although I have thought
this for over a year now and been wrong), but I would even buy equities rather than gold if I was
worried about inflation.  In an inflationary stance, companies should have pricing power and
grow their earnings near the rate of inflation, so equities should be able to keep pace with inflation
over a longer run.
 I believe gold owners are figuring out this argument, especially as it pertains to the nascent bull
market in real estate, and that is why they are selling. I also think the "gold is just another currency" 
argument is terribly flawed, as I have yet to go to a country where I can walk into Subway and buy
a foot-long with gold or silver.  Moreover, if gold were a currency, it would be viewed with a great
deal of skepticism considering it has fallen over 10% in one day before, something that has never
happened with a major currency.
I think as gold ETF holders continue to turn elsewhere to hedge their fears, the price of gold will
continue to fall, regardless of what happens in the risk market.  If stocks continue to rise, people
will sell gold and buy stocks.  If stocks fall, people will sell gold and buy real estate or treasuries. 
I strongly believe the bull market in gold is over, and over the course of the next couple years, we
will see substantially lower prices, eventually falling well below $1000/oz.
My definition of inflation is rising prices, with a bias towards consumer
prices vs. asset prices.  In the past few years, US consumer prices have been flat or falling in my
estimation, while asset prices have been going through the roof.I believe a large part of the gold bull
market was an expectation of CPI inflation, that has simply failed to materialize.
I agree that gold prices have never tracked the CPI.  Gold prices have risen and fallen for many
different reasons over the past few decades, but that is largely my point: gold's price is purely a
psychological function.  That would also be my answer to your question about gold's utility,
its utility is simply what the next buyer is willing to pay, or said another way, its utility is the
reason the next buyer is buying it.  That price had risen for a decade straight because of fears over
monetary debasement, inflation, and general pessimism on the effectiveness of central banking,
but it appears there are no more marginal buyers left.
 The advent of gold ETFs brought a huge number of new players in the market, and they were
largely responsible for the run-up in prices from 2008 to 2011.  However, many of these players 
were simply allocating to gold because their advisors were telling them to, without truly 
understanding why they were doing it.  They were doing what investors do in any mature bull
market, they buy because the price is rising. Now, these same investors are selling because the 
price is falling. Teoretically, they could turn around and start buying again, but the problem is,
what would actually cause this?  What positive surprise is there left for gold that has not already 
been disclosed?
When gold prices ran up to $1900/oz in September 2011, it was not quantitative easing that caused
it, but rather the expectation of QE3.  At this point, the Fed has already indicated they will print
an unlimited amount of money, only varying the size of their asset purchases, with no time limit set.
It is already on the table that the Fed will print unlimited, so what positive surprise is left?  Every
other central bank has stepped up their liquidity too over the past 1.5 years, yet the price of gold 
continues to drop. My point is that, in the past, gold has served as protection against future currency
debasement, but it has now ceased to serve that function.  This is a problem because gold only protects
us from anything if the rest of the market thinks it does.  This key change in sentiment and market 
thought on gold is why I believe the price is falling.
As I said before, with marginal cost on gold way below where it is now, there is plenty of room
for the metal to fall.  In the long run, commodities must return to their marginal cost, even after
moving up or down according to demand shocks.As for central banks, I do not believe them to be a
reliable indicator of anything.  If they knew what they were doing, the GFC would never have
happened in the first place.  Also, central banks were massive net sellers of gold at the bottom i
in 2000, yet are big buyers of gold now that prices are near their all-time high.  If anything, 
they are a contrarian indicator. 

Lastly, countries like Germany will probably continue to repatriate their gold because they
are broke.  European countries are some of the largest holders of gold inthe world, and\
considering how high the price of gold is, I would want mine back too if I were them.
With their failing economies and possibly soon to be failing currency, gold is their asset of highest
worth.  If Germany, Italy, and the EU were to sell their gold or have less of it, the credit of these 
countries would almost certainly drop, in the same way that if they had less currency reserves. 
However, with the Cypriot central bank selling gold to finance their bailout recently, the writing
is on the wall that gold reserves may be tapped.  This would turn the EU into net sellers of gold, 
potentially dumping huge amounts onto the market if their debt crisis ever flares up again. END

3 responses to “A Discussion on Money and Gold with a Reader

  1. I guess we fundamentally disagree, because my premise is that gold is not money, and that US dollars are. I do not understand the distaste for “paper” money, when paper money is what we all use as a medium of exchange, and have been using for the past century. The equities we seek to locate as value investors, the food we eat, the clothes we wear, and even precious metals themselves are all measured in US dollars. While I freely admit that fiat currencies are fungible, they remain the medium of exchange, and I believe it is unlikely that this will not be the case going forward. I don’t see how gold is more “money” than US dollars, and would argue that it is less so.

    I must say that I am surprised of your taste for gold given your interest in value investment. The problem is, even if you are right, what is the “correct” price for gold? $1,000? $5,000? $10,000? There is no “value” for gold, because the price is psychological, based on supply/demand from investors. Even when I was a bull on gold, I never dared put a price target on it, only attempting to surmise the vector, because I knew full well I was investing in an asset whose value was only based on what the next buyer was willing to pay. At this point in time and for the past 1.5 years, I believe the vector is downwards, and with significant magnitude.

    As with any commodity, the marginal cost = marginal demand equation provides us with something of a floor, but as I discussed before, this floor is hundreds of dollars an ounce lower than the current price. With gold so far above its marginal cost, where is the value in investing in gold?

  2. I have been too busy to write-up my reply–which I intend to do and answer point by point. Yes, I believe both gold (coins) and dollar bills are mediums of exchange. But you don’t realize how unique this period is in history–since 1971 ALL currencies are irredeemable FIAT (forced by the govt.) paper or IOU nothings. The paper or gold’s price is an exchange ratio.

    But you said that gold is a commodity. Yes, it is since it is used for jewelry, dentistry, electronics, but 95% of its value is as a wealth transfer/medium of exchange.) That is what the market is telling me over the past 2,000 years. Bitcoin has a way to go!

    So you say that gold’s price as a commodity will decline to its marginal cost of production. If that is true, then holding dollars under the same economic laws would mean that all paper money declines to its marginal cost of production $0.00. In fact, this is true, since EVERY fiat currency has declined to $0. The US has had two currencies go to $0 (The Continental Dollar and the Confederate Dollar). The US dollar has lost about 95% of its purchasing power over 100 years.

    But I still am a value investor, the best investment in the world is a company that has a franchise that can keep redeploying capital. I still own stocks, just not as much as before since I hold 40% in cash waiting for profits margins to mean revert.

    Also, another good investment is to buy real estate and lock-in low rates because these interest rates will not stay at these levels over the next 40 years.

    Again, I view gold as REAL money that doesn’t increase in supply very much so it holds its long-term value over a 50 year period and is the reciprocal of monetary chaos. I am betting that the central banks–like all central planners will fail in whatever they are doing–resulting in huge inflation or deflation. The Fed is monetizing a trillion dollar deficit EACH year and as long as banks don’t lend out the reserves and foreign central banks continue to hold excess dollars (using them to buy US bonds and/or stocks) then the game will continue–I don’t know how long, but what can’t continue will end especially with the silly valuation of many stocks.

    I plan to write up my piece on the insanity of paper dollars under current conditions soon.

    Stop and think, if dollars are just tickets used for exchange into goods and services, then no matter what the increase or decrease of paper dollars, the goods and services will stay the same only the exchange ratio will change.

    Today a dollar can buy 4 apples and 2 bananas. Overnight, money supply doubles, so assuming no change in market preferences, the exchange ratios are $1.00 buys 2 apples and 1 banana. The “price” of the dollar went down or the price or the price of the goods went up–take your choice but the real amount of goods did not increase. The purchasing power of the dollar declined as it has for the past 100 years.

    All inflation (increase in fiat currency) is a wealth transfer from those who receive and spend the money BEFORE others do. Right now the Fed is transferring wealth from savers (widows and pensioners) to Wall Street and the Banks.

    I will post a full reply soon.

    • I think we agree on nearly every point, except gold’s future. I agree that stocks are way too expensive, and that income-producing real estate, especially when coupled with permanent, cheap financing, is a great investment.

      However, even with the Fed clearly transferring wealth from those who have acted conservatively (savers) to those who act recklessly (speculators), gold’s price has fallen for the past 20 months. All the bullish fundamentals have been there and on the table for all to view, but nobody wants to own gold anymore. I believe the reason why is because people have found other assets to better protect themselves, such as income-producing real estate and US treasuries. After all, if the government is going to help out debtors so much in creating future inflation and keep interest rates low for the time being, wouldn’t we be better off trying to profit from this trend by buying real estate?

      While gold might prove a good asset to own when inflation does actually happen (which I do not believe is anywhere near happening, 4-5 years away in my opinion), other assets could produce much better returns, and current income, during the same time span. Can you honestly say that you have more certainty regarding gold’s price 5-10 years from now than Class A or B apartments in prime areas in major cities in the US? The answer must be no, and considering that many residential real estate investments produce current income in excess of junk bond yields, I would clearly rather hold rental residential real estate than gold. When buying this type of real estate, you will profit in all the same ways that you would profit from buying gold, i.e. inflation and bias towards hard assets. However, you are not taking nearly the same type of risk, as rental real estate’s price is supported by its yield as well as the value of the land/building to an owner-occupier.

      I’m not really following your argument regarding the money supply. The money supply in the US has exploded since 2008, yet consumer prices have remained largely the same. While you could argue that asset prices have experienced inflation, this has not changed the price I pay for food by much (the price of a foot-long at Subway has not risen by nearly the same magnitude as the stock market since 2009). I don’t see how the money supply going up has actually caused inflation, whereas I do see how the problem is the falling velocity of money. Correct me if I am wrong.

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