Gold and Silver Snips

As the gold price continues its steady climb higher and the U.S. dollar remains immersed in a downtrend, it is worth considering the importance of these macro trends. The headlines with respect to the ongoing depreciation of the U.S. dollar relative to the gold price and other global currencies have been recurring for a number of years. However, in recent months the number of stories has increased as the dollar has made 52-week lows versus a number of currencies and as the gold price, measured in U.S. dollars, has climbed near all-time highs.

What does the weak dollar really mean to an investor? We often read about large, disturbing macro trends, yet rarely think about the micro implications. What does it matter if the budget deficit is $800 billion, or 6.5% of GDP, versus the current estimate of $1.6 trillion, or 13% of GDP? Admittedly, the ramifications over short intervals of time are difficult to discern. This is one of the ways that policymakers sell programs such as stimulus checks or “cash for clunkers.” These programs are all about political posturing and creating the appearance of forging a solution. And while they deliver some semblance of short-term relief to a recession-battered public, crudely put, they are analogous to abetting drug addiction. Give the addict a quick fix and he’s momentarily liberated from his torment and sickness. The real solution, withholding the drug, requires a more painful short-term outcome but gives the addict a chance at recovery and renewal.

The innate desire to want short-term fixes is heightened by the ease with which the fixes are offered. Faced with brief, two-year congressional election cycles, politicians govern in order to keep their jobs, rather than to promote the long-term good of the people, however politically unpopular. Hence it is nearly impossible for the hard, but correct policy route to be taken. With respect to the declining dollar, the correct route is for consumers to pay down their debt and bolster their assets through savings, but the price of this is short-term pain. Saving leads to lower retail sales, which leads to lower economic growth, which leads to higher short-term unemployment - the unavoidable consequence of taking the correct route to solve the public and private spending excesses of this decade. Instead, policymakers are providing more incentives to consume, such as the “cash for clunkers” program, which compounds the declining dollar problem by driving both consumers and the federal government deeper into debt, even if consumers do save a few bucks on a new car. The patient cannot be cured by the same ailment that made him sick in the first place. Easy money is not the cure for a disease contracted by easy money.

With consumers burdened with debt and unable to muster more spending, the federal government has stepped in to fill the void. Keynesian deficit spending is in full force. But just as the creditworthiness of an individual declines as his balance sheet deteriorates, the same is true of sovereign governments. Think of a nation’s currency as the barometer of that country’s fiscal health. The persistent dollar depreciation we are witnessing is a vote of no-confidence on both America’s current financial health, and the outlook for its balance sheet going forward.

This past week, World Bank President Robert Zoellick provoked controversy with his comments on the economic policies of the United States and the U.S. dollar. Zoellick stated that the U.S. dollar is at risk of losing its role as the global reserve currency as both the euro and Chinese renminbi achieve greater prominence in global markets. He questioned whether the United States would be able to resolve its debt problems without resorting to inflation.

The concern of Mr. Zoellick, shared by world leaders, is that in order to manage the debt load America is incurring through large and growing deficits, the Federal Reserve, in conjunction with the executive and legislative branches, must resort to inflating away its debt problems. By making dollars cheaper, it becomes easier to pay off future debts. This insidious, hidden tax on savers robs hard-working Americans.

Ernest Hemingway famously penned that, “the first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin.”

Inflation is a decline in the value of money caused by an increase in the money supply. As the supply of paper money increases – without a commensurate increase in production – the excess demand manifested by a greater money supply causes the price of goods and services to rise. More currency chasing fewer goods will eventually lead to price inflation. If the money supply is growing faster than GDP then prices will necessarily move upward. Business decisions become more difficult to make without stable money, hence investment often declines. Inflation can distort the economy and can lead to hoarding out of concern that purchases must be made now because prices will be higher in the future.

The U.S. dollar has lost 89% of its purchasing power over the past 59 years. The $10,000 life insurance policy held by the World War II veteran on his return home represented a significant amount of money in the 1940s. Now, that policy would barely cover the cost of a burial plot and funeral for a war hero. But the material decline in purchasing power is in no way a given, and the precedent for stable prices has a longer history than the era of inflation we have endured for three generations. From 1800 to 1929, the value of the dollar was stable – there was essentially no change in consumer prices for 130 years. It is ironic that the beginning of the inflation tidal wave started shortly after the creation of the Federal Reserve Bank in 1913, an entity designed to preserve price stability.

The acceleration of money supply growth following the collapse of the technology boom - and the cheap money and liberal credit that sprang from it - created the housing bubble that is chiefly responsible for the magnitude of today’s frozen credit markets. A similar misallocation of resources is occurring now and, as always, there will be consequences. In spite of the deflationary headwinds emanating from excess capacity utilization and a low velocity of money, inflation is always and everywhere a monetary phenomenon, just as Milton Friedman penned many years ago. Public sector deficit spending combined with a Federal Reserve that has implemented quantitative easing, or money-printing, alongside an unprecedented loose monetary policy will accelerate the decline in the purchasing power of the dollar. Nearly $19 trillion in U.S. public funds were pledged to save the global financial system. While a great deal of this total will be undrawn or repaid, a significant amount will not be.

Formerly, under gold-based monetary systems, inflation occurred when governments melted down or mixed other metals into the coinage, thereby diluting the gold content. Goods and services would require a greater amount of coins as money was debased. Inflation is a form of currency debasement. But how can the individual investor protect herself against inflation? One solution is to exchange inflation-sensitive assets like cash and bonds for hard assets like gold and real estate. As inflation rises, the level of real interest rates decline. Consequently, the opportunity cost of holding a sterile asset that pays no rate of interest declines. Gold acts as a store of value in such an economic climate, and has the advantage of fungibility, portability and ease of conversion into cash that other hard assets like real estate lack. Those analysts and market commentators who talk of a bubble in gold simply ignore the fact that its inflation-adjusted 1980 high is nearly $2,300 per ounce, a number 120% higher than the current price of just under $990 per ounce.

In such an environment of currency instability, the gold price and gold mining equities tend to preserve wealth. Larry Summers, former Secretary of the Treasury and current Chief Economic Advisor to President Obama, and Robert Barsky wrote an academic paper in 1998 titled Gibson's Paradox and the Gold Standard. Their research led them to conclude that price action in the gold price is driven by the reciprocal of the real rate of return from the global capital markets. Demand for gold and, accordingly, the gold price are dependent on what alternative rate of return is available in other asset classes. A low-return environment in traditional asset classes such as equities and bonds will create increased demand for gold. The relatively small size of the gold bullion market and the gold equity market, combined with the magnitude of potential demand, creates a situation wherein explosive price gains are a possibility. Per Summers and Barsky's research, the recent investment climate characterized by tepid long-term returns in stocks and bonds, combined with the prospect of continued monetary inflation to combat the credit crisis, strengthens the case for increasing an investor’s exposure to the gold price and gold equities in spite of the risk associated with short-term oscillations.