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Amid the global
crisis in confidence, investors seem to be rediscovering the fact that gold
has been used as money for thousands of years. In periods where black swans
are no singular occurrences but are practically coming in flocks, the status
of gold as a safe haven has yet again proven its worth. -
Ronald-Peter Stoferle, The Erste Group
A few years ago
I did an appraisal for a client who was pledging his gold as collateral in a
commercial real estate transaction. In the course of doing the appraisal, I
was struck with the large gain in value. His original purchase in 2002 was in
the seven figures when gold was still trading in the $300 range. His holdings
had appreciated 50% after a roughly three-year holding period. (Since that
appraisal, the value has risen another three times.) I asked his permission
tell his story at our website as an example how gold can further one’s
business plans.
"No
problem at all,” he wrote by return e-mail, “I have viewed it as
a hedge, but also as an alternative to money market funds. Now I can leverage
it for investment purposes -- private equity and real estate mostly. The
holding has averaged 7%-10% of my total assets. And I do hope to buy
substantially more, when appropriate. Thanks again."
It needs to be
emphasized that he was not selling his gold, but pledging it as collateral to
finance other aspects of his business. Selling it would have meant giving up
his hedge -- something he didn’t want to do. Instead, he was using gold
to further his business interests in a transaction in which he would become a
principal owner.
Upon publishing
his story at the USAGOLD website, we received a letter from another client
with a similar story to tell:
I read the
article in the newsletter about one of your client’s buying 1 million
of gold four years ago and it now being worth $1.5 million. I have a similar
true story if you would like to use it. About four years ago, I talked my
father into converting about a third of his cash into gold, mostly pre-33
British Sovereigns. I bought for him from USAGOLD-Centennial Precious Metals
approximately $80,000 when spot gold was about $290 per ounce. He had the
rest of his money in 1-2% CDs in the bank. My father passed away recently and
I am executor. He willed my brother $250,000 which was essentially all of his
gold and cash. I gave my brother the gold along with the bank CDs. While the
CDs had earned barely a pittance in those 4 years the gold had become 41%
more valuable.
So instead of
receiving $250,000 my brother really received about $282,800 ($80,000 x 141%
= $112,800 or + $32,800). Had my father converted all his paper money to gold
my brother would have received $352,500. Ironically my father was very
conservative and didn't like to gamble. In this case his biggest gamble was
watching those CDs smolder and not acquiring real money -- gold.
(Author’s
note: Today this client’s holdings have nearly tripled in value again
to nearly $350,000. A modest inheritance has become quite valuable.)
It is
interesting to note that both clients view their gold as a savings and safe
haven instrument as opposed to an investment for capital gains -- a viewpoint
very different from the way gold is commonly portrayed in the media. An
interesting sidenote to their successful utilization of gold is that it
occurred in the predominantly disinflationary environment of the
“double-ought” decade (from 2000-2009) when inflation was
moderate -- a counter-intuitive result covered in more detail below.
Now, as the
economy has gotten progressively worse, many investors are beginning to ask
about gold’s practicality and efficiency under more dire circumstances
-- the ultimate black swan, or outlier event like a deflationary depression,
severe disinflation, runaway stagflation or hyperinflation. The following
thumbnail sketches draw from the historical record to provide insights on how
gold is likely to perform under each of those scenarios.
Gold as a
deflation hedge (United States, 1933)
Webster defines
deflation as “a contraction in the volume of available money and credit
that results in a general decline in prices.” Typically deflations
occur in gold standard economies when the state is deprived of its ability to
conduct bailouts, run deficits and print money. Characterized by high
unemployment, bankruptcies, government austerity measures and bank runs, a
deflationary economic environment is usually accompanied by a stock and bond
market collapse and general financial panic -- an altogether unpleasant set
of circumstances. The Great Depression of the 1930s serves as a workable
example of the degree to which gold protects its owners under deflationary
circumstances in a gold standard economy.
First, because
the price of gold was fixed at $20.67 per ounce, it gained purchasing power
as the general price level fell. Later, when the U.S. government raised the
price of gold to $35 per ounce in an effort to reflate the economy through a
formal devaluation of the dollar, gold gained even more purchasing power. The
accompanying graph illustrates those gains, and the gap between consumer
prices and the gold price.
Second, since
gold acts as a stand-alone asset that is not another’s liability, it
played an effective store of value function for those who either converted a
portion of their capital to gold bullion or withdrew their savings from the
banking system in the form of gold coins before the crisis struck. Those who
did not have gold as part of their savings plan found themselves at the mercy
of events when the stock market crashed and the banks closed their doors
(many of which had already been bankrupted).
How gold might
react to a deflation under a fiat money system is a horse of another color.
Economists who make the deflationary argument within the context of a fiat
money economy usually use the analogy of the central bank “pushing on a
string.” It wants to inflate, but no matter how hard it tries the
public refuses to borrow and spend. (If this all sounds familiar, it should.
This is precisely the situation in which the Federal Reserve finds itself
today.) In the end, so goes the deflationist argument, the central bank fails
in its efforts and the economy rolls over from recession to a full-blown
deflationary depression.
During a
deflation, even one under a fiat money system, the general price level would
be falling by definition. How the authorities decide to treat gold under such
circumstances is an open question that figures largely in the role it would
play in the private portfolio. If subjected to price controls, gold would
likely perform the same function it did under the 1930's deflation as
described above. It would gain in purchasing power as the price level fell.
If free to float (the more likely scenario), the price would most likely rise
as a result of increased demand from investors hedging systemic risks and
financial market instability (as was the case globally during the 2008 credit
meltdown).
The
disinflationary period leading up to and following the financial market
meltdown of 2008 serves as a good example of how the process just described
might unfold. The disinflationary economy is a close cousin to deflation, and
is covered in the next section. It provides some solid clues as to what we
might expect from gold under a full deflationary breakdown.
Gold as a
disinflation hedge (United States, 2008)
JUST AS THE
1970s REINFORCED GOLD'S EFFICIENCY as a stagflation (combination of economic
stagnation and inflation) hedge, the 2000's decade solidly established
gold’s credentials as a disinflation hedge. Disinflation is defined as
a decrease in the inflation rate over time, and should not be confused with
deflation, which is an actual drop in the price level. Disinflations, as
pointed out above, are close cousins to deflations and can evolve to that if
the central bank fails, for whatever reasons, in its stimulus program.
Central banks today are activist by design. To think that a modern central
bank would sit back during a disinflation and let the chips fall where they
may is to misunderstand its role. It will attempt to stimulate the economy by
one means or another. The only question is whether or not it will succeed.
Up until the
“double oughts,” the manual on gold read that it performed well
under inflationary and deflationary circumstances, but not much else.
However, as the decade of asset bubbles, financial institution failures, and
global systemic risk progressed, and gold continued
its march to higher ground one year after another, it became increasingly
clear that the metal was capable of delivering the goods under
disinflationary circumstances as well. The fact of the matter is that during
the 2000s even as the inflation rate remained relatively calm, gold managed
to rise from just under $300 per ounce in January, 2000 and rise to well over
$1000 per ounce by December, 2009 -- a rise of 333% over the ten-year period.
Following the
collapses of Bear Stearns, AIG and Lehman Brothers in 2008, gold rose to record
levels and firmly established itself in the public consciousness as perhaps
the ultimate asset of last resort. As the economy flirted with a tumble into
the deflationary abyss, it encouraged the kind of behavior among investors
that one might have expected in the early days of a full deflationary
breakdown with all the elements of a financial panic. Stocks tumbled. Banks
teetered. Unemployment rose. Mortgages went into foreclosure.
Gold came under
accumulation by investors concerned with a major breakdown in the
international financial system. In 2009, U.S. Gold Eagle sales broke all
records. Reports filtered into the gold market that bullion gold coins simply
could not be purchased. The national mints globally could not keep up with
demand. In September, 2008 when the crisis began, gold was trading at the $750
level. As 2010 drew to a close, it crossed the $1400 mark as investors
reacted to an announcement by the Federal Reserve that it would begin a
second round of quantitative easing (money printing) to deal with the very
same crisis that began in 2008. All in all, gold proved to be among the most
reliable assets under stubborn and trying disinflationary conditions.
Gold as a
hyperinflation hedge (France, 1790s)
ANDREW DICKSON
WHITE ENDS HIS CLASSIC HISTORICAL ESSAY on hyperinflation, "Fiat Money
Inflation in France," with one of the more famous lines in economic
literature: "There is a lesson in all this which it behooves every
thinking man to ponder." The lesson that there is a connection between
government over-issuance of paper money, inflation and the destruction of
middle-class savings has been routinely ignored in the modern era. So much
so, that enlightened savers the world over wonder if public officials will
ever learn it.
White’s
essay tells the story of how good men -- with nothing but the noblest of
intentions - can drag a nation into monetary chaos in service to a political
end. Still, there is something else in White's essay -- something perhaps
even more profound. Democratic institutions, he reminds us, well-meaning
though they might be, have a fateful, almost predestined inclination to print
money when backed against the wall by unpleasant circumstances.
Episodes of
hyperinflation ranging from the first (Ghenghis Khan’s complete
debasement of the very first paper currency) through the most recent (the
debacle in Zimbabwe) all start modestly and progress almost quietly until
something takes hold in the public consciousness that unleashes the pent-up
price inflation with all its fury. Frederich Kessler, a Berkeley law
professor who experienced the 1920s nightmare German Inflation first-hand,
gave this description some years later during an interview: “"It
was horrible. Horrible! Like lightning it struck. No one was prepared. You
cannot imagine the rapidity with which the whole thing happened. The shelves
in the grocery stores were empty. You could buy nothing with your paper
money."
Towards the end
of “Fiat Money Inflation in France,” White sketches the price
performance of the roughly one-fifth ounce Louis d’ Or gold coin:
“The
louis d'or [a French gold coin .1867 net fine ounces] stood in the market as
a monitor, noting each day, with unerring fidelity, the
decline in value of the assignat; a monitor not to be bribed, not to be
scared. As well might the National Convention try to bribe or scare away the
polarity of the mariner's compass. On August 1,
1795, this gold louis of 25 francs was worth in paper, 920 francs; on
September 1st, 1,200 francs; on November 1st, 2,600 francs; on December 1st,
3,050 francs. In February, 1796, it was worth 7,200 francs or one franc in
gold was worth 288 francs in paper. Prices of all commodities went up nearly
in proportion. . .
Examples from
other sources are such as the following -- a measure of flour advanced from
two francs in 1790, to 225 francs in 1795; a pair of shoes, from five francs
to 200; a hat, from 14 francs to 500; butter, to, 560 francs a pound; a
turkey, to 900 francs. Everything was enormously inflated in price except the
wages of labor. As manufacturers had closed, wages had fallen, until all that
kept them up seemed to be the fact that so many laborers were drafted off
into the army. From this state of things came grievous wrong and gross fraud.
Men who had foreseen these results and had gone into debt were of course
jubilant. He who in 1790 had borrowed 10,000 francs could pay his debts in
1796 for about 35 francs.”
Those two short
paragraphs speak volumes of gold’s safe-haven status during a
tumultuous period and may raise the most important lesson of all to ponder:
the roll of gold coins in the private investment portfolio. According to an
International Monetary Fund study by Stanley Fischer, Ratna Sahay and Carlos
Veigh (2002) "the link with the French revolution supports the view that
hyperinflations are modern phenomena related to printing paper money in order
to finance large fiscal deficits caused by wars, revolutions, the end of
empires and the establishment of new states." How many Americans can
read those words without some degree of apprehension?
Gold as a
runaway stagflation hedge (United States, 1970s)
IN THE
CONTEMPORARY GLOBAL FIAT MONEY SYSTEM, when the economy goes into a major
tailspin, both the unemployment and inflation rates tend to move higher in
tandem. The word “stagflation” is a combination of the words
“stagnation” and “inflation.” President Ronad Reagan
famously added unemployment and inflation together in describing the economy
of the 1970s and called it the Misery Index. As the Misery Index moved higher
throughout the decade so did the price of gold, as shown in the graph
immediately below.
At a glance,
the chart tells the story of gold as a runaway inflation/stagflation hedge.
The Misery Index more than tripled in that ten-year period, but gold rose by
nearly 16 times. Much of that rise has been attributed to pent-up pressure
resulting from many years of price suppression during the gold standard years
when gold was fixed by government mandate. Even after accounting for the
fixed price, it would be difficult to argue that gold did not respond readily
and directly to the Misery Index during the stagflationary 1970s.
In a certain
sense, the U. S. experience in the 1970s was the first of the runaway
stagflationary breakdowns, following President Nixon’s abandonment of
the gold standard in 1971. Following the 1970's U.S. experience, similar
situations cropped up from time to time in other nation-states. Argentina
(late 1990s) comes to mind, as does the Asian Contagion (1997), and Mexico
(1986). In each instance, as the Misery Index rose, the investor who took
shelter in gold preserved his or her assets as the crisis moved from one
stage to the next.
Fortunately,
the 1970's experience in the United States was relatively moderate by
historical standards in that the situation fell short of dissolving into
either a deflationary or hyperinflationary nightmare. These lesser events,
however, quite often serve as preludes to more severe and debilitating events
at some point down the road. All in all, it is difficult to classify
stagflations of any size and duration as insignificant to the middle class.
Few of us would gain comfort from the fact that the Misery Index we were
experiencing failed to transcend the 100% per annum threshold or failed to escalate
to a state of hyperinflation and deflation. Just the specter of a
double-digit Misery Index is enough to provoke some judicious portfolio
planning with gold serving as the hedge.
A portfolio
choice for all seasons
A BOOK COULD BE
WRITTEN ON THE SUBJECT OF GOLD AS A HEDGE against the various
‘flations. I hope the short sketches just provided will serve at least
as a functional introduction to the subject. The conclusion is clear: History
shows that gold, better than any other asset, protects the portfolio against
the range of ultra-negative economic scenarios, such so-called black swan, or
outlier, events as - deflation, severe disinflation, hyperinflation or
runaway stagflation.
Please note
that I was careful not to favor one scenario over the other throughout this
essay. The argument as to which of these maladies is most likely to strike
the economy next is purely academic with respect to gold ownership. A solid
hedge in gold protects against all of the disorders just outlined and no
matter in which order they arrive.
I would like to
close with a thoughtful justification for gold ownership from a UK
parliamentarian, Sir Peter Tapsell. He made these comments in 1999 after then
Chancellor of the Exchequer, Gordon Brown, forced the auction sale of over
half of Britain’s gold reserve. Tapsell’s reference to
“dollars, yen and euros” has to do with the British
treasury’s proposal to sell the gold reserve and convert the proceeds
to “interest bearing” instruments denominated in those
currencies. Though he was addressing gold’s function with respect to
the reserve of a nation-state (the United Kingdom), he could have just as
easily been talking about gold’s role for the private investor:
The whole point
about gold, and the quality that makes it so special and almost mystical in
its appeal, is that it is universal, eternal and almost indestructible. The
Minister will agree that it is also beautiful. The most enduring brand slogan
of all time is, 'As good as gold.' The scientists can clone sheep, and may
soon be able to clone humans, but they are still a long way from being able
to clone gold, although they have been trying to do so for 10,000 years. The
Chancellor [Gordon Brown] may think that he has discovered a new Labour version
of the alchemist's stone, but his dollars, yen and euros will not always
glitter in a storm and they will never be mistaken for gold.
These words are
profound. They capture the essence of gold ownership. In the decade following
the British sale, gold went from $300 per ounce to over $1400 per ounce --
making a mockery of what has come to be known in Britain as Brown’s
Folly. The “dollars, yen and euros” that the Bank of England
received in place of the gold have only continued to erode in value while
paying a negligible to non-existent return. And most certainly they have not
glittered in the storm. What would the conservative government of the new
prime minister, David Cameron, give to have that 415 tonnes of gold back as
it introduces austerity measures in Britain and attempts to undergird the
pound?
Returning to the stories told at the top of this essay, these are just two
accounts among thousands that could be swapped among our clientele.** I
receive calls regularly from what I like to call the “Old Guard”
-- those who bought gold in the $300s, $400s and $500s, even the $600s. Many
had read The ABCs of Gold Investing: How to Protect
and Build Your Wealth with Gold. Some have
become very wealthy as a result of those early purchases. The most important
result though is that these clients managed to maintain their assets at a
time when others watched their wealth dissipate. Gold has performed as
advertised -- something it is likely to continue doing in the years ahead.
After all is said and done, as I wrote in The ABCs many years ago, gold is
the one asset that can be relied upon when the chips are down. Now more than
ever, when it comes to preserving assets, gold remains, in the most
fundamental sense, the portfolio choice for all seasons.
Michael J. Kosares
USAGold - Centennial Precious Metals, Inc.
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