Gold: Where to from here (Christopher G. Galakoutis)

Here is a recent post offering a fairly main stream opinion on the role and value of gold. I’ll copy the entirety of the post and intersperse my comments prefixed with “GR”.

http://www.financialsense.com/fsu/editorials/galakoutis/2010/0611.html

The focus of this month’s post will be about gold and the gold shares.  Will the price of gold record 10 straight years of gains, or might it be in for a correction?  A good starting point might be to understand what happened to gold and the gold stocks in the 1920’s & 1930’s, and why.

For the most part, gold’s price was fixed at $20.67 per ounce from 1792 through 1933, when the US government confiscated the gold of its citizens and revalued it at $35 per ounce, reaping the benefits.  The point to remember here is that a gold price fixed to the dollar during that time meant there were no gains to be made in dollar terms by holding gold.  Peace of mind, but no nominal gains.

The gold shares, as reflected by the bellwether of that time, Homestake Mining, weren’t doing much of anything during the roaring twenties — albeit they were, grudgingly, lifted by the euphoria of the times along with everything else.  But the lack or firepower is telling, and makes a lot of sense: the price action in the shares was consistent with a fixed price for gold during that time, in that mining companies received $20.67 per ounce for each ounce they mined — no more, no less — despite the fact that the inflationary twenties pushed up their costs of doing business, hence hurting profits.

It wasn’t until the 1929 crash and the years that followed that we see Homestake taking off.  Why was that?

In the panic following the 1929 stock market crash, as bank runs became more pronounced and without a market bottom in sight, Americans rushed into and hoarded gold, which had a fixed value in dollar terms that would not crash – a safe haven while all else was crashing.  This demand for gold meant good business for Homestake Mining.

In a depression the prices of goods and services fall.  Asset prices fall.  Therefore, the purchasing power of money goes up.  Otherwise said, the value of money goes up because money buys more than it did.  When gold is fixed to the dollar, and the value of dollars is going up, then gold’s value is going up as well.

A mining company operating during that time was highly profitable, in that it was guaranteed a fixed price for its product while the prices for everything else were collapsing.  That is why Homestake took off after the depression had taken hold, and saw further gains in 1933 as revenues increased, since with costs in check thanks to the depression, they were able to charge $35 per ounce after a 41% dollar devaluation.

Many have wrongfully concluded from the Homestake chart that gold and gold stocks do well in deflations.  They argue that whether it is inflation or deflation, they are protected holding gold and the gold stocks.  We don’t agree.

Had the free market priced gold in the 1920’s, as it does today, its price would arguably have been much higher than $20.67 per ounce to account for the inflation of that decade.   The money supply increased over 60% during the 1920’s, an average annual increase of 7.7%, with the entire boom taking place via credit expansion, not the “printing” of greenback cash.

Consequently, the gold shares would have been much more expensive during the 1920’s with a free-trading gold price.  I would suggest the ensuing deflation would have re-priced gold to a much lower level, probably bringing down the gold shares as well.

Gold’s price is not fixed today as it was then.  A free trading gold price in today’s monetary system can not be a hedge against deflation, for its initial price increase due to inflation fears would have to be reversed as the deflationary threat became obvious, drying up the investment demand that helped drive up its price in the first place.

GR – The author here assumes that the initial ramp up in the price of gold is due to inflationary fears. This is a fairly main stream view. However, this opinion does not stand up to scrutiny as can be seen in the following chart – from the top down, this is the value of gold in Euros, in Sterling Pounds, in Japanese Yen, in Swiss Francs and finally at the bottom, the nominal price of gold which of course is in USDollars.

http://stockcharts.com/h-sc/ui?s=$GOLD:$XEU&p=M&b=5&g=0&id=p08340599659

If you click this link, a chart will open in a separate window. Keep this chart in mind and refer to it as you read the rest of the article. I’ll offer my comments at the bottom of the page.

The gold price has more than quadrupled this past decade due to the credit inflation we have had.  But if a $1200 gold price represents a truly free market determination of the price of gold, and if that price reflects a credit inflation that is heading into reverse, then the gold price should fall.  Perhaps that is why the shares as well as the silver price aren’t confirming the new high in gold.

GR – Author assumes the price of gold trades freely

We also hear the comparison to the 1970’s.  Gold at $850 then is the equivalent of over $2000 today, we are told.  I have made that point as well, but prior to the US consumer losing his willingness and ability to keep borrowing.  That was a valid point when it appeared that a continued credit bubble could bring on further gold price gains.

GR – considering that throughout the credit inflation of the 80s gold went nowhere but down, this observation too does not stand up to scrutiny

We didn’t get there [$2000 per ounce] , probably because the deflationary forces are so strong.  Forces that were not there in the 1970’s.  Gold is real money.  If currency money, i.e. the US dollar, is to have increased purchasing power in the future due to an imminent deflation, then the gold price would be held in check and wouldn’t need to go up as much as it did in the 1970’s.

One final point.  We read that when major credit markets breakdown, as they are doing today, a certain amount of confidence is lost in all paper currencies, including the senior currency, which is the US dollar.  That premise is then used as justification for buying gold.

I would argue that the US dollar’s value has been stretched very thin since the creation of the Fed in 1913 because of the buildup in credit, not the printing of greenback cash.  Accordingly, the dollar can snap back in a big way as US money supply contracts by way of US dollar debt defaults.

While in a sense the US dollar might be rising because of depression and deflation, i.e., bad news, not good, the other way to look at this is that it is rising because of good news after all, since that means a broken credit machine that had siphoned off value from the dollar since 1913 is finally being revealed to be the culprit and destroyer of purchasing power that it was.

If that is the case, then the chart showing the dollar losing over 90% of its value since the creation of the Federal Reserve is in the process of building upon a historic reversal.

Readers are welcome to read more about our thoughts on the dollar and gold here and here.

Portions of the foregoing had been previously made available to MurkyMarkets.com subscribers.

Copyright © 2010 Christopher G. Galakoutis

GR – I don’t quite follow the author’s argument in the final paragraphs. The author identifies gold as real money as I do. However, he also makes a distinction between credit and physical money. As I understand it, in his view, because deflation brings about a revaluation of the US$, the value of gold would be held in check because people would sell gold along with other depreciating assets? I am not clear on this dynamic. To sell an asset you need a counterparty that takes it off your hands.  But gold is real money and is priced in US$. So if someone was to liquidate depreciating assets to raise cash, why would they liquidate gold? And even if they should liquidate gold the fact that credit outstanding is several hundred times the value of the entire global stock of gold at current prices, the arithmetics say there isn’t enough gold at current prices to cover outstanding credit. In this scenario therefore, the price of gold would have to rise significantly.

Go back to the chart you opened previously. Observe how the nominal price of gold began lifting around end 2001 and then began lifting in all major currencies around 2005.

Here’s my opinion worth exactly what you are paying for it.

Fiat money is the single most brilliant human construct ever devised.

But, fiat money in the context of open societies based on democratic principles inevitably and necessarily results in an artificially accelerating inflationary trajectory.

Since the dawn of man, gold has been the only true money.

Fiat money is a brilliant construct and serves a useful purpose. But as politics interferes with the natural dynamic inherent in fiat money, fiat money is necessarily debased. But money cannot be debased forever. There is an arithmetical limit to how far a currency can be debased.

Monetary debasement always brings about credit expansion. These are generational dynamics; they don’t just happen over a few years. In the overarching debasement dynamic there are recurrent crisis that are always and inevitably met with more debasement (liquidity). But because debasement is limited mathematically, then this solution is obviously limited in time.

When the mathematical limits of debasement are reached, credit contraction must follow. This is the point at which the authorities will try to counteract deflatioanry winds with credit injections of galactic proportions thereby undermining whatever vestige of value may be left in the currency.

When these policies are identified as debilitating for the currency, economic actors will gradually seek refuge in the only thing that has held its value over millenia; gold.

Thus, towards the end of the inflationary dynamic, the moment at which credit markets begin to contract taking down asset prices and as the authorities go nuclear in an attempt at reigniting the credit dynamic currencies are trashed leaving gold as a last refuge.

Thus unlike a bout of deflation that may happen during the overarching inflationary cycle, deflation pressures at the mathematical end of the inflationary cycle does not result in a revaluation of currencies. Rather, credit and asset implosion countered as it is by reflationary credit and money injections results in the destruction of the currencies.

The revaluation of currency due to deflationary effects shows up in real money – i.e. gold.

And that is what we are witnessing today.

For more charts on gold, follow the link “my charts” in the right hand side column.

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