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My colleague and erstwhile nemesis Gonzalo
Lira posed the question above in a recent essay, and it is indeed a most
puzzling one. Given that the world’s central banks — joined most
recently by a shockingly reckless Switzerland — are waging all-out
economic war by inflating their currencies, shouldn’t gold be soaring,? In fact, prices have continued to meander between $1500
and $1700 since September of 2011, when gold topped out at $1945 after a
spectacular run-up from $728 in just three years.
What could have caused the bull market to go
lifeless since then, even as more and more countries appear hell-bent on
devaluing their currencies to keep their exports competitive? The answer that Lira has offered is novel and engaging, but it did not persuade me,
perhaps because the underlying conceit seems forced. For he has likened the current
gold market to the one for credit default swaps (CDS) prior to the Great
Financial Crash of 2008. Because swaps provided
insurance against bond defaults, they rose in value as the crisis mounted.
But then, suddenly, they ceased to appreciate, Lira says, because “the
markets collectively realized that the counterparties to those CDS contracts
might not be able to pay up.” This, Lira asserts, is exactly what is
occurring in gold, as paper certificates have come to greatly exceed the supply
of ingots held in vaults. The result, he says, is that “the global
precious metals markets are essentially a game of musical chairs, with far
fewer seats than players—far less gold than gold holders. And market
participants collectively know this. Which is why they don’t
trust their counterparties. Which is why gold
isn’t rising like a shot.”
I think there’s a more convincing
explanation for why gold isn’t rising, and I will get to it in a
moment. But first let me say that my intention is not to assail Lira or his
ideas. Even though we had a nasty spat on the Web a couple of years ago over
the inflation vs. deflation conundrum, I’ve always found his essays
insightful, original and well wrought. Putting
aside our differences over whether the inevitable collapse of the financial
system will be brought on by hyperinflation or deflation, we probably agree
on 90% of the things we write about.
‘Vague’ Insurance
This time, however, his logic would seem to
equate apples and oranges. To begin with, the swaps he would compare to gold
are a contractual form of insurance against default risks in certain types of
financial instruments. As such, it is at least theoretically possible to
calculate exactly how much risk is insured, even in a market as large as
mortgage securities. Gold, on the other hand, and relative to inflation,
offers only a vague kind of insurance. Moreover, unlike swaps, gold does not
give its owner a claim on anything.
Lira’s argument might have been more
persuasive if he had simply asserted that an effectively unlimited supply of
“paper gold” has been absorbing enough demand to suppress the
price of physical. But if, as he evidently believes, ruinous inflation, never
mind hyperinflation, were immediately in prospect, then we should have
expected to see the demand for bullion soar, pushing up paper gold no matter
how large the supply.
Physical vs. Paper Gold
Lira lumps paper and physical together to
argue that “the current spot price of gold is reflecting market
uncertainty as to who has actual gold, and who has worthless paper
certificates of gold.” Again, if this were so, then we should have
expected uncertainty itself to have spiked the preference of investors for
physical over paper, overwhelming carry-traders and other feather merchants
playing gold from the short side. And if investors were indeed worried about
whether the insurance they hold is properly matched to the endgame, would
they be buying the Treasury paper of a country that owes so much more than it
will ever be able to repay? In fact, the risk of a U.S. default is the last
thing on their minds at the moment, and it will likely remain so until the
day when events no one can predict cause creditors or debtors – it will
have to be one or the other – to get stiffed.
In the meantime, whither gold? My own theory
as to why prices aren’t bounding above $2000 is simply this: the
central banks have so far failed to produce any meaningful inflation. The
untold trillions worth of stimulus they have shot at this goal have barely
kept deflation at bay. Granted, prices for groceries, health care and some
other necessities have gone through the roof. But the inflationary impact of
all of these things together is inconsequential in comparison to the
deflationary down force of a quadrillion dollar financial edifice that
remains in a state of incipient collapse.
Hyperinflation Scenario
Under the circumstances, I continue to believe
that deflation, rather than hyperinflation, will wreck the global financial
system. I did not, by the way, “switch sides” in this argument as
Gary North asserted in an essay he wrote for LewRockwell.com. It was when the
debate turned unendurably ugly that I was impelled to take a closer look at what
some of the hyperinflationists were saying. Peter Schiff, for one. In his scenario – which, along with the running
debate at FOFOA blogspot is the most persuasive
case for hyperinflation that I’ve come across — a run on the
dollar would force the Fed to absorb the entire supply of Treasury paper at
auction. An unintended result, says Schiff, is that ostensibly unsupported
bond markets such as corporates and municipals would collapse, forcing the
Fed to extend open-ended buying to all fixed-income securities.
This would most surely trigger a
hyperinflation – would in fact be a hyperinflation. However, this scenario, and virtually every other hyperinflation scenario
of which I am aware, envision hyperinflation occurring as a result of
political decisions made, Fed actions taken and markets
“rescued.” My gut feeling, however, is that the collapse of
global markets will be so swift as to preclude intervention, let alone
rescue. Pent-up forces will take their course, and the entire financial
system will experience an instantaneous collapse for which the May 2010 Flash
Crash will seem to have been just a warm-up.
Whatever we might predict about the outcome,
one result that seems entirely likely is that banks in the U.S and elsewhere
will not open for business the next day. Over the short-run — a few
weeks, perhaps — this would be ruinously deflationary, since a hitherto
inexhaustible supply of digital money will have become inaccessible via
checks, ATMs or charge cards. The fragility of the clearing system that allows
such money conduits to function will be tragically obvious by then, as will
the distinction between cyber money and the real stuff. And you had better
have some of the “real stuff” stashed away in your home, by the
way, since, The Morning After, that’s the only kind of money Safeway
cashiers and gas station attendants will understand. Nor should you expect
them to be up to speed right away on the junk silver you’ve socked
away, since, at the retail level, although perhaps not in barter circles, pre-1964
coins are likely to be treated the same as the pot-metal coins that have
driven silver dimes, quarters, halfs and dollars
into secure storage.
Gold Hoarders,
Beware
A couple of caveats for gold hoarders.
Don’t count on exchanging gold at $5000 an ounce for something with
high intrinsic value, such as farmland. For all we know, supply-chain
disruptions could be so severe that you’ll pay a Krugerrand
just for a loaf of bread. And while it has always been possible in theory for
short-squeeze pressures to push gold well above the $5000 level, this is most
unlikely for reasons that Lira’s essay implicitly recognizes. Consider
who is short all of that paper gold: carry-traders
such as Morgan Stanley, J.P. Morgan, Goldman Sachs and other bullion bankers
who have always been able to borrow gold for next to nothing. The likelihood
of regulators forcing them to make good on their paper gold obligations can
be dismissed in advance as negligible.
Despite the seeming paradox of intrinsically
worthless fiat money gaining traction in a post-apocalyptic economy, there
will remain the possibility of a hyperinflationary spike. It could happen if,
say, the Fed were to attempt a lump-sum pension payment to all government
workers. For political reasons, this would have to be matched by similar
windfall benefits to private-sector workers in the form of Social Security,
welfare payments, unemployment compensation and food stamps. The Catch-22 of
this approach is that any benefits in excess of what is needed to keep the
economy functioning, if only barely, would touch off
an inflationary spiral. Imagine how the world would react if someone in
Congress merely mentioned that The Government was going to cover all of the
obligations and liabilities of public and private pensions and health plans.
If and when that day arrives, I will have no argument with Lira and the hyperinflationists about the likely outcome.
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