Refuting the Arguments of Gold Bugs

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February 1st, 2009 Brian Leave a comment Go to comments

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Today, I answer the blogposts of a couple of gold bugs who are a little overwrought with the idea of a new age where gold is king:

"Another Case for Gold": http://livingoffdividends.com/2009/01/31/another-case-for-gold/comment-page-1/#comment-32504

"Boy, Nirav, is the author of this piece mixed up. There are parts of it that are correct, but the overall picture is decidedly mixed and confused.

You and I have been in agreement that gold and other precious metals and hard assets will benefit from a period of monetary expansion once the deleveraging is done. I believe that as long as dollars are printed to replace the financial assets lost in write-downs, there is no inflationary pressure created: no extra demand chasing too little supply. (and in fact, we are now entering a period of excessive inventory, whether houses, cars or clothing, which is the source of all deflations).

But once inventory (supply) is back in balance, then all the excess money supply (demand) will probably cause inflation. How much inflation will be determined by how fast the Fed and Treasury can remove the dollars from circulation. One way is as the author described: by selling Treasuries. But this also is the source of one of his misdirections. Here are the errors I saw in his arguments:

“if the Fed floods the market with Treasuries, it will achieve exactly the opposite effect it’s looking for — it will cause rates to rise” - POINT: when the Fed uses this policy of selling Treasuries to reduce monetary supply, it is INTENTIONALLY trying to raise interest rates (see Paul Volcker in 1980). Interest rates must go up to attract buyers to Treasuries. That is the whole point, which addresses another of his confused arguments:
“Do you really think the Chinese and the Japanese are going to buy Treasuries at a 2% yield if the Fed is panicking and trying to buy dollars to stop an inflationary price explosion?” POINT - NO, of course not. The Fed already knows it will need to raise interest rates to attract capital to Treasuries once de-leveraging (fear) is out of the market. The very low rates of today are a product of global fear of economic failure. I find it very interesting that global wealth is flowing to the US dollar through Treasuries and not to Gold. It really refutes the Gold Bug argument, doesn’t it?
“They’re not going to fund an inflationary dollar at 2%. Ever.” POINT - DUH!! Come on, the author of this piece seems smart and well-educated, but this statement makes me wonder. First, the mechanism for issuing debt of any kind, government or corporate, is through auction. The 2% rate is a product of what the market will bear, not some Federal fiat. Interest rates of all types are set by the market, not be some pre-ordained decision. The Fed officials (really, any one educated in economics) understand that when we enter a period of excess money supply (we can only wish for that right now), then interest rates will be bid higher.
The reason for this is also Economics 101: investors are only concerned with the REAL return of an investment, not the NOMINAL return. The real return is the investment return minus inflation. So, the market will ALWAYS require a return that is positive or in excess of inflation. 2-2.5% is the normal expected REAL return for a riskless investment (Treasury). How do we know this? It is quoted every day in the Treasury Inflation Protected Securities (TIPS). When inflation is negative, as it is right now with a contracting GDP, very low interest rates still generate positive Real Returns.
“[In the past] the U.S. money supply was much smaller, and our ability to borrow was much stronger. But those days are gone.” POINT - many younger writers, or those not solid students of economic history, forget the context of “the past”. In the 1950s and early 60s, America’s economic nexus, America was the only country with its economic infrastructure left intact after World War 2. America was never bombed or invaded and its manufacturing infrastructure had been built to the sky in support of the Western World’s war machine. Because hard assets were plentiful, soft assets (currency) were not widely needed. People miss this very important point. Currency is just a substitue for real or hard assets. Those assets can be buildings, machinery, coal, oil or gold. American then, like China now, had lots of assets and against those assets, loaned the rest of the world money so they could rebuild theirs. When you loan money, money supply contracts, just as when you borrow money in expands.
The author (and most goldbugs) forget that currencies are comparative. If the entire world prints more money in concert, how can any harm be done? The dollar is just a unit of measure that represents economic exchange. Each dollar represents a fractional claim on the national aggregate assets of America. When I was a small boy, $1 meant a lot (could buy 3 loaves of bread). Today, $1 is probably represented by $10 in making purchases (still buys 3 loaves of bread). Does that change my life in any way? NO. Does it change my buying power in any way? NO. As long as my income is 10 times what it was before (and on average for Americans, it is), it is a wash. No one cares. And as long as the rest of the world follows the same path, it matters not. But, if you hold Real Assets over that time period (gold or real estate, among others), they will hopefully be worth 10 times as much, but probably no more (at least not for long). So, does that ounce of gold today buy any more than it did in 1972? NO. Money is symbolic and comparative, and to try to make some case for a new paradigm for Gold is as hopeless and mindless as those who tried to dismiss it entirely 10 years ago.