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Saturday, October 03, 2009

Gold tells you bubble hasn't popped yet

Gold tells you bubble hasn't popped yet
Business Times - 03 Oct 2009

IF you owned stocks and gold and had to sell one, which would it be? The Standard & Poor's 500 Index has gained almost 60 per cent since its low on March 9. Gold is near a record price. I know a fair number of people who would keep the gold.

I've never been a gold bug myself. They get no respect. They are associated with survivalists, conspiracy theorists and nutcases. They are always looking for the hyperinflation that never comes. Gold bugs pay a premium over the metal price for gold and silver coins on the notion that they will need the currency, come the Apocalypse.

On the other hand, the relationship between gold and financial crises goes back centuries. In the aftermath of the credit-bubble bust, we confront a Moby Dick-size pile of leverage and the question of whether this is inflationary or deflationary. So it's worth considering what the price of gold may be telling us.

Leverage is a broad term that covers the complete history of finance, which all boils down essentially to the same structure: debt secured by assets. You give me a cow, I give you a piece of paper. Later innovations are simply variations of obligations secured by assets.

So a simple explanation of bubbles is that they form whenever someone creates a rationale to increase obligations too far beyond the level justified by the assets, regardless of the form of the asset or obligation. Consider tulip mania, which like all bubbles featured leverage; it was fuelled not just by ordinary debt, but by leveraged tulip options. When the end came, the government of Holland declined to bail out those who had mortgaged their houses and businesses to buy tulip bulbs, and the multiyear depression that followed ruined an otherwise sound economy.

Our recent real-estate bubble wasn't like tulip mania, in which the inflated asset had only a tenuous connection to the economy it came to dominate. The real-estate bubble swelled on the genuine beliefs among consumers about their future prospects and earnings. To be sure, some of those prospects and earnings were exaggerated to the point of fraud.

Thus the bubble burst when credit-card junkies had spent the last dollars they could justify, and the final peanut brain had been unearthed who could be persuaded to sign up for a negative-amortising mortgage.

Because this link, however slim, remained between people's prospects and earnings and the debt they could carry, real-estate prices even in hard-hit cities such as Las Vegas declined only by half. Stockmarket losses were similar. These numbers are reported as if they were staggering, but they are less so compared with many bubbles.

Some now blame consumers' disinclination to spend and get the economy going again on banks' newfound reluctance to lend. To the contrary, Americans are in the midst of a deflationary trend that is temporarily being masked by inventory restocking and free lunches like 'cash for clunkers'.

Consumers are done with borrowing. They will keep fuelling the deflation by going through their attics and garages to find stuff they can sell on eBay to raise cash. That's because consumers have figured out that it was all a big head-fake from the Federal Reserve. Real incomes haven't grown in years. Manufacturing and, increasingly, service jobs are still moving overseas. The Treasury is trying to pump the economy back to a high-water mark that was phony to begin with, and doing so in the face of a savings rate that is going up.

The Treasury will succeed in printing enough money to forestall severe deflation. Even so, dollars will keep flowing out of the US to other countries as the trade gap widens. Only when we start creating more jobs and higher earnings can this dynamic reverse.

The question is, when will that be? Enter the gold bugs. They aren't just betting on inflation, as is the conventional wisdom. Gold has a wicked history of being an unreliable inflation hedge. It has, though, at times been a haven against sudden currency depreciation.

In all the talk of inflation because the Treasury is printing so much money versus deflation because it may not print enough, there is one type of inflation that is rarely discussed. This is the mega-inflation caused by a sudden currency devaluation. Currency is like any financial innovation, an obligation secured by assets. When the obligation is perceived to have increased far beyond the level justifiable by the assets, which in this case make up a country's economy, a bubble has formed.

As in any bubble, those who recognise this need to act well in advance. Historically, governments have taken action to prevent currency flight when the owners of a severely overvalued medium of exchange start selling so much that it adds to the pressure on its price. They make private purchases of gold illegal, or tax the exchange of currency.

Right now, the American economy is worth less than the value implied by the market value of its obligations and gold bugs will tell you, privately, that this is why they are buyers. Might as well stock up, they say, before gold becomes a controlled substance.

I haven't, so far, but the temptation is rising by the day.

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