Gold Versus The Dollar

Introduction

Gold has been a poor investment for many years. This is a statement which is almost universally accepted in today's world, but one which is only partially true. The truth is that gold has been a very poor investment when measured in US dollars, but has generally proven to be a sound investment when measured in terms of almost any other national currency. The Indians and the Chinese, the world's largest buyers of gold, have seen the value of their gold investments increase by approximately 200% over the last decade. Due to a collapse in their national currencies, South East Asians and Koreans have also seen the value of owning gold.

The US dollar reached a cyclical low in April 1995, from which it has risen over 50% against the Yen and 30% against the Deutsche Mark . This means that German and Japanese investors who exchanged their national currency for gold in April 95 would now be showing a profit on their investment, despite a 21% decrease in the US dollar gold price over the same period.

What we have witnessed over the past 2.5 years is a massive shift of investment capital into the US dollar from all other currencies, including gold. Investors around the world have placed enormous faith in the US dollar and, therefore, in the US economic, financial and political system which supports the dollar. Gold has been a victim of this flight to the US dollar, although it has fared better than many of the government controlled forms of money.

With the US dollar continuing to strengthen as capital flees from EMU-generated uncertainty in Europe and debt-based currency crises throughout Asia, why should anyone invest in gold ? Why not just invest in US dollars and US dollar denominated assets ? In my opinion, there are only two reasons to invest in gold.

Reason # 1 To Own Gold

Many supporters of gold continue to put forward the argument that Central Banks are controlling the gold price. The reason for the popularity of this argument appears to be the misconception that the demand for gold exceeds the supply of gold. After all, if the demand for something does exceed its supply by a substantial amount and for a long time, and the price goes down, then it is logical to assume that there must be dark forces at work to manufacture this unreal situation. The problem is, whenever you start from an incorrect premise and then develop your arguments based on flawless logic, you must necessarily arrive at the wrong conclusion.

Perhaps it is hard for goldbugs to accept that gold is a genuinely unpopular investment at the moment when compared to the all-conquering US dollar. However, the fact is that net CB sales of gold over the past few years have been small. Gold loans by CBs have probably had some effect, but the over-riding factor is that private investment demand for gold has reached its lowest point since 1971. Until there is an increase in this demand then the above-ground stock of monetary gold, more than 60% of which is held in private hands, will be an available source of supply.

Just as it is wrong to think that the supposed annual deficit in gold supply (the difference between newly mined supply and commercial demand) will lead to a higher gold price, it is equally wrong to think that the above-ground stock held by the CBs is necessarily sufficient to meet demand for many years to come. Trillions of dollars of investment capital is moving around the world each day searching out stability or protection or investment returns. If confidence in financial assets and government controlled currencies was to significantly reduce, then the total gold reserves of all CBs (worth 320 billion dollars at current gold prices) could be absorbed in an instant by private investors.

Government controlled currencies are liabilities of the monetary agents and are backed by debt. Their value is hence based on the level of confidence in the financial and political systems and their rates of exchange tend to oscillate daily based on changes in this confidence level. For example, if doubt arises regarding the quality of the debt which provides the asset backing for a currency, then capital will shift from that currency into an alternative investment. Gold, a tangible asset which has been valued as a store of wealth for thousands of years, provides an ideal alternative.

Those who are advocating the CB conspiracy theories are failing to appreciate a very important point : The primary reason to own gold as an investment is because it is not controlled by central banks and governments.

Reason # 2 To Own Gold

The second reason to own gold is a corollary of the first. The debt which forms the asset backing of a national currency can be split into two groups - private debt and government debt. The quality of private debt will reduce if the cashflow of the borrowers is insufficient to meet the repayments and /or the value of the underlying security for the loan (real estate, shares, etc) becomes less than the amount of the loan. This is the situation which Japan has faced since 1990 (lending based on collateral rather than cashflow followed by a substantial reduction in asset values has resulted in huge, non-performing private debts). Large scale defaults on private debts will force asset sales, pushing down asset values even further, and stop new investment . Liquidity will thus be removed from the system and interest rates will fall to a point where investment once again becomes feasible. The process is self correcting unless, of course, the government tries to help.

A different set of rules, however, apply to government debt . These rules can begin to be understood by first reading the following explanation of central bank powers taken from a speech given by Alan Greenspan in January of this year :

"Central banks can issue currency, a non-interest-bearing claim on the government, effectively without limit. They can discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank. That all of these claims on government are readily accepted reflects the fact that a government cannot become insolvent with respect to obligations in its own currency."

A problem for a country occurs when new money is created at a consistently greater rate than the increase in the supply of tangible assets, resulting in rising prices, reduced demand for financial assets, and increasing interest rates. This situation arises as greater and greater levels of debt are needed to sustain a stock market or real estate bubble, or to pay for government/business expansion, or simply to service the repayments on existing debt (both private and government).

US Money Supply Versus The Gold Price

Throughout the 1970s and early 1980s, American investors were gripped by a fear that their national currency would continue to lose purchasing power . There was a complete lack of confidence in the government's ability to restrict the expansion of the money supply, culminating in panic buying of precious metals in 1979/1980 as investors desperately sought to protect themselves from the effects of inflation.

The response of the US Federal Reserve at the time was to put the brakes on money supply growth through the instigation of extremely high interest rates. This policy achieved its purpose and by 1982 the rate of increase in the money supply was trending downwards, interest rates had fallen from their peaks, and the fear of inflation had abated. Investment capital had responded to the changed situation by moving from commodities into financial assets, and the great equities bull market had begun.

Below is a chart showing the relationship between the total US money supply (M3), M3 growth rates (shown as annualised monthly figures), and the gold price, from 1972 to present time. It can be seen from this chart that the gold price tracked the increase in money supply from 1972 until 1982, apart from the 1979/1980 spike. Between 1982 and the early 1990s the M3 growth rate trended downwards to a low point of zero in 1992. During this period money flowed into financial assets as confidence was restored in the ability of the Fed to control inflation, whilst the gold price remained relatively stable (apart from the 1985 to 1987 period when the G5 tried to "fix" the US trade deficit by engineering a 40% depreciation in the US dollar, which in turn led to a rising gold price and culminated in the 1987 share market crash as foreign capital panicked out of US assets) .

Since 1993, the M3 growth rate has been trending upwards and is currently around 9%. Studies have shown that increasing money supply growth rates lead the commodities markets by 1.5 to 3 years. This means that we should have seen a rising gold price in US dollars by 1995/1996. What we have actually witnessed, however, is a declining gold price. In fact, with money supply now increasing at rates not seen since the early 1980s and the gold price falling almost continuously since February 1996, the chart shows a distinct divergence between the two . This has contributed to the currently popular belief that increasing the quantity of money no longer results in rising prices.

As mentioned at the beginning of this article, gold has performed quite well during recent years when measured in terms of almost any currency with the exception of the US dollar. In other words, gold has performed its historical function as a store of value for anyone living outside the US. However, since 1995, the time at which we would have expected to see the increasing supply of US dollars begin to have an impact on the gold price, a massive shift of investment into the US dollar has occurred. The excess dollars which have been created due to expanding US debt levels and trade deficits have been absorbed by foreign investors looking for stability. The seemingly insatiable demand of foreign capital for US dollars has been stimulated even further by the Asian financial crisis. The US is now seen as the only safe place in the world for investment.

The demand of foreign capital for US dollars and US debt has allowed US interest rates to remain at relatively low levels, given the money supply growth rate and the strength of the economy, and has supported a speculative boom in the US stock market since 1995. The US stock market is itself supported by debt, and that debt is in turn supported by the value of the stock market. A significant downturn in the stock market would most likely lead to widespread defaults on loans, a financial collapse and a severe recession. This situation will be avoided at all costs by the US political and monetary authorities using the power of the US Federal Reserve to "…discount loans and other assets of banks or other private depository institutions, thereby converting potentially illiquid private assets into riskless claims on the government in the form of deposits at the central bank." If the Fed must purchase every non-performing loan in the US in order to avoid a serious recession, it will be done. A boom feeds on itself and is always propelled by liquidity. Once a speculative boom has occurred, liquidity must be maintained in order to avoid a bust. Look for continued high levels of US money supply growth.

Conclusion

The entire US financial system is based on confidence - the confidence of foreign investors who continue to pour money into US dollar assets, and the confidence of local investors who are betting their life savings on a continued stock market boom. Recent experience in Asia suggests that this extraordinarily high level of confidence in financial assets may be overdone.

In the near term, the above-ground stock of gold will most likely continue to be a hindrance to any sustainable rally in the gold price. The supply of gold will probably increase over the coming months as European CBs sell gold in the lead up to selection of the initial EMU participants in May 1998. At the same time, uncertainty regarding EMU and on-going problems in Asia should continue to support the US dollar.

The reader is invited to respond to Milhouse's wisdom via email: [email protected]

Milhouse

Hong Kong, 1 December 1997