Friday, March 1, 2013

Gold or Paper?

            In the past decade, those who chose to invest in gold certainly felt glad they did.  It outperformed most other major assets worldwide.  The average yearly price increased from $280 an ounce in 2000, to $1570 an ounce in 2011.  In the past year however, gold stumbled and is now predicted to take a significant dive in value by technical traders, as well as Goldman Sachs.  Therefore, this must mean that paper is king again, because after all, paper is the major alternative to gold.  When I say paper, I am referring to currency, bonds, stocks and fancy innovations, such as derivatives and credit default swaps.  Some paper assets, such as stocks are backed by solid assets, to some extent.  Other paper, such as currency and government bonds are backed by very little, aside from the state’s legal power (but not necessarily the ability) to increase taxes, print money, or cut spending if the need arises to cover their debt obligations.  If paper assets are indeed ready to assume their role as solid investments after the financial debacle of the last decade, then perhaps the drop in gold prices is justified.  On the other hand, if paper assets are still lacking credibility, then perhaps something else is at work. Is it possible that technical trading is overshadowing the fundamentals?  If so, we once again have an example of failing institutions (exchanges), distorting reality, which in the end will once more end in much pain for the majority of us.


            It is important to understand the nature of the risk involved in the two asset classes I am comparing here.  Gold prices can be highly volatile, and people can lose money by holding on to it in the short or long-term.  Gold however will most likely never go to zero in its value.  Even if jewelry and some industrial applications will become the sole use of the metal, it will retain some value, due to its relative scarce nature.  Its value is safeguarded also by the fact that it is becoming increasingly expensive to get more of it out of the ground, because all the easy to get to stuff has been mined.  It is not at all unusual for new mines that are coming into production today to have initial estimated breakeven production costs at around $1,200 an ounce, or more.  Going bellow $1,200 for an ounce of gold, would therefore mean that many producers would likely start dropping out and supply would start to decrease.  So, while the price of an ounce of gold could potentially decline to as little as perhaps $2-300 an ounce, more realistically, it will never break bellow $1,200 for a prolonged period of time, unless extreme deflation takes hold, which is unlikely to happen.

            When it comes to paper assets, the absolute bottom is zero.  Stocks and corporate bonds are backed by the assets of the issuing company, but companies have been known to go bankrupt.  Government bonds can similarly go to zero, because while outright defaults are rare, defaulting through currency devaluation is actually quite common.  Most people think of Weimar Germany, or Zimbabwe, when someone mentions hyperinflation, but I actually experienced it myself in the early 1990’s in Romania.  It is incredible how fast the value of fiat money can go down.  In 1990, a good monthly net wage was about 5,000 lei (Romania’s currency then). By 1992, 100,000 lei was considered a decent wage, however it bought significantly less of most goods than 5,000 lei din in 1990.  So now, imagine someone having ventured to purchase a 1,000 lei bond, yielding perhaps 10% in yearly compounded interest in 1990.  By 1992, the nominal value of the bond would have increased to 1,210 lei, but it would have actually been worth about 60 lei in real terms, adjusted for inflation.  If the maturity of the bond would have been ten years, by the year 2000, the value of the bond would have been about 1 lei in 1990 terms, because by then everyone became a millionaire, even though it did not feel like it for most people.  So in effect, the value of a 1000 lei bond, in 1990, when 1000 lei could buy about 200 loaves of bread, by the year 2000 had an insignificant value, because it would have been less than the price of one loaf of bread.  The inflation I experienced is not even close to what can potentially happen, as the recent situation in Zimbabwe has demonstrated.  I know that the US the EU, China and Japan are not exactly Zimbabwe, for there are far deeper resources that the larger countries can draw on in case of economic distress.  It is important to remember however that in 2008, the financial markets came close to a complete freeze, which would have had far worse global scale consequences than the regional collapse of communism experienced in Eastern Europe.  With the cessation of all lending worldwide, most paper assets would have become nothing more than paper within a few years at the most.  It seems we were just days, or even possibly hours and one or two bad decisions away from such a situation coming to fruition.

Is the financial system back on firm legs?

            The banking sector is slowly starting to repair its balance sheets, mainly through the process of borrowing money from central banks in the developed world for very low interest rates, and then investing the money in government bonds, which do not pay much lately, precisely because of the issuance of cheap money, which is gobbled up by the banks.  For a person, eager to save up for retirement, putting his/her savings into a ten year US government bond, which yields about 2% per year, may not seem all that attractive, because after all, that money came through hard work, and 2% is the expected rate of inflation, so there is no real gain.  A bank however can borrow $ ten million from the fed, at a rate of 0.25%, pay the money back plus the 0.25% at the end of a year, which comes out to $25,000 in interest on the loan, and pocket most of the $200,000, earned in interest, for a net profit of $175,000.  Inflation is not really an issue in the case of the bank, because the $175,000 profit was not earned by investing their own money, but central bank money instead, which they can pay back without inflation adjustments.  So yes, the balance sheets of the banks are improving, and as many may have noticed, banks are announcing profits lately, even after the cost of paying for the write-down of their toxic assets.  It is my view however that at this point we need to start paying much closer attention to the balance sheets of governments, because that is where the next most likely bubble will pop.

State Finances:

            Governments are also benefiting from this financial trend, because it gives them the opportunity to auction off their bonds in a market, where there is a high degree of interest in purchasing their bonds, giving them the ability to borrow at a low interest rate.  The low interest rates are a welcome trend indeed, because since the economic crisis in 2008, economic growth across the world has been luck-luster, and even this rate of growth has to be supported though higher deficit spending.  On this issue, we have a useless and even harmful ideological battle being waged, between left and right, which I wrote about last year ( link ).  I say it is useless, because the lack of growth and the presence of growing debt to GDP ratios in the developed world has already been proven to be a problem to which neither ideological camp has a solution to.  The problem is structural and global in nature, stemming primarily from the event of the plateau and stagnation in global conventional oil production, which happened in 2006, confirmed by the International Energy Agency in 2010, and predicted to be permanent.  In other words, there is only one way from here and that will be down.  Unconventional sources of liquid fuels came to the rescue partially, in response to market signals stemming from the 500% increase in the price of crude oil, which most people still do not understand that it was a one-time event, which will not be repeated again.  We have been experiencing a yearly rate of increase of all liquid fuels production globally of almost 1%, since 2006 (I added the production forecasts for 2013, and 2014 of the EIA to this average).  According to the formula I found to be most closely correlated to historical trends of global growth in GDP and liquid fuels supply, this rate of increase in liquid fuels, gives the world a maximum rate of potential growth of roughly 3.5% per year.  That is a full percentage point lower than the maximum potential we had in the past few decades, and is even lower than actual recorded average rates of growth from 1990 to 2008.  I should also note that global growth has been significantly lower than the maximum potential since 2007, comming in at around 2% per year.

1.5% max potential growth due to innovation + (average rate of yearly increase in liquid fuel supplies X 2)

            Given this constraint on growth, to which we should be wise to add other constraints, such as a declining rate of food production growth, there seems to be little hope of getting government finances back on a sustainable path.  Comparing the EU where austerity is being tried and imposed, by EU treaties, as well as by the market, with the US, where no serious attempts at austerity were tried, or imposed to date, we get a very similar gap between nominal GDP growth and yearly deficits.  In the US, nominal growth in 2012 (real growth + rate of inflation) was about 4.3% (2.2% growth + 2.1% inflation).  The federal deficit was 6.9% of GDP, which means that the gap between nominal growth and deficits was 2.6%.  In other words, debt is growing significantly faster than the economy.  Incidentally, 2012 was by far the best year since 2008, in terms of the gap.

            The Euro zone economy shrank by .6% in 2012 and the rate of inflation was about 2.2%, giving us nominal growth of 1.6%.  The Euro area deficit was about 3.5%, giving us a gap of 1.4%, so not much better than the US performance, despite years of austerity and pain already implemented.  The debt to GDP ratios will continue to worsen in the EU as well as in the US as growth forecasts are repeatedly adjusted downwards as we move forward in time.  The picture in the other major developed economy, Japan is even worse with a gap between growth and deficit at 3.2% for 2012.  Depending on a number of factors, this gap between the growth of the economy and debt will continue to narrow, or widen in the foreseeable future.  It is my humble opinion however that whether we will see austerity, stimulus or status quo in the future as policy directions, the gap will remain in the US, the EU and in Japan, which together account for almost half of the world’s economy.  This gap cannot be allowed to remain forever, because eventually something will have to give, and when it will, it will be worse than most people realize.

The way out:

            Growth is the only thing that could get things back on a sustainable path fiscally speaking.  As I pointed out however global growth is currently constrained by global geological factors.  A way out would be to change the dynamics of global growth, but that would require global scale action, similar to the solution I presented in my book published last year.  The solution I proposed was in the form of standardized global trade tariffs, designed to encourage efficiency, replacing all current trade agreements.  More efficiency would in effect change the current formula I provided, which gives us the rate of maximum potential global growth, given liquid fuels availability, as well as other commodity related limits.  We should not hold our breath for such a global shift in policy to happen any time soon, which is our sad reality.  Therefore, despite what ideologues from the left and right will tell us, growth will not return to the path we became used to since 1945, no matter which side we choose to believe and follow at a national level.

            In the absence of a solution, there are only two paths left.  The first path, which is the most likely one, we are already witnessing the first signs that major global players are willing to take and that is currency devaluation.  Not surprisingly, it is Japan, which has the worst gap between nominal growth and deficits, which seems to be taking the first steps towards an eventual global currency devaluation war.  In the absence of collective sustainable growth, the only strategy we can expect is for individual countries to improve their individual position through stimulating net exports, by lowering the cost of doing business, thus out-competing others.  Devaluing the currency has the added effect of stimulating inflation, which can improve the nominal rate of GDP growth.  Unfortunately, it also leads to a rise in government spending, because interest on debt rises, as well as the cost of providing government services.  All this is now unfolding in the context of a severe time limit assumed to be there, given that bond vigilantes around the world seem to be out to get anyone who seems stuck on the wrong unsustainable fiscal path, and we never know, who might be next (perhaps George Soros and a few others have an idea already).  This is in my opinion the main global economic trend of the current decade, and it will most likely end badly, for most of us.

            There is the second path, which strangely leads to the same result in the long-term as the first path.  This path is already being tried in Europe, and contemplated in the US and its name is austerity.  This path in my opinion has the same effect on the net value of paper, because while spending would shrink, so will the economy and thus government revenues, requiring more cuts, leading to more economic contraction.  If the multiplier in the economy for government spending is equal or greater than one, this cycle could potentially go on forever, or until the state collapses[i].  In this scenario, some sovereign states, as well as local governments around the world, which currently issue debt, would end up choking on their debts and obligations, and eventually default, given that they cannot devalue the currency in which they borrowed (some states issued significant volumes of foreign currency debt, so devaluation is not a solution).  Economic contraction would be exacerbated, leaving more people without a way of earning a living, or in fear of losing their income, as well as major problems with pension funds, and a loss in the faith of people in the expectation of the social safety net being there for them in the future.  Major cutbacks in personal spending would result, hitting corporations and their paper issues very hard.  As central government revenues would continue to shrink drastically, eventually, governments would give up on austerity and devalue their currency instead.  Like I said, it would have the same result, but perhaps the path would be more painful.

Back to Gold prices:

            It is against this fundamental backdrop that technical traders are telling us that because the 50-day moving average for gold prices moved bellow the 200-day average, which they see as a “death cross”, we should sell gold, thus creating a self-fulfilling prophecy.  I believe the technical traders, looking at short-term moves, not related to fundamentals can dominate the movement in gold prices, more than any other major commodity, because gold is more of a currency than a commodity.  They can do it as long as the move in gold prices does not bump up against the marginal price of production, because once that bottom is reached, trading based on fundamentals will take over again, at which point, we are back to the reality of limits to mine production output, being chased by increasingly devalued fiat currencies.  In the meantime, it could be a bumpy ride for long-term gold investors, but fundamentals seem to indicate that it will be worth holding on.

Note:  For the purpose of full disclosure, I currently own physical gold.  


[i] The multiplier is calculated using the Marginal Propensity to Consume.  For Government spending to be fully accounted for in the economy, we have to realize that aside from the value the government injects into the economy, we also have the ripple effects stemming from consumer demand.  For instance a construction worker working on a government funded project will earn his pay, and spend the money in his/her community, creating more economic activity.


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