Like a battering ram in a Medieval siege, gold keeps hammering away at the
gate. For the third time in less than 12 months, the yellow metal is again
crashing into the US$1,000 per ounce level. Even if the breach is fleeting, who
can doubt that it will mount another assault soon?
In the meantime, there is no shortage of market analysts who are not buying
gold while questioning the motives of those who are. Although they offer a
variety of strained reasons, they nearly all agree that it has nothing to do
with inflation, which is nearly universally considered dead and buried. As a
self-confessed gold bug, I can assure all that inflation is the only reason I
buy gold. And recently, I'm buying a lot.
When individuals choose to accumulate savings in the form of
gold rather than interest-bearing paper deposits in government-insured
accounts, there is only one reason for doing so: they fear that the interest
will not be enough to compensate for their expected loss of purchasing power
through inflation. This fear reflects both current inflation and the
expectation for future inflation.
While there are those who buy gold to speculate on its appreciation, the
underlying factor that drives that appreciation in the first place will always
be inflation. If governments were not creating inflation, there would be little
investment advantage to owning gold.
Some believe that gold investors are primarily motivated by fear. It is often
assumed that gold is the one asset class that holds its value when all other
asset classes are falling due to market uncertainty. But this explanation
brings us right back to inflation. When economies move into recession, there is
always political pressure for governments to intervene. Their one tool is the
printing press.
When governments act to prop up sagging markets, or bailout investors or
depositors of failed institutions, they create inflation (print money) to pay
for it. This, in effect, transfers capital from prudent investors to
speculators. At the same time, it pulls the rug out from under the safest
vehicles of traditional investment - bonds and cash. It becomes hard for
investors to protect their principal, much less grow their wealth. Some turn to
gold, with its historically guaranteed "floor" against losses, and others start
making ever riskier investments to try to "beat" the inflation rate.
Gold's appeal as an asset of choice during times of political uncertainty,
particularly during wartime, is again a function of its being a hedge against
inflation. Wars are always expensive. They are also often unpopular, which
makes paying for them through tax increases politically dangerous. As a result,
they are almost always financed through the "secret tax" of inflation.
For a nation that loses a war, or suffers revolution or systemic civil
conflict, there is always the chance that its currency could become worthless.
While this may not be the kind of inflation that we read about in the business
section, it is the ultimate form of the monetary malady - whereby a currency
loses all of its purchasing power.
Whenever the price of gold rises sharply, I always take it as an early warning
sign that inflation expectations are rising. If those expectations are not met,
its price will fall. If the market is correct, gold will maintain its gains. If
the inflation continues to intensify, so too will gold's rise. Most analysts,
however, simply look at the dubious Consumer Price Index to determine the
presence of inflation and inflation expectations. They perennially forget that
prices are a lagging indicator and only a symptom of inflation and may in fact
not be rising at the moment when inflation kicks into high gear.
The anti-gold camp takes its greatest solace from the bond market, where things
have been eerily quiet. They maintain that since bond yields have not risen
much, inflation must not be a problem, and so the gold bugs are simply
paranoid. The bond market, they tell us, is populated by "vigilantes", who
sound a bugle call at the first whiff of inflation. But this argument ignores
the fact that central bankers themselves are the biggest bond buyers and are in
effect "vigilantes-in-chief". Their outsized participation in the market has
led to gross distortions.
When the US Federal Reserve or another central bank buys treasuries, real
returns are not considered. Purchases are made for political reasons rather
than investment merit, which renders meaningless the signals current bond
prices are sending.
The gold-bashers also believe that reduced consumer demand due to unemployment
will keep inflation pressures at bay for the foreseeable future. However,
inflation will ultimately act to reduce the supply of goods much faster than
unemployment reduces demand for goods, sending prices up despite lower demand.
The stagflation of the 1970s is an example of such an outcome.
The bottom line is that gold is continuing its long-term bull run, and those
who dismiss the message behind its rise do so at their own financial peril.
When it comes to inflation, gold is the canary in the economic coal mine. Just
as unseen toxins kill the canary before the miners succumb to the fumes, a
spike in gold is a harbinger of reckless monetary devaluation.
Our leading commentators think that since they can't see or smell the gas, all
those canaries (gold prices, commodity prices) must be dying of natural causes.
Good luck to them when the toxins flood the mine.
Peter Schiff is president of Euro Pacific Capital and author of The
Little Book of Bull Moves in Bear Markets. Euro Pacific Capital commentary and
market news is available at http://www.europac.net
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