I am not one of those dyed-in-the-wool you will pry my gold out of my dead cold hands gold bugs. If I believed the global financial system was balanced, and being prudently managed by the government officials in charge of setting monetary policy, then I would ditch my gold in a heartbeat. In an ideal world, Warren Buffett is correct when he says:
“Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head.”
Yet today’s financial system is far from ideal. We have spent the last six decades piling on more and more debt. This is an old chart, but not too many economists keep total worldwide credit outstanding up to date:
Every modern day economic slowdown has been met with ever increasingly easy Central Bankers who have encouraged more debt as an alternative to allowing the business cycle to take its natural course and balance the economy. The result is a horribly lopsided global financial system.
Eventually this strategy of piling more debt on every economic hiccup will cease to work. At that point we will face two simple choices; either we will have an Austrian style credit destruction event like during the 1930s’ Great Depression, or we will inflate away the debts. Some economic optimists believe there is a third choice which entails a little bit of both with a big slug of economic growth. I call bullshit on this option. We are never going to grow our way out of this mess. The debt is simply so massive, and worldwide growth is slowing, not increasing, so mathematically this is nothing more than a Central Banker’s wet dream.
So the question hangs out there – depression or inflation? Actually the market has already forced the governments’ hand, and the answer was clearly communicated. In 2008 the private credit cycle ceased to expand and rolled over. Central Bankers were shocked to learn how vulnerable the global economy was to the pace of credit creation. Of course they tried to put a good face on it. “It’s contained” comments streamed out of Central Bankers’ meeting rooms, but as the global economy imploded, governments panicked. They could not afford the painful deleveraging, so instead they stepped up to offset private sector credit destruction with public sector credit creation.
Have a look at this great chart from McKinsey that shows the extent of credit creation since the 2008 crisis:
<img src=”http://themacrotourist.com/images/McKinseyDec1615.png” style=”margin:30px auto;display:block;” alt=”http://themacrotourist.com/images/McKinseyDec1615.png” width=”600” height=600”>
The sheer weight of the amount of debt outstanding has created an environment where absent aggressive monetary policy, credit destruction will be the natural state. Yet instead of allowing that credit destruction to occur, government officials have taken the baton from the private sector, and cranked it up a notch.
So I ask you, what do you think the chances are the government and Central Banks will allow a credit destruction recession (depression) occur to wipe away the debts and start fresh? Given the actions taken in 2008, I think the answer is pretty close to zero.
The playbook has been drawn out. They pretend the end game is different, but that is just for show. When push comes to shove, they have demonstrated exactly how they are going to deal with economic contractions.
Now you might be saying to yourself, “great but so far that theory is dead wrong.” Inflation is nowhere to be found. The Fed is on its way to normalizing rates. And most importantly, Buffett seems to be right about his belief that owning financial assets is vastly superior to owning gold.
But I would argue it is all a question of timing…
If you step back and take a longer term view of gold, it isn’t that bad.
The gold bulls have had a tough few years, but maybe this is just a correction in the big, big picture?
If the massive amount of debt will force governments and Central Banks to inflate aggressively, then the key will be for real rates to be driven to low and even negative levels.
During the past few years as the Federal Reserve has withdrawn their stimulus, real rates (interest rates minus inflation) have risen. Whether it is because the Fed’s actions have decreased inflation, or increased rates – it doesn’t matter. As the Fed has tapered and stopped QE, real rates have risen. Their hawkish insistence to raise rates off the zero bound has only made things worse.
Here is a chart of the US 30 year real rate inverted versus gold:
Gold peaked in 2011 when the US 30 year treasury was yielding 100 basis points below the rate of inflation. Since then, inflation has been declining, all the while rates have been creeping higher.
If you believe the US economy can handle the relatively high real rates, then you should ignore all this and buy financial assets. If however you think the massive amount of debt makes high real rates unsustainable, then it is only a matter of time before real rates are once again pushed down.
Right now the US government and Federal Reserve are hopeful the economy can withstand these higher rates. This has taken a toll on gold. Gold after all is no one’s liability, but yields nothing. With positive real rates, investors willingness to own gold is diminished. But I am confident we are approaching the pain point for the US economy.
During the history of man, how many currencies have collapsed due to the deflationary effects of a credit bubble imploding? Contrast that to how many currencies have been inflated away. Then ask yourself what side of history you are betting on.
I will leave you with one of my buddy’s favourite lines about his trading – “I am never wrong, my timing just sucks sometimes.” (FYI, I am often wrong, and my timing doesn’t suck sometime, but most of the time, yet I still like gold in here…)
Thanks for reading,