By John Dizard
Published: May 8 2011 09:48
“No man is poor who can do what he likes to do once in a while! And I like to dive around in my money like a porpoise! And burrow through it like a gopher! And toss it up and let it hit me on the head!”
Scrooge McDuck
There’s been a lot of news about precious metals prices lately, given the reports of the dramatic fall in the price of silver, and the somewhat less dramatic fall in the price of gold. A lot of news, but not much information, since the price of precious metals in the various currencies, particularly the dollar, is really following market events, rather than creating them.
Silver and gold were not “overbought”; you could more accurately say that the major currencies were “oversold”. Too many people were prepared to believe that governments and central banks in the US, Japan, and Europe were about to completely lose control of their economic destinies and financial systems. Or they were prepared to believe it a bit too early.
And while the longer term (or “secular”) bull market in the metals, or bear market in the currencies, will probably resume, we can already see that this one will end as the previous ones have, with a significant, sustained increase in real interest rates.
The problem that gold enthusiasts have, in the end, is that they are correct: gold is “real” money. As currencies have declined with the credibility of central banks and governments, gold’s “moneyness” has become ever more important, relative to its value as a commodity.
Real money, un-invested in any enterprise or security, does not earn any return. That is true if it is in the form of precious metal or hard currency.
Warren Buffett made this point in an accurate, if rambling, answer to a shareholder question at the Berkshire Hathaway annual meeting a couple of weeks ago. If you owned all $7,000bn of gold in the world, he pointed out, you could climb on top of it, “fondle” it, and declare yourself king, but you couldn’t earn anything on it.
For that price, Mr Buffett said, you could own all the farmland in the US, several ExxonMobils, and a lot of other earning assets. He prefers that “stuff”.
A more systematic answer to the value of gold relative to earning assets was offered in 1985 by two Harvard economists, Larry Summers and Robert Barsky, in a paper called Gibson’s Paradox and the Gold Standard.
To brutally summarise their conclusion in a single quote, the two found “Strong co-movement between the inverse relative price of gold (and other metals) on the one hand, and the real interest rate on the other... ” If real rates on bonds, or equities, are high, holders of money have more incentive to use their cash to buy assets.
Messrs Summers and Barsky were developing a theory to explain, in their words, “price levels and interest rates over long periods of economic history”, not to be used as the basis for trading tactics.
However, the Summers-Barsky model can be reasonably incorporated into a multi-year investment strategy. When real returns are high, the fiat-currency price of gold will stagnate or decline. When real returns have been low or stagnant, as they have been during the past decade, the gold price has been strong.
In the past three years, as one rescue operation or monetary stimulus has followed another, the S&P 500 cumulative total return has been less than half of 1 per cent, while the dollar gold price has increased by more than 78 per cent.
Right now, thanks to the profligacy of central banks, real interest rates are negative. So why buy the two-year Treasury, let alone T-Bills, rather than gold? Conservative capital preservation strategies are now only ensuring capital destruction.
The most recent run in gold coincided with the Federal Reserve’s QE2 monetary expansion since the Jackson Hole summit in August. Its recent weakness has followed chairman Ben Bernanke’s confirmation that QE2 will end on schedule this summer.
Cheap money, expensive gold; expensive money, cheap gold.
I have my doubts that this moment is comparable to the late conversion of the Carter administration and the Volcker Fed to a strong dollar and tight money.
This administration and this Fed are, respectively, not that desperate and not that principled.
So this gold (and silver) price correction will be followed by a resumption of the secular bull market.
There is another issue with being too dogmatic about gold. Yes, the goldbugs are right, governments are degenerating, and their paper/electronic money is losing value.
But what if the political and social order completely collapse, as many of them expect? Who’s going to protect their piles of gold? Without that oppressive and intrusive nanny state, those can be taken by someone with a $600 Kalashnikov.
Even with the present price weakness, gold-as-real-money is a useful capital preserver. Over the decades, though, staying in cash rather than earning assets is as pointless as Scrooge McDuck’s money bin.
Copyright The Financial Times Limited 2011.
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