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November 14, 2003

Why Gold, Why Now?
by Ed Bugos

What is the case for gold, you ask?

Our regular readers may want to skip this editorial, or not. Its mostly for the benefit of readers that are newly curious, long, or still somewhat unsure about their enthusiasm for gold.

Before I start this daunting task of trying to condense and simplify some of the lessons that we've learned from several hundred years of the progress of economic theory, as I understand it, let me make something that I do know very clear. Gold doesn't need a case to be presented in its favor. That's just the whole entire point.

Throughout history the market has rediscovered gold as money time and again. It's not an assertion that needs proving to any but the most deprived students of history. It is so fundamental to gold's value my report should end here. But you're in luck...

The reasons for its veracity may be hotly debated. But nevertheless, why should the market prefer gold to silver, platinum, or digital money is far less relevant to the economist than why it does.

When we say money is a market phenomenon we mean governments at most can influence the market (sellers of goods) to embrace a particular medium of exchange over another. They cannot create money... especially not fiat money, unless it derived from commodity money to begin with (say the findings of the Austrian school).

The only way this is not true is in a planned society where exchange is outlawed, and money isn't necessary. This is because money's only reason for existence is to fulfill the requirements of indirect exchange - in other words, to facilitate the free exchange of goods and services in an economic society based on the division of labor and private property.

Don't you want an honest currency in exchange for your hard work, or the goods that you sell? It's bad enough taxes are going up, hey? What would you do if you had to accept as payment for your labor a currency that lost 50% of its value in a year - as some do in some parts of the world still? Wouldn't you be more productive if you got paid money, rather than such currency?

Don't think it can happen here? It does, about every thirty years in recent history.

How Does the Market Value Money... Differently Than Policymakers Do
Money is valued differently than other economic goods. Just like a consumption good is valued differently than a production good, so is money's value arrived at independent of those processes.

Whereas a consumption good has a specific value for the buyer in terms of the satisfaction that can be derived from consuming it, a price need not exist for this value to be determined. The price of a new car can be determined without one having been established yet. Similarly, a production good has value owing to the income stream it promises, or the money or other goods it can command. Neither a consumption good nor a production good have to have a predetermined price in order to have value to the buyer.

But money is different because it is the one economic good that necessarily has a predetermined purchasing power, and whose SOLE value as a medium of exchange is dependent on its already having some price if you will - one that Mises showed can only be transmitted through time.

Here we are precisely getting to the core of the gold debate. Policymakers refuse to accept this reality, and accordingly implement policies that result in a failure of the currency. Hence gold prices rise as the market assigns an increasing monetary value to gold - which is better suited to THE function of money under most conditions brought about by poor monetary policy.

Monetary policy today mostly rationalizes the expansion of money and credit as if there were some benefit the economy is getting from it - either social or economic - such as full employment, as if money could be more than just a medium of exchange... as if it could be a tool of expansion.

Even when a central bank says or implies it wants to sell all of its gold because other assets offer better yields it is conveniently suggesting gold is merely an asset, in the sense of savings or a production good.

When most people look at the situation today and think to themselves, you know, gold isn't going anywhere until the central banks finish selling, they are assuming that central banks actually see their gold as simply another investment, without monetary value, when we know they know very well that money is not meant to earn a return, it's meant to be kept on hand.

There are a lot of counterintuitive truths in life, and certainly this is true of money even more than economics generally.

Omitting the defense of the theory of the value of money that nobody but Ludwig von Mises could be credited for developing more fully, the basic debate in the field of money (thus at gold's center) is over the idea that Mises put forth - that once the market has chosen its money, any change in its quantity confers no additional economic benefit.

And although it is clearly the veracity of that statement that best explains the persistent long-term upward trajectory of gold prices in a century where money and credit inflation - the opposite - reigned, critics nevertheless charge this point of view as extreme. Heresy! C'mon, what's wrong with a little bit of money growth, they say, it's good for the economy. Mises is an extremist, an absolutist!

Anyone who's read the guy knows it's not true - that he was only an absolutist in the sense of discovering laws that were absolute. In other words he was a scientist. But the academic establishment isn't ready to accept science in the field of economics. It prefers to mix economics with politics, religion, and psychology, and higher gold prices obviously.

For all his critics, however, they have yet to disprove the basic tenets of that idea, which rests on the notion that money's value is derived solely from its use as a medium of exchange, and does not exist for any other reason. It is at root what the two sides, the bulls and the bears, are fighting over in the gold market.

Okay, I'll ease up on the brain a little. That's the kind of stuff you have to study for yourself to get the maximum benefit from.

The bottom line is that money is valued differently than other economic goods, and unlike the benefit derived from an increase in the quantity of other goods - which capitalism does handily - increasing the quantity of money amounts to nothing more than altering the price structure within an economy.

Money is nothing more than the medium of exchange, and it is valued as such.

Inflation Is a Monetary Phenomenon, Not a Growth Phenomenon
When people talk about the case for gold, they usually think of it as a hedge against inflation, of which there are many. I wouldn't object to this way of thinking in most cases.

However, the main problem facing the investor today - as we often write - lies in identifying and defining inflation. Most people think of inflation as an increasing rate of growth in the general price level (CPI, PPI, etc.).

In so doing they are ignoring the implications of Mises' theory above, and consequently, by tacitly allowing the policy of money and credit inflation to continue are unwittingly putting themselves at the back of the line. In other words, the first benefactors of an increase in money supply are paying yesterday's prices while the rest are paying tomorrow's prices. This fact need not show up in the general price level.

Acceptance of the popular definition of inflation keeps people in the dark about that, and amounts to essentially a rejection of the idea that money is valued independently in its exchange for other goods at all. Instead, we're lumping it in with the other factors that affect this exchange ratio (price).

For if money is valued independently, as it tends to be, it means that the exchange value of economic goods (their price if it's a money society) is determined by the interaction not just of the supply and demand for the good, but also, the supply and demand for money.

In other words, there are factors independently determining the value of money, and there are factors independently determining the value of goods in the exchange for it, which together culminate in a price.

Thus to say a rise in the general price level constitutes inflation is inadequate, and inconsistent. Similarly, to say that growth in final or aggregate demand causes this kind of inflation is quite the opposite of the truth. In fact, defining inflation by the change in a price level is circular because it omits an explanation of what causes it.

If the cause is simply economic growth why is it inflation? Why does growth in final demand cause the value of the currency to fall? It doesn't.

What is happening is that the value of the currency is falling due to an increase in its supply, and it's that monetary impact on prices that economists need to separate from the real impact stemming from a change in the supply and demand for specific goods when discussing the term inflation.

Prices that rise due to real shifts in demand aren't rising due to inflation.

We call the monetary impact on (or component of) prices nominal for the very reason stated in Mises' theory, that an increase in the quantity of money confers no economic benefit.

Hence, the proponents of the general price level as a barometer of inflation are left without the tools to differentiate between the growth resulting from productivity and the apparent growth resulting from higher prices merely due to a debasing currency... from a change in the balance between the supply and demand for it.

Let's put it this way. If we define inflation as an increase in money supply, and if we accept that in any given exchange two distinct processes - the valuation of the good as well as a separate valuation of the money - determine the price of a good exchanged for money then frankly it's easier to discuss the topic. There'd be fewer mistakes and fewer assumptions. Heck, we'd be more scientific.

Nevertheless, one of the reasons the idea that inflation is the rate of growth in the general price level gets the currency it does is that the Monetarist school has developed the idea that the worst part about inflation is its impact on the value of the currency - it debases it.

Consequently, they target the price level (i.e. inflation targeting) and assume if they can stabilize inflation's impact on the general price level, they can neutralize its impact on the currency, and ergo, inflation doesn't exist in the sense we're trying to say it does at all. This way they can manipulate interest rates and money supply with abandon, and without retribution, so they think.

Yet again, we arrive at a theory based on assumptions that refuse to ground valuations in the individual actions that in reality determine them. Otherwise policymakers would see that monetary inflation has many other effects.

They'd see that there is no uniform value for the monetary unit, that aiming for the unattainable concept of price stability contradicts the principle of sound money, and that inflation's impact on the 'relative' structure of prices is often even more deadly to a market economy than its primary and ultimate consequence - debasement.

They'd see how manipulating interest rates causes changes in individual patterns of savings and consumption. They'd see that gradual increases in money supply increases the relative wealth of those who get it first (wealth redistribution).

And they'd see how their policies subsidize uneconomic enterprise, protect cartels, and exculpate governments from their blunders - in turn fueling the growth of anticapitalist rhetoric that results from a misunderstanding of the source of the resultant social and economic chaos.

They overlook these things, and as for Mises, a man who tried to show that you were a rational thinking being, more than an animal needing the oversight of an omnipotent government - they call him a reactionary.

And in the end, because these secondary impacts of inflation are overlooked, their effect is to overvalue the currency and postpone the debasement. This is where we're at today - the consequences of the policy.

The Importance of Structure - Where's the Beef?
The opponents of gold and money (same thing) are really the government's (or banking cartel's) apologists. They would have you believe that putting the country on a gold standard is akin to crucifying mankind on a cross of gold, as though money had a value other than in its use as a medium of exchange. Economic growth requires more money, they say.

It's a convincing case if you're unaware of the fallacies in the theory. It is obviously counterintuitive to think otherwise for most people. The idea that money supply couldn't increase at will today is unfathomable.

How much money is exactly the right amount? Truly, we don't know.

The market determines that in its choice of what money is. All we're saying is that changes in the quantity of a good that has become money are not at all necessary, and in fact work against the intent of a market system - capitalism.

A change in the quantity of the medium of exchange tends to alter prices. But the more gradual, uniform, and invisible the change is, the more it alters the relative structure of prices, which leads to what the Austrians call malinvestment.

This concept means to describe a circumstance where the impact on prices causes the market to misfire... to shift the economy's capital and limited resources towards the production of the goods whose prices rise first or most due to inflation (as opposed to a real shift in demand), at the expense of the production of those which may be needed but whose "relative" prices fall too low in the process.

I would refer any serious questions on this to the Austrian Trade Cycle Theory developed by Frederick Hayek - the only Austrian schooled economist ever to win a Nobel Prize in economics for his work on this theory (though there is some controversy in Austrian circles surrounding Hayek's view on human action - rational behavior).

http://www.mises.org/tradcycl.asp

But for the sake of some clarity for those of you that have never come across this theory before, essentially it is based on the premise that the development of prices in a market order is the mode of economic organization - how we determine what to produce, how much, and for whom.

The opponents of this doctrine - usually Statists at some level - argue that it doesn't matter what the economy produces, just that it produces more of it and that everyone's employed. Even if they are unaware of it, an objection to the market economy is an objection over the mode of organizing the economy's capital. It's not our task here to defend the market's sovereignty in these matters however.

Nevertheless, in order to understand the significance of money's impact on the process, imagine a situation where it was possible to compare two identical economies. One has a certain amount of money; the other has exactly twice the amount in circulation.

But since we are assuming that they are equal in every other respect, there can be absolutely no difference in the relative exchange ratios between goods. Price levels will be somewhere in the neighborhood of twice as high in the latter, but the ratio of the value of one good relative to the value of another will be the same.

It's exactly this notion of the relative price structure alluded to above that ultimately determines the organization of the economy's productive capital.

Now consider a further analogy that most investors should have no trouble with.

Likening the structure of an economy to that of a portfolio, we can state that the act of adding shares or money to the portfolio does NOT actually increase its returns (unless it's really big). What's in it does. It's the composition of the portfolio that matters... the arrangement of assets, not more of them, determines return.

In much the same way, in a market economy participants (entrepreneurs) through exchange arrange its scarce productive capital to produce the maximum amount of satisfaction possible. It's the composition of this capital structure that gives it its depth (i.e. the potential to achieve the main aim), not we argue, some nominalist or expansionist notion of forced savings and growth through more money and credit, which ultimately in reality causes the reverse - capital decumulation.

As in the case of any portfolio, in fact, such a dynamic impacting on its expansion is in the first place typically excluded from most calculations of return, and in the second place unsustainable. If anyone did otherwise we wouldn't look to him or her for credibility.

Money is a medium of exchange. That's all. Consequently, its value is related to its marketability in exchange, which consideration begins with yesterday's price for it. The fact that prices would actually fall in an economic system where the monetary aggregates change less frequently is a tribute to capitalism.

That's what's supposed to happen. It's neither inflation nor deflation.

The fact that prices don't fall in our economy is a consequence of inflation policies promulgated by the interests of unions wishing to alleviate the pressure on wages in dying industries, governments wishing to spend frivolously, and banking cartels engaged in the larcenous art of fractional reserve lending.

Certainly gold is a hedge against inflation. But it isn't if you don't understand what inflation is, and don't act in time to prevent your government from reaching a point where it has no choice but to confiscate your property.

If only debasement was the only consequence of inflation... then it would hardly even matter, 'tis true perhaps, at least relatively speaking.

Views of Gold Reveal Preponderance of the State
To understand the case for gold is to understand both the primary and secondary effects of inflation. It is to understand the case for freer markets. To understand the case against inflation is also to understand the case for freer markets.

So to really understand the case for gold is to understand the case against it - the war on gold as it were - which is, frankly, the subsidization of fractional reserve banking cartels at source... representing the accumulation of legal tender monopoly privileges.

To understand the case for gold is to understand why the market chooses gold as money time and again, and how facilitating this choice stands to protect your property and liberty against the inroads of despots.

"It is impossible to grasp the meaning of the idea of sound money if one does not realize that it was devised as an instrument for the protection of civil liberties against despotic inroads on the part of governments." (Mises; the Theory of Money & Credit pp. 454 - in a chapter on the principle of sound money added in 1952).

The gold standard lies in the way of inflation (for reference to the difference between a true gold standard, which there has rarely been, and a government guaranteed standard refer to our editorial "Gold Standards, the State, and Free Banking"), and that's precisely why it was abandoned.

Mainstream USA's disdain for gold bugs is obvious these days, but it's ironic since true gold bugs are among the most market oriented, freedom loving, and environmentally friendly, democratically inclined people on earth.

I realize they're painted differently.

But that's just the point. What has America come to?

People often wonder why I've painted myself into a corner by titling my report after gold when there are so many other sectors of the market that are worthy. They assume that being bullish on gold is being bearish on the world. I suppose I just see a day in the future when people understand markets better - where asking me that question would be like asking Jim Grant, why are you painting yourself into a corner titling your report after interest rates, or so and so after money.

When the world understands that money is a market phenomenon, and gold is the market's usual choice for money, the Goldenbar Report ought to be no different than calling something the money report today.

Anyhow, understanding the case for gold isn't something you can do just by reading a single article. It requires study and experience. It requires knowledge about how markets work or don't work in order to understand money's role in all of it. More than anything it requires the knowledge of the theory of the value of money - a subject that is necessarily still self-taught.

It's not extreme to oppose any increase in money supply. It's not even a matter of opposing it. It's simply a matter of realizing that it confers no benefit - economic or social.

If one comes to understand this, they'll be bullish on gold as long as central banking doctrine survives. On the other hand, they'll be persecuted by all those that don't understand it, as well as the interests of those that do but try and exploit it anyway, or by those in a position where they enjoy the fruits of central banking.

It's not popular to be bullish on gold. But that's just a reflection of the preponderance of the State - gold's natural opponent - in today's economy, and in matters of money specifically.

The Proof of All This is In the Pudding
So why the heck buy gold now?

We can understand that gold has a monetary value, and even that it is a hedge against inflation. However, if inflation is the increase in money supply, why wouldn't we have owned gold over the past two decades and watched it fall while the Dow rose 10-fold? What's so special about now?

Just that we are entering a phase of the inflationary boom where the value of the currency is falling sharply, and where inflation and deficit spending have become increasingly visible and dominant influences on economic activity - the aggregates.

The government can report great productivity figures all it wants. But the reality is that real time commodity prices are rising - in many cases faster than profits.

This, among other things, indicates to us that fewer real factors are producing profits today than there were in, say, the late nineties when the dollar benefited from international currency crises, when oil prices fell to $10 / barrel and OPEC seemed ready to disband, and when gold prices fell to $250, etc.

We could and do point to many underlying bearish unsustainable facts of contemporary economic life as supporting the case for gold, including:

• The size of the trade deficit,
• The growth in credit and money supplies,
• The budget deficit,
• Low savings rates,
• The overvalued dollar,
• The pent up market imbalances resulting from central banks selling too much gold too low,
• Chinese demand and its liberalization of the gold market,
• The change in attitudes towards hedging,
• The work of GATA in revealing the incentives in suppressing gold prices

But most of these things aren't different. Some are. The case can be made that Chinese demand is new, or that the budget surplus has only recently turned into a deficit, or that the Fed has indicated it wants a weaker dollar. However, these are mostly inevitable facts if we apply our theory, as are the other symptoms listed.

Even the Chinese demand can be argued to represent a validation of sorts that gold is still money since demand for it is arising at the same time that markets are being liberalized over there.

The question is one of timing; when do these things begin to weigh on the value of the international reserve currency?

Gold is rising now because the world is experiencing the primary (or final) consequences of the extended policy of inflation in the international reserve currency - broad based debasement. The volatile foreign factors - related to the fall of communist blocks - that had supported the value of the dollar and helped the Fed hide its inflation in the past decade have dissipated leaving us with the consequences of the policy: malinvestment.

This malinvestment is currently sustained on a structure of expectations for stock market earnings inflated by the Fed's rhetoric and interest rate manipulations. In other words, stock price to earnings ratios remain at levels that can't be supported by real developments - yet are supported in the moment by the hope we are wrong.

The latest primary bottom in gold prices occurred first after the Bank of England gold sale in 1999 at around $255, and then again two years later. Market technicians like myself call it a double bottom. The following move back up to $400 currently, is marked by indications that suggest we are entering a new bull market.

The last one ended in about 1980. I've never been part of a bull market in gold. I'm too young (37). When I first started in the brokerage business - after the 1987 crash - I told my clients to buy the market... the Dow, the bank stocks, the carmakers. Nobody believed us about the bull market that was coming.

The point isn't to show you how smart I was. The point is to clarify my bias.

I didn't buy gold at $799 an ounce 20 some years ago, and stayed mad at the establishment ever since because of it.

I am bullish on gold today for the same reasons I think everyone else should be; because the desperados tried to fix their problems by inflating out of the mess, and in the process created new ones. The time to capitalize on this is when the great bull market was complete, which we argue is now the case.

Sure there will be rallies, all the way down.

But the great bull market of the nineties culminated in an unprecedented level of malinvestment that the authorities continue to pile new problems on top of in a desperate attempt to exculpate themselves from the predicament they helped cause. It's no coincidence that gold prices put in an important bottom just as the Wall Street bubble climaxed in 1999, and confirmed it as the bubble burst in 2001.

All of the factors we highlighted above as having been in existence for some time now are increasingly weighing where they hadn't before.

The most relevant consequence of the arrival of the great bear market in stocks for gold prices is a marked downturn in equity returns that is weighing on the dollar now because the trade deficit has become so large (i.e. America has become so dependent on importing its savings and raw materials) that to keep it from devaluing the US dollar requires higher real returns than are possible today in the stock or bond market - especially at current PE ratios, or from current expectations in other words.

The return of the US budget deficit is due solely to the absence of the kind of real stock market gains seen during the late nineties. The fact of budgetary life is that the only surplus there ever was happened during the period where capital gains tax receipts made up a significant component of overall receipts, which was due to the rare period of exceptional back-to-back 20% gains in the S&P 500.

Nevertheless, the swing back to a deficit is par for the course in this period of confidence destruction.

The bottom line is that the main problems - malinvestment and the excess of expectations over reality - that brought an end to the great bull market in stocks haven't been liquidated. Quite to the contrary, the policies being implemented to resurrect the economy are precisely the ones that are responsible for creating the bubble and its aftermath - i.e. the buildup of malinvestment.

Yes, they are again trying to inflate their way out of a familiar mess. The difference between now and the aftermath of 1987, however, is where your answer lies as to why it's timely to invest in gold.

One difference is, we would argue, the structural dislocation is many times worse this time 'round. Another is, 1987 wasn't the peak of a secular bull market cycle in stocks if you believe in such things as bull and bear markets (careful, you might have to reject the random walk). Another difference is in the policy mix - it seems more reactionary at the moment. And yet another is that the tools of policy - interest rates and confidence - have become considerably compromised in the aftermath of the bubble.

One final difference; credit for the success of the late nineties boom to an extent must be attributed to the veneer of restraint displayed by both the Fed - in the application of monetary policy during 1994 and 1995 - as well as Clinton's handling of the budget. These were crucial to the revival of confidence in the greenback that followed, and concomitantly, for the ability of the Fed to use interest rates effectively.

Our conclusion is that the brunt of the retribution will occur in the value of the greenback, as was the case during the seventies - which was marked by a monetary boom that too was merely intended to replicate the success of a bygone era (the prior nifty fifty era). Good intentions aside, what happened was simply the inevitable result of the prior two decades of monetary excess - dollar devaluation. It happens whenever a major equity boom era ends in the United States. It's no different this time.

Even after 1987, instead of deflation, and before the Fed began dropping rates in the early 1990's, there was a mild outbreak in the growth rates of the general price level due to the floppy nature of the US dollar at the time.

It could have gone in gold's favor even then.

But the late nineties saw several things occur to the dollar's favor that temporarily offset this inevitability, such as the productivity advances brought on by the Internet and related technologies, as well as the crises of communism abroad.

Sure more productivity shocks could come. Our view is they will if the economy can heal itself. What's more, there will undoubtedly be currency crises overseas in the future so long as other countries equally mismanage their monetary affairs. But the combination and extent of these factors were a rare and happy coincidence for the managers of US dollar policy.

It's true we could add the suppression of gold prices here that Bill Murphy (Chairman of the Gold Antitrust Action Committee) et al claim were responsible for the plunge in gold prices during the late nineties.

Or we could just call the actions of certain central banks and hedgers during that time stupid decisions marked by the excesses of the time.

For the record, since it should be discussed in an article on the case for gold, my personal opinion is this. While I would agree it is true that markets often seem to act collectively as though there were a single large player pulling the strings, in gold it is more than often.

And in light of the ongoing campaign by central banks to make a big public thing of selling their gold reserves, after the excuse of the time has worn off, we can only conclude that either these people haven't the foggiest about the nature of money, or that it is evidence of propaganda.

I think a lot of things about central bankers, but I don't think they're stupid.

Nobody, and I mean nobody, telegraphs the sale of their assets to the market if they want a good price for them. If the purpose is to not negatively affect the market, allow me introduce them to some very savvy sellers.

You won't even know they were there.

I have no proof of conspiracy. I only have the knowledge that allows me to determine the incentives. GATA has accumulated plenty of circumstantial evidence, much of which cannot be disputed.

The case for gold is the case for freer markets. The case for investing in gold today is the case for a resolution to the structural problems afflicting the US and global economy... a reorganization of prices, which involves a revaluation of assets and money.

So while we see this as in the making, which means sooner or later the authorities will have little choice but to confess to higher growth rates in the PPI or CPI, gold bears make the case that the timeliness for investing in gold is poor because there is no sign of inflation in these measures.

It's not that they necessarily disagree with the bulls over most of the important things, just that since the inflation hasn't shown up in the CPI they don't see the case for investing in gold, yet.

The timeliness of the case for gold, however, starts with the outlook for the value of the US dollar.

It ends at the CPI.

Edmond J. Bugos
GoldenBar.com

Edmond J. Bugos is the founder and editor of the Goldenbar Report - specializing in economic research & mining finance.

The GoldenBar Report is not a registered advisory service and does not give investment advice. Our comments are an expression of opinion only and should not be construed in any manner whatsoever as recommendations to buy or sell a stock, option, future, bond, commodity or any other financial instrument at any time. While we believe our statements to be true, they always depend on the reliability of our own credible sources. Of course, we recommend that you consult with a qualified investment advisor, one licensed by appropriate regulatory agencies in your legal jurisdiction, before making any investment decisions, and barring that, we encourage you confirm the facts on your own before making important investment commitments.

Copyright © 2000-2009 Edmond J. Bugos

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