Fool's Gold (revisited)
Mark Lewis is a staff writer at Forbes. On August 13th 2002, MSN posted an article written by him titled "Fool's Gold" in which he indicts gold as a barbarous relic mostly on grounds that it hasn't performed well in spite of the financial crises that have been unfolding before our eyes.
I had to grit my teeth to read the article and suggest you do the same, if only for the sake of exercising your own mind and judgment, or maybe just for the sake of exercising some patience.
The essay reminds me of the reason we wrote an article earlier this year called "Loathing Opportunity" where we observed the many investors loathing gold, as an opportunity. And so it's a good exhibit of the echo of the noise that seems further and further away in our past. If the bear market in gold is dying, Mr. Lewis tries to revive it here.
Mr. Lewis makes the following premises and suppositions either explicitly or implicitly to support his conclusion - that gold is dead (some overlap of course; repetition is a terrific way to get the message across):
- If Gold were not a relic it should go to $800 because of what is going on in Argentina, Corporate America, and the Middle East.
- Gold's been dying (falling) for twenty years and the latest rally pales in comparison to prior ones, just when it's supposed to be making its way into the stratosphere.
- Gold is supposed to be a hedge against financial disaster; and it isn't proving that true? (Question mark is mine)
- Gold still backs the dollar, implicitly, even though it decoupled long ago from its link to money, thus (I presume) it is overvalued.
- The convenient utility of a medium of exchange determines money, or its value.
- It isn't desirable to be a gold bull, since it means doomsaying.
- Stocks and bonds are the best investment ever, not gold.
"We've got a buyer fellas'!!" That's what it would probably sound like at the brokerage office Mr. Lewis phones when he wants to put in an order, to buy presumably. He's been trained well… he's kept his religion so to speak.
Let me add another premise that will support his case: why would we need gold when investors can just flip from one currency to another?
I've heard that one many times. But we'll have to leave it for another essay except to say that why would the investor take the additional risk when gold has proven to be a more (or equally) stable money relative to say the Canadian dollar, Rand, Australian dollar, Japanese Yen, and even the Euro just over the past five to ten years? The dangerous assumption in this fallacy is investors would no longer need either money or a SafeHaven, when merely the existence of the Fed creates such demand - some would say unpredictably.
Since gold is a relic, Lewis offers the natural secondary conclusion: it is better to sell the gold in order to pay down the Federal deficit.
In suggesting this, he's become political and we fear his case just may be taken with some degree of seriousness in a world full of political fools.
This is why we criticize the article, as well as the author's financial market prowess. We don't like beating up on people for the sake of it. We only do when the author is of relatively high standing, and his or her work is loaded with what we believe to be fallacies. Then they're fair game.
Any criticism we offer is justified by the belief that it will not only help you, but perhaps the author as well. Besides, everybody lighten up they're only words.
Gold is Money; the Dollar is Simply a Substitute
Clearly, Mr. Lewis doesn't grasp the significance of the role of money in a free market economy; the only kind where money is necessary.
Mises proved money had only one function: to foster the free exchange of goods and services (which obviously can only occur in a free market economy).
All of the other functions created or seen for money over time, before and after Mises, are derivations of this single stipulation. All the attributes - fungibility, liquidity, and the superior ability to transfer wealth through time and space - we prefer in our money (over and above those that other commodities or currencies possess) are those that make it ideal for this single purpose, and which make it so liquid. The matter of the need for a convenient medium of exchange is easily dealt with by sound money substitutes. But it is a mistake to assume that all currencies used as a medium of exchange are money.
From an economic point of view (as opposed to legal) it is incorrect to call legal tender money simply because it's accepted payment in a court of law. Fiat money, currency, and money substitutes can be legal tender, but they all hold a degree of risk, as do stocks and bonds, which often are also employed as currency.
The value of such currency is determined by the market relative to money, and it is done regardless of government interventions or fixing arrangements, which tend to postpone the cumulative negative consequences of such policies at best.
Gold bears would like to think the 20-year bear market in gold means it has ceased to be money, or as Mr. Lewis says, has decoupled from such a link. He correctly states that confidence is still not shattered in the dollar, but fails to tell us the difference between it and money or even what makes him so sure that confidence in the dollar won't crumble further.
Moreover, gold doesn't back the dollar in any way and hasn't since 1934. The link Nixon broke was hardly real in the first place, and in the second place it only applied to select foreign investment. Indeed, under Bretton Woods, individual Americans were still not allowed to own, or convert their dollars into, gold. They weren't until 1973/74 when the Par Value Modification Act created in September 1973 began to loosen restrictions on the private ownership of gold. It was after that the market was free to make its decision that gold was money.
From 1934 until 1974 the dollar was backed by gold by invitation at best. Thus if individuals didn't have a choice in the matter then the link between the dollar and gold was simply show. At best it was a promise by the government to stabilize the dollar relative to the price of gold (or stabilize the dollar by suppressing gold, which is exactly what was done and why gold reserves fell while the dollar became overvalued).
However, gold has never decoupled from its link to money, just its link to the dollar. It is the dollar then that has decoupled from its link to (sound) money, which is evident in its long-term devaluation against most commodities - unlike gold that has kept its value relative to most commodities, as money should if it is sound. According to the chart below, an ounce of gold could buy more raw materials today than it could while they were at their cheapest in 1932.
At least two major devaluations in the dollar occurred in the 20th century; one occurred from 1933-1949, as you can see in the chart; and the other occurred from 1971 to 1980. In both cases, the dollar turned out to be worth less at the end of the period in terms of both gold & commodities than it was at the beginning. And in both cases the dollar never fully recovered in the intervening periods even as it did gradually gain back some value… just not enough to make the previous devaluation a wash.
As you can see in one of my favorite charts (above) of the historical progression of the dollar's value in the 20th century (assuming the rising raw materials prices over the long term imply falling dollar values), there are long periods of time when paper assets became worth more than commodities and real assets, or in other words, where raw materials prices fell in dollar terms. It is during these times that our greatest stock market bubbles formed. In fact, the period between 1945 and 1973 is almost twenty years long itself.
Note also the fact that declines began in commodity prices in 1928 and carried through to 1932. Remember, however, those prices were in terms of a dollar that was indeed still backed by gold.
To the extent that inflation affects a version of Gresham's law, or simply the valuation preference for paper over real assets (as it often has in the 20th century), devaluation then becomes inevitable when the inflation no longer sustains such conceptual values, which it does for a while to the extent it achieves so called full employment concurrent with rooting investment expectations for relatively high nominal returns in dollar assets (we call this latter condition the dollar's investment premium and measure it by comparing equity valuations and bond yields between the major currency blocs).
The delinkeage of the dollar from gold in 1934 only served to replace bank runs with dollar devaluations; people no longer need to go to their banks to withdraw money. They'd be going to the wrong place - if gold is money. I'm being a little facetious now, but the fact remains that the 1933 bank panic was halted when Roosevelt confiscated the right to own gold, or the privilege to cash in dollars for bullion (money), probably because people couldn't exchange their dollars for gold.
The central bank has replaced the role that gold used to have with respect to the dollar, so there is no need for citizens to worry about their deposits… until devaluation time anyway, when the decreasing viability of the lender of last resort puts into question the viability of the banking system. Even then, it may not be that your deposits won't be there, only that they'll be worth less.
When the dollar's value falls precipitously it is normally the result of the economic effects of the prior excessive inflation and it results in what is then naively and commonly referred to as inflation.
The seventies was an era in economic history that can only correctly be described in terms of a tremendous devaluation in the dollar, which was overvalued due to the government's attempt to fix the gold price in the prior twenty years. I'm sure there were few gold bulls in the sixties and that bearish articles similar to Mr. Lewis' influenced many minds for years to come. After all, it was outlawed to own gold, and even if it weren't completely, gold had proven to be a much worse investment than any stock or bond right up until then.
Check Your Crisis Barometer; It's the Dollar Stupid!
Mr. Lewis' emphasis on the past 20 years and the use of his anecdotal crises barometers to judge gold's performance is inappropriate.
He doesn't offer any explanation for what has changed in the past 20 years to explain gold's death, only that it has been devaluing over that time therefore it must be dead. Yet he assumes Nixon's de-linking of the dollar-gold relationship in 1973 as the official acknowledgement of its death. So why not judge gold's performance since that date? Why would he use only the last twenty years?
It's a convenient premise for his conclusion, that's why. We know of a few deflationists that like to use this 20-year period to prove their case. Gold's bear market has lasted about 20 years now, which is not atypical for its history.
If it were declining because the link between gold and money were broken it would have declined back down to $35 an ounce or further, where it was before 1971. It only took 9 years for gold to get to $800 from $35 an ounce back then, but 20 years for it to fall back to $300 from $800, which still puts it almost 10 times higher than the last time the author of the article says it was money - actually it took only 5 years to fall back to $300. From 1982 to 1997 gold prices stabilized between $300 - $500.
From 1980 to 1985 it was a recovery in the dollar that explained gold's $500 point decline. The dollar index nearly doubled during that time.
But when the dollar again lost a third of its value from 1986-1987 gold prices almost doubled, from just under $300 to just over $500.
While it didn't decline much further after 1987, the dollar continued to hover near its trough until 1993/1994, when gold began its trek from about $330 to over $400 as fear grew for the dollar's inevitable demise. Gold prices hugged the $400 level until 1996, by which time the dollar's recovery was becoming increasingly evident. The hammer came in 1997 and then in 1998 when global currencies collapsed on fleeing money flows, ultimately in pursuit of richer gains in the developing stock market bubble in the United States.
Over the next five years the dollar index gained more than 30% and over the three years 1997 - 1999, gold fell almost 40%. Commodities too generally had their worst years here, as well as in the previous period of dollar strength from 1980 - 1985. The severe drop in gold prices was exaggerated by the conspicuous pick up in gold lending activity during those years, which ended in 1999 with the Washington Agreement.
Since 1999, and despite the dollar's strength during 2000 and 2001, the price of gold stopped falling and since 2001 has made a recovery, trading from $255 to $330 by June 2002. However, although the dollar arguably peaked last summer it only began to crumble this year - a few months ago. At the moment it is again near its 1999 highs or its average 2000 level.
If we were to use the US dollar index as a benchmark for gold's value, historically, we may be able to say that gold prices ought to be in the high $300 range, but not $800 quite yet. The reason is that in 2000, the last time the dollar index averaged this level, gold prices averaged around $280. The peak in the dollar index during 1999 matched the low of the dollar index in July this year. The price of gold was at $255 at that point in 1999, but it was higher in July of this year.
The last time the dollar was near current levels was at its peak value in 1989 (it's average value was lower). In that year gold prices hovered around $380. In 1986 when the dollar was coming off a higher high than the current cycle but is observed at this level, the price of gold traded near $400. That's as far back as my data on the dollar go. The only justification for an $800 gold prices today is if GATA supporters are right and there is an active suppression of it's value relative to the dollar.
Of course, if GATA is right then they'd still be suppressing the darn thing, which they could until... you guessed it, until confidence in the dollar crumbles.
Two things can be gleaned from these facts. First, gold's performance isn't all that bad relative to where the dollar is today (compared to other times it has been at these values relative to other fiat currencies), and considering that the currency has only started to decline in value against other currencies as well as many commodities.
Second, gold's value is still largely determined by the dollar's value as a money substitute, or a medium of exchange, which value is determined not by how easy it is to go to your local ATM and withdraw it.
If the message isn't clear, try this: gold should not go up in terms of the dollar simply because there are problems in Argentina, Corporate America, or the Middle East unless those problems undermine the value of the dollar. To the extent any of them are consequences of the currency inflation, and/or the currency policy required to sustain it, they are merely symptoms - more accurately called moral hazard. I suppose Mr. Lewis would disagree that anything which happens outside of the US economy has anything to do with the rampant nineties Fed inflation.
At any rate, our assessment of gold's past performance is really moot because we see the fact that gold prices haven't gone to the stratosphere yet as an opportunity made conspicuous for the brave by the dollar's still young bear market.
In fact, this is the first cycle I know of since 1929 where the dollar didn't turn down ahead of a major bear market in stocks, and in 1929 it was because the dollar was fixed on a government gold standard.
In the early seventies the dollar had already been falling for a few years before the infamous 73/74 collapse on Wall Street; during the eighties it had been falling for almost two years before the 1987 stock market crash.
Thus in light of current dollar weakness it is way too early, if not naïve, to judge gold's performance in terms of ultimate meaning. Let's see what happens after a year or more of this kind of dollar decline. It's the future we're interested in. The past is for journalists to write about. The trouble is most of them seem to be unable to recall much beyond the past twenty years.
Mr. Lewis' eyes are on the wrong ball. He should be using only the dollar as his crisis barometer, and by that measure he is right, confidence is still high in the dollar generally, and relative to gold.
That's why gold is still cheap. Get it?
Sound Money Activists Aren't Pessimists
Gold bulls aren't pessimists. They have a vision of capitalism working better when it is supported by a system of sound money. It doesn't get much simpler than that.
The dire circumstances Mr. Lewis writes we should not hope for, we only know to be inevitable. Maybe we're wrong. But how could we be? They seem to be happening. Besides, if we're going to make the transition from corrupt to sound money of course there will be turbulence.
Certainly to the extent that the world economy has become dependent upon the system of inflation and dollar recycling, rising gold values will result when such a system fails to sustain the value of the dollar and those businesses. But inflation is a problem largely because it leads to poor investment decisions, known as malinvestment. In other words, those businesses may not necessarily be sound in the first place.
The problem is one of economic justice and freedom. Inflation undermines all of that and so it is unjust, if not unsustainable. It is a hidden tax; meaning most of us are too dumb to see it, which is plain true. After all, even the Fed chairman reportedly can't see it, even as the whole world depends on it and decries its demise as bad for the rest of us.
Now the Bank for International Settlements writes a piece that asset bubbles are just as bad as inflation when they know well that asset bubbles are a result of the inflation.
What are they trying to do, plead ignorance? Give me a break. Inflation is not accurately defined in terms of prices or their rate of change. It's a widely known fallacy to assume so. Inflation is actually too much money, something that is hard to measure because money supply figures only account for the supply side of the equation to the exclusion of any reliable calculation of the demand concept for money. Still, it has proven more reliable to at least define inflation in terms of money supply changes than prices, even if the money we're referring to is only currency, or money substitute.
All that gold bulls ask is that we stop producing so much green cheese and start producing productively. That can only sound pessimistic to a moron.
Lewis' criticisms of gold are the naive ramblings that are a symptom of the last ten to twenty years of historical perspective, about the lifespan of the careers of most investment professionals today, including myself. In order to get from the system of inflation as it is today to a system of sound money as we hope it is tomorrow - for the sake of capitalism and the best of our means of life - those that have benefited from the inflation would probably lose tomorrow.
Yet it is a delusion to think most of us have benefited from it, and probably even that any one ever will in the end. The only thing dire about this system of inflation failing is the social response by our governments and future starving billionaires... and the acts they have yet to condone to sustain their power, privilege, and everyone else's pecking order.
The truth is simple if you've got the courage of your own conviction, or if God is answering, as Einstein would say.
It is inappropriate if not inept to compare the current situation to either that of the seventies or 1987. They are quite different. For one, 1987 wasn't a crisis for the dollar, as it turned out, and as became evident in its ability to stabilize against most commodity markets after 1989. Since stock values had crashed and multiples were somewhat more reasonable after 1987, the Fed could afford to raise interest rates and affect some deflation. Today, any rise in interest rates only threatens to further undermine equity values and therefore the dollar. It didn't then.
Also making the current situation incomparable to either the seventies or 1987 is the fact that the dollar has yet to decline materially.
To be sure, we haven't really had a full blown financial crisis since the seventies, but to say that what is happening now won't lead to one is naïve, wishful, or plain optimistic. It would be hard to call it objective.
Financial disaster turns into crisis only when the value of the dollar is compromised such that the lender of last resort becomes powerless. Until then the inflation can postpone almost any financial calamity all on its own. Believe it.
There is no financial crisis that could happen which we cannot afford to bailout so long as the dollar is able to hold its value while the Fed is able to create more and more of it's quantity. If such policies did not corrupt the value of the currency Mr. Lewis would be right, gold would indeed be a relic.
But they do. And when the currency experiences devaluation, or debases, therein lies the tax in such a system.
For it's those policies that determine the dollar's long run valuation and have for all of eternity. It's those policies that create asset bubbles, which turn us into believers, but which often prove monetary or nominal in nature.
Gold of course only goes to the stratosphere when the financial crisis manifests in the dollar. Mr. Lewis figures we are in a crisis, yet admits confidence is high in the dollar. Of course, we aren't in a crisis technically, but it's fundamental inevitability is why gold bulls call it one right now. Mr. Lewis interprets that to mean we're in a crisis, and questions why gold hasn't responded as if one presented itself, since he's deemed that it has. But then he provides us with the answer when he implies this is the worst it'll get, because it is by his very example of confidence in the dollar that has yet to erode which explains why his own bias is bearish on gold. When Mr. Lewis' own confidence in the dollar drops, perhaps then he'll have a better perspective in which to judge gold's performance. For then I suspect the crisis will have matured.
Of course, every street beggar will be calling for a doomsday by then.
It's true equities have been the best performing asset over the past century even after accounting for the devaluation of the dollar, and I would never argue that it isn't more worthwhile to invest one's "money" than to hoard it; only that excessive inflation and resultant asset bubbles make it unwise to invest for the long haul due to the difficulty in assessing a businesses prospects for the long term in an environment of excessive inflation (malinvestment).
For instance, even if the Dow is up 3,000 and some percent from its peak in 1929 to its peak in 2000, its components are entirely different today, save a few like GE. I don't know of too many static or passively managed portfolios that would have been able to keep up with the continually (through time) updated Dow over the century.
I'm certain that if we measured the value of the Dow according to its original components the difference between those returns and gold's returns would shrink in gold's favor. Sure, investors can be active. But beyond the past twenty years it is usually the minority of them that have made money through the crisis years and the fat years. These booms and busts we experience through time are largely monetary in nature.
I would contend that absent the inflation, our markets would work better, long term savings and investment would be easier to assess the prospects for, and gold might very well turn out to be a relic. But so far Fed inflation policies sustain gold as a long-term growth industry.
The bear market in gold thus draws inevitably to a close. It can only be the dollar, which is fool's gold; for the same reason that bubbles can't exist in gold prices. If gold were really a relic then Mr. Lewis is right. Banks should sell it. But if gold is a relic in the current global inflationist system of production, so is money. And so is capitalism. This I would believe in today's (bigger) government managed economy.
Ridiculous. But patience is required, for only time will tell.