Gold: The Ultimate Unlevered Hard Asset

The age of de-leveraging is upon us. Bad news for the US economy; good news for gold.

For the past 60 years, corporate debt has grown faster than the economy – 4.1% annually for debt, compared with only 2.7% for the economy as a whole. In short, more and more debt went toward producing each dollar of GDP growth.

What if this 60-year trend reverses?

In fact, I think that is the likely scenario. The deleveraging will take some time…and it won’t be fun.

“Today’s overleveraged assets will become tomorrow’s underleveraged assets, and vice versa,” QB Partners, a hedge fund, explained in a recent letter to shareholders.

What will this new world look like? More people will save more money. And they will focus more on preserving that wealth than on making a big score. We’ve been here before. Michael Farrell, the chairman of Annaly, says the psychology of people will change as it did for those of 1930s, as he discussed on his company’s first-quarter conference call:

Exhausted by the uncertainties of the 1930s and 1940s, the older generation just felt lucky to be alive and they settled into a time of saving, preservation of capital and lowered expectations as consumers.

If that kind of financial orthodoxy takes root, then leveraged assets like real estate and bank balance sheets face a long period of stagnant returns as they continue to deliver – that is, as borrowers and lenders ratchet down the debt on these things. (I find it ridiculous that government officials want us to believe that the US banking system is OK at 25-to-1 leverage. The banking system’s insolvency will become more apparent as it continues to take losses from bad debts made during the bubble.)

Deleveraging puts pricing pressure on leveraged assets. Banks must raise capital, diluting their shareholders and hurting their stock prices. Real estate owners must sell property to raise capital to defend other properties, thus putting pricing pressures on real estate assets. And so on…

So as an investor, it will pay better to stick with the unlevered assets, which face no such head winds. After all, there is no pressure to sell an asset with no debt, no ticking clock. “What are the most underleveraged assets?” you ask. QB Partners gives the answer: hard assets and natural resources.

The ultimate unlevered hard asset may be humble old gold.

In fact, something important is happening in the gold markets right now. All through the 1990s to the present day, the world’s central banks were net sellers of gold. Europe’s central banks, for instance, have sold 3,800 tonnes of gold in the last 10 years. According to The Financial Times, this move has cost them $40 billion, and that’s with gold at $900 an ounce.

Well, too bad for them. But suddenly, that recent habit of selling gold is changing. Last year, central banks sold only 46 tonnes, which was the lowest amount in 10 years.

As the FT reports: “Sales in Europe have slowed to a crawl and fresh demand is emerging elsewhere and the financial crisis has helped to highlight gold’s value in turbulent times.” In fact, we may soon see central banks flip to net buyers of gold.

China has doubled its holdings of gold this year and is now the world’s fifth largest holder of the metal. China is likely to be a buyer of gold for years because its gold holdings are still very small relative to the size of its total reserves. Gold represents only 1.6% of China’s reserves, versus a global average of nearly 11%. To further diversify its reserves – just to get to average – would require significant amounts of gold.

In a post-2008, deleveraging world, it is the unleveraged assets that will outperform against those saddled with debt. It’s another plank in the case for gold, which just seems to get stronger with each passing month. “A new chapter has begun in the gold market,” the FT opines. Indeed, it has.

The International Monetary Fund, never known as a wise handler of money, is selling a bunch of gold. India bought half of it. A number of emerging market central banks are also upping their gold exposure. Maybe these CBs are onto something.

Russia’s gold holdings now make up 4% of its foreign reserves, compared with only 2.2% at the beginning of the year. Smaller central banks are also being crafty. Ecuador’s gold holdings have more than doubled since the start of the year – to 54.7 tons, from only 26.3 tons. Gold now represents 32% of that country’s reserves. Even Venezuela is buying gold. Gold now makes up 36% of its reserves, compared with only 23% in 2009.

So who is the sucker here?

Perhaps central bankers see more clearly than most what the effect of all their money creation will be. In recent months, we’ve seen a truly unprecedented boom in bank reserves. Bank reserves drive money creation. More money means money buys less – and the gold price should rise.

Then there is this chart of the Shadow Gold Price. In the old days of the Bretton Woods Agreement, countries had to maintain certain ratios of gold against their currencies. The Shadow Gold Price aims to replicate this discipline. So for the US, the Shadow Gold Price is Federal Reserve Bank liabilities (bank reserves) plus money in circulation divided by US gold holdings. Also on the chart, you can see the spot price of gold.

Shadow Gold Price

The important thing here is that you see how massive amounts of money creation have barely made an impact at all in the gold price – so far. Gold is fundamentally cheap compared with all the money added to the system in recent months.

As Paul Brodsky and Lee Quaintance of the hedge fund QB Partners write:

“If one allows for even a small probability of a future monetary system that reflects more honest/tangible money, then a quick glance at the graph above makes it easy to conclude that spot gold is fundamentally cheap. Even if this is too far a stretch for market participants skeptical of such a radical change in monetary policy, it is reasonable to conclude that the prices of spot gold and the Shadow Gold Price should converge somewhat over time.”

They note that the spot gold price has never been so cheap compared with the Shadow Gold Price. For parity to set in, gold would have to trade for $16,000 per ounce! No one is predicting $16,000 per ounce gold. In any case, it shows you the risk of holding paper – and bonds – on the eve of a massive devaluation of the dollar. Maybe the central bankers of Russia, Venezuela and Ecuador understand all of this better than they let on and that’s why they are buyers of gold.

It seems pretty obvious to me that if you create a lot of money, you are going to destroy the value of that money. And in that case, you want to own something other than that money.


Chris Mayer
for Markets and Money

Chris Mayer
Chris Mayer is a veteran of the banking industry, specifically in the area of corporate lending. A financial writer since 1998, Mr. Mayer's essays have appeared in a wide variety of publications, from the Daily Article series to here in Markets and Money. He is the editor of Mayer's Special Situations and Capital and Crisis - formerly the Fleet Street Letter.

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12 Comments on "Gold: The Ultimate Unlevered Hard Asset"

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“It seems pretty obvious to me that if you create a lot of money, you are going to destroy the value of that money. And in that case, you want to own something other than that money.” Gold is nice to own, and it might well approach its ‘shadow price’ (which is easy to calculate with a little bit of googling), so it’s a good hedge against hyperinflation, especially since as the article suggests, central banks suddenly believe in it again. However, for the average person in Australia, what is a hundred times more urgent is to get out of… Read more »

The ultimate unlevered asset?

Are you sure?

Spot Gold price is driven by futures prices.

Gold futures are 100x leveraged.

Margin requirements mean an investor or traders leverage can be 15X.

I would say GOLD is the ultimate levered asset.

CIGA John L.
It would be interesting to know how much unreported, refined gold exists in the world. If the Seagrave’s book, “Gold Warriors,” is even half accurate then there are tens of thousands of unreported tons gold kept by individuals, banks and governments – perhaps more than a hundred thousand tons if it were all added up. I’ve seen pictures of what were reported to be military members discovering gold caches from Saddam’s government. IF the pictures are authentic, and I do not know if they are or not, then I wonder how much of Saddam’s gold was confiscated and where it… Read more »

The value of all the gold ever dug up in history (at less than insane price levels) doesn’t go anywhere near being a basis for a contemporary monetary base and we are unlikely to idolatorise it in a crisis when more pressing currency is required in a contemporary daily life. Life that is detached from self sufficiency must trade more currency. Looking around and you will be hard pressed to see much remnant self sufficiency and any move back toward it would set off a painfull collapse of economic activity as we know it.

Ross, you’re right about a true gold standard never returning. It can’t, really, but they can pretend, of course. I think, though, that DR has reasons to predict gold’s rise – I can see the central banks tying the idea of gold into determining who gets how much of any new currency that is brought about … a partial gold standard, perhaps. Self sufficiency won’t ruin economic activity, though. People will still do what’s cheaper, and there is plenty of scope for innovation. But there is an excessive reliance on infrastructure for very basic things that can be done in… Read more »

It’s probably worth also pointing out that the end result of the economic changes that are taking place is a fall in living standards in the first world. There are ways to beat that problem.


Even OPEC is talking about a Gold standard.
Makes sense. If you had lots of oil – would you trade it for depreciating paper money?
Gold & Silver are the only currencies that cannot be printed out of thin air.
Whether Gold ends up being worth $2,000 or $30,000 is irrelevant I think. Gold will always buy you food, shelter, etc.

Further on the topic of gold, perhaps it’s a good time to invest in Tungsten, as according to a really odd article I just stumbled across: “Roughly 15 years ago – during the Clinton Administration [think Robert Rubin, Sir Alan Greenspan and Lawrence Summers] – between 1.3 and 1.5 million 400 oz tungsten blanks were allegedly manufactured by a very high-end, sophisticated refiner in the USA [more than 16 Thousand metric tonnes]. Subsequently, 640,000 of these tungsten blanks received their gold plating and WERE shipped to Ft. Knox and remain there to this day. I know folks who have copies… Read more »

the mass media is pushing to buy gold now. what does it mean? time to get out and sell the stuff!!! i dont know what the hype is all about? aussi dollar get stsronger and stronger, 50% up last 6 month… gold only went up 10%… if you wanna make money start to buy US Dollars now… when they carry trade is over US dollar will jump up… always the same circle in this system you buy stuff when nobody wants to buy it and when everybody buys you sell. whats so hard to understand?


Nice link Dan re: Tungsten bars. Very, very interesting – sitting here wondering… surely not… would they?…. I read your link yesterday and then today Gold is front page on the AFR…. I think I feel dizzy.

tar and feathers
If things go bad Govts will want to claim all the gold held in banks and trade it for fiat stuff. Aus Govt outlawed private possession of gold bullion but I’m fairly sure silver was clear to own and trade as money – its smaller denominations make it into viable money easier to trade. The price of silver to fiat will escalate to probably its 17:1 abundance ratio to gold, currently gold:silver price ratio is about 65:1 The best option is to have silver stored secretly in various locations amongst relatives (trusted??) – not bank safety deposit boxes. You still… Read more »

I don’t know about your last paragraph tar & feathers. Comparing the AUD gold price over the last decade to the USD & the Euro, you can see the AUD price is far more volatile. Hardly a store of value.

When things go bad the AUD is the last place capital will hide. Well, maybe not the last but I won’t put my faith in it.

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