Why Gold is the Only Answer to Preventing ‘Booms and Busts’ – Part 2

In this five part series, we’re exploring the reasons gold remains the only shield against boom and bust cycles. In part two, we will look at the seven characteristics of sound money. And why these characteristics have made gold the only true store of value.

The Global Economic Slowdown: an Imminent Meltdown?

Consider the breadth of the problems facing the global economy today.

The situation in Greece has cooled, but not before the nation lost much of its sovereignty. Despite securing a new bail out deal, the Greek people were left betrayed. The government they elected to oppose punishing reforms let them down. And that isn’t likely to be the last twist in this saga.

Once the reforms targeting pensions kick in, there’s no telling how long it’ll be before the people revolt. As long as that’s the case, the future of Greece in the Eurozone hangs in the balance. As do the fates of other indebted European nations. From Italy to Portugal and Spain, the contagion effect of a Grexit would send shockwaves through global markets. With the rise of far right parties across Europe, the solidity of the European project has never been flimsier.

Yet, while Europe dominated the first half of the year, the rest of the world kicked things up a notch in the second.

China continues to struggle to maintain its historically high growth rates. While it declared GDP growth of 7% in the year to June, many economists put that down to creative accounting. Chinese manufacturing and trade are both down.

Manufacturing activity fell to a six year low in September. Imports plunged 17% year on year in September. And, while faring better, exports were down 1.1% during the same period.

The biggest sign that something wasn’t right took place in June. Chinese stocks lost a barely believable $3 trillion in the space of six weeks.

Not surprisingly, China’s sputtering fortunes are weighing down the global economy.

Closer to home, Australia’s reliance on China as our biggest trading partner puts us at greatest risk. The Aussie economy has already started feeling the strain of declining export revenues and worsening national debt. The trade deficit is at its worst level in 44 years. Most of that is due to declining commodity revenues amid decade low prices. At last count, iron ore was trading just below US$40 a tonne. That’s down more than 80% since it sold for US$190 a tonne in 2012.

Ever since China started to wilt, pessimism over the global economy has soared. Experts even talk of a decade long rut.

Of course, this is only a sample of the laundry list of problems facing the global economy. Yet it’s no exaggeration to claim the world is entering its most volatile period since the 2008 crisis. And it’s the money tied up in paper assets like stocks that’s at most threat of being wiped clean.

So, in light of this, why are markets so reluctant to invest in gold?

Part of the reason is that few investors are prepared to consider how quickly things can turn for the worse. You may recall that in the aftermath of the GFC, gold rose by US$800 an ounce over a three year period to 2011.

Back then, few saw the US subprime mortgage crisis coming. Even fewer had any idea as to what it would do to banks on a global scale.

But this hubris on the part of investors — that the good times will last — was misplaced. And we haven’t learned our lesson. Stock markets have, for the most part, appreciated in value since the downturn. But we retain faith in them as if they’re indestructible. Why is that?

In truth, we’re all gullible, emotional creatures. We’re being duped into believing that gold is a worthless investment. There’s a coordinated PR campaign against gold. And if you can’t see it, you’re not looking hard enough. It’s the mainstream economists, who delight in falling gold prices, leading this crusade.

We’ve seen this crop up time and again. So-called experts downplaying the importance of gold against other assets. They tell the public that gold is useless. And, with a straight face, they champion assets at the mercy of price fluctuations.

We know why they’re doing this. Riskier investments, like stocks and real estate, have surged since 2008. You only need to look at China, where stock markets have tripled in the space of four years. Despite going through a correction, Chinese markets remain positive in long term trends. Even after the massive losses of June–July, the market is still up 60% from this time last year. Whatever lessons there were from the crash, no one seems to have paid it any attention.

Property, too, has been on a tear, with prices rising to bubble like proportions. Australia’s real estate market grew 9% this year. Sydney’s house prices have risen 15% year and year. And that’s despite a recent slump in price growth. Most people are still looking at north of $1 million to enter the housing market in Sydney. Market activity is cooling, but prices remain prohibitive.

Even cash, prized by savers, has received its fair share of attention despite historically low interest rates. The returns on cash are miserly compared to even a decade ago, when rates were as high as 7%. Returns on term deposits have halved in just four years.

And yet gold is overlooked.

How do these people retain their credibility? And why are we so eager to believe them? The one thing keeping this campaign ‘credible’, as we saw in Part One, is the strength of the US dollar.

The greenback retains its allure because of its position as the world’s reserve currency. As long as it remains essential to trade, international markets will flock to it in numbers. After all, any nation that wants to buy or sell most goods needs substantial dollar reserves.

In comparison to other assets, the markets are far less bullish on gold. Economists continue to downplay its importance as an investment, with arguments falling along these lines:

Gold prices are trending down over the past few years. Gold earns no interest; the returns on it are negligible.’

That’s what it boils down to.

Economists have convinced markets that gold is useless because it has weaker returns. Remember, though, gold isn’t ultimately about returns. It’s a safeguard of wealth first and foremost. Because it never loses its true value, gold is a support mechanism.

That’s not to dismiss concerns over returns altogether. In the event of a financial meltdown, gold prices would catapult. While gold is a defence against volatility, its price skyrockets in the event of market collapses. If experts convince us that a crash isn’t coming, we’ll be more inclined to believe them that gold is useless.

Short of another financial crisis, however, markets are likely to remain relatively cool on gold for the foreseeable future.

But it pays to be prepared.

As Australia — and the world at large — lurches ever closer to a major downturn (and possible depression), the doubts over gold look increasingly out of place. We’ve already seen signs of slowing global growth around the world. In addition to China, Canada, Brazil, and Russia are also already in recession.

Our answer to this challenge of weak growth will be to ‘go harder’. More credit, more debt, and, unfortunately, more problems. Problems that, taken together, could send us towards a major market collapse.

One of the reasons we’re all oblivious to it is because we see policymakers as good guys. We look up to central banks as guardians of the economy. We see them as saints, rather than the root of the problem.

Years of loose central bank monetary policy has brought us imaginary wealth. We watch as our homes and stocks go up in value, but fail to see the effects of credit expansion on inflation and wages.

Truth is, no single economy can ever hope to escape the traps of the slippery road of credit expansion that central bankers have lead us down. They’ve crafted an international system built on spiralling debt, with no recourse to service it other than to take on ever more debt.

In the long run, none of this is sustainable. History catches up with everyone. And once it does, economic disaster is never far behind.

Gold investors, at least those who still have faith in it, know that, sooner or later, inflationary policies consign economies to ruin. Unfortunately, that’s exactly where we’re heading. And this is precisely what makes gold so important.

Gold is a hard asset that never loses its value. Unlike stocks, it doesn’t disappear without a trace on the back of a bad decision. In fact, gold is the perfect store of value. Its price may fluctuate, but its characteristics make gold invaluable when currencies fail.

Unlike paper money, gold is durable, fungible, rare, divisible, and not consumable. It is these properties that make it the perfect tonic for steering clear of economic crises. And it’s why gold is the ideal investment to protect you from the coming crash — a crash that could wipe out Australia’s entire accumulated wealth in stocks and real estate. These characteristics represent what we’ll effectively term Sound Money.

Sound money usually describes currencies backed by something, such as a commodity. But it can also refer to a currency that’s not wildly inflating or deflating in value.

It should be made clear that we’re not talking about currency when referring to Sound Money. We’re talking about real money — gold.

The seven properties of Sound Money

If you’re like most people, you’ve no doubt come across a gold sceptic at one time or another. These people, for whatever reason, can’t fathom why anyone would waste their time with bullion.

Yet gold is more valuable than any paper currency will ever be.

Make no mistake, gold isn’t merely an investment — gold is money. The dollars you use to buy goods? That’s currency — not money.

Money has to have certain properties to qualify it as such. And where paper currencies fail, gold stands tall by comparison.

For one, real money needs to be durable. That means it can’t decay over time. It’s the reason we don’t use apples to buy goods.

Money also needs to be fungible. In other words, every unit of currency must be of equal value. So continuing with our fruit analogy, apples wouldn’t suffice because they come in different shapes and sizes.

Next, money must be non-consumable. Again, that rules out apples as they are readily consumed. Our fondness for eating apples makes it relatively obsolete as a form of real money.

Fourth, money must be scarce. Anyone can grow an apple tree — we’ve always been taught that money doesn’t (or shouldn’t) grow on trees.

Divisibility is the next characteristic of sound money. Currencies need to be divided so that units can be paid to match the value of any purchase.

Now, this next prerequisite is where almost all paper currencies fall flat.

Money needs to be rare in the long run. Otherwise, it’s destined to fail. If something is easily reproducible, it will eventually lead to a gradual loss of value over time through inflation.

Finally, money needs to portable. You need to be able to carry it around with you.

Otherwise, you won’t be able to buy anything. It really is as simple as that.

You might be saying to yourself, ‘But gold isn’t portable, is it?’

That’s certainly true. It’s not practical to walk around with an ounce of gold in your pocket. Portability is perhaps the only reason gold isn’t used in day to day transactions. But that doesn’t mean that there isn’t a way around this.

There are precedents for pegging currencies to gold, with long lasting, positive results. The problem is that there is no will on the part of governments and central bankers to do anything of the sort.

We’ll look at why that’s the case in more detail later. But we should reemphasise an important point here: Compared to paper currencies, gold always makes for a better source of real money.

Paper currencies fall short because they’re not limited by scarcity. You can keep printing paper ‘money’ because there’s no shortage of trees to cut down. And a ‘cash-less’ society wouldn’t change that either. It would make it even easier to produce money via a few keyboard strokes.

It’s not hard to understand why government’s and banks prefer paper currencies. It gives them the power to tax people indirectly through inflation. What’s more, banks don’t like the fact that gold doesn’t pay interest.

These reasons are why policymakers push paper currencies onto us. However, currencies always meet their eventual demise.

The tide of paper money flooding the system will end the way these things always do. The inevitable effects of inflation and debt accumulation will hollow out national — and global — wealth.

That leaves us with two questions worth asking:

First, what will replace the current system once it collapses?

And, more importantly, will gold feature as part of the solution to this crisis?

To answer that, it’s worth revisiting the (mis)fortunes of paper currencies throughout history. Join us again tomorrow for Part Three of our special look at gold.

Mat Spasic,

Junior Analyst, Markets and Money

Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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