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Gold may decline 50% before the World Cup is over
And the World Cup may be won by a herd of wild Burundi elephants
Monday Morgan Stanley issued a headline grabbing prediction that gold prices may crash 70% as they did in the 1980s:
Possibility of gold experiencing a meltdown
Ruchir Sharma - Times of India
It is hard to drown in a sea of liquidity. That's the notion the bulls are keeping their faith in despite the myriad of structural problems in the global economy. But in what’s reflective of the widespread optimism on gold, even the bulls want to hold on to the yellow metal as a lifebuoy — just in case.
Gold is the best performing asset class this year and while most other financial assets have struggled to make their way back to pre-Lehman levels, the yellow metal is up by more than 50% since September 2008. As a result, gold is currently trading well above the long-term average levels relative to stocks and bonds and also in comparison to its own historical trend-line .
ETF holdings for copper total 50 days of demand for the commodity in contrast while aluminum and zinc ETFs represent around 100 days of underlying demand. The daily turnover in gold ETFs — now at $3- $4 billion a day — is up nearly 10fold from levels of three years ago.
Investment demand currently represents the largest component of overall demand for gold compared with a mere 4% just a decade ago.
Some gold bugs are throwing about very aggressive price targets of $2,000 or $3,000 an ounce, from levels of just over $1,200 an ounce now.
If the yellow metal does reach those levels, it would form a bubble of epic proportions. Gold’s peak at $850 an ounce in 1980 marked one of the biggest bubbles in post WWII history and the yellow metal then fell by more than 70% in the following two decades as real interest rates rose and the global economic environment improved significantly. At $1,800 an ounce in current dollar terms, gold would be at the same level as at the absolute peak in 1980.
(Ruchir Sharma is head of emerging markets at Morgan Stanley Investment Management)
Ruchir Sharma - Times of India
It is hard to drown in a sea of liquidity. That's the notion the bulls are keeping their faith in despite the myriad of structural problems in the global economy. But in what’s reflective of the widespread optimism on gold, even the bulls want to hold on to the yellow metal as a lifebuoy — just in case.
Gold is the best performing asset class this year and while most other financial assets have struggled to make their way back to pre-Lehman levels, the yellow metal is up by more than 50% since September 2008. As a result, gold is currently trading well above the long-term average levels relative to stocks and bonds and also in comparison to its own historical trend-line .
ETF holdings for copper total 50 days of demand for the commodity in contrast while aluminum and zinc ETFs represent around 100 days of underlying demand. The daily turnover in gold ETFs — now at $3- $4 billion a day — is up nearly 10fold from levels of three years ago.
Investment demand currently represents the largest component of overall demand for gold compared with a mere 4% just a decade ago.
Some gold bugs are throwing about very aggressive price targets of $2,000 or $3,000 an ounce, from levels of just over $1,200 an ounce now.
If the yellow metal does reach those levels, it would form a bubble of epic proportions. Gold’s peak at $850 an ounce in 1980 marked one of the biggest bubbles in post WWII history and the yellow metal then fell by more than 70% in the following two decades as real interest rates rose and the global economic environment improved significantly. At $1,800 an ounce in current dollar terms, gold would be at the same level as at the absolute peak in 1980.
(Ruchir Sharma is head of emerging markets at Morgan Stanley Investment Management)
(Hat tip to member hayekvindicated)
The author makes a number of valid points, such as the high level of money flows into gold ETFs, but he misses the single most important contributor to the extraordinary event of gold's continuous nine year rise, and it’s not gold bugs. He, like most analysts, does not understand the role gold plays as a sovereign global financial asset and currency. Gold hedges currency risk, and currency risk is rising
Gold hedges the second order effect of bad fiscal policy, a weak currency.
Remember this?
"We can guarantee cash benefits as far out and at whatever size you like, but we cannot guarantee their purchasing power."
—Alan Greenspan, appearing before the Senate Banking Committee on Feb. 15, 2005, in response to Democratic Senator Jack Reed of Rhode Island on the topic of funding Social Security.
- Debtor Nations Dream of Deflation, April 6, 2005
That’s Greenspan reminding a U.S. senator that a central bank can print the money to pay for government spending programs till the cows come home but as the purchasing power of tax revenues declines, so will the fortunes of elected officials. Take your pain now not later. —Alan Greenspan, appearing before the Senate Banking Committee on Feb. 15, 2005, in response to Democratic Senator Jack Reed of Rhode Island on the topic of funding Social Security.
- Debtor Nations Dream of Deflation, April 6, 2005
But they never do. One policy error leads to another. The ultimate source of the currency risk that gold hedges is politicians kicking the debt can down the road to the next election.
The U.S. government has over the past ten years financed two seriously expensive bread and circus events, first the technology stock bubble, second the housing bubble. They first allowed asset inflation to get out of control and then, after the bubbles collapsed, dipped into the public till to bribe the public with their own money to keep quiet about it.
Ten years after the tech bubble popped, the NASDAQ remains 50% below its peak. Ten years from now, so will housing (See Housing Bubble Correction: Fifteen Years to Revert to the Mean, January 20, 2005). When the asset price deflation in the FIRE Economy threatens to spill over into the Productive Economy through the private credit markets and commercial banking system, causing a "break in the chain of payments" as the classical economics called it. As businesses fail and unemployment rises a recession and output gap develop, the difference between potential and actual economic growth. Elected officials are then compelled to rush in with emergency spending to halt the incipient deflation spiral process. Economists on the government payroll, or who hope to be, then get on TV as they did in late 2008 and early 2009 to explain how the emergency government spending will not only halt the economic collapse, which it does, but will also miraculously produce more tax revenue than it consumes, which it will not.
This obvious fallacy is called the “Keynesian multiplier,” as if government borrowing—collecting tomorrow’s taxes today and adding interest expense to it—can possibly be cheaper than collecting taxes out of income as you go along, which option has been eliminated politically by the crash produced by asset price inflation.
The entire string of events started with captured regulators permitting the asset price inflation in the first place but doesn't end with bailing out households and business from the nasty effects of the bubbles' collapse using future with tax revenues collected from mostly middle class citizens who benefited no one bit from the bubbles themselves. The process will go on and on, eventually resulting in a weak dollar and the kind of inflation that a weak currency produces, from the rising the prices of imports. For a net energy importer like the U.S. that means higher fuel and food input prices to food manufacturing that producers may not be able to pass on to customers. That will result in a stealth inflation by a steady decline in the quality of food and other products, even as prices remain steady or event decline (See Fed cuts dollar, Fire sales vs FIRE sales, Duh-flation, and Bezzle shrinks again, Dec. 2008). As you see gasoline and food prices rise, or food packages shrink and high quality ingredients replaced with low quality ingredients, remember that the process started with the bubbles in the late 1990s. It be viewed as one gigantic and continuous fraud spanning, so far, a decade.
By the time it all plays out and tomorrow’s U.S. dollar has substantially less purchasing power to buy imports than today’s, I’m certain that the thread of causation that we have tracked here since 1998, starting with the technology bubble, will be utterly lost. The forgetting of the roots of economic devolution is a function of how the story is retold.
Historical Amnesia
An Argentine economist told me last year that the people of Argentina popularly recall the period of the late 1980s as their day in the sun. Argentina’s leaders secured foreign loans that produced a great economic expansion that the populace attributed to the wisdom of their leaders and their own productivity. Twenty years later the debt proved to be their ruin, but that’s not how they remember it. They only recall the boom that the borrowing paid for. The average Argentine does not connect the debt that resulted from the 1980s borrowing to the economic misery they've suffered since 2001 when Argentina's economy collapsed in an inflationary crash from which it has yet to recover.
Ten years from now, when the full impact of the U.S. asset bubbles of 1998 to 2008 are fully felt, the dot com era, when money flowed like oil from a geyser, before the wars and financial crisis, will be remembered as the good old says, the high water mark for American power and influence. Not one in a million Americans will connect the antecedents to financial crisis and excessive government borrowing to the inflation that we will experience in the future. Not our readers, of course.
As American living standards decline for broad swaths of the population, first by underemployment and unemployment, then by inflation, the thread of cause and effect will be lost by a media that’s forced by its consumers to report daily events without context, as if the latest stage in the ongoing crisis fell out of the sky, from the clouds.
Americans experience periods when food prices rise faster than incomes as inflationary
During the period from after WWII until the U.S. abandoned the international gold standard, food prices remained steady while personal incomes increased. Then, from the late 1970s and again since 2000, food prices increased faster than personal income. That inflation era is seared into the memory of anyone who was high school age or older at the time. Since late 2007, personal incomes plunged while food prices, after a brief decline, continued to rise -- no wonder we have 40 million Americans on food stamps. Today's inflation is experienced more by lower income groups rather than society as a whole. This disparity will be relevant in future elections and is likely to result in demands for compensatory tax cuts for lower income groups and higher taxes at the top.
A well engineered asset price inflation is a political checkmate for its instigators and beneficiaries. Politicians whose elections are financed by the investment banks that trade in asset price inflation, such as the sellers and raters of mortgage securities — the asset price inflation industries of the FIRE Economy — turn their sometimes opponent, sometimes friend, the central bank, into an agent of wealth transfer by forcing them to either directly bear the risk of loss or take responsibility for the collapse of the financial system. Only the issuer of the world’s reserve currency can behave this way and get away with it, although I’d argue that this last time was the last time.
Spain’s is an example of a poorly engineered asset price inflation by a country that is not the issuer of the world’s reserve currency. The result? An economy in recession and 20% unemployment. Now Spain’s creditors demand austerity, as if the nation was flying high on an inflationary boom. Far from it. Austerity programs sink over-indebted countries by reducing economic output and the ability to repay debt. Default now and get it over with, is my advice, because once the IMF is done with you and the capital and entrepreneurs leave, there will be no one left but the oligarchs to run things.
If government spending in response to financial crisis is the primary source of currency risk today, who is the source of demand for gold as a currency hedge that is driving gold prices to new highs?
The great central banking paradox
Central banks are in theory politically independent from national legislatures, but not insulated from government largess. To protect themselves, they hold gold.
Who are the world’s largest gold hoarders? Governments.
Central bank holdings of 31 countries plus the IMF with gold reserves in excess of 100 tonnes each
I found this most curious of all the facts I came across back when I did my original research into gold in the late 1990s before taking a 15% gold position in 2001, a year after liquidating technology stocks in the spring of 2000. All of the papers written by economists on a central bank payroll asserted that gold no longer had any role as a monetary unit backing any national currency—not dollars, nor deutschmarks, nor yen.
Gold was unplugged from the global monetary system by the Fed in 1971 like a toaster on fire when the US found itself unable to make foreign debt payments in gold. Yet even as I’m reading these central bank protests against gold in 1998 the Bank of International Settlements data show that three decades after spurning it central banks still owned 25% of all of the gold ever produced since the birth of Christ. And not only a few of them held a metal they professed to be of no value as money, but nearly all of them did so, and still do.
Now, most articles you’ll read about gold claim that it is just a commodity whose value is levitated artificially above the level justified by jewelry and industrial demand by the religious fervor of mystics and fruitcakes known as “gold bugs.” The theoretical price of gold as determined by demand for industrial uses is the real and rational price and the incremental price produced by the demand for gold by gold bugs is an unreal and irrational gold bug premium, so the argument goes. Once the magic disappears and rationality returns, the gold price will collapse along with the gold bug premium. Maybe by 70%.
The first to put a version of this argument forward was Chairman of the Bank for International Settlements William White. In 1972, a year after the international gold standard ended, he proclaimed that gold without central bank demand as a monetary asset was free to fall from its then fixed price of $35 to its true market value as an industrial commodity to "...around $7.50 per ounce." Then, over the eight years that followed, the gold price proceeded to rise to more than 100 times the Chairman’s price forecast. Gold has proved similarly uncooperative since 2001, rising more than four fold despite dozens of articles by various flavors of William White since then predicting an imminent price collapse.
Gold cannot be “just a commodity” if gold is the only metal owned by central banks
Central banks don’t own silver, or platinum, or copper, or lead, or aluminum, or zinc, or nickel, or any other metal for that matter but only one metal, gold, and not a few pounds but 30,000 tonnes of it. So the next time you come across the uninformed opinion that gold is a commodity like platinum and over-priced due to the irrational enthusiasm of crackpots, kooks, and cranks, remember that gold is the one and only commodity owned by central banks and in monumental quantities. Literally.
Why do central banks still own gold? I wondered back in 1998. Why didn’t central banks sell the useless yellow metal and use the proceeds for more constructive purposes than hoarding?
So I began to look for a credible explanation for this apparent contradiction. The only argument I could find that had any merit was that central banks did not want to disrupt the gold mining industries of gold producing countries, such as South Africa’s, where Brazil is playing North Korea not talking rabbits from Burundi at the World Cup is as I write, by dumping large quantities of gold onto the global market.
The argument is not baseless. Even if central banks dis-hoarded the 36 thousand tonnes of gold reserves they had in 1971 at the rate of only 1% per year, that represented 25% of the 1,500 tonnes of total gold production that year. The sudden addition of 25% to the supply in any commodity is guaranteed to depress the price, unless demand picks up to absorb it. And even if central banks maintained a rate of sales of 25% of production for the past 30 years, by 2001 they’d still have 22,000 tonnes of the gold left. Selling that much gold without wrecking the gold market for gold producers and exporters indeed appears impossible.
Since 1971 when the international gold standard ended, central banks have managed to sell off more than 6,000 tons, and approximately 2,500 tonnes of reserves, or about one year of global production, since 2001 when we took our gold position.
That works out to 10% of annual production, in rough numbers. Yet over that nine-year period, the price of gold increased more than four fold. Presumably if sales increased several times that average since 2001 the gold price might not have gone up as much, but the assertion that central bank divestiture of gold cannot be accomplished without materially undermining gold producers is not supported by recent history.
Even as central banks lightened their load of gold since 2001, not everyone sold, particularly since the start of Gulf War II in 2003.
China and Russia have been major gold buyers since 2003
From a geopolitical perspective it doesn’t take a rocket scientist to understand why China and Russia in particular started buying gold while other counties, though not the US, sold it since 2003: as the largest lender to the US, it is imprudent for China to not insure against the risk of a devaluation of America’s $60 trillion and growing contingent liabilities. The fact that the dollar is a reserve currency is the one and only reason that the dollar has not already weakened precipitously. Primarily via swap agreements and purchases of dollar denominated debt, foreign lenders have kept the U.S. government and its currency afloat. The dollar is not a market-priced currency any more than the U.S. housing is market priced. The latter is a ward of the state, 90% maintained by government subsidies of the mortgage credit market, and the former by foreign and domestic subsidies, by official and “private” sources, of the U.S. government credit market.
Central bankers worldwide are in the awkward position of needing to profess 100% confidence in a hopelessly flawed and outdated international money standard while simultaneously hedging its potential demise with a reserve asset that they claim to have abandoned nearly 40 years ago. On the one hand they are all-in on global monetary system based on a fiat currency issued by a single nation with a declining global output share, an unsustainable structural fiscal deficit, $60 trillion in total contingent liabilities, and dependence on asset price inflation for economic growth, with no path out of any of them under a political system dominated by special interest. On the other hand they have to hedge the risk that some day systemic flaws are expressed as a currency crisis. The only way to do that is with the only international currency in existence that does not have national origins: the fourth currency, gold.
Who’s got the gold?
At north of 8,000 tonnes, the United States government is by far the world’s largest gold hoarder. By way of comparison, the 484 total pallets of $100 bills shipped from the Federal Reserve Bank of New York to Iraq on C-130 transports in 2003 were worth $12 billion and weighed only 363 tonnes, according to a Majority staff memorandum to the House Committee on Oversight and Government Reform, Feb. 6, 2007. If the pallets were piled with gold instead of $100 bills, at 363 tons they’d carry 11.7 million ounces. That works out to $14.4 billion at today’s $1,233 per ounce gold price but only $4.2 billion at the 2003 price of $363 when the payment was made, the authorization and use of which remains a mystery. Since then, a pallet of $100 bills has plummeted from a value of three times its weight in gold to 83%. The decline is not coincidental. That $12 billion was minuscule compared to the trillions squandered on war and financial mishaps since. The Iraqis should have demanded the $12 billion payment in gold. Today they’d have $41 billion.
This leads us once again back to the one and only rational explanation why so many central banks still hold so much gold so many years after official use of gold to settle international payments ended.
Gold is the one and only pure-play insurance policy available against a disorderly disintegration of an outdated, US-centric global monetary order straining under the weight of government debt taken on to keep angry voters off the streets. Gold remains on the balance sheets of central banks as insurance against a global currency crash. As long as it does, it remains on our personal balance sheets, too.
Countdown to crisis
As the risk of the kind of currency crisis that gold insures against rises, so does the price of that insurance. When we bought gold in 2001 the market priced the risk at $270, and as of today June 18, 2010 at $1,259. This year central banks became net buyers. Here is today’s report from the World Gold Counsel on the latest IMF report that sent gold prices to new highs.
Official sector gold reserves as at June 2010
European central banks sold virtually no gold over the past quarter, save a small amount for minting gold coins. Total sales by European central banks have amounted to just 1.8 tonnes since the third central bank gold agreement began in September of last year. The only sales of note made via CGBA3 have been by the IMF, which has sold 38.7 tonnes since mid-February. We expect the IMF to sell at a similar pace this quarter.
Outside of the agreement, the main purchases reported over the last quarter have been by Russia and the Philippines, both of which have long-standing gold buying programmes. The Central Bank of Russia bought another 26.6 tonnes of gold over the past quarter, taking its total gold holdings to 668.6 tonnes or 5.5% of its total reserves, and remains the 9th largest official sector gold holder. The Philippines central bank bought 9.5 tonnes of gold in March, taking its gold holdings to 164.7 tonnes or 13.7% of total reserves.
The Saudi Arabian Monetary Authority reported last quarter that “gold data have been modified from First Quarter 2008 as a result of the adjustment of the SAMA’s gold accounts”, meaning SAMA’s gold reserves are now reported to be 322.9 tonnes or 2.8% of reserves, from 143 tonnes or 1.2% previously.
The Saudis turn out to own more than twice as much gold as previously reported, a 179 tonne difference. European central banks sold virtually no gold over the past quarter, save a small amount for minting gold coins. Total sales by European central banks have amounted to just 1.8 tonnes since the third central bank gold agreement began in September of last year. The only sales of note made via CGBA3 have been by the IMF, which has sold 38.7 tonnes since mid-February. We expect the IMF to sell at a similar pace this quarter.
Outside of the agreement, the main purchases reported over the last quarter have been by Russia and the Philippines, both of which have long-standing gold buying programmes. The Central Bank of Russia bought another 26.6 tonnes of gold over the past quarter, taking its total gold holdings to 668.6 tonnes or 5.5% of its total reserves, and remains the 9th largest official sector gold holder. The Philippines central bank bought 9.5 tonnes of gold in March, taking its gold holdings to 164.7 tonnes or 13.7% of total reserves.
The Saudi Arabian Monetary Authority reported last quarter that “gold data have been modified from First Quarter 2008 as a result of the adjustment of the SAMA’s gold accounts”, meaning SAMA’s gold reserves are now reported to be 322.9 tonnes or 2.8% of reserves, from 143 tonnes or 1.2% previously.
Conclusion
For gold to plunge 70%, as the Morgan Stanley analysis predicts, a credible proposal to pay down U.S. government debt and reduce contingent liabilities must be constructed and make it through the gauntlet of dozens special interest groups. How likely is that to happen?
The recent performance of the U.S. political system at the relatively simple task of getting more health care to Americans at a lower cost does not encourage optimism. A debate about the value of reducing the 40% health care cost overhead created by health insurance companies was turned seemingly overnight by the health insurance industry’s media into an free-for-all about death panels and socialism. Now imagine how swiftly a discussion about needed cuts in military spending to help bring the budget deficit in line will be turned by the military industrial complex into a media circus about aiding terrorists, replete with images of nuclear weapons going off on American soil.
Since 2001 I have not lost a minute’s sleep worrying about gold prices plunging. Instead, I worry about the disastrous financial condition of U.S. households and the U.S. government, and the lack of political will to address them, that threaten the very foundation of the global money system. This is the reason for gold’s relentless rise.
The problems are structural. They are endemic. Current course and speed perhaps only war will dislodge the special interests that perpetuate them.
Gold prices do not float on a sea of liquidity, as Ruchir Sharma claims. They float on a sea of dangerous fallacies — that asset bubbles don’t cause lasting damage to economies, the Keynesian multiplier, that the U.S. can continue to borrow to finance its fiscal deficit, and the invulnerability of the dollar as a reserve currency.
We are not willing to bet against global central banks. They’re betting on gold. We don’t blame them, and everyone is catching on.
See also:
Lessons of the American Lost Decade – Part 1: The gold bugs were right - Eric Janszen
Before the FIRE Gold Update: Is $1,237 the new $720? - Eric Janszen
Gold Myths Cheat Sheet
iTulip Select: The Investment Thesis for the Next Cycle™
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