Thursday, February 16, 2012

The Case for Gold

This is going to be brief.  There is an important case for owning gold long term instead of the US dollar.

Take a look at the following chart (click on the image for a larger view):

Nixon eliminated the gold standard back in August 1971 and it lead to serious inflation and higher gold prices thereafter.  Also visible in the chart is the effect of Fed Reserve chief Paul Volcker's action to kill rising inflation in 1981.  Inflation has remained "subdued" at about 3 to 4% through the 2000s and present.  (3 to 4% inflation used to be consider crisis levels!  Now our Fed Reserve chairman calls for higher inflation!  What insanity!)


The rise of gold prices in the mid-2000s is co-incident with rapid credit expansion and ballooning Federal Budget deficits.  But it's interesting that this occurred with relatively low general price inflation but serious asset price inflation such as housing.   Gold itself is subject to such asset price inflation, in part due to fear of future inflation.

The case for owning gold long term is that, with outstanding government debt rising from $15 trillion today to $25 trillion in 10 years, there is little chance that the Federal reserve will be able to restore normal interest rates--now locked at zero percent and seriously below current inflation rates (ie., negative real interest rates).

You see, due to abnormally low (negative real interest) rates and runaway gov't spending, inflation will likely tend to rise in the coming years from it's current level of about 3%.  (If you don't believe it can happen, just look at  the UK with 5% inflation in the middle of a prolonged economic slump)

Today, at $250 billion per year, current interest payments by the government imply an average interest rate of 1.6% on $15 trillion of outstanding debt (much of it is short term and at less than 1%).   Consider the following scenario.   In 3 years, with $18 trillion of debt outstanding and  interest rates up 3 percentage points to 4.5% (average for the past 40 years) we'd have an explosion in the budget deficit of $540 billion per year.  That's on top of $1+ trillion deficits!  

The Fed Reserve won't be able to raise rates.   If they can't they won't.

This means that there will be no inflation fighting in the future. You can see how we're riding a runaway financial bus on a dangerous mountain road.   Inflation will eventually be a problem---thus the long term case for owning some gold.

One warning:  If our country follows the economic path of Japan after 1990, it IS possible that inflation will not rise in the next decade due to a poor economy.   Gold may fall back in the years ahead, but should be bought on pullbacks as it looks like there will never be any financial discipline given to markets going forward.  Eventually the economy will recover and eventually it will be time to raise interest rates.  It will be extremely difficult to do so.

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