Eureka! When Gold Struck Me
Posted Feb 16, 2012
Probably more nonsense has been expended on discussions of gold than on any other investment vehicle. Including by me - until my eureka moment.
THE TWO EXTREMES
On one side are the true believers who become almost fanatical in their devotion. Incas waxed lyrical about gold, calling it "the tears of the sun." Ancient Egyptians called it "the skin of the gods." It has been coveted and sought after from time immemorial at practically any cost, including moral considerations. Lovers symbolically pledge their devotion with it, poets and musicians rhapsodize about it, and most people measure excellence by reference to it.
Gold's detractors are equally passionate about it. Keynes called it a "barbarous relic." Charlie Munger more succinctly called it "stupid." In his latest letter to Berkshire Hathaway shareholders, Warren Buffett was equally dismissive, pointing out that "gold doesn't produce anything." He repeated the familiar observation that "gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again, and pay people to stand around guarding it... Anyone watching from Mars would be scratching their head."
Buffett's observations are correct. Gold is unproductive. It pays no interest. You can't eat or drink it. It may be beautiful, but its industrial uses are limited. It is difficult to value vis-a-vis other assets.
So why did I conclude that the Buffetts of the world, and even my hero Milton Friedman, are wrong with respect to gold?
ARRIVING AT A RESPECT FOR GOLD
In order to understand that question, you must know a bit about me. I am an economist, with a degree in Money and Banking from the London School of Economics. I know all about the gold and gold-exchange standards. I analyzed the gold mining industry from Canada to Australia, and descended into mines a mile deep in South Africa. I became thoroughly familiar with gold's supply and demand components, and with the mines' marginal cost and revenue curves. And like Keynes and Buffett, I pontificated eruditely but cluelessly on the subject of gold's worth, while totally missing the core issue.
You see, all my education provided less insight than a single conversation I had many years later with the late Dr. Bernard Pacella, then President of the American Psychoanalytic Association. Though he was a quiet and modest man, in the course of our conversation, I soon understood that I was in the presence of an extraordinarily perceptive mind that could see around corners. By the time he was through, I felt that I understood gold for the first time in my life.
Dr. Pacella started by pointing out that the single most powerful force in all of nature is survival. Above all, survival of one's body, and then of the species. By extension, he continued, this involves protection of savings, the fruits of one's toil, and the expectation that there will be a reward for forgoing immediate consumption and gratification. Just as squirrels collect acorns which may sustain them and ensure their survival in the winter, so humans will, if they can, save for enhanced well-being in the future. The medium in which they hold their savings is crucially important: they will not rationally choose a vehicle which is vulnerable to erosion or worse, disappearance.
Here, the significance of gold falls into place. Consider its characteristics:
- It is rare, and its quantity is limited. The entire amount extracted from the ground in all of history amounts to 165,000 metric tons. This is equivalent to a cube 20 meters long/deep/wide.
- It is difficult and expensive to find, mine, and bring to the surface. It is therefore subject to only small and slow incremental supply.
- It is indestructible, homogeneous, and easily reconstituted if diluted or broken up.
- It is compact, and therefore permits transportation of a high value in a relatively small space.
- It is the only universally used asset that can be instantly converted to cash (even by the world's central banks) that is not someone else's liability.
- And, of crucial importance, it is anonymous.
Not one of these attributes is unique to gold. What makes gold unique is that it is the only form of money which combines all of them.
And while its monetary nature makes it difficult to price in the short-run, it also means an investor can count on one thing in the long run: it doesn't change its value - it merely mirrors the erosion in the purchasing power of fiat currency. For example, in the relatively brief 40 years since President Nixon untethered the dollar from its gold anchor, it has shrunk to 18 cents of its previous purchasing power.
So, gold's value is not primarily a question of supply and demand. There is sufficient gold in that above-ground cube to satisfy normal commercial demand for some 65 years.
Instead, gold appreciates when forces are, or are expected to be, at work which would erode returns on savings. The single most significant inverse correlation with the gold price is the real rate of return on savings, i.e. on capital. In that sense, Keynes and Buffett are correct: if one can obtain a positive real rate of return in reward for saving, then buying and holding gold makes no sense. But that is not always possible.
What could potentially erode real rates of return on savings? The answers include not only inflation, but concerns stemming from political and social uncertainty, high taxes, poor legal protection of assets, and war.
The futurologist Herman Kahn once observed that all of humanity believes in gold, but that it takes more to trigger the urge to acquire it in what he characterized as the world's "Northwest Tier," i.e. the Scandinavian countries, the British Isles, and North America. This is not an accident. What these countries have in common is a relatively longer and stronger history of nurturing capital formation - rule of law, financial institutions, democracy, political stability - than the rest of the world.
WHY A GOLD STANDARD IS NECESSARY
At the core of the historical gold standard was this overriding premise: a government in deficit because it was living beyond its means would have to lose gold and accept the pain of economic contraction to cleanse excesses. It was an objective discipline, divorced from political or social considerations. It could not be denied or manipulated by utopian theoreticians, corrupt politicians, lazy bureaucrats, or soft electorates.
Not that the upward economic trajectory was smooth - far from it. A gold standard is far from perfect; given human nature, it is merely the least bad of alternative options, because ultimately its objective discipline involves - indeed, imposes - an honest, and therefore moral, response.
At the simplest level, the fundamental issue is whether following a binge of excess, a society is willing to tolerate the pain of deflation (including bankruptcies, unemployment, workouts, restructurings, and all the rest) or will seek to inflate its way out of its problems. Hayek's and Schumpeter's "creative destruction" versus Keynes' "animal spirits."
ARE WE ENTERING A GOLD STANDARD GENERATION?
A study of history would strongly suggest that these issues are heavily influenced by cyclical generational considerations.
Living in London in the '90s, I witnessed the explosion of emotion that followed the death of Princess Diana. One incident stuck in my mind. A TV camera caught an old biddy wearing unfashionable clothes and sensible shoes watching the proceedings with evident disapproval, while making sarcastic remarks about the mushiness of the crowds. The BBC twit interviewing her remarked, "But Princess Diana said all you really need is love." She shot back, "In my day, we needed Spitfires too!"
She had a point. Further, one could argue that it was precisely the sacrifices of the World War II generation that made possible the softness of their children and grandchildren. Historians remind us that civilizations don't necessarily perish because they have been successfully attacked by superior forces from outside but more likely because they have become frivolous and unserious on
At present, the confluence of forces which financial markets must contend with include:
- A debt-ridden United States in the personal, corporate, and government sectors.
- A divided and entitled Europe, so there is no escaping problems in the US by fleeing into the euro.
- A world without a strong anchor to set the agenda, leading to uncoordinated policies across countries.
HISTORY AS A GUIDE
The last time the US found itself in a roughly similar situation was in the early '80s. At that time, two forces emerged which turned things around. The first was Ronald Reagan, a revolutionary who cut taxes and wrapped up the Cold War, which allowed the release of enormous resources from the public to the private sector. The second was Fed Chairman Paul Volcker, who broke the back of inflation with double-digit interest rates. It was a very painful period, but real rates of return reappeared, and a new era of prosperity was born. Predictably, gold prices stayed low and steady until macroeconomic troubles returned in force in the early '00s.
THE ONLY CERTAINTY IS UNCERTAINTY
Is the current crisis likely to be resolved in the miraculous fashion of the 1980s? Everybody must draw their own conclusion, based on their assessment of the outlook as well as their own situation and risk tolerance. A total optimist would have zero exposure to gold, a total pessimist a whole lot, and those unsure a small percentage as insurance. I always remember the lesson from my wise colleague... gold is a means to reliably store our wealth, and therefore a means to survival.
Andre Sharon is a professional economist and acknowledged expert on gold, having served as Director of International Research covering gold mining investments at Drexel Burnham Lambert and Director of European Research for Merrill Lynch. A version of this article was originally published at www.minyanville.com
This article first appeared in the February 2012 edition of Peter Schiff's Gold Report, a monthly newsletter featuring original contributions from Peter Schiff, Casey Research, and other leading experts in the gold market. Click here for your free subscription.