Wednesday, February 10, 2010

Plenty of Time to Invest in Gold

Ned W. Schmidt features the above graph on his Kitco commentary and on his newsletter's website (the newsletter costs $149, a reasonable price for an investment letter).

The price of gold for the past few years seems to have tracked the rate of monetary growth, but recently diverged sharply. The reason, as Schmidt shows, is contraction of industrial loans leading to less monetary growth. However, the monetary base expanded exponentially, far more rapidly than money itself, which would explain the divergence along with the contraction in loans.

The point that Schmidt is making is very good. First, note on the graph that at least until '08 the gold price has tended to anticipate monetary expansion but trail monetary contraction. Gold investors underestimate the possibility that the Fed will raise rates and contract the money supply. They are right in the long term but can be wrong in the short term. Second, the gold investors have diverged from monetary growth since '08. This may be a larger than usual short term error. Third, it is true that in the short run the contraction in loan activity in a fractional reserve banking system leads to reduced inflation or deflation. But longer term, over the next couple of years, there will be heavy pressure to inflate further, as Schmidt points out. Moreover, government borrowing will create pressure on the Fed to expand the money supply to purchase additional bonds. Until recently, foreign governments have been buying US debt to keep the dollar strong. There are signs that this policy will abate as China has been talking about tightening its money supply. On the other hand, there may be pressure to inflate in Europe as southern European countries suffer from socialist fiscal mismanagement.

Schmidt asks:

"Will that red line turn positive? Yes. Already the lack of economic growth inspired by weak U.S. money supply growth is evident in the economic statistics. Preliminary report on the U.S. economy for the fourth quarter of 2009 was dismal, despite the praise of journalists unschooled in economics. That weak economic growth will increase the pain felt by the Obama Regime and the U.S. Congress. With U.S. national election only nine months in the future, great pressure will be applied to the Federal Reserve. Bernanke may finally get to use that helicopter, either from which to hurl money or to seek asylum in some other land."

In fact, the helicopter left the heliport years ago. The tripling of the monetary base in '08 provides the banks with plenty of liquidity. Government will take advantage of it if consumers cannot. Government spending is inevitably inflationary. Inflation is the difference between the value that the investments facilitated by the new money create and the amount of new money. Government does not create value, it merely allocates consumption. So when most of the new money is borrowed by government, hyper-inflation is likely.

This provides a simple explanation for the recent weakness in gold. But longer term the liquidity-addicted financial-bureaucratic complex will take advantage of the liquidity to expand relentlessly.

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