Monday, November 14, 2011

Gold in a bubble? A contrarian view

From the Automatic Earth:

Our most consistent theme here at The Automatic Earth has been the developing deflationary environment and the knock-on effects that will follow as a result. Now that the rally from March 2009 appears to be well and truly over, it is time to revisit aspects of the bigger picture, in order for people to prepare for a full-blown liquidity crunch. October 2007-March 2009 was merely a taster.

As we have explained before, inflation and deflation are monetary phenomena - respectively an increase and decrease in the supply of money plus credit relative to available goods and services - and are major drivers of price movements. They are not the only price drivers, to be sure, but they are usually the most significant. People generally focus on nominal prices, when understanding price drivers is far more important. A focus merely on nominal price also obscures what is happening to affordability - the comparison between price and purchasing power.

We have lived through some 30 years of inflationary times, since the financial liberalization of the early 1980s under Reagan and Thatcher initiated the era of globalization. Money freed from capital controls was free to look for opportunities worldwide, and the resulting global economic boom greatly increased trade, resource consumption, financial interconnectedness and the multiplier effect for monetary expansion.

The increased purchasing power that resulted, largely for the better off, found its way into asset markets around the world, allowing people to bid up prices. This created a psychological 'wealth effect', which spawned an orgy of consumption through borrowing against rising nominal assets values. This in turn led to greater monetary expansion, since money is lent into existence. Fractional reserve banking, securitization, the enormous expansion of the shadow banking system and many other factors acted as engines of monetary expansion.

This spiral of positive feedback started slowly, but gradually morphed into a global mania of epic proportions. Caution was thrown to the wind, debt expanded exponentially, risk multiplied, wealth concentration increased with higher returns to capital and consumption became almost frenetic where increasing purchasing power supported it. At the same time, rising consumer prices put increasing pressure on the less privileged, who were forced to compete for basic necessities becoming ever more expensive. As we have seen in a number of places, this has been a major ingredient in the development of social unrest. High prices, and fear of both higher prices and actual shortages, can be socially explosive.

Rising prices are not themselves inflation, as we have repeatedly explained, but are the result of it. Credit expansions create excess claims to underlying real wealth through the creation of artificial, or virtual, value. They also bring demand forward, increasing pressure on resources for the duration of the expansion period. Extrapolating consumption trends forwards linearly leads to fear of shortages, which encourages market participants to bid up prices speculatively.

However, being based on Ponzi dynamics, credit expansions and speculative manias are naturally self-limiting. Credit expansions proceed until the debt they generate can no longer be serviced, and there are no more willing borrowers and lenders to continue lending money into existence. Speculative manias continue until the greatest fool has committed himself to the exhausted trend, and no one remains to push prices up further.

As an expansion develops, one can generally expect increasing upward pressure on commodity prices, thanks to both demand stimulation and latterly the perception that prices can only continue to increase. The resulting crescendo of fear - of impending shortages - is accompanied by the parabolic price rise typical of speculative bubbles, as momentum chasing creates a self-fulfilling prophecy. At the point where almost everyone with the capacity to do so has jumped on the bandwagon, and all agree that the upward trend is set in stone, a trend change is typically imminent.

We find ourselves still near the peak of the largest credit bubble in history. As faith in many of the more spurious 'asset' classes devised by 'financial innovation' has been shaken, faith in the ever increasing value of commodities has strengthened. However, commodities are not immune to the effects of a shift from credit expansion to credit contraction, despite justifications for endless price rises, such as apparently bottomless demand from China and the other BRIC countries.

Every bubble is accompanied by the story that it is different this time, that this time prices are justified by fundamentals which can only propel prices ever upwards. It is never different this time, no matter what rationalizations exist for speculative fervour. BRIC demand only appears to be insatiable if we make our predictions solely by extrapolating past trends, but that approach leaves us blind to trend changes and therefore vulnerable to running off a cliff. Insatiable demand results from seemingly endless cheap credit, given that demand is not what one wants, but what one can pay for. When credit collapses, so will demand, and with it the justification for higher prices.

While credit expansion (inflation) is a powerful driver of increasing prices, credit contraction (deflation) is a far more powerful driver of decreasing prices. Credit, having no substance, is subject to abrupt fear-driven disappearance. Confidence and liquidity are synonymous, and confidence is once again evaporating quickly, as it did in phase one of the credit crunch (October 2007-March 2009). As contraction picks up momentum, the loss of credit will rapidly lead to liquidity crunch, drastically undermining price support for almost everything. With purchasing power in sharp retreat, however, lower prices will not lead to greater affordability. Purchasing power typically falls faster than price under such circumstances, so that almost everything becomes less affordable even as prices fall.

Credit expansion reversed in 2008, and this is deflation by definition. Despite the talked-up attempts to monetize debt through quantitative easing - a deliberate attempt to stoke inflation fears in order to counteract the psychology of deflation - money plus credit has been in net contraction. Talk of monetary growth based on only the money fraction misses the elephant in the room, since the vast majority of the effective money supply is credit, and the tightening of credit is by far the dominant factor.

Gold has been increasingly considered to be the ultimate safe haven. The certainty has been so great that prices rose by hundreds of dollars an ounce in a blow-off top over a mere two months. The speculative reversal currently underway should be rapid and devastating for the True Believers in gold's ability to defy gravity eternally. Expect to hear all about the enormous Ponzi scheme in paper gold, and a lot more about plated tungsten masquerading as gold. It doesn't even matter whether or not that rumor is true. What matters is whether or not people believe it, and how it could feed into a spiral of fear as prices fall.

Central banks are buying gold, which some consider to be a major vote of confidence, and therefore bullish for gold prices. However, it is instructive to look at the previous behavior of central banks in relation to gold prices. When gold hit its low point eleven years ago, after a long and drawn out decline, central bankers were selling, in an atmosphere where gold was dismissed as a mere industrial metal of little interest, or even as a 'barbarous relic'.

Selling by central banks, which are always one of the last parties to act on developing received wisdom, was actually a very strong contrarian signal that gold was bottoming. They would not have been selling if they had anticipated a major price run up, but central banks are reactive rather than proactive, and often suffer from considerable inertia. As a result they tend to be overtaken by events. Regarding them as omnipotent directors and acting accordingly is therefore very dangerous.

Now we are seeing the opposite scenario. After eleven years of increasingly sharp rise, central banks are finally buying, and they are doing so at a time when the received wisdom is that gold will continue to reach for the sky. Once again, central banks are issuing a strong contrarian signal, this time in the opposite direction. While commentators opine that central banks will hold their gold even if they develop an urgent need for cash, this is highly unlikely. In a deflationary environment, it is cash that is scarce, and cash that everyone, including central bankers, will be chasing. Selling gold to raise cash may well not be a matter of choice.

Typically a speculative bubble is followed by the reversal of speculation causing prices to fall, and then by falling demand, which undermines prices further. As the bubble unwinds, people begin to jump on a new bandwagon in the opposite direction, chasing momentum as always. The need to access cash by selling whatever can be sold (rather than what one might like to sell), and the on-going collapse of the effective money supply as credit tightens mercilessly, will also factor into the developing vicious circle.

Gold has been considered money for thousands of years, and will hold its value over the long term. However, this does not preclude a huge downward move in the shorter term, and for those forced to sell early, there is no longer term perspective. Spot prices will fall, but those with no bargaining power will get much less than the spot price if they are forced to sell into what is likely to be the ultimate buyers market during the next few years. They will never be able to buy back into the market, and would generally have been better off holding the cash that will appreciate in value for the few years of the credit collapse. Only those who can genuinely hold gold for the duration of the deleveraging, without having to rely on the value it represents in the meantime, will really be able to use it as a store of value.

We stand on the verge of a precipice. The effects of the first real liquidity crunch for decades will be profound. We are going to see prices fall across the board, but far fewer will be able to afford goods or assets at those lower prices than can currently afford them at today's lofty levels. The social effects of this will be enormous, and will spread to many more countries. The collapse of our credit pyramid will be the driving factor and it will sweep all before it like a hurricane for at least the next several years. Beware.


Automatic earth maintains a deflationary viewpoint. As a open minded investor, you must consider well argued positions that conflict with your own thesis. I highly recommend you all read the entire article as it includes pretty charts and graphs. I maintain the view that central banks will continue to press on the monetary peddle until something goes terribly wrong.


  1. Yeah this author is assuming that Ben Bernanke will watch the economy take a nose dive without running the printer at full speed. This is same guy who doubled the monetary base in 2008 and believes that falling prices are the worst thing that can happen to consumers. I'm skeptical.

  2. I believe the author is assuming that the Fed is not some God-like force (no more than markets are) like the inflationary arguments assume. That just as in the 1920s/30s things spiraled out of control, they can do the same now. Much of the inflation argument at this point relies on assuming everyone is in control. That the Chinese, for example, are not engaged in an assets bubble is one of them. What happens if all the raw materials China is gobbling up is just being stockpiled somewhere rather than reflecting real demand? What does that mean as we move further down the road?

    At bottom, you are making a supply side argument. At bottom, the author is making a scare resources (or demand) side argument. The later is not taught in most intro macroeconomics courses anymore because we are suppose to believe growth can go on forever. What happens if it doesn't because demand is not there for the growth?

  3. "until something goes terribly wrong"

    Until? 9/16% unemployment and a collapsing employment to population ratio are pretty wrong.

    A few big jolts of inflation are likely just what the doctor ordered.

  4. By terribly wrong I mean panic selling of the $7 trillion in USD held overseas which would cause an disorderly crash in the value of the USD which cause a spike in the price of items we import. If you think things are bad now just wait until our beloved treasury yields blow out to PIGS levels. As of this morning, the US gov still gets to borrow at 6 months for .05%. If/when yields blow out over here that is when you will hear Americans scream as true austerity bites. For now, the US continues to borrow up to 12% of GDP at rock bottom rates.

  5. So true Subprime, the difference between Italy and the US is that we can print money and they can't. There fiscal situation is arguably better.

  6. Many of the US Treasury bears got slaughtered on bets that UST yields would blow out. Peter Schiff is one of them. Although his long term thesis is correct, his timing is god awful. Given that so many claims are to be paid in dollars, this USD funding reliance continues to cause vicious USD rallies against other forms of fiat toilet paper. But as the dipshits on CNN Money continue to profess, we are the tallest man in a room full of midgets. This Euro Zone crisis will buy the US some time. But in the event, our economic fundamentals are horrid with trillion dollar deficits until the big kaboom.

    Just yesterday we became a 15 handle nation ($15 Trillion in public debt). Within three years many analysts project we will hit 20T. At some point this madness will end and our profligate spending will be curbed by market forces. But for now the US Treasury ponzi steams ahead undeterred.

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