Why gold if deflation is the threat?

October 2, 2009

Alice Schroeder wrote a great column for Bloomberg yesterday that I’m just getting to. The best stuff comes at the end, where she describes why some people are buying gold even though inflation doesn’t seem to be a big risk. (Apologies in advance for block-quoting lots of stuff in this post, but I think it’s worth it…)

In a nutshell: They aren’t playing a conventional inflation trade. They’re buying currency crisis insurance.

[Gold bugs] aren’t just betting on inflation, as is the conventional wisdom. Gold has a wicked history of being an unreliable inflation hedge. It has, though, at times been a haven against sudden currency depreciation.

In all the talk of inflation because the Treasury is printing so much money versus deflation because it may not print enough, there is one type of inflation that is rarely discussed. This is the mega-inflation caused by a sudden currency devaluation. Currency is like any financial innovation, an obligation secured by assets. When the obligation is perceived to have increased far beyond the level justifiable by the assets, which in this case make up a country’s economy, a bubble has formed.

Schroeder is describing, in much simpler terms, what economist William Buiter has called a “sudden stop” event. (I’m having trouble logging on to FT to find the right link, but the guys at Baseline Scenario have a good one here.) Let’s take a quick detour to Buiter then, writing early this year:

But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expected inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia….

The US is helped by the absence of ‘original sin’ – its ability to borrow abroad in securities denominated in its own currency – and the closely related status of the US dollar as the world’s leading reserve currency.  But this elastic cannot be stretched indefinitely….

The only element of a classical emerging market crisis that is missing from the US and UK experiences since August 2007 is the ’sudden stop’ – the cessation of capital inflows to both the private and public sectors. . . . But that should not be taken for granted, even for the US with its extra protection layer from the status of the US dollar as the world’s leading reserve currency.  A large fiscal stimulus from a government without fiscal credibility could be the trigger for a ’sudden stop’.

Most economists, using their conventional models, are looking at things like “output gaps” to rationalize additional borrowing to stimulate the economy. So long as people and capital are unemployed, cost-push inflation isn’t seen as a threat so stimulus is believed to be cost-free. The risk, of course, is that we can’t borrow to infinity. At a certain point — tough to say when — we’ll tap out the national credit line. Where economists get in trouble, IMHO, is they envision this nebulous period in the “medium term” when the economy will be growing again and debt can be paid back. As I argued in my column yesterday, this ignores the fact that growth, which is to say growth in spending, is no longer possible without incremental borrowing. We’ve gotten ourselves into a cycle of perpetual borrowing to, in Schroeder’s words, “pump the economy back to a high-water mark that was phony to begin with.”

To Schroeder’s conclusion:

As in any bubble, those who recognize this need to act well in advance. Historically, governments have taken action to prevent currency flight when the owners of a severely overvalued medium of exchange start selling so much that it adds to the pressure on its price. They make private purchases of gold illegal, or tax the exchange of currency.

Right now, the American economy is worth less than the value implied by the market value of its obligations. How much less, no one knows. But gold bugs will tell you, privately, that this is why they are buyers. Might as well stock up, they say, before gold becomes a controlled substance.

The bolded section is why I haven’t touched stocks in two years and don’t plan to for some time: The U.S. economy is underwater. The value of our obligations is greater than the value of our assets, which is to say the equity value of the economy is negative. The best proxy for that is the stock market.

Stocks aren’t going to zero. They have option value. But a 90% fall from the peak is what I see happening eventually. Either explicitly or priced in gold. Over what time frame, I haven’t a clue.

But that’s what happened during the Depression. Today we’re far more leveraged


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“Stocks aren’t going to zero. They have option value. But a 90% fall from the peak is what I see happening eventually. Over what time frame, I haven’t a clue.”

Watch out Rolfe, if Felix gets a commission for trashing people who “don’t talk up the market”, he’s getting it from YOUR sponsor…

If you really think a 90% fall from peak is what’ll happen, why not buy long-dated out of the money puts. I’m sure Buffet would sell them to you.

I believe the generally accepted default risk premia for US treasuries is 0. If the full-faith & credit of the US govt is not safe, then unless your gold is hidden in the Alps, it’s probably not safe either.

Posted by winstongator | Report as abusive

The only cure for high-debt depressions is to CANCEL DEBT. Call it the People’s Bailout: cancel their debts, reset the financial system. Explore the plan and spread the word:


We don’t have to watch our real economy get destroyed!

The U.S. is insolvent, bankrupt under any objective rational analysis. Our ad hominem debt-to-infinity money print factory notwithstanding, our hour of reckoning cometh like the dawn. It is as inevitable as the passing of time. This psychological concept we conceived in that long ago age when our reason became hoodwinked will be evaporated as quickly as one blows out a candle and there will be nothing left but blood in the streets. Hang on to that irrational folly of value media which man calls his sacred dollar as long as you wish. A fool and his money soon part.

Posted by Lance Schultz | Report as abusive

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I find I really don’t understand money all that well. I notice that gold is ceaselessly offered for sale over the airwaves. I get weary of hearing the hawkers trying to get rid of the stuff and exchange it for your greenbacks. If it were to be so valuable you would thing they would just be hoarding it. I’m not saying the dollar is secure or even safe I’m saying that to me it doesn’t add up.

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