Sunday, July 1, 2012

Why You Should Still Own Gold

There is one central rule of human political behavior that underpins the logic of owning gold -- any sufficiently large body of people will resist responding to a problem until that the problem becomes a crisis.  The larger the body of people and the longer its behavioral dynamics have been established, the more binding this statement becomes and the deeper into crisis the problem must escalate before sufficient will can be mustered to overcome behavioral inertia.  This is what is called "kicking the can."

The world is now four years into the financial crisis that began in 2008, and almost a century into the monetary dilemma that began at the outbreak of World War I, when central banking became a universal institution.  Since that egregious mistake was made, the can has been kicked over and over, and newer and consistently worse arrangements devised to keep the game going as each successive crisis presented itself.  The present crisis is really nothing new; it is merely an extension of the original mistake made way back when.

As far as the central issues of the present bout of can-kicking is concerned, there are two principle monetary dilemmas influencing policy -- overextension of bank credit into uneconomic activities which threatens bank solvency, and a sovereign debt crisis.  The second was precipitated by the first, and the first is the endemic problem created by central banking.

The question the would-be gold investor must ask himself is this:  how will this dilemma be resolved?  Whether one is talking about the various crises in Europe, the US, or anywhere else, there are basically two possibilities.  First, politicians and the banks can refuse to act and allow the chips to fall where they may.  Second, they may choose to further extend credit -- increasing money supplies in the process -- to delay the onset of legal insolvency. The first course of action would result in a wave of bankruptcies and mass asset liquidation, followed by a redeployment of those resources towards economic recovery.  The second will result in continued economic inaction, but continued legal solvency and monetary inflation.  In the simplest terms, the first approach is 'default,' the second 'inflation.'

For example, take the case of Greece.  The Greek government has taken on more debt than it can service, primarily because of the extension of cheap credit from northern European members of the EU.  This continual stream of cheap credit was made possible by the expansionary activities of European banks as they steadily increased money supplies.  Now that the solvency of Greece has been called into question, the dilemma arises -- will Greece be allowed to default, causing European banks to incur enormous losses which threaten their solvency, or will further credit be extended?  The question has already been asked and answered, several times.  The various governments of Europe, especially Germany, have consistently extended credit to the Greek government, kicking the can of insolvency further down the road, and 'paying for' these credit extensions by taking on more debt themselves.  Every new bank loan results in the creation of more and more money.

As more and more nations are threatened with financial insolvency, one finds the question answered the same way, again and again.  When the insolvency of the major US banks loomed large on the horizon, the central bank of the United States -- the Federal Reserve -- began a 'program' of mass asset purchases, which is nothing more than the further extension of credit through the creation of money.  Now a near identical program is being announced in Europe.  Again and again, the same problem produces the same response.

The effect of every one of these activities is to erode the value of money, and further, to ensure further extension of the economic activities which are creating real economic losses and inhibiting the forces of production.  Conversely, not to act and to allow mass default to take place would result in the constriction of money supplies and an increase in the value of money, as well as an eventual economic recovery.  The first is bullish for gold and bearish for human well-being, the second is the reverse.

Gold investors must ask themselves which response they expect going forward.  So long as the answer is 'more kick the can,' gold is a buy.  The European Central Bank has just confirmed that further extensions of credit and bailouts are a safe bet for the near future.  The intuition presented in the beginning of this post is the logic behind the expectation that such activities will continue for some time.

The recent downturn in gold and silver prices appears primarily to be the result of the expectation that Germany would 'hold the line' against further credit extension, as well as the possibility of the onset of recession in late 2012 here in the US.   The announcement by the European Central Bank cuts the German government out of the picture.  Expect precious metals prices to respond accordingly.  Recession, however, remains a real possibility, and in my opinion, a likelihood.

But again, what is to be the likely response to recession?  Default or inflation?  The question answers itself.

At some point, further credit extension will no longer be possible and the intuition will no longer hold.  That will be the time to sell, but not until then.

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