SERIOUS MONEY:WELCOME TO the bailout age. A new era began with the rescue of Bear Stearns and its shotgun marriage to JP Morgan in March 2008, and bailouts soon became the norm as governments across the developed world afforded blanket protection to almost every major banking institution in their respective financial systems.
Gargantuan fiscal stimulus and aggressive monetary easing insulated the global economy from the worst of the deflationary impulses stemming from much-needed financial deleveraging. But government rescue packages simply transferred private sector debt to public sector balance sheets, and aggregate debt-to-GDP ratios remain either close to, or at, record levels.
The rapid deterioration in public finances meant it was only a matter of time before the sustainability of sovereign nations’ debt positions would be called into question, and so it came to pass, as investors singled out the weakest links among fiscally-stretched nations – the so-called PIGS of Portugal, Ireland, Greece and Spain. EU officialdom in concert with the International Monetary Fund, was forced to respond with a rescue package of up to €750 billion that provides not only a safety net for the ailing sovereigns, but also insulates financial institutions from the negative impact of their bad lending decisions. The age of bailouts is truly in full swing, but investors have responded less than enthusiastically, and gold is increasingly being preferred as a store of wealth over currencies and government debt securities.
The precious metal has enjoyed a powerful bull market since it bottomed at little more than $250 per troy ounce in the summer of 1999, following the announcement that then UK chancellor Gordon Brown intended to sell more than half of the UK’s gold reserves.
A number of factors combined to produce a turnaround in the yellow metal’s fortunes, including a reduction in short-term interest rates to the lowest level in a generation following the collapse of the dot.com bubble, the downward trend in the dollar due to the issuer’s large and persistent current account deficit, and a surge in commodity prices precipitated by strong demand and supply shortages across the entire resource complex.
The latest move in gold prices to almost $1,240 per troy ounce is notable, however, because it has taken place in the face of a stronger dollar that has benefited from a renewed flight to quality bid and in spite of a slump in commodity prices from their recent highs as concerns over the fragility of the global economic recovery have sprung to the fore. The precious metal’s recent price behaviour suggests that it is reasserting its historical role as a monetary asset and is increasingly being viewed as a viable currency alternative.
The gold renaissance is not difficult to understand given that the independence of the world’s major central banks has been compromised through the use of unconventional policy tools to influence the prices of long-term fixed income securities. The credibility of the Federal Reserve and the Bank of England has already been called into question and, following the EU/IMF stabilisation package, it is now the turn of the European Central Bank. The suspicion that it too will engage in quantitative easing has served to undermine the euro.
The presumed independence or otherwise of central bank policy is critical in the present environment, because the combination of low real growth and high real interest rates means that monetary policymakers are likely to come under intense pressure sooner or later, to debase the currency and inflate away unsustainable public sector debt burdens.
Gold’s role as an inflationary hedge is not in dispute, though it is frequently misunderstood. It is true that the precious metal serves as a store of value over long periods, but it can lag a basket of consumer goods over shorter intervals, so long as the underlying inflationary trend is benign and does not give rise to significant economic instability.
A move away from relative price stability, however, and the accompanying sustained upward shift in inflation expectations produces the perfect climate in which gold will shine. The dollar devaluation of 1971 in concert with negative real interest through the remainder of that decade springs to mind. Thus, a deliberate attempt to reduce public sector debt burdens through monetary inflation would almost certainly precipitate a surge in the price of gold.
The observation that gold serves as an effective store of value during malign inflationary periods leads many commentators to conclude that the precious metal would perform badly should the developed world succumb to a destructive debt deflation, but this conclusion is not borne out by historical fact. Indeed, Roy Jastrams The Golden Constant, which analysed the behaviour of gold prices from 1560 to 1976 in the UK and from 1800 to 1976 in the US, revealed that the precious metal performed far better during deflationary periods.
Investors scramble for liquidity and flee financial assets during deflations, but the deteriorating credit quality of currency issuers and the resulting loss of confidence mean that gold is typically preferred to paper currency as a hoarding vehicle. Thus, the deflationary pressures unleashed by self-defeating fiscal consolidation efforts via a further downturn, would in all likelihood result in a higher gold price. The dispersion of possible future economic outcomes has rarely been wider in modern history, and tail risk is high as the bailout age could well give way to either malign inflation or destructive deflation.
A return to price stability cannot be assured, and the actions by some investors to purchase protection in the form of gold appear well advised. The bull market in gold may pause for breath, but it’s far from over.
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