August 4, 2008

Caution is the Standard for Gold

By John Browne

As a select group of Americans continues to prepare for this week's Beijing Olympics, other Americans continue to worry about their dwindling portfolios. They are looking at gold as an alternative investment to the volatile stock and bond markets.

Both athletes and the investors are "going for gold." The athletes will follow clear Olympic rules of competition. Investors, on the other hand, will go for gold in a market where governments "influence" the rules of the free market. The decision to purchase gold, therefore, must be made with caution, taking into account a myriad of market factors.

Three basic factors influence the price of gold. First, gold trades as a "commodity," based on quality, supply and demand. It also trades as a "hedge" against inflation. Finally, it trades as an "insurance" against systemic risk, either of war or financial collapse.

With today's looming recession, industrial demand may fall, reducing the "commodity" price of gold.

The U.S. government appears committed to propping up the financial system by placing the cost on taxpayers. Nouriel Roubini commented in The Wall Street Journal recently that it was the price of a system that "privatizes profits and socializes losses."

The risks to the financial sector that have so far emerged have been related to real property. Defaults on the massive debts associated with credit cards, automobiles and student loans have yet to surface. If the recession deepens, major losses in corporate and personal loan defaults are likely.

The pressures on the banking and insurance systems have only just begun to show. How far the government will go in doling out rescue funds? Unquestionably, it will involve trillions of dollars and likely will result in hyperinflation. This puts a major upward "hedge" pressure on gold.

In past decades, the interest-bearing U.S. dollar also was viewed as a panic "insurance" refuge, sharing that role with gold. However, with continued dollar debasement, gold increasingly has resumed its solo role of ultimate monetary "insurance."

Recently, increased Middle East war risk combined with two major systemic risks to threaten the entire financial system. This added further upward "insurance" pressures on gold.

As the risk of war appeared to subside and Bear Stearns, Fannie Mae and Freddie Mac were "socialized," the downward pressures of "commodity" recession and the decreasing pressure of panic "insurance" coincided. The gold price fell by over 10 percent. But news of spreading inflation corrected gold's price upward to the mid $900s!

There are three additional outside factors that further complicate the pricing of gold.

First, gold is priced internationally in U.S. dollars. Therefore, the rise and fall of the U.S. dollar has a direct influence on the dollar price of gold.

Second, central bank lending of gold effectively has increased the supply of gold, on paper. Magnified by the derivatives market, this has brought added downward pressure on the gold price.

Third, unlike most commodities, the market price of gold does not reflect a "free" market.

Historically, many governments have diluted their gold and silver coinage content. The evolution of the London "goldsmiths' notes" of the 1670s into paper currency was an invitation for governments to cheat on the grandest scale.

Many governments, ignoring the rules of prudent finance, defrauded their creditors by adopting inflationary policies and debasing their currencies. Each, in turn, has found the escalating gold price an acute political embarrassment.

On Sept. 26, 1999, the American government "encouraged" the central banks of certain other similarly economically embarrassed governments which together held some 33,000 tonnes, or metric tons, of gold.

Acting in concert, under the first Central Bank Gold Agreement (CBGA), they set out to demonetize gold. Protesting the contrary, they set out to destabilize the free market in gold by selling some 500 tonnes each year. Sales were timed to increase the price volatility in order to destroy gold's inherent value as an investment "hedge."

The Greek poet Pindar said: "Gold is the child of Zeus. Neither moth nor rust devour it but the mind of man is devoured by it." And that, of course, is the point.

The political greed of most governments encourages them to overspend. Rather than face the true embarrassment of currency debasement, modern governments have resorted to bending the rules of the free market in gold. In addition, they hold out the latent threat of possibly declaring private gold holdings illegal.

Without "game rules," gold is difficult to value correctly. Many investors have shunned gold in favor of assets whose prices were more predictable. Perhaps, therefore, gold has been largely undervalued.

This week, the Olympians will be playing under strict rules. Investors in gold, however, are hampered by fluctuating market conditions and no clear-cut rules because the free market, in gold, has been usurped.

Until the freedom of the gold market is restored, it is hard for gold to reach "fair value."

Unfortunately, the strategic options for the world economy make the restoration of a free market for gold unlikely in the foreseeable future.

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