Why Gold and Precious Metals Investment? How Would Gold Perform in a Deflationary Global Recession? A Contrarian Approach to Investing.

July 6, 2010 by · 6 Comments
Filed under: Economics, Investment 

Dr. Marc Faber, author of ‘Tomorrow’s Gold’ and ‘The Great Money Illusion’, is the Hong Kong-based publisher of the Gloom, Boom and Doom Report, a monthly commentary on global market conditions and monetary policy. A former managing director at Drexel Burnham Lambert, he now heads Marc Faber Limited, an investment advisor and fund management firm known for its contrarian approach to investing.

Years from now, the events of late 2007 and early 2008 will be remembered as a classic case study of the flawed thinking by governments that choose to use monetary policy to try to sustain an unsustainable economic bubble, and how that action broadens and deepens the pain when the bubble inevitably bursts. And the bubble always bursts.

The old image of cranking up the printing press to increase money supply is outdated in the digital age. Now computer keystrokes can create dollars or euros or yen by the billions, and then move them around the globe at cyberspeed. But advances in technology and global finance have not changed the basic economic principle represented by the printing press: when central banks can churn out paper money at will, the value of this paper is highly suspect.

Paper money can be valued, of course. The question is, ‘Against what?’ It would seem that cash is losing its purchasing power at an accelerating rate against other assets because of expansionary monetary policies. You can print money, you can increase the supply of bonds, you can increase the supply of equities through new issues, but you simply cannot increase the supply of oil endlessly, nor of copper, nor of gold.

Certainly not of gold.

Since 2000 gold and precious metals have significantly outperformed other financial assets. And the worse the economic and financial conditions of the United States and other countries become, the more value cash will lose against hard assets, which have now become the world’s ‘new money’. In an environment of monetary debasement — that is, when cash loses rapidly its purchasing power — all goods, services and assets become currencies. It is during these times that investors and savers realise that the only way to protect their purchasing power is to move away from paper assets.

The problem is that the US Federal Reserve, after having built up a massive financial sector through its easy money policies over the last quarter-century, does not have the will to clean up the financial mess it created. Rather, it is dealing with its fiscal ailment by simply accelerating the rate at which it prints paper money.

The Fed, led by its Chairman Ben Bernanke, is following an asymmetrical monetary policy. Bernanke and his crew let asset bubbles develop, and then when the marketplace tries to correct those bubbles through price declines, the Fed barges in to keep those overinflated assets aloft. It is an utterly illogical monetary policy that over the long run will backfire and devastate the global economy.

In the third quarter of 2007, the US money supply increased at an annual rate of 18% as the Fed rushed to cut interest rates to provide liquidity in response to the widening mortgage debt crisis. By following this expansionist monetary policy, the Fed is creating a massive glut of dollars that add to global liquidity, which stokes global inflation and leads to global bubbles.

The Fed followed a similar loose-money policy in the late 1990s, which as we all remember culminated with a technology-led stock bubble that abruptly burst in 2000. It seems that the current crop of American central bankers learned little to nothing from their predecessors’ mistakes a decade ago. How can a responsible central bank cut interest rates and pursue an expansionary monetary policy when the stock market is near an all-time high, when the dollar is staggering and when food and commodity prices are going through the roof? If these conditions were found in virtually any other country, the prescription from the World Bank or International Monetary Fund would be to tighten monetary policies and to raise interest rates.

These risks are not limited to the United States, of course. If the dollar continues to lose ground against the euro, I foresee that at some point the European Central Bank would feel tremendous political pressure to cut interest rates to try to lower the value of the euro against the dollar. At that point, everyone around the world would also have to cut rates, no matter how illogical and irresponsible such a move might be. This would, in effect, trigger a competitive devaluation, a global race to the monetary bottom.

There is a very real danger that the whole world will go into hyperinflation and that paper money will be rendered worthless. This would create what I call the ‘Zimbabwe-ization’ of the world. It’s almost mind-boggling to think that little more than a quarter-century ago, a Zimbabwean dollar was worth about one and a half US dollars. But years of inept monetary policies have destroyed that country’s currency: the official exchange rate was 30000 Zimbabwean dollars to one US dollar in late 2007, but the black market rate was near 2000000:1 and worsening each day.

Mr. Bernanke’s philosophy, like that of Alan Greenspan before him, is that monetary policy should target core inflation. In other words, the rate of inflation if you don’t count energy or food prices. Using core inflation to structure monetary policy is fundamentally flawed because it is designed to underreport true inflation — energy and food are far from free these days. I’m convinced that most Americans are facing a rate inflation of at least 5 to 6% per annum, and for some it is 9% and even 10%. Nobody enjoys the ‘official’ rate of inflation of 4%.

The Fed’s policy of monetary manipulation to keep asset prices up at all costs by use of artificially low interest rates means an era of continuous depreciation has arrived. Cash, once perceived as reasonably safe, has actually become quite a dangerous asset class due to its depreciation not only against asset prices but also against consumer prices.

In fact, I would argue that because of artificially low interest rates around the world, paper currencies have lost one of their principal functions, which is to be a store of value. Paper currencies have essentially become confetti! People will eventually realise that these confetti, deposited in a bank or loaned out at a low interest rate, are of little enduring value, and when that happens, they will get rid of that paper and store their value in real estate, commodities, equities and collectibles to avoid becoming ‘penniless billionaires,’ as so many Zimbabweans find themselves.

An exchange of cash into assets would lead to speculation by those who leverage their purchasing power with funds borrowed at the artificially suppressed interest rates. The increase in leverage, of course, would drive asset prices even higher, and the upward spiral would continue.

Now, someone could argue that there is nothing wrong with asset prices appreciating. I completely agree — provided that asset prices are indeed increasing because of favourable fundamental factors. On the other hand, if asset prices skyrocket because of excessive liquidity, the result is unsustainable asset bubbles that end in pronounced economic pain.

And if these decorative monetary confetti are no longer a store of value, they are also ill-suited to serve as a unit of accounting. The irresponsibility by central bankers makes it clear that we need to trade in the dollar and other paper currencies for an alternative that would serve as a unit of account to measure economic growth in the world and as a dependable store of value. In my opinion, this currency should be gold.

I don’t mean to suggest that commodities cannot also decline in value. It should be clear, however, that the supply of paper money can be increased ad infinitum, whereas the supply of hard assets is extremely limited. I’m not particularly skilled at moving assets around to ensure they retain their value, so my tendency would be to stick to gold.

You as an investor are now faced with a monumental choice. Either you believe that the expansionary monetary policies of central banks will lift asset prices further, or you take the strongly contrarian view that this artificial creation will not work and that the world is heading toward a deflationary recession.

How would gold perform in a deflationary global recession? Initially gold could come under some deflationary pressure as well, but once the realisation sinks in as to how messy deflation would be for countries and households carrying too much debt, its price would likely soar.

Therefore, under both scenarios — stagflation or deflationary recession — gold and gold equities, and to a lesser degree other precious metals, should continue to perform better than financial assets.

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