Twilight of central banking: Why gold remains the best hope

This is probably not the best of times to give everyone a “buy” recommendation on gold, but the steep correction over the last few months and the moderate returns over the last year or two prior to the recent drop - especially in the face of the exceptionally supportive macroeconomic environment - has created a very attractive proposition.

The conditions prevailing today are very comparable to the 1975-76 period in which, just after a near 50 percent correction (from over $200 an ounce to less than $100 an ounce) gold prices went up by 800 percent over the subsequent five years. The environment today is even better - fiscal policies are much worse, US Fed Chairman Ben Bernanke is no Paul Volcker, President Obama is no Ronald Reagan, and US debt is almost entirely short-term and held outside of the US compared to long-term debt held by US citizens during the 1970s. As I have written before , these factors alone can justify a five-digit gold price.

The icings on the cake would be the unfunded liabilities of the US government that are likely to be well in excess of $200 trillion (The Clash of Generations, Laurence Kotlikoff) and the very real prospect of the US Fed not owning the gold they officially claim on their books (Do the Western Central Banks have any Gold left? Sprott Asset Management). Who knows how high gold prices will go when these factors get resolved over the next few years, but I suspect the numbers are going to be much higher than what even the gold bugs are willingly to publicly proclaim.

But, fortunately for us, gold prices are much lower and so we do not have to get into the above issues to justify a “buy recommendation” at current prices. After all, we are still debating if printing money leads to debasement of the currency and we shall explore the same in this article. Just to illustrate the point further, what the US Fed directly creates (also known as “M0” or M Zero or “base money”) has nearly quadrupled between 2008 and now from just a shade over $800 billion to over $3 trillion today and expanding at the rate of $1 trillion a year. But estimates of the broadest measure of money supply, i.e. M3, have hovered around $15 trillion over this entire period with a mildly decreasing pattern (since the US Fed has stopped publishing M3 numbers since 2006, I have used the numbers published by John Williams of Shadow Statistics ). To that extent, one should confirm that even though the Federal Reserve has been creating/printing money at an unprecedented rate, it does not automatically lead to an increase in the total money supply.

But the relevant question here is what would be the future direction of M3 - the broad money measure that surely causes inflation if growing too fast. That will largely be the determinant of future gold prices.To know that we have to understand what inflation and deflation really are and who benefits under what conditions.

Defined properly, inflation/deflation is the “expansion/contraction in the total amount of money and credit circulating within an economy relative to the goods and services produced”. The natural monetary order, i.e. the free market-based gold standard, would be a mildly deflationary system where gold production goes up about 1.5 to 2 percent a year relative to the total available stock above ground and the economy typically grows at a much faster clip. This was the case during most periods of the nineteenth century and this system naturally encouraged savings as money gained purchasing power.

As an aside, there is a very popular misconception that the gold standard (or at least the version of the gold standard adopted by the US Fed) led to the Great Depression. This is a revisionist version of history and not too unexpected as they were mostly written by government-appointed/dependent economists. For a true understanding of what caused and prolonged these events, refer to The Great Depression by Murray Rothbard. The real story in short is that the US Fed blew up the stock market bubble referred to as “the roaring twenties” and, when it burst in 1929, President Hoover and later Franklin Roosevelt, repeatedly intervened to prevent the much required market cleansing of the malinvestment that had occurred during the bubble’s formative years.

There is an even more popular and egregious misconception that World War II ended the Great Depression, but that’s a story for another date.

Getting back to the inflation/deflation theme, the free market tries to cleanse the system of the excesses of the stock market/housing bubble and that’s a naturally deflationary process as credit gets destroyed. The US Fed has been working overtime to prevent this from happening as deflation hurts borrowers the most. The biggest borrower today is the US Government with an official debt of over $16 trillion (and perhaps many times that number, as referred to earlier) and the unstated policy goal is to reduce the real value of this debt by creating inflation.

Of course, in terms of the stated intent, Bernanke has been saying that he has been trying to increase the total credit that flows to consumers and businesses, and it’s only a matter of time before he succeeds in that. He may perhaps succeed in a very big way with various other consequences. Nothing unintentional and entirely foreseeable.

So what are the chances that Bernanke withdraws the QE (quantitative easing) as he has intermittently suggested over the last few years? In my opinion, pretty much “zero”. For all of the misinformation that the US economy is getting better and that consumer confidence is improving, I think the near zero interest rates and the accompanying QE constitute a ventilator system that is sustaining, for all practical purposes, an ICU economy. Even the non-government buyers of the US treasury are doing so today because the US Fed’s purchases are supporting the prices. So forget the US Fed selling what it has purchased already - even if it stops buying treasuries, the bond market would collapse. As far as the US treasury market is concerned, the US Fed is the buyer of the only resort.

So Bernanke would indefinitely try to continue what he has been doing for the last several years - and perhaps with an increased dose of QE rather than a decrease. I wouldn’t be entirely surprised if the monthly purchase of treasuries is increased to $100 billion from the current levels of $85 billion before the year is out. After all, he has eloquently described the benefits of QE and there’s little chance that the economy gets better. Behind the scenes though, he must be praying that the inevitable transition from this mildly deflationary pattern to one of high inflation/hyperinflation doesn’t happen under his watch.

Just to complete the recommendation to “buy gold”, even considering the largely theoretical possibility of a deflationary collapse, gold would perform well and retain its purchasing power just as it did under the Great Depression. Just that the upside under what is a nearly certain scenario would be spectacular.

So is this inevitable transition also imminent? I wish I knew… but given the continued monetary debasement and the fiscal recklessness of the Obama administration, we should be counting in months and not years. We are indeed living in the twilight zone of central banking and the world’s monetary system would change much more in the next five years than it has in the last 50.

Shanmuganathan “Shan” Nagasundaramis the founding director of Benchmark Advisory Services - an economic consulting firm. He is also the India Economist for the World Money Analyst, a monthly publication of International Man. He can be contacted at shanmuganathan.sundaram@gmail.com