by Howard S. Katz
(www.thegoldspeculator.com.)
7-20-09
This is an interesting take on the inflation/deflation issue. However, I believe that gold could also appreciate in a deflationary environment. I think Howard is correct in his assumption that we will look in retrospect and ask why didn’t we buy more gold? DSA / ED
Alas, poor gold bug. Things are better than a week ago. Monday’s gap is explosive. But here you sit, with gold about to break above $1000 and make you rich. Yet you are torn with fear and doubt. When you look back at this period, you will think, “Why was I so scared? I made a beautiful play. I beat the stuffings out of all my friends. Why did I have such doubts?”
And therein hangs a tale, dear gold bug. Listen to the wisdom of the One-handed Economist, and you will learn a valuable lesson, a lesson which will serve you well both in the financial markets and in life. Because it is easy to observe that every powerful move in the markets is preceded by a period where the large majority of the people are supremely confident that the exact opposite is going to happen. And the social pressure put on by these fools is difficult to resist.
Well people, we are in such a period right now. Pretty much every newspaper, news magazine and TV news show is lying to you. (To be completely fair, not all of them are deliberately lying. Some of them – the stupid ones – actually believe what they are saying. It is only the smart ones that are lying. But that is not much comfort to your bottom line.)
Yes, virtually every source of news and opinion in this country is screaming one word at you: “deflation.” Whether they use the words “Great Depression,” “Great Recession,” “economic crisis,” or whatever, the message is the same. Prices are going down. To their eternal shame, there are even some writers on the gold bug sites who are shouting “deflation.”
Well, it is not very hard to figure. If “inflation” is coming, then gold is going up. If “deflation” is coming, then gold is going down. You can’t have it both ways. You have to make a choice. There was a period in the late ‘60s and early ‘70s when gold was good pretty much whatever happened. That was because it had been suppressed in price for 35 years by the U.S. Government working through the London Gold Pool. This was a consortium of 10 countries which sold their own gold stocks in an attempt to manipulate the price and keep it from rising. The high price of labor and production materials forced the gold mines to close (in 1956), and very little new gold was being produced. So in 1968, when the London Gold Pool was broken, the prognosis for gold was very strongly up, and even a mild “deflation” would not have stopped it.
But even a mild “deflation” was not in the cards. Exactly the opposite happened. President Nixon broke America’s promise to the world to redeem their dollars for 1/35 oz. of gold (just as he broke his own promise to his supporters by instituting price and wage controls). And then the Republicans went on a binge of printing money. By the end of that decade, consumer prices had doubled, commodity prices had more than tripled, and the price of gold had multiplied by 25 times! And then the Republicans blamed it all on the hapless Jimmy Carter, who did not know his front end from his rear end but who had not been the cause of the large rise in prices. They ran as the Party which was against “inflation,” kicked the Democrats out, and started printing money even faster. (This was another lie. Reagan had promised that he would adhere to Milton Friedman’s monetary rule of 3-4% growth in the money supply. But in 1986, he increased the money supply by 17%.)
Today we do not have that same undervaluation of gold that we had in the early 1970s. And, quite frankly, whether or not gold goes up or down long term depends on whether the U.S. Government follows a policy of increasing or decreasing the money supply. (I should say that the power of the gold market is so incredible that it has not yet discounted the money which has been created. It is currently undervalued. Thus, if the Government followed a policy of “deflation,” it would take gold some time to dissipate its current bullishness. However, in the long run it would have to go down. IS THIS A REALISTIC POSSIBILITY?
The best way to understand this, without getting into abstract economics, is to just look at the facts. And the fact is that every single change in prices (of any size) in American history has been caused by the U.S. Government changing the money supply.
1. During the Revolutionary War, the Continental Congress issued a paper currency called the continental. They issued it to excess, and the currency began to decline in value, which is to say that prices began to rise dramatically. After a while, they had the good grace to repeal the legal tender law supporting the continental, and its value declined even faster. From 1776 to 1780, the value of $1.00 in continentals fell to 1¢
2. While Congress was dawdling, the people of the U.S. chose a currency for themselves, the Spanish thaller (which they mispronounced dollar). The thaller was (approximately) ¾ oz. of silver and is the old piece-of-eight which we know from pirate stories. Congress later added a gold dollar (1/20oz.), and with one exception this gold/silver currency brought stable prices from 1780 to 1860.
3. The exception was the War of 1812. To finance the war, Congress allowed private banks to create money (by issuing paper notes redeemable in gold/silver but in excess of their holdings of gold/silver). The banks of the South and the Middle Atlantic states created money and lent it to the Government. The banks of New England (which was anti-war) did not. The result was that prices rose in the South and Middle Atlantic region (by as much as 33% according to Daniel Webster) but remained stable in New England. This incident made it clear to everyone that the paper money was going down in value; goods were not going up. And the people of the time called it a depreciation of the currency (going down of the money) not an inflation (going up of goods).
4. To fight the Civil War, Lincoln issued paper money (called greenbacks) from 1862-65. The quantity of money doubled, and the value of money fell in half. That is, by 1866, the average good had doubled from its 1861 price.
5. Since the country intended to return to the gold/silver standard, the first order of business was to retire the greenbacks. This was done gradually between 1866 and 1879, and in 1879 hard money was resumed. The Wholesale Price Index for 1879 was the same as it had been in 1860, which in turn was the same as 1793.
6. However, in returning to hard money Congress decided that it was a better idea to use only one metal than two. They therefore went to a gold standard and demonetized silver. This reduced the reserves that banks could count to back their paper “notes” and led to a further decrease in the money supply in the 1880s and early ‘90s. This led to an appreciation of the dollar to its highest value in American history. Prices were so low that a new coin, the mill, equal in value to 1/10 cent, was created. The price of the New York Times around the turn of the 20th century was 1¢. This high value of money caused large scale discoveries of gold (South Africa, Alaska), and the increased gold supply caused a mild depreciation of the currency. By 1914, the Wholesale Price Index was back to the same level it had been at in 1879, 1860 and 1793. So the government kept destabilizing the currency, and the currency kept righting itself and returning to the same value.
7. From 1914-1919, the U.S. money supply once more doubled (WWI), and prices doubled with it. To copy the post-Civil War policy (which had proven so successful), the Republicans of that day adopted the policy of “a good 5¢ cigar.” Since cigars had gone from 5¢ to 10¢ over the course of WWI, this was a policy to return prices to their pre-war level. This was achieved in 1933. So the American economy went from 1793 to 1933 with a largely stable price level.
8. Then in 1933, F.D.R. took us off the gold standard. Since that time the government has continually created paper money, and the average level of prices has multiplied by a factor of 17.
These facts present a very clear picture. The only times that prices changed by any significant amount were times that government changed the money supply. When the money supply was increased, prices went up. When the money supply was decreased, prices went down.
If you pretend to be an American economist, then you ought to have studied the economic history of America. So when we consider the question, are prices, here in 2009, going to go up or down, the first thing we must ask is, “What has government done to the supply of money?”
The answer to that question is not difficult. The chart above is constructed from figures published by the Federal Reserve System. It shows the monetary base (the base upon which the money supply is constructed) over the past year-and-a-half. Through the autumn of 2008, the monetary base increased by a trillion dollars. As this money flows into the private banks, they will get a chance to create additional money on this base, and the regular money supply will increase by even more.
This $1 trillion represents a 70% increase on the money supply over a year ago. Worse than this, the Obama Administration is now projecting budget deficits of over a $trillion per year for the next 4 years. What is alarming about this is that all budget deficits of any size in a democracy get monetized. Whenever a government runs a sizable budget deficit and tries to borrow the money, the credit markets of the country seize up. Interest rates advance sharply, and all sorts of vested interests (who want low rates) scream bloody murder. To avoid this protest, the government simply prints up the money and goes through the pretense of lending it to itself. For example, the huge budget deficits of the Reagan years caused the money supply of the country to almost double.
Starting with a money supply of $1.3 trillion in May ’08, I estimate that the current U.S. money supply was $2.3 trillion this past May and will be $3.3 trillion in May ’10; $4.3 trillion in May ’11 and $5.3 trillion in May ’12. That is to say, unless there is a radical change in announced policy, the money supply of the U.S. will multiply by 4 times over the next 4-6 years.
What will happen to people who flew to “safety” by buying T-bills and T-bonds in the recent crisis? In 2014, they will be sitting with fixed income investments worth ¼ as much (in buying power) as they are now. What will happen to people who put their assets into gold and gold stocks? They will be ahead of the game as the investing public rushes into gold (as it did in 1979).
When I confront people with the above facts, I get all kinds of stupid answers. “Yes, the Government is creating money, but the people won’t spend it.” “The Government is creating money, but the people are destroying money.” “This time is different.”
No, this time is the same. It is exactly the same. The paper aristocracy puts out a parade of pseudo-experts, who have not studied economics, and people go ga-ga because all the “experts have impressive titles. So they obey the “experts.” Lo and behold, the “experts” prove wrong, and the paper aristocracy winds up with the wealth they have produced. And they don’t have a clue.
Do you remember the late 1970s? There were gold conferences throughout the country. There was intense excitement. And the gold stocks made phenomenal gains. That was caused by a 13.3% rise in the Consumer Price Index. What do you think will be the result of a 70% rise in the Consumer Price Index? (Please note, the Government is perfectly capable of lying about the CPI. It has already done so by taking housing prices out of the CPI and substituting rents. Thus the enormous rise in housing prices from 1997 to 2006 was not registered in the CPI, and this then helps provide ammunition for the second lie that we are in danger of “deflation.”
Therefore, the American public has no concept of how bad things are and what they need to do to protect themselves. This gives you a historical opportunity. You have the chance to buy gold while it is still cheap. People will say to you, “You bought gold under $1000? Boy, I wish I had done that.”
Once you have understood the basic proposition, that you must have your assets in gold, there are a host of subsidiary questions. Should it be stocks or metal? Should it be gold, or its sister element silver? If stocks, should you be in the blue chips or the more speculative exploration companies? Actually, the decision to buy gold is not merely one decision. Once you have your gold, you are beset by doubts. Two days later you are beset by doubts, and you have to make another decision (not to sell). Then a week later, more doubts – another decision. To resist all these doubts and hold your position, it can make the difference of life and death to have a friendly, reliable economic newsletter. That is what I intend my newsletter, the One-handed Economist, to be: good solid economic advice in accord with the facts, sound theoretical work so you can understand the facts, hard recommendations on what to do, and continual bolstering of your convictions so that you can hold your positions for maximum profits. You can subscribe ($300/year) via my (new) website, www.thegoldspeculator.com. And you can see more of my articles on my blog site, www.thegoldspeculator.blogspot.com, (no charge).
Thank you for your interest.
Posted by D.Stewart Armstrong in Articles