Spare a Thought for Gold in the Bail-Out Age

Welcome to the bail-out age. A new era began with the rescue of Bear Stearns and its
shotgun marriage to JP Morgan in March 2008, and bail-outs 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 that 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 IMF, 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
Gordon Brown, the then-chancellor 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 US
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 US 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 re-asserting 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 ECB, and the
suspicion that it too will engage in quantitative easing has served to undermine the euro’s
position as a viable challenger to the US dollar’s role as the world’s reserve currency.
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 US dollar devaluation of 1971 in concert with negative real interest
through the remainder of the 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 Jastram’s “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, registering sizable increases in its purchasing power. 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 bail-out 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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