The Case For Gold

BullionVault's Director, Paul Tustain, makes The Case For Gold:

(emphasis mine)
[my comment]

The Case For Gold

Paul Tustain outlines the case for gold.

Welcome to 'The Case for Gold'. I'm Paul Tustain, BullionVault's Director.

Many of our visitors ask our opinion about gold. To answer that question more thoroughly we have produced this electronic book.

For those of you in a hurry the introduction gives a quick version of the answer. For a more leisurely read it continues with several chapters within Parts 1, 2 and 3. You can read through the whole report with the links to left, or below.


Why gold?

Clearly it is not always right to be buying gold. Often - in fact, usually - it is better to go in search of business growth.

Right now we can look back over 25 years where the conditions have generally been very good for growing businesses. Unsurprisingly in those 25 years gold has underperformed business investments - by as much as 20 times.

But nobody makes money today from yesterday's price moves, and now there are many indicators which suggest things could soon turn very bad for investors seeking growth.

The list of dangers is getting longer. Here are a few:-

Budget deficits
Trade deficits
Asset bubbles
Financial systemics (open derivatives held on margin accounts etc)
The bond market overhang
Sovereign and corporate default risk
Accounting holes (e.g. corporate pension liabilities)
Foreign central bank currency mountains
Social program bankruptcies (medicare / medicaid / state pensions)
100% consumption, 0% saving

Whether directly or indirectly most of these problems ultimately resolve to a single form. The savings of the developed world have been bound up in promises to repay, and it looks less and less likely that repayment is possible. The level of debt is the central problem threatening the wealth of today's investor, and keeping all that debt under control is becoming impossible.

The difficulty is that as economies move from a low debt to a high debt environment the self correcting nature of the economy changes. Overindebtedness seeks to correct itself either with rapid inflation which devalues savings indiscriminately, or with a deflationary squeeze, which kills specific businesses, and their creditors, through default. The current wild swings in interest rates demonstrate our monetary authorities trying with increasing desperation to prevent first one and then the other.

Economies rarely return to stability in an orderly way, and late moving investors usually get caught. Once even one or two percent of savers go in search of protection - to things like gold - prices change to the limit of what is acceptable to the rest, and they hold out stubbornly.

There is never enough room in the lifeboats of financial markets.

A three way bet

The world's oldest investors can just about remember the Great Depression. In America, from 1929's top to the bottom in 1932, the price of business assets fell by 90%. The purchasing power of gold, in terms of business assets, rose about seventeen-fold. The key during the deflation was to avoid default - i.e. your savings being lost to a failing financial institution unable to meet its obligations.

In the 1970s gold's price rose from $42 to $850. The price of business assets stayed approximately the same in money, with stock markets opening and closing the decade at broadly similar levels. Gold's business purchasing power rose about fifteen times. The 70s were a decade of worldwide inflation and stagflation, and this time the key was to avoid your money losing its purchasing power.

More inflations

The following illustration shows just a sample of hyperinflations from the last hundred years.

In each case once the currency tipped over the edge the journey to worthlessness was rapid and painful. Gold stored offshore protected its owners from the consequences of these inflations. But in every case the local deposits and bond portfolios of the sensible saver were destroyed.

What caused these inflations?

Underlying these hyperinflations there has been more than one root cause, and both lost wars and financial corruption have contributed. But the single most common factor was a failure to contain debt. When countries lose control of their public finances they can generally look forward to watching the value of their currency evaporate.

BullionVault's view is that the demands of modern democracy have caused the public finances of the USA to fall into the early stage of the same sort of death spiral while - tragically - its government and many of its people are distracted.
At the same time in terms of fiscal irresponsibility Japan and the UK are not far behind, and Europe as a whole is far from healthy.

Our view is that the correction from this very high debt situation will directly cost a large percentage of savings.
It will also deprive the world of the previously insatiable American consumer (we British are almost as bad, but there's not so many of us), and for a long time overcapacity in the world and a shortage of customers willing and able to pay will make productive business a painful and unrewarding pursuit.

Is this delusional? It is a bit embarrassing to be so publicly pessimistic, but we know for certain that we share these thoughts with more and more shrewd people, on whose behalf BullionVault now stores more than 1.8 tonnes of gold - mostly in Switzerland.

Debt, debt, and more debt

Argentina collapsed in 2001 when its sovereign debt hit $12,000 per family. The world's lenders had realised it would never be able to raise the taxes to pay back this debt, so they refused to fund it with ever more of their money.

This year the United States official public debt hit $83,000 per household.
This public debt was only $20,000 in 1985, but even that was widely considered an irresponsible level and described mockingly as "Reaganomics". It has since then quietly quadrupled, which is the hidden cost of promising "no new taxes" while continuing to spend; both of which appear to be necessary to win modern elections in the USA. Currently each household's debt is growing by $5,000 a year.

These figures are straight off the official public debt site at :

The conventional view is to believe the US household capable of paying back this money through economic expansion, because apparently this will generate more tax. But this view makes little sense. Encouraging economic expansion is all very well when people are spending money they have previously saved, but in the USA saving has declined steadily from an already low figure in 2002, and turned negative in 2005. New spending will therefore need more credit, and if it is to be state sponsored the US Treasury will be adding to the $450 per month of increasing indebtedness every US family currently contributes to the US Government's public debt. Only bankrupts and gamblers think borrowing more is the solution to high indebtedness.

Since the options are so painful it is quite likely nothing significant will be done, and the public debt will continue growing in the meantime at about $5,000 per year per family. It will probably not be paid off until normal everyday banknotes have got one or two more zeros on them.

Would anyone in the US Federal Reserve sanction such inflationary money printing?
[they are doing it right now] It is unlikely, but it can be taken out of their hands. The market itself could take charge; it usually does.

One day we will hit the tipping point. Some small event will probably end up being identified as the direct cause and will knock the markets surprisingly hard. Whether it's a hedge fund implosion, a bank failure, a political crisis, or perhaps even a natural disaster, it will trigger the re-evaluation which will correct 20 years of overconfidence in the ability of borrowers to repay. It will be impossible to identify it as the beginning of the long slide back to reality until 10 years later, by which time it will be too late to be useful.

The bond glut

The US dollar has for a long time been the reserve currency of choice. The result is that for each US household there is now a total of about 440,000 in dollar denominated bonds spread out across the world (this includes commercial bonds denominated in US dollars). The size of this debt mountain has grown about 40 times in 25 years.

A big chunk of this debt falls due for re-financing every year, which places many billions of dollars in the hands of global investors, who are not especially loyal to the US dollar and must decide whether to re-invest in dollar bonds, or buy something else.

This $44trn aggregation is easily the largest stockpile of debt ever, and keeping it off the market requires near zero inflation. Once this frozen stockpile starts to melt it will be self-sustaining, and a trickle could turn quickly into a flood.

This is the conundrum at the heart of the world's monetary system. People will steadily realise that without inflation the US cannot pay its public debts and must default. Yet with inflation the overhang of bond money will flood the world with worthless dollars.
Which is the way out? Default and deflation, or glut and inflation?


"We are about to enter an era of $400 billion to $500 billion annual deficits, and reach the point where it is almost impossible to borrow the money we need. The money we have worked so hard to save all our lives will be worthless."

Warren B. Rudman (U.S. Senator)


Hyperinflation is about unattractive money

No printing press required

Typically price rises in a hyperinflation massively outstrip the rate at which money has been recently issued, so it's not just about the rate of printing.
There must be more to it.

Attractive money

The dollar became the world's reserve currency by having the longest reliable history of increasing purchasing power. That quality is intricately tied up with US economic expansion, because people who chose to save a dollar instead of spend it had a good chance of their money finding its way to a productive project, and later returning them more purchasing power than they originally saved.

But being a favoured international reserve currency is a double-edged sword. While the world chooses to accumulate your money everything is doubly easy. You put dollars into circulation and foreigners willingly accumulate them, allowing your citizens to enjoy the exports of the world at rock-bottom prices. What a life!

Unfortunately when you lose that special status everything changes. The flip side of being the world's reserve is that everyone is soon sitting on a great pile of your money, and you become exposed to the possibility that they dump it back into circulation. [Exactly. As the US loses its reserve status, a flood of dollars is going to come into circulation]

The Dollar charge

High school science provides a useful analogy. A dollar is a bit like a positively charged atom existing in a world of negatively charged people. Like static electricity the dollars are attractive to the people.

At different times, depending upon the actions of central bankers, the attractiveness of dollars varies. If dollars store and gain monetary value over time, then like a strong positive charge they stick like glue in the pockets of their negatively charged owners.

This sticky money does not get spent as quickly as central bankers would like. Instead it is cautiously hoarded and economic activity stalls, eventually causing a cycle of falling prices - deflation - because it profits people to put off their spending. But money created by central banks can be injected into the economy to create a nervousness in savers; a hint that it should be spent or risk losing value. It makes the existing supply stick less in peoples' pockets and keeps it circulating in economic activity.

Governments have discovered this economic trick. It is quite easy to do and appears to be so safe for such a long time that they have grown to rely on it as a trusted, indeed almost the only mechanism necessary for economic management. But it leads to aggressive inflation, and the reason for introducing the electric charge analogy is it can show us how.

Chargeless money

As the tendency of money to increase in value diminishes towards zero its velocity around the economy increases because people and businesses become ambivalent about keeping it to store value. Like atoms with no charge these dollars are not attractive, so they don' t settle.

At this stage economic activity - which is measured by the rate at which these dollars are flying around - looks magnificent in all the statistics, but little of it is productive. What is actually happening is that people are ditching their dollars to find a better store of value, so what looks like 'growth' of the dollar economy is - more accurately - an exit.

You can see this happening wherever economic figures reporting in excess of your direct experience, and wherever alternative stores of value start to rise in price.

Repulsive money

The expected central bank reaction to this kind of thing would be to raise interest rates, to bind the issued supply back into savers' pockets.

But this is where the catch is. The raising of rates can only be done when there is low risk of it causing debt servicing problems for large numbers of borrowers, because otherwise different risks arise. After a long borrowing binge consumer debt is high, corporate debt is high and public debt is high, and the increase of rates now risks causing previous borrowers to find their debt burdens unaffordable. This is a big problem, because it has been the demand of all these borrowing consumers which has been keeping the dollar saving habit profitable for decades.

So after polarization into savers and borrowers the monetary system is caught between two very unattractive options. The likely result is a runaway effect in which increasingly repulsive cash is dumped, while the central bank looks on, powerless to raise rates because it would induce previous borrowers to default.

It is made more severe when savers over the whole world have been stockpiling this currency as their reserve too. Hyperinflation needs no printing press if 35 years of surplus money supply has been frozen into savers' bond portfolios. [Again, exactly right. It is something I am planning on writing more about. Basically, if large number of investors start fleeing treasusies, the fed will have to step in and buy them, expanding the money supply. Treasuries should be seen for what they trully are: promises to print money]

In such circumstances alternate assets - like the precious metals, cash commodities, well run foreign currencies, or the very few sound equities - rise in price to uncomfortable levels.
These rises cause most savers to hold on to dollars in hope, fearful that having lost half their purchasing power already they'll lose another half by panicking out of weak currency into highly priced solid assets.

Towards the end of last year the US sovereign debt increased to $8 trillion - about $80,000 for every US family. The Iranians announced the termination of trading their oil for US Dollars. Russia decided to double its gold reserve. Gold coins minted in China disappeared off the shelves in hours. Gold's price continued to rise aggressively. In dollar terms gold has now much more than doubled from its 2000 lows of around $270. It is already an uncomfortable purchase - but that may be why it is such an important one.

The value of rarity

Understand your upside before buying gold

The Deficit Triangle

The number of zeros on formal statistics sometimes disguises their real meaning.

The US government currently borrows $5,000 a year on behalf of each US family, which it dares not tax for electoral reasons. This is the source of the budget deficit. That uncollected money remains in the hands of the family, which currently prefers buying foreign goods and spends $5,000 on them, producing the trade deficit. The foreign supplier sends the $5,000 back to the US by buying government bonds and American businesses. This money from abroad is the source of the fine-sounding US capital inflow.

Give or take $1,000 this same $5,000 deficit triangle is completed for each of about 100 million US households every year, and that is why there is a $500 billion budget deficit, and similar trade deficit and US capital inflow. It is tempting to assume that this is the way it has always been and that somehow it must be stable, but that is wrong. This is a wholly new way of arranging things.

Source of US economic growth

The last four-year administration ended having increased the average US family's gross future tax debt by about $19,000. The family's total accumulated uncollected tax - i.e. its share of the country's public debt - grew by that $19,000 to about $74,000, three quarters of which has been built up since 1985. The demand which has sustained growth for twenty years has arisen from this money being spent twice, once by the family, and once by the state, and this duplicated spending is the only explanation that is needed to understand the remarkable strength of the USA's economy. But the legacy of it was this $74,000 tax debt for each of just over 100 million families, which just 18 months later has grown to $83,000.

The downside of debt

How serious is an $83,000 tax debt? We don't know because it has never happened before, but we do know that in Argentina in 2001 their sovereign public debt was about $12,000 per family, and at that level it triggered the capital flight which was the direct cause of their debt default and subsequent economic crunch. It is both extraordinary confidence in underlying USA economic robustness and an apparent lack of alternate options which appears to be preventing a similar US setback. But the confidence rests on the demand strength, which itself arises from the scale of the deficit triangle.

What happens next?

To resolve the US public debt problem safely is very difficult. [impossible now] Raising taxes to the required level is unthinkable - both electorally and because it would hurt domestic spending and feed back into a deflationary spiral of declining output and demand. Trade protectionism was tried before and it triggered tit-for-tat export restrictions and global depression. The only viable route out is devaluation of the debt, which is equivalent to inflation.

Assessing how severe the coming inflation might be is also difficult, but it is possible to get an idea by looking at the bond market. For twenty five years the bond market has been growing fast, to about 40 times what it was in the early eighties. Through most of that time interest rates and inflation were falling, so fixing a rate of return with a bond was an attractive option for a saver. As a result while borrowers were spending savers were diverting their cash out of the economy and freezing it in bond portfolios, until eventually US dollar bond markets have grown to contain 50 times all the dollars in current circulation.

This frozen money is up for redemption over the coming years so it will turn back into cash, and little of it can sensibly be re-invested in bonds with inflation threatening and rates turning up from long cycle lows. In any event much of it must be returned as consumable cash to the retiring boomer generation.

This suggests a possible cash glut in the medium term, and that indicates inflation too. Aggressive inflations do tend to follow an accumulation of official indebtedness. It would be unusual if the current US situation did not result in something similar.

Fear of this should have already caused a downwards dollar correction, but this has not happened because the alternate currencies have similar problems. The Yen is afflicted by an equally difficult sovereign debt problem, while the Euro looks politically unstable and can agree neither a constitution nor an ongoing budget. Commodities on the other hand have been rising in price - and gold particularly so.

Gold's rarity

Gold is famously useless in almost everything except that it cannot be made, and is reliably difficult to find. Even now if all the gold ever produced on Earth were formed into a single cube its edge would be less than 20 metres - 2 metres shorter than a tennis court. Annually mined production grows that cube by about 12 centimetres a year, and more than each year's production is used up by jewellers such that now 75% of that cube is fabricated in an art form worth several times its bullion value. Meanwhile after 15 years of consistent selling into private demand central bank ownership is now down to about 20% of the world's gold.

That 20 metre cube of gold would weigh about 140,000 tonnes and each tonne is worth about 20,000,000 dollars. So all the gold in the world is currently valued at $2.8 trillion, which compares to a US public debt of $8.3 trillion, and an unreserved US generational debt of $44 trillion. By contrast the US has the biggest gold reserve in the world which at 8,000 tonnes is worth only $0.16 trillion, enough, were it all sold, to stop the deficits growing for about 12 weeks.

Pricing rarity

Arising from this there are are powerful fundamental forces at work on the gold price which cautious savers understand intuitively - even if some cannot put their finger on what those forces are.

The value of anything reflects its utility at the margin, which means it only needs a slight shortage to create price surges and a slight surplus to create price slumps. The utility of gold is simply that it is rare, and for 5,000 years people have used reliably rare stuff to store value for the future. They call it money. [nicely said]

Almost all human societies have been able to arrange and enforce a respectable rarity of artificial forms of money, and so long as savers have been able to trust in this artificially created rarity the marginal utility of gold's natural rarity stays low. Paradoxically 'rarity' is in adequate supply wherever artificial money is being reasonably well managed, and this makes gold's natural rarity less valued in those times.

But what savers are now realising is that official money is not being well managed and cannot in future be relied upon for rarity, and they believe there will soon be great quantities of artificial money in circulation.
Even if the underlying demand for rare stuff were to stay the same then the value of the few naturally scarce things would go up. Much more likely is that the underlying demand for natural rarity will increase, and it's utility at the margin, where a diminishing supply of rarity meets an increasing demand, will continue to force up the price.

This is what is happening to gold now. Arising from the scale of public debt and the enormous overhang of dollar bonds savers are valuing the unimpeachable rarity of gold higher. More and more people no longer believe that the artificial rarity of dollars are offering that same assurance of future scarcity, and until responsible fiscal and monetary management returns to government the outlook for gold is likely to remain resolutely positive.

My reaction: Great article. My comments are already in the article above.

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