Gold Trends: The Mirage of Wealth

Dec 26th, 2009 – Gold Trends
How did your Dad pay his college tuition with a part-time summer job? Why does it take two breadwinners to support a family these days? What with all the recent fuss about gold?

The answer to these seemingly unrelated questions have a common answer.
Cause and Effect

Governments have a curious tendency to run deficits; and when they do, they have two options.

1) Decrease disbursements
This usually takes the form of spending cuts. Public servants are laid off, social programs lose funding and government bureaucracies are consolidated. Politicians typically consider spending cuts a last resort and have a dubious record of fiscal discipline in this regard.

2) Increase receipts
This usually takes the form of tax hikes and loans from foreign creditors. Politicians frown upon this option as well, especially during an election year.
There is also third, sneakier option that you may not hear about on the campaign trail or in state-of-the-union address.

3) Monetize the difference
This simply means governments fire up the printing press and create enough cash to cover the budget deficit. No cuts, no taxes. Needless to say, politicians love this option and have abused it for decades.
So what is the effect of money creation?

Inflation
“By a continuing process of inflation, governments can confiscate secretly and unobserved an important part of the wealth of their citizens.” -John Maynard Keynes

There are three things guaranteed in nations with fiat currencies: death, taxes, and inflation. Inflation is, by definition, expansion of the money supply. As the newly printed money circulates in the economy, the value of the old money is diluted. In other words, as freshly created dollars – conjured up by elected officials to balance the budget- filters into the money supply, it steals value from pre-existing dollars. That means every dollar printed by the government appropriates purchasing power from every dollar in existence. From cash in your wallet to money in your bank account and dollars held by foreign creditors, all money in the system is indiscriminately deprived of value.

Think of inflation as a hidden tax or a trade-off. When governments create money to engage in aggressive foreign policy, enact socialized health care and slash taxes, citizens pay in the form of inflation. Most of us, however, are oblivious to the root cause of inflation and tend to ignore its devastating effects.

The by-product of all this excess money in circulation is higher prices. As money loses purchasing power it takes more cash to buy things. Food, rent, gas, tuition, movie tickets and anything else denominated in dollars becomes more expensive. Even wages and salaries increase, but not at the rate of consumer goods. As a result, a larger portion of our income is allocated towards basic expenses like groceries and mortgage payments and less money is available for discretionary spending. Inflation gives us the illusion of wealth. Our stocks, houses and wages may be appreciating from a nominal standpoint, but relatively speaking, we are become poorer.

This explains why even though we are being paid more, our standard of living is plummeting. Mom and Dad have to work full time to make ends meet. Summer earnings become insufficient to cover tuition and students are forced to take out massive student loans. The benefactors are the politicians who get their hands on the hot-off-the-press cash while it still has full value. By the time the new money gains velocity and consumer prices rise sharply they are long out of office collecting their pension checks.

This vicious cycle has perpetuated itself for decades and is reaching a tipping point in many countries. The United States in particular has raised the stakes with bailouts, stimulus packages and promises to insure virtually every American mortgage and bank account. Of course, tax hikes and spending cuts are not funding these bold initiatives; the monopoly-money maker at the Fed is.

Unless the fundamental laws of economics are magically repelled, inflationary pressures will ultimately engulf deflationary ones. Unfortunately, no nation is immune from the cause and effect nature of economics. Governments who venture away from the principals of sound money and create grotesque amounts of unbacked cash are locking their currency into a long-term downward trajectory.

Hyper inflation has many precedents in modern society and has crippled a myriad of robust economies.

Gold
Gold is a dynamic metal. Aside from being industrially useful, gold has a variety of attributes that naturally lend itself as a medium of exchange. Gold is easily divisible, fungible, has a superb value to weight ratio and never decays or rusts. It is rare, difficult to mine, nearly impossible to counterfeit, and has a magnificent track record of holding its value.

In fact, according to Jeff Clark at Casey Research, in 1935, when an ounce of gold was worth $35, you could buy:
• a top-quality tailored suit for $19.75 – or 0.56 ounces of gold
• a family car for $500 – or 14.3 ounces of gold
• a house for $7,150 – or 204.2 ounces of gold

Today, with an ounce of gold worth north of $1000 an ounce:
• that same top-quality, tailored suit costs $600 – or 0.56 ounces of gold
• the family car now costs $15,000 – or 14.2 ounces of gold
• the house averages $181,100* – or 204.6 ounces of gold*
• *average house price from 2008 / gold at 2008 price of $880/ounce

If your grandfather locked $7,000 USD – the approximate value of an early 20th century home- in a vault when he was young, the state-run printing press would relentlessly dilute the purchasing power of his saved money. 75 years later, you would be hard-pressed to find a decent used car for the same amount. Conversely, if he instead purchased 200 one-ounce gold coins with his $7000 in cash and locked it in the same vault, his hard earned wealth would be remarkably preserved. With proceeds from your grandfathers gold coins you could buy an average American house, just like he could have back in 1935.

Today, gold’s inverse relationship with the USD continues. As money creation continues to destroy the value of USD’s, gold casually mirrors the decline. In essence, the fuss about gold is really just a reaction to drastic government spending programs.

Implications, Considerations and Recommendations

The prospects of gold look increasingly bullish.

• Gold as a hedge against inflation is becoming more mainstream. It is only a matter of time before inflation rears its ugly head.
• Central banks are expected to be net buyers of gold in 2010 for the first time in decades.
• Gold production is in a state of perpetual decline. Old mines are closing at alarming rate while capital for new mines has dried up. New deposits are being reported less frequently and at lower grades.
• China is allowing and even encouraging its citizens to buy physical gold.
• Ben Bernake occasionally refers to his mystical exit strategy yet refuses to budge interest rates. All sign point to more stimulus, more bailouts and more government spending.

This all adds up to gold turning the corner in 2010 and cementing its bull-market status.

In the context of recent events, any day trader will tell you that unprecedented interventionism by world leaders has spelled unprecedented volatility in stocks and commodities. From a macro-economic standpoint, we expect this trend to continue for the foreseeable future. Technical analysis and experienced advice is vital to playing today’s gold market profitably. Opportunities are everywhere.

As gold continues to march higher at the expense of the USD, there are many ways to profit. Purchasing physical gold bullion, gold ETFs and gold funds are a great way to insure your wealth against over-zealous elected officials. For even better returns, consider leveraged plays like gold producers and explorers. Regardless of the platform, it is highly recommended that you have a portion of your portfolio exposed to gold in these uncertain times. And if you want to pleasantly surprise your future grand kids, please, don’t bury stacks on 20’s in a time capsule.

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Trevor Koverko
Contributing Analyst
www.GoldAndOilGuy.com