Canary
in the Coal Mine By
Peter Schiff - September 12, 2009
Like
a battering ram in a medieval siege, gold keeps hammering
away at the gate. For the third time in less than twelve months,
the yellow metal is once again crashing into the $1,000 per
ounce level. As of press time, it looks like gold will close
above that level today and will set a new record in the process.
Even if the breach is fleeting, who can doubt that it will
mount another assault soon? In the meantime, there is no shortage
of market analysts who are not buying gold while questioning
the motives of those who are. Although they offer a variety
of strained reasons, they nearly all agree that it has nothing
to do with inflation, which is nearly universally considered
dead and buried. As a self-confessed gold bug, I can assure
all that inflation is the only reason I buy gold. And recently,
I'm buying a lot.
When individuals choose to accumulate savings
in the form of gold rather than interest-bearing paper deposits
in government-insured accounts, there is only one reason for
doing so: they fear that the interest will not be enough to
compensate for their expected loss of purchasing power through
inflation. This fear reflects both current inflation and the
expectation for future inflation. While there are those who
buy gold to speculate on its appreciation, the underlying
factor that drives that appreciation in the first place will
always be inflation. If governments were not creating inflation,
there would be little investment advantage to owning gold.
Some believe that gold investors are primarily motivated
by fear. It is often assumed that gold is the one asset class
that holds its value when all other asset classes are falling
due to market uncertainty. But this explanation brings us
right back to inflation. When economies move into recession,
there is always political pressure for governments to intervene.
Their one tool is the printing press.
When governments act to prop up sagging markets, or bail
out investors or depositors of failed institutions, they create
inflation (print money) to pay for it. This, in effect, transfers
capital from prudent investors to speculators. At the same
time, it pulls the rug out from under the safest vehicles
of traditional investment – bonds and cash. It becomes hard
for investors to protect their principal, much less grow their
wealth. Some turn to gold, with its historically guaranteed
‘floor’ against losses, and others start making ever riskier
investments to try to ‘beat’ the inflation rate.
Gold’s appeal as an asset of choice during times of political
uncertainty, particularly during wartime, is again a function
of its being a hedge against inflation. Wars are always expensive.
They are also often unpopular, which makes paying for them
through tax increases politically dangerous. As a result,
they are almost always financed through the ‘secret tax’ of
inflation. For a nation that loses a war, or suffers revolution
or systemic civil conflict, there is always the chance that
its currency could become worthless. While this may not be
the kind of inflation that we read about in the business section,
it is the ultimate form of the monetary malady – whereby a
currency loses all of its purchasing power.
Whenever the price of gold rises sharply, I always take it
as an early warning sign that inflation expectations are rising.
If those expectations are not met, its price will fall. If
the market is correct, gold will maintain its gains. And if
the inflation continues to intensify, so too will gold’s rise.
Most analysts, however, simply look at the dubious CPI to
determine the presence of inflation and inflation expectations.
They perennially forget that prices are a lagging indicator
and only a symptom of inflation, and may in fact not be rising
at the moment when inflation kicks into high gear.
The anti-gold camp takes their greatest solace from the
bond market, where things have been eerily quiet. They maintain
that since bond yields have not risen much, inflation must
not be a problem, and so the gold bugs are simply paranoid.
The bond market, they tell us, is populated by ‘vigilantes’
who sound a bugle call at the first whiff of inflation. But
this argument ignores the fact that central bankers themselves
are the biggest bond buyers and are in effect ‘vigilantes-in-chief.’
Their outsized participation in the market has led to gross
distortions. When the Fed or another central bank buys treasuries,
real returns are not considered. Purchases are made for political
reasons rather than investment merit, which renders meaningless
the signals current bond prices are sending.
The gold-bashers also believe that reduced consumer demand
due to unemployment will keep inflation pressures at bay for
the foreseeable future. However, inflation will ultimately
act to reduce the supply of goods much faster than unemployment
reduces demand for goods, sending prices up despite lower
demand. The stagflation of the 1970s is an example of such
an outcome.
The bottom line is that gold is continuing its long-term
bull run, and those who dismiss the message behind its rise
do so at their own financial peril. When it comes to inflation,
gold is the canary in the economic coal mine. Just as unseen
toxins kill the canary before the miners succumb to the fumes,
a spike in gold is a harbinger of reckless monetary devaluation.
Our leading commentators think that since they can’t see or
smell the gas, all those canaries (gold prices, commodity
prices) must be dying of natural causes. Good luck to them
when the toxins flood the mine.