The crowd understands gold not…

January 8th, 2008

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Today, we saw this article, Flight to gold when investors lose faith in cash, from the Sydney Morning Herald (SMH):

“We think gold is … overvalued by about $US150, but that can go on for a long time,” John Reade, the precious metals chief at UBS, said. “A lot of our clients have been buying gold since the credit crunch because they think central banks will respond with aggressive monetary easing. If that becomes a mainstream view, gold will soon have four figures on it. The feeling is there is a lot of money around, and not much gold.”

This paragraph reveals a lot about the difference between mainstream views and our contrarian view. If you are a long time readers of this publication, you will notice that the words and terms that we use are different from them. For example, what the mainstream calls “monetary easing” (in the above-mentioned quote of SMH) is what we call the debasement of fiat money, which is the corollary of the Austrian School of economic thought’s definition for inflation (see Cause of inflation: Shanghai bubble case study).

For this article, we would like to question some of the mainstream thinking in that quote.

First, what is the basis of determining that gold is “overvalued by about $US150?” That magic number, “150” sounds precise, but is it accurate? Dear readers, do take care to avoid the confusion between accuracy and precision (see Confusion between precision & accuracy).

Next, this little word, “overvalued” reveals a lot about the underlying logical inconsistency in mainstream thinking. When they say that gold is ‘overvalued,’ what is the unit of measurement with which they use to measure the level of over-valuation? Clearly, in this case, the US dollar is the unit of measurement. As we said before in How is inflation sabotaging our ability to measure the value of things?,

If you want to measure the length of a box, you may use the ruler to do it. The reason why a ruler can do such a job is because its length is reasonably consistent for the foreseeable future. Now, imagine that ruler is as elastic as a rubber band. Do you think it is still a useful tool to measure the length of the box? An elastic ruler is useless because you can always make up the measurement of the box to whatever you please just by stretching the ruler such that the edge of the box is aligned to any intended measurement markings in the ruler.

Now, let come back to measuring the value of oil. Since oil is priced in US dollars and if the supply of US dollars can be expanded and contracted at will by the Federal Reserve, how useful do you think it is as a calibration for measuring the value of oil?

How reliable is the Australian dollar as a unit of measurement? You may want to take a look at the monetary aggregate graph in Australia?s monetary debasement & credit expansion. What about the US dollar? Well, the US had already stopped publishing the M3 monetary aggregates, citing excuses so flimsy that we cannot even remember. With the credit crunch threatening to descend into monetary deflation, the central bankers around the world had been working the money printing press overtime (e.g. cutting interest rates, discount rates, auctioning money at below market rate, accepting lower quality paper such as mortgage-backed securities as collaterals). How can we ever rely on fiat money and credit as units of measurements? If they are unreliable as units of measurements, then how reliable are economic calculations that uses them as a ruler?

As we quoted Ludwig von Mises on our earlier article, How is inflation sabotaging our ability to measure the value of things?,

The endeavors to expand the quantity of money in circulation either in order to increase the government?s capacity to spend or in order to bring about a temporary lowering of the rate of interest disintegrate all currency matters and derange economic calculation. The first aim of monetary policy must be to prevent governments from embarking upon inflation and from creating conditions which encourage credit expansion on the part of banks.

Dear readers, don’t you see a contradiction in today’s financial system? On one hand, we all believe in the importance of the free market to determine the prices of things, from copper and toys to soya beans and oil. But why is it that when it comes the price of money, the most important lubricant of the modern economy, we let central bankers engage in price fixing? We may question the ability of Soviet central planners to set the correct price of things in the economy. But why is it that we never question the ability of central bankers to know what the right price of money should be? Meddling with the price of money set the scene for the dreaded business cycle (see What causes economic booms and busts?).

Yes, in the short term, the ‘price’ of gold may fall. In fact, we had warned our readers last year in Warning: gold price can still fall significantly that this is a possibility. But make no mistake about it: it will not be for the reason that it is ‘overvalued.’

Next, as John Reade (the precious metals chief at UBS) said, a lot of their “clients have been buying gold since the credit crunch because they think central banks will respond with aggressive monetary easing.” Again, does the mainstream understand the fundamental reason for accumulating gold? As we said before in What should be your fundamental reason for accumulating gold?,

We accumulate gold not just simply because we believe its ?price? is going up (though we think it is most likely to be so as a side effect?in case you are confused by what we mean, read on).

The root issue is trust. As we said before in Have we escaped from the dangers of inflation?,

One final word: fiat money is only as stable as the government that enforce it, and only as safe as the stringency and integrity of the central banks who create it. Gold, on the other hand, yield to neither control nor will of any government.

We favour gold because we do not trust the government to preserve the integrity of fiat money in the long run. Are we extremists for thinking that way? Well, for those who thinks we are, we would suggest that that they take a serious study of economic history. As we said before in Ancient Chinese fiat paper money,

The ancient Chinese were the first to experiment with fiat paper money. Records showed that the first paper money was used in China in around A.D. 600s. After 1455, there have been no known references to paper money. Thus, after having 500 to 800 years of paper money experience with repeated episodes of inflation and currency reforms, the ancient Chinese finally gave up using fiat money.

Every other civilisations (e.g. the Americans with the Continentals, the French with their Assignats) that uses fiat paper money end up destroying the integrity of money. Today, the US dollar (and the rest of the currencies) became fully fiat when President Nixon finally severed the last link between the US dollar and gold in 1971. Thus, excluding today’s fiat money regime, the failure rate of fiat money is 100% as recorded in the annals of human history. Will we see the demise of today’s fiat money system in our lifetime? We do not know whether we will live to see it, but we are sure the day will surely come, for we are very sure human nature has never changed and will never change. When it happens, most people will be caught with their pants down, as shown by history.

As John Reade said in the quote above, “If that becomes a mainstream view, gold will soon have four figures on it.” We would like to add this: by the time that view becomes mainstream, it will be too late- the loss of confidence in fiat monetary system will already have happened by then, along with many upheavals and disruptions in the financial system. You will want to own some gold before such a day.

Meanwhile, it still looks to us that the mainstream still does not understand gold and its long history. For example, some are still calling gold a commodity (see Is gold a commodity?). For you, you may want to read our short introductory premiere on gold at Why should you invest in gold?. Meanwhile, we will be doing what we said before in Recipe for hyperinflation:

Therefore, watch what the US government is doing with the monetary ?rules? in its attempt to fight deflation [see Spectre of deflation].

Actions speak louder than words.