Posts Tagged ‘fiat currencies’

Is gold going parabolic?

Tuesday, December 8th, 2009

No doubt, as gold prices run up in the latter half of 2009, a lot of commentators are saying that gold is in a bubble territory. Their justification for such a claim is that when an industrially useless metal to go up in price so quickly, irrationality is the only explanation. Hence, according to them, it can only be described as a “bubble.” Even the Sydney Morning Herald, came up with an article titled, Gold a ‘useless asset to own’.

But as contrarian investors, we welcome such ignorance. That is how wealth is transferred from the weak hands to the strong hands. If you have not already, we recommend that you read If gold has no intrinsic value, is it a bubble?. Those who believe that gold is in a bubble do not understand the fundamental of what money is- they fail to see the mirror image irrationality. With that, we shall take a quote from Marco Polo in our book, How to buy and invest in physical gold and silver bullion,

With regard to the money of Kambalu the great be called a perfect alchymist for he makes it himself. He orders people to collect the bark of a whose leaves are eaten by the worms that spin silk thin rind between the bark and the interior wood is taken and from it cards are formed like those of paper all black He then causes them to be cut into pieces and each is declared worth respectively half a livre a whole one a silver grosso of Venice and so on to the value of ten bezants All these cards are stamped with his seal and so many are fabricated that they would buy all the treasuries in the world He makes all his payments in them and circulates them through the kingdoms and provinces over which he holds dominion and none dares to refuse them under pain of death All the nations under his sway receive and pay this money for their merchandise gold silver precious stones and whatever they transport buy or sell The merchants often bring to him goods worth 400,000 bezants and he pays them all in these cards which they willingly accept because they can make purchases with them throughout the whole empire He frequently commands those who have gold silver cloths of silk and gold or other precious commodities to bring them to him Then he calls twelve men skilful in these matters and commands them to look at the articles and fix their price Whatever they name is paid in these cards which the merchant cordially receives In this manner the great sire possesses all the gold silver pearls and precious stones in his dominions When any of the cards are torn or spoiled the owner carries them to the place whence they were issued and receives fresh ones with a deduction of 3 per cent If a man wishes gold or silver to make plate girdles or other ornaments he goes to the office carrying a sufficient number of cards and gives them in payment for the quantity which he requires. This is the reason why the khan has more treasure than other lord in the world nay all the princes in the together have not an equal amount.

Chapter XXVI, Paper Money Immense Wealth of the Great Khan, The Travels of Marco Polo

To understand gold, one needs to understand the history of money (which our book, How to buy and invest in physical gold and silver bullion has more information on). If we can laugh at the irrationality of the ancients as described in Marco Polo’s memoirs, then we certainly have to laugh at humanity’s irrationality today with regards to money.

But at the same time, we are not saying that gold is the cure-all for the the ills of today’s monetary system. In other words, we are not worshipping gold (see When to sell your gold?).

But if you are still worried that gold prices are running up too fast, you ain’t seen nothing yet. This speed in price increase is nothing compared to what happened in 1980. Let’s take a look at the gold price chart back then:

Gold price from 1975

Gold price from 1975

By 1979, inflation in most countries was running in double digits in most countries. Oil prices was spiking and the Iranian revolution toppled the Shahs. The Soviets was entering Afghanistan. Back then, there was a real fear that the world will end and that seemed like the end of fiat currencies (8 years after President Nixon cut the final link between gold and the US dollar). The price of gold doubled in a few weeks between December 1979 and January 1980. That’s really a parabolic movement. Today’s run up in gold prices is nothing compared what happened in 1979/1980. We have friends who bought gold in 1980 at around US$800. Back then, there was talk that gold price would be hitting US$1000. Unfortunately, gold price fell and our friends lost half their capital in a flash.

But fortunately, fiat currencies survived and the world did not end. But those who ridiculed gold used that as a basis to believe fiat currencies will still survive i.e. fiat currencies will survive because they did survive after 1979. This is an example of a mental pitfall that we call “lazy induction” (see Mental pitfall: Lazy Induction). That’s because if you take an even bigger picture view, there were many countless examples whereby all the other fiat currencies in the entire history of human civilisation failed to survive. The Mongol currency during Marco Polo’s time was such an example.

As Nassimb Nicholas Taleb wrote in The Black Swan: The Impact of the Highly Improbable, the wrong way to learn from history and looked at happened and then extrapolate it into today. It is equally important to look at what could have happened and evaluate whether it is still applicable today. In his words, we have to study the “alternative paths” of history. For all we know, fiat currencies could have died after 1979. Maybe, someone powerful back then could have made a slightly different decision and that could have set a chain reaction that would culminate in the death of fiat currencies.

We never know whether the “alternative path” of history will happen today. But it pays to be prepared.

When to sell your gold?

Thursday, November 5th, 2009

Our long time readers know that we are very much in favour of gold. All our articles about gold are in the context of an entrance strategy into gold (e.g. our book How to buy and invest in physical gold and silver bullion).

But what about the exit strategy from gold? When is it time to sell gold?

Even though the season to disinvest in gold is still quite a long time away, investors have to be very clear in their minds when the right time for an exit is. Otherwise, they will end up like the fictional Mr Goldbug mentioned in our book.

To understand the answer to this question, we must first understand clearly the reasons for getting into gold in the first place. Our book has a very clear exposition on that. Also, when we use the word “gold,” we mean physical gold, not financial asset disguised as ‘gold’ (see Is long gold mainstream? if you do not know what we mean).

As we wrote in our book,

Remember, gold will only do well in times of economic disaster?in every other time, the investment performance of gold is mediocre.

Thus, we will repeat this point again: gold is not a hedge against common types of? price inflation. Instead, it is a hedge against the loss of confidence in fiat money (extreme price inflation is a symptom and warning of such) and the financial system (price deflation is one of the possible symptoms of such).

Each step of the path towards economic disaster will see the rising price of gold. Initially, the bull market in gold is still confined to ‘gold’ (i.e. financial assets disguised as gold). As long as the masses have yet to switch from investing in ‘gold’ to gold (i.e. physical gold bullion), it means that there’s still confidence in fiat currencies and the financial system. This is because ‘gold’ is still denominated in terms of fiat currencies, which means the yardstick to measure the value of ‘gold’ is still in fiat currencies. So, while a bull market in ‘gold’ is still in progress, the complete breakdown in fiat currencies has yet to occur.

Of course, should sound monetary policies emerge at that time, it is time to sell your gold. You can learn from what happened in the 1980s. As we wrote in Peering into the soul of Ben Bernanke,

Paul Volcker, the chairman of the Fed in the 1980s, is the anti-thesis of Ben Bernanke. He was credited with ending the US?s stagflation crisis in the 1970s by crushing the economy into the worst recession since the Great Depression. To do this, he had to raise interest rates to unbelievably high levels, to the point that in 1981, interest rates charged by banks exceeded 20 percent (Note to Australian readers: the Labor was often blamed for the super high interest rates of the 1980s. Now you know where such high interest rates come from- such high interest rates was a global phenomenon). Paul Volcker crushed severe inflation by crushing the growth of money supply.

So, should someone like Paul Volcker take the reins of the Federal Reserve and dishes out really tough medicine, you know it is time to sell your gold. Those gold bugs who fail to see this and hung on to their gold obstinately suffered serious losses.

As the economic and monetary system deteriorates further, it is only a matter of time when confidence in fiat currencies will be completely eroded. By that time, the bull market in ‘gold’ will become a bull market in gold (the real, physical ones), which will eventually become a mania at the peak of the hyperinflation. The extreme pain of hyperinflation will eventually trigger monetary reforms. Assuming that the successor of the completely broken fiat currency is based on a much sounder monetary system, then as we wrote in Is deflation inevitable?,

When that happens, confidence is finally restored to the newly introduced money, which will have the immediate effect of price deflation. Deflation will happen because people no longer fear that their money will lose value and no longer need to spend it immediately (i.e. demand for money increases), which decreases the velocity of money.

This will also be the time to sell your gold for whatever the successor money is (unless gold itself becomes money).

If the successor is another fiat currency system, then the cycle will repeat once again. Hopefully, the next breakdown will happen outside your lifetime.