From Sardis to Sub-Prime

Gold in a world of inflation

Originally published in the November 2007 issue

For the past 21/2 millennia, the Lydian king Croesus has been a byword for fabulous wealth, the prime beneficiary of vast riches accumulated partly by the trading skills of his subjects and partly as a result of the copious alluvial deposits of electrum – a naturally-occurring alloy of gold, silver, and copper – which were to be found in the country’s rivers (placed there when the even more legendary Midas washed away the curse of his golden touch, we are told). Indeed, it was here in Lydia that the first stamped and standardised coins began to circulate, at the turn of the 6th century BC; a development which allowed for a wider monetisation of trade and hence unleashed what some historians have called a ‘commercial revolution’ across the Ancient world.

The idea that financial innovation can provide a stimulus to real activity – warranted or otherwise – is one with which we should all be very familiar, but there is a slightly darker parallel at the core of Croesus’ extreme affluence: namely, that the official Lydian coins show a suspiciously low 50-60% gold content, in sharp contrast to the 80% and higher constituency to be found in the unadulterated local alloy.

The strong implication is that, not content with earning a modest degree of seignorage from the royal mint and too impatient to wait for genuine economic growth to add to his storied pile, Croesus greatly enhanced his status as the prototypical Ueber-High Net Worth individual by practising the world’s first recorded instance of surreptitious currency debasement and by profiting all the more from the ensuing inflation.

The analogy goes further, for Croesus, professing himself alarmed at the rise of Persian power on his borders, decided to spend some of his immense hoard in launching a pre-emptive strike on his neighbours’ upwardly-mobile ruler Cyrus (does this all sound horribly familiar?), having been bolstered in his aggression by a quintessentially Delphic prophecy that if he crossed over the border into hostile territory he would bring down a great empire.

Alas! Our Pre-o-Neocon plutocrat forgot to ask the Pythia just which empire she meant exactly and nearly paid the ultimate price for ‘sexing up’ the intelligence in this manner when, shortly thereafter, he found himself at Cyrus’ mercy, having been delivered into his conqueror’s hands during the sack of the Lydian capital, Sardis.

Even if we can’t link Croesus’ inflationary policies directly to his subsequent military humiliation, we can share Hemingway’s sour observation that for such ‘political and economic opportunists’ as he, the ‘first panacea for a mismanaged nation is inflation of the currency; the second is war’ and that while ‘both bring a temporary prosperity’, they also both lead to ‘permanent ruin’.

Gold – more of an asset than a currency?

Morality tales aside, however, does this have any relevance to the role of gold in one’s portfolio today? We think the answer is, yes. But, before expanding upon this assertion, the first thing we have to make clear is that – however ardently the Goldbugs may wish it were – gold is no longer, in any sense, a ‘money’: that is, it does not function as the present good par excellence, the medium of exchange, the one thing universally accepted, on demand and at par, for all the other goods and services one wishes to buy with it.

In short, you can’t easily settle your bar bill with a bar of bullion, nor – under current political circumstances – are you ever likely to be able to, no matter how much better off we all might be were the yellow metal to be reinstated in its rightful place at the heart of economic life.

Accordingly, the fact that gold is no longer money means we have to turn its historic function upside down and accept that it is no longer able to provide protection during those rare periods when money itself becomes painfully scarce – ie., during a deflation (properly defined).

In microcosm, we can see an example of this axiom at work whenever we suffer that lesser species of contraction which is a margin-driven liquidation of market positions – hence gold’s ~7% decline when the credit crunch first began to bite in August of this year. Conversely, ever since this uniquely liquid, highly fungible, easily storable, durable, scarce, real asset has been denied its monetary birthright by virtue of its intrinsic lack of compatibility with the workings of populist-democracy welfare states, it has had to be thought of as a kind of anti-money: one largely to be held during periods of inflation, when the impaired currency we actually use is in a dangerous overabundance.

Gold’s late run has therefore come about since the Bernanke Fed was first panicked into cutting the discount rate, since the ECB abandoned its stance of ‘strong vigilance’ to send the Eurocopters flying over its shaky banks, and since the Old Lady begrudgingly bailed out Northern Rock (and hence its counterparts) under explicit government duress.

Caught up in the flow of money

The arguments may still be raging about exactly who, or what, was responsible for the recent financial turmoil, or to what extent it will come to affect the wider economy, but one unavoidable conclusion can already be reached: namely, that the sustained inflation of money and credit has become such an integral part of our modern way of life that our rulers fervently believe that it must never be allowed to slow (much less reverse) for fear of toppling over the whole, precarious house of cards which we have so painstakingly built about ourselves.

During the past few months, the stark truth is that our central bankers have once more revealed – both in word and deed – that, as Charles Goodhart explicitly put it a few years back, ‘deflation is a policy choice’: the unspoken corollary to which is that ‘inflation is, and always will be, the preferred policy choice’.

The prudent investor cannot afford to ignore the implications of this doctrine. He must realise that the money which he holds in his hands – and in which he routinely calculates both his profit and loss and his overall wealth – is not to be trusted: that it is doomed to lose value – now at a slower, now at a faster, rate – but always diminishing in worth.

Not only must he contend with this broad, underlying current of depreciation, but he must also be aware that the quickening and slowing of its stream, as well as the twists and turns which make up its course, give rise to the business cycle itself and so make the longer-term preservation of capital an all the more difficult task to accomplish.

Forget all the fine words about containing ‘inflation expectations’ or ‘preserving price stability’, from their very first incarnations in 17th century Sweden and England, central banks have been purposeful mechanisms for shoring up profligate governments (whether these are buying guns or butter without properly funding the purchase) while serving as a backstop to the inherently flawed and highly unstable practice of fractional reserve banking.

Thus, at the first sign that a crisis is about to erupt in a financial system which could only have become so perilously over-extended because of an prolonged prior episode of central bank laxity, the first priority will invariably be to rescue the principal culprits by dousing the wildfires raging about them with exactly the same brand of flammable liquid which was used to fuel them in the first place.

A crisis in the making

In running true to form at this particular juncture, we can only underline that we feel the price risks being run by the central banks are extraordinary. Not the least of these is the danger that the US will provoke the fourth great reserve currency crisis in a century – the previous three being the abandonment of the gold standard during the Great War, the collapse of the gold exchange standard during the Great Depression, and the break-up of Bretton Woods at the start of the Great Inflation.

Since this is a chronicle of the successive adulteration of money and of the serial acceptance of a more bastardised replacement when the burdens of the previous one become too much for political expediency to bear, we can expect profound consequences to follow – social and political, as well as purely financial – if the ailing dollar does, indeed, end up being widely forsaken by its anxious sponsors.

A flight to real values might well be unleashed in such a pass, potentially boosting the price of our anti-money, gold, to unheard of heights along the way. At the same time, the full panoply of protectionism, export bans, income support, wage freezes, and the direct administration of prices – already surfacing in several countries around the world – could devastate entrepreneurial activity and usher in a nasty and protracted recession.

Should this transpire, the thing to bear in mind is that, in the two years from the first quarter of 1973, annualised, quarterly real GDP in the US plunged from 10.6% to -4.7%, yet the price of gold tripled, that of oil quadrupled, and wheat’s gain to the monthly peak was 160%.

Nor was this an isolated incident, for worse was to come, just five years later, during the two years from the second quarter of 1978, when US GDP underwent an even more remarkable swoop from +16.7% to -7.8%. That time, wheat rose 70%; the price of a barrel of crude was well on its way to tripling; and the number of rapidly shrinking dollars needed to buy an ounce of gold quintupled.

Look back to the basics

Along the way, the world painfully re-learned the truth that inflation and recession were not mutually exclusive. Perhaps the lesson is about to be repeated for a generation which has again forgotten the rudiments of proper, pre-Keynesian economics.

Back in 6th Century BC Lydia, Cyrus’ first impulse was to have his captured enemy, Croesus, burnt at the stake. However, soon after the faggots were lit, his royal victim could be heard plaintively uttering the name of Solon. Piqued by this, the Persian ordered the flames to be doused and inquired of his erstwhile foe what he had meant, only to be told that the famous Athenian law-giver had once warned Croesus that fortune was so fickle that it was impossible to say which man was truly fortunate until his life had finally ended and a full account of it rendered.

Recognising true wisdom when he heard it, Cyrus immediately ordered Croesus to be spared and, indeed, went so far in his reconciliation as to make him a senior member of his council – a far-sighted piece of clemency well beyond the ken of the present era’s serial regime changers. As for Solon, well he, too, would have been fully at home today.

A well-known establishment figure who was appointed to the archonship amid the severe credit crisis which was mowing down broad swathes of woefully over-mortgaged smallholders, he first absolved the sad, deluded ‘condo flippers’ of his day of all responsibility for the unpayable debts imposed upon them by oligarchic ‘predatory lenders’.

“Along the way, the world painfully re-learned the truth that inflation and recession were not mutually exclusive”

Next, he attempted to counteract the deflationary affects of this officially sanctioned mass default by means of a 37% devaluation of the drachma – moves which laid him open to charges that he had allowed certain of his acquaintances into the secret ahead of time, so enabling them to profit inordinately from the eventual rescue plan.

Making the same mistakes again

Plus ça change, for today we see Treasury Secretary Henry Paulson scrambling to prevent the contemporary mortgage crisis from worsening, while the Fed has cut rates in the face of a dollar declining at an annualised pace not that far removed from Solon’s one-off parity change.

With almost preternatural resonance, Chairman Bernanke has also been reviled for naively sounding out the opinions of the good and great immediately before he started cutting rates, while Paulson, for his part, has been accused of tipping off the members of his notorious Working Group early enough for them to take a lucrative advantage of the imminent policy easing. Neither charge, however unfounded it might be, has done much to restore confidence in either the credit system or the ailing dollar.

So, where for a gold price which has already surged through the largely illusory ‘barrier’ of $800oz and is now pushing on to new highs against the Euro/DEM as well? Well, in the short run, caution must be exercised as net speculative longs on COMEX have hit the unprecedented heights of 230,000 contracts (though, as a proportion of total open interest, the 45% this represents is barely above the median which has prevailed throughout the last six years’ bull market).

Looking beyond this, however, consider that, over the past two years alone, broad money in the US, the UK, the Eurozone, and the BRIC quartet has risen a combined $11.5 trillion – equivalent to around $70,000 for every ounce of newly mined gold wrested from anything down to 4 1/2 kilometres deep in the Earth’s crust in that same period.

Bear in mind also that the outstanding notional stock of derivatives has soared an incredible $14 quadrillion over this horizon, representing an extra $1.3 million haystack in which to search for the poisoned needle of mathematically-abstruse, systemic risk for every new ounce of metal brought laboriously up from the Stygian gloom and into the light of day.

Will gold vanquish the evil of inflation?

Such are the risks and so great is the disproportion entailed in this orgy of overtrading and speculation that even the highly respected Bill Gross was reduced to ending a recent, critical discussion of the situation with a plaintive appeal for yet more inflation (“…an increasingly recessionary looking US economy will likely require 1% real short rates and 31/2% Fed Funds…”) in order to stave off a potentially damaging aftermath.

You see, no matter how big the inflationary bubble, an offsetting deflation is merely a policy choice to be avoided in its wake. No cold turkey will be endured here – no emetic taken to purge the poison – only a stiff hair of the dog to spare the drunk the worst of his pain.

In light of this – and with gold still some 60-65% off its CPI-adjusted peaks in dollars, Deutschemarks, and in terms of US average wages – we can confidently argue that while the metal may have undergone an impressive degree of reassessment already in this young century, it has hardly exhausted all its strength in this latest round of its multi-millennium struggle against the endemic evil of inflation.