Should You Own Gold? Demystifying and Decoding the Yellow Metal
A total optimist would have zero exposure to gold, a total pessimist would have a whole lot, and those unsure would have a small percentage as insurance and hope it declines. What's the right thing to do?
Probably more nonsense has been expended on discussions of gold than on any other investment vehicle. Including by me, until my eureka moment.
On one side are the true believers, who become almost fanatical in their devotion. Incas waxed lyrical about gold, calling it "the tears of the sun." Ancient Egyptians called it "the skin of the gods." It has been coveted and sought after from time immemorial at practically any cost, including moral considerations. Lovers symbolically pledge their devotion with it, poets and musicians rhapsodize about it, and most people measure excellence by reference to it.
Gold's detractors are equally passionate about it. John Maynard Keynes called it a "barbarous relic." Charlie Munger more succinctly called it "stupid." In his latest letter to Berkshire Hathaway (BRK-A) shareholders, Warren Buffett was equally dismissive, correctly pointing out that "gold doesn't produce anything." He repeated the familiar observation that "gold gets dug out of the ground in Africa, or someplace. Then we melt it down, dig another hole, bury it again and pay people to stand around guarding it... Anyone watching from Mars would be scratching their head."
Buffett's observations are correct, even if they are irrelevant. Yes, gold is unproductive. It pays no interest. You can't eat or drink it. It may be beautiful, but its industrial uses are limited. It can't be valued objectively.
So why, when, and how did I conclude that the Buffetts of the world, and even my hero Milton Friedman, are wrong with respect to gold?
Personal background: I am an economist, with a degree in Money and Banking from the London School of Economics. I know all about the gold and gold exchange standards. I analyzed the gold mining industry from Canada to Australia, and descended into mines a mile deep in South Africa. I became thoroughly familiar with gold's supply-and-demand components, and with mines' marginal cost and revenue curves. And like Keynes and Buffett I pontificated eruditely but cluelessly on the subject, totally missing the core issue.
That issue surfaced for me in the course of a conversation I had many years ago with the late Dr. Bernard Pacella, then President of the American Psychoanalytical Association. A quiet and modest man, in the course of our conversation I soon understood that I was in the presence of an extraordinarily perceptive mind that could see around corners. By the time he was through I felt that I understood gold for the first time in my life. His explanation (plus a Freudian theory I shall leave aside) was roughly as follows:
The single most powerful force in all of nature is survival. Above all, survival of one's body, and then of the species. By extension this involves protection of savings, the fruits of one's toil, and the expectation that there will be a reward for foregoing immediate consumption and gratification. Just as squirrels hide acorns which may sustain them and ensure their survival in the future, so humans will, if they can, save for consumption, physical survival and enhanced well-being in the future. By definition, the medium in which they hold their savings is crucially important: they will not rationally choose a vehicle which is vulnerable to erosion or worse, disappearance.
As soon as we grasp the significance and power of these basic primordial instincts, the significance of gold falls into place. Consider its characteristics:
- It is rare, and its quantity is limited. The entire amount extracted from the ground in all of history amounts to 165,000 metric tons. This is equivalent to a cube 20 meters long/deep/wide.
- It is difficult and expensive to find, mine, and bring to the surface. It is therefore subject to only small and slow incremental supply.
- It is indestructible, homogeneous, and easily reconstituted if diluted or broken up, and thereby instantly recognized and accepted anywhere on the planet; i.e. it is perfectly fungible.
- It is compact, and therefore permits transportation of a high value in a relatively small space.
- It is the only universally used asset that can be instantly converted to cash (even by the world's central banks) that is not someone else's liability.
- And of crucial importance it is anonymous.
Not one of these attributes is unique to gold. What makes gold unique is that it is the only "store of value" which combines all of them.
This still begs the question: When? First off, it is not a question of supply and demand. There is sufficient gold in that above-ground cube to satisfy normal commercial demand for some 65 years.
The short answer is: when forces are, or are expected to be, at work which would erode returns on savings. The single most significant inverse correlation with the gold price is the real rate of return on savings, i.e. on capital. In that sense the Keyneses and Buffetts are correct: if one can obtain a positive real rate of return on something productive in reward for saving, then buying and holding gold makes no sense.
What could potentially erode real rates of return on savings? The answers include not only inflation but concerns stemming from political and social uncertainty and instability, high taxes, poorer legal recourse protecting assets, and war.
The futurologist Herman Kahn once observed that all of humanity believes in gold, but that it takes more to trigger the urge to acquire it in what he characterized as the world's "North-west Tier," i.e. the Scandinavian countries, the British Isles, and North America. What these countries have in common is a relatively longer and stronger history of nurturing capital formation ---- rule of law, financial institutions, democracy, political stability ---- than the rest of the world.
At the core of the historical gold standard was this overriding premise: a nation in deficit because it was living beyond its means would have to lose gold --- i.e. accept the pain of economic contraction to cleanse excesses. It was an objective discipline, divorced from political or social considerations. It could not be denied or manipulated by utopian theoreticians, corrupt politicians, lazy bureaucrats, or soft electorates. Not that the upward economic trajectory was smooth --- far from it. A gold standard is far from perfect; given human nature it is merely the least bad of alternative options, because ultimately its objective discipline involves an honest and therefore moral response.
At present the confluence of forces which financial markets must contend with include:
- In the United States excessive debt at the personal, national, and international levels.
- Much of Europe is arguably in even worse shape, so there is no escaping problems here by fleeing into European currencies and assets.
- The diminished ability of the U.S. to control or influence international events.
The last time the U.S. found itself in a roughly similar situation was in the early 1980s. At that time two forces emerged that turned things around. The first was Ronald Reagan, a revolutionary who transformed the economy and won the Cold War, which allowed the release of enormous resources from the public to the private sector. The second was Paul Volcker, who broke the back of inflation with double-digit interest rates. It was a very painful period, but real rates of return reappeared, and a new era of prosperity was born.
Are either of these forces in sight? Everybody must draw their own conclusion. I have for myself. Everybody else must come up with their assessment of the outlook as well as their personality. A total optimist would have zero exposure to gold, a total pessimist a whole lot, and those unsure a small percentage as insurance and hope it declines. You decide.
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