Of Gold, Greeks And Governance

By Stephen D. Simpson, CFA | September 12, 2011 AAA

Few assets both confound and fascinate investors or politicians like gold. Like stocks, there is a great deal of conventional wisdom and many rules of thumb regarding what makes gold tick, but many of these notions fail careful inspection. Gold is an inconsistent hedge of inflation and hardly an international proxy for "real money," but it does seem to be a global decree on the current state of government policies and the near-term economic outlook. The past 10 years have offered up a lot of evidence and anecdotes as to what really matters when it comes to government actions ultimately influencing the price of gold. (For more on gold, read 8 Reasons To Own Gold.)

TUTORIAL: Inflation

In the Beginning
Looking at a long term chart of gold, the price really started to get going around mid-2001. One of the first things that President Bush did in his administration was to pass a major tax cut; a cut that even in the day looked to reverse a lot of the fiscal solvency achieved during the prior Clinton administration. When the September 11 attacks occurred later that year, gold prices spiked again on a rather more familiar "global chaos" trade.

As time went on, there was more and more concern about deficits and government profligacy. Then-Vice President Cheney's comment that "deficits don't matter" arguably highlighted this concern, while the U.S. government began a program of heavy deficit spending to fund new counter-terror military efforts.

At the same time, China began to emerge on the stage as a larger influence in the global economy and the commodity markets. Incremental emerging market demand led to major gains in commodity prices and fears of inflation began to emerge.

Said differently, the threat of inflation came out of hibernation for the first time in many years; investors reacted to the sudden disappearance of budget surpluses and a credible path towards much less national debt, and the entire world was faced with the very real threat of a multi-year war on terror.

The Credit Crisis Exposes More Flaws
As commodity prices and housing prices marched steadily upward through the 2000s, gold went along for the ride. Then came the collapse of the housing market and the resulting credit crisis. Gold actually had a curious performance as the crisis developed. As prices collapsed and banks, hedge funds, insurance companies and other financial institutions teetered, gold jumped.

Curiously, gold briefly gave a lot of that back. Whether it was optimism that the Bush administration was moving aggressively to stem the damage of the subprime collapse, confidence in measures like interest rate cuts and explicit government support, or a belief that housing prices would soon stabilize, gold prices traded broadly lower until the collapse of Lehman brothers, the November elections and the passage of TARP in the fall of 2008.

The fall of 2008 is also when Europe began to dominate the story. Iceland began to nationalize its failing banks and the impact of the financial crisis began to show in countries like Greece and Ireland - countries that used their membership in the eurozone to gorge on low-rate debt when growth was flush. These fears continued to accelerate and reached a fever pitch in 2010, all the while, spot price of gold jumped from around $870 to almost $1,400 an ounce.

In a nutshell, what happened was the realization that many national governments had built spending and debt infrastructures predicated on unsustainable asset valuations and tax flows. As the revenue dried up in the recession, the question of how (or even if) governments could maintain their debt payments rose to the fore - potential defaults (and still more bank failures) dominated the discussion and gold was buoyed by a fear trade predicated on the collapse of the eurozone system, the possibility of multiple national defaults in Europe, and further knock-on bank failures. At the same time, global central banks may have exacerbated the gold trade by entering the market to repurchase gold sold many years before, in an attempt to show support for their currencies and restore confidence. (To learn more about the correlation between gold and currencies, check out How Gold Affects Currencies.)

The Debt Ceiling Puts a Head on the Story
While the European debt crisis is far from over, gold has picked up more momentum from the foibles and failings of the U.S. government. The wrangling in the summer of 2011 offers a good microcosm of some of the issues that seem to be driving more momentum in gold.

The U.S. government has raised its debt ceiling many times with no appreciable correlation in gold prices. Several things were different this time around. First, while there have been rancorous debates in the past about debt ceilings, the rhetoric was even more heated this last time and there was sober discussion of the U.S. defaulting on its debt for the first time in decades. With the prospect of technical default on the world's largest investment class (U.S. government bonds), the default immunity of gold became even more attractive.

At the same time, the debate over the debt ceiling highlighted the parlous state of the U.S. national balance sheet - huge deficits, an increasingly dangerous national debt, and truly intimidating future liabilities from programs like Medicare. With the presumption that the U.S. would ultimately have to deal with that debt through economically crippling tax increases and spending cuts or rampant inflation, the gold-as-inflation-hedge story got another boost.

Arguably worse still, the dialog in Washington fed into one of the key motives of many gold investors. Gold historically trades higher when investors are most concerned about the global economic outlook and government commitment to solvent and sustainable policy. As the wrangling within Congress seemed to suggest that workable compromise was out of reach and economic policy would take the form of either rampant deficit spending or draconian spending cuts, gold continued to run on the fear that the U.S. dollar would continue to lose value, inflation would get out of control and economic growth would be hamstrung for years (if not decades) to come - a situation very much like the past peak in gold in the early 1980s.

The Bottom Line
Gold does poorly when governments appear rational and responsible and the global growth outlook is positive (but not overheated). In the past 10 years, much of that scenario has crumbled. Governments in the U.S., Greece, Ireland and other countries gorged on cheap debt that was seldom put to productive or sustainable use. The rise of major emerging economies, and their robust demand for raw materials, resurrected widespread fear of demand-driven inflation and investors began to fear that widespread monetary stimulus, currency depreciation and stagnant growth would be the new world order.

Gold has a dodgy history as an inflation play, but it has a rather more glorious history as a proxy and hedge for fear and feckless government. While a return to sound fiscal policies and a period of balance sheet recovery would likely be bad news for the price of gold, investors who believe there will be yet more fear, uncertainty and government half-measures could yet see gold outperform on an ongoing "fear trade." (To learn more about the stability of gold, see The Gold Standard Revisited.)

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