Friday, May 15, 2009

What if gold bugs' fantasies came true?

There have been a number recent of very bullish analysis on gold, with a target price in the $5,000 to $10,000/oz. range (for examples, see this, this and this).

I would like to explore the question of what happens if every gold bug’s fantasy came true. The endgame would not be a happy one and the roads ahead are arduous, even if you owned lots of the yellow metal.

Happily ever after?
Modern children’s fairy tales end with “and they lived happily ever after.” Unfortunately, real life isn’t like that.

Even if the price of gold were to go to the aforementioned stratospheric levels, there are several questions that a commodity bull has to answer before he can truly live happily ever after:
  • Does it even matter?
  • Will you get to keep it?
  • What happens afterwards?

Does it matter?
If you were long gold and gold went from $900/oz. to $9,000/oz. or more, does that make you rich?

The traditional reason to hold gold is that it is an insurance policy against inflation and the erosion of purchasing power from the debasement of paper currency. Gold is the constant in defining value. If everything else goes down, does that make you rich? What have you gained?

Gold is just inflation insurance. If your house burned down, would you hold a party and dance on the front lawn because you have fire insurance?

Do you get to keep it?
A skyrocketing gold price implies hyperinflation. Hyperinflation is often accompanied by political turmoil. Would political circumstances allow you to keep that wealth?

During these times of economic dislocation, society would be split between haves and have-nots. There would be searches for scapegoats under a populist government. When lynch mobs form, anything can happen.

Could you become a scapegoat?

As an example, not everyone suffered during the hyperinflationary days of the Weimar Republic. The holders of capital made out like bandits, while savers and suppliers of labor suffered. Those very painful market adjustments contributed to the rise of Nazism and Hitler. They had to find scapegoats. It just so happened that Jews formed much of the business class. In more recent memory, Malaysian prime minister Mahathir railed against evil foreign currency speculators during the Asian crisis.

If you think that populism and authoritarianism are unlikely to happen here, then consider this. In the wake of the controversy of prosecuting former Bush Administration officials over torture, the Fabius Maximus blog reports that many Americans are supportive of these officials and support some form of torture. What was more surprising is that in the wake of the My Lai massacre in 1972, the author notes that: “[i]n the twenty-four hours after the military court declared Calley’s guilt, the White House received more than 5,000 telegrams and 1,500 phone calls. The messages ran 100:1 in Calley’s favor.”

Put it another way. If you were the owner of a food and grocery store in New Orleans in the aftermath of Hurricane Katrina, did it make you rich? Would your inventory be worth a lot more in light of the shortages? The answer is “yes”. But if the mobs were at the door and windows, would you be able to realize your windfall profit?

Unless you are willing to hole up in the metaphorical compound in the wilds of Idaho, stocked with food, fuel, water and surrounded by razor wire and claymore mines, you may not be able to stick around long enough to enjoy your wealth under these circumstances.

Is this the lifestyle change you really want if gold goes from $900 to $9,000?

What happens afterwards?
Even if we were to assume that society doesn’t totally disintegrate, such a massive revaluation in the gold price would cause incredible economic dislocation. There would be a gargantuan number of bankruptcies and business failures, which will result in widespread unemployment.

Consider the case of GM and Chrysler. The reason why the U.S. government tried to step in was because of the substantial employment effects if these companies were to be shuttered. It’s not just about the direct employment of GM and Chrysler. If these car companies went down, such an event would also affect all the car parts manufacturers and their employees. Car plants and parts plants are located in specific parts of the country. That’s not all. Car dealers, which are located in every city and town in the country, would also be forced to close and lay off staff.

Multiply those car manufacturer employment effects by five to ten and you start to get the idea of the implications of a skyrocketing gold price.

It would cause a gigantic deflationary collapse.

As an investor, you would have to be nimble enough to sell out your gold holdings at the top and move into cash or other deflation hedge vehicles. Are you that good a market timer? Even Jesse Livermore, who was prescient enough to be short and profit from the market crash in 1929, lost his fortune by going long too soon afterwards.

An arduous road ahead
For gold bugs, a tenfold increase or more in the price of gold is the end of the road. It isn’t. The road beyond is incredibly treacherous.

Out of control inflation is likely to be followed by an episode of deflationary collapse. Be prepared.

This is an excerpt from my free commodity newsletter. I have posted it here at the urging of some readers. If you are interested in getting on the email list, please sign up here.

1 comment:

Unknown said...

Thanks for that post, I am going to go shoot myself now