The Debt Bubble and Gold Investment

In today’s newsletter, Simon Black writes,

Whether any potential deflationary effects are short-lived (like 2008) or long-term (Japan), I still want to own gold. Along with a debt-bubble bursting will come a severe loss of confidence in the fiat system… and gold is a great hedge in this scenario.

I am not sure I agree.  I am guessing that what he refers to as the bursting “debt-bubble” is the possibility that Greece will declare bankruptcy, causing a ripple effect throughout debt-ridden Europe.  This will not cause the same thing to occur in the United States; I am not sure about the various South American and African countries which economies might heavily depend on European and American industry (i.e. imported producers’ and consumers’ goods).

Whatever the case, this crisis leads to further monetary and price deflation, causing the price of gold to drop.  Black suggests not selling your investment in gold prior or (early) during the deflation, because gold will still be useful to hedge against the possibility of a currency that loses its value out of lack of confidence.  The problem with this suggestion is that the conclusion does not follow from the premise in Black’s theoretical rendition.

Confidence crises are caused by inflation, not deflation.  Further, a fall in confidence in the safety of government debt is not the same as a fall in confidence in the dollar.  Now, there may be some shot at a confidence crisis in money if the response to the debt crisis is heavy debt monetization.  But, I would think that a good investor would sell his investment in gold prior to any debt crisis and then would simply re-buy when gold is nearing its trough, because there will be a lag time between crisis and policy response (a response that is not guaranteed; and even if it does occur, the likelihood of hyperinflation [especially sustained hyperinflation] is still incredibly low).

I do not disagree with owning gold.  I am just saying that there is no reason to sustain the losses during sharp deflation if you can avoid it (even it cuts short any profits you might make if you sell your investment too early).

11 thoughts on “The Debt Bubble and Gold Investment

  1. Smiling Dave

    Good to to see you writing. A few comments:
    …”This will not cause the same thing to occur in the United States…”
    The thinking is that once lenders see that Greece and the PIIGS have lived beyond their means and cannot possibly repay their debt, they will take a good hard look at the USA, the nation with the world’s largest debt and equally unable to repay. They will decide to stop lending the USA any more money, asking for their money back when the short term loans [which are basically all of them] become due, unless the US pays a huge risk premium for new loans [which the US cannot afford to do].
    In either case, the US will have huge sums to pay, and no money to pay it with. Talk about a reason for a crisis in confidence!

    Now many say the US is different from the PIIGS, because it can print money. But that certainly means inflation, which means the price of gold going up.

    As for your claim that “a good investor would sell his investment in gold prior to any debt crisis and then would simply re-buy when gold is nearing its trough, because there will be a lag time between crisis and policy response, ” I see a few flaws.

    1. You assume there exists a class called “good investors” who understand the situation clearly and also know how to time the market. But good investors are those who do not attempt to time the market. They understand the fundamentals, note that some commodity is over or under priced, do their buying or shorting WITHOUT RELIANCE ON PRECISION TIMING, and wait patiently for the fruit to fall into their laps. Because nobody can time when things will happen. Can you?

    Similarly, nobody knows until after the fact when gold is “nearing its trough”. For every price, there is always a lower one. Can you state, with sound reasoning to back you up, not just guess work or intuition, what gold will fall to when it falls?

    There may be a time lag, but how long will that lag be? Impossible to say.

    2. …”Further, a fall in confidence in the safety of government debt is not the same as a fall in confidence in the dollar.”
    No, they are not the same. But a fall in confidence in safety of govt debt will lead to the govt not being able to borrow money, except at impossible interest rates. We talked about how the very likely govt response of printing money will lead to a rise in the price of gold. What about if the govt just sticks out its tongue and says it has no money, tough luck, we are defaulting?
    In that scenario, China and the other importing countries will stop importing unless they get paid in cash. No more loans. And there won’t be cash. In other words, no more imported goods, meaning huge price increases in the US due to lack of supply. This may well cause a crisis in confidence, because it will be interpreted as inflation.

    3. …”the likelihood of hyperinflation [especially sustained hyperinflation] is still incredibly low).”
    As an Austrian, I think you know that hyperinflation depends on one thing only. Vast increases in the money supply. Why do you say that is very unlikely, given the unprecedented rate of increase happening as we speak. Why do you think politicians will understand, much less accept, that they have to stop doing it? There are plenty of Keynesian cheerleaders telling them they are doing the right thing, only not enough. And the benefits to the politicians are too great to forego. So why do you rate the likelihood of hyperinflation as incredibly low?

    4. …”there is no reason to sustain the losses during sharp deflation”…
    With the Fed beating the drums 24/7 that they are commited to fighting deflation, the worst thing in the world, they declare, what makes you think there will ever be a sharp deflation?

    1. Jonathan Finegold Catalán Post author

      Since you didn’t number your first point, all my numbers should be (X-1); so, my #2 refers to your #1.

      1. There is a difference between a fall in confidence in the belief that the U.S. can repay its debt and a crisis of confidence in the dollar (which is what Simon Black is referring to). In any case, I never said that investors will lose confidence in the U.S.’ ability to repay debt — I said that the U.S. would not declare bankruptcy. But, neither would I count on a massive sudden demand for debt repayment (and Fed buy-out of some debt is not necessarily inflationary).

      2. The post is clear that I’m not saying that precision is possible. That’s why I said you should accept a short-term loss in profits by selling gold early, if you can. And, when you buy at the trough — like anything else — you take an educated guess. Nobody is asking for precision in expectations. But, neither do we have to assume that there’s no way to time well, or time better than any timing that would see you suffer most of your losses.

      The time of the lag is irrelevant and besides the point. My point is that if there is a lag there will be a dramatic fall in the price of gold; this translates to huge and important losses. I would prefer to avoid these if I could, even if it meant cutting my gains (or even cutting my losses).

      3. (A) I don’t think your scenario is very serious. (B) That still would not lead to a crisis in the confidence in the dollar, so it’s besides the point.

      4. You write,

      As an Austrian, I think you know that hyperinflation depends on one thing only. Vast increases in the money supply.

      This is absolutely silly. Most hyperinflation is actually probably caused by debt monetization than anything else; that is, most historical circumstances of hyperinflation are not just money printing, but money printing that is directly used to finance infinite government expenditures.

      I thought that the past three years have empirically invalidated any wild “Austrian” claims for hyperinflation. I guess not. There are more caveats that one has to consider before one can really predict hyperinflation, I’m sorry.

      I think that the chances of hyperinflation are incredibly low, because I don’t think that the Fed will monetize all government expenditure any time soon.

      5. The Fed responded to the financial crisis in 2008 with a monetary package. These don’t stop sudden falls in the value of stocks (which is what your gold investment is made up of).

      1. Smiling Dave

        Why will the govt print huge amounts of money but to pay its debt? They have no other reason to it. So that there might be a correlation there. However the cause is the huge amounts of printing, not the detail that the money is used to pay off debt.
        After all, there is no magic power the govt has that makes money passing through its hands to pay off debt create hyperinflation, and money not used for that purpose not creating hyperinflation.

        You may heard of Operation Bernhard [check wikipedia if you need to], where the germans planned to ruin the english economy by literally dropping millions and millions of british pounds from airplanes onto england. The english found out about it, and were terrified.
        But you seem to be saying that those foolish germans and the equally “silly” british were both in error. Since the money was not going to be used to pay off govt debt, there was nothing to worry about.

        I think I’m missing something, that the germans and the british also did not grasp. Can you kindly explain why only money used to pay off govt debt is hyperinflationary, and no other?

        1. Jonathan Finegold Catalán Post author

          Smiling Dave,

          The “detail” is not just money printing. The detail is putting that money into circulation, and an accelerating rate of money printing. What gives central banks cause to do this is direct monetization of government expenditure (look at the case of Venezuela, for example, and Argentine in the early 1990s).

          I don’t think hyperinflation is possibly by monetary expansion that targets the loanable funds market. When inflation manifests itself in the CPI (consumer expenditure) the Fed usually is keen enough to contract monetary expansion; and, for the most part, inflation through the loanable funds market manifests itself in the prices of capital goods (causing malinvestment — and there’s only a limited amount of capital goods that can be squandered).

          What I’m saying is that there are nuances and caveats to any theory of “hyperinflation.” Relying only on the rate of monetary expansion is a poor metric to use (and this has been proven historically). I think the lack of focus on all the nuances has come back to bite the Austrians in the rear, because a lot of them are making wild predictions without taking into consideration the details.

    2. Silvano

      Just two observations:

      When you talk about events that can have serious consequences (upward or downward) on your portfolio from a strategic point of view, timing is more than something it is almost everything. In my opinion owning physical gold has a particular downside that you must care (unless you are already very very rich or you can move it into a vault in Switzerland): it can be banned and outlawed. Physical gold is now a good store of value for common people because it is not widely used as a mean of exchange and because masses mostly ignore it. Until the Republic of Saint Rothbard is more unrealistic than the independence of Texas I advise you to include political responses, political processes and the resilience of hegemonic bonds in future scenarios.

      While inflation is always and everywhere a monetary phenomenon, hyperinflation is always – at least historically – a political one. Mostly you need government printing new money and bidding existing goods at a fast and furious speed. Monetary base and money supply are different things: in a debt deflation scenario you can have the first one rising and the second one falling down or being steady. That’s why there has been no hyperinflation. In my opinion the relevant questions are i) when this trend will finish? And II) do one or more monetary systems will break up in the meanwhile?

    1. Jonathan Finegold Catalán Post author

      No, but I’ve read his paper on debt deflation. I had to review it in order to write one of my articles on (“Krugman contra Hayek”).

  2. Mike

    I have a couple questions that I was wonder if you could answer form your point of view:

    How does a debt bubble bursting lead to deflation? How will this raise the value of the currency? Will the governments all of a sudden pull money out of the economy? I really don’t see that happening. How does a debt bubble burst when the debt is held by a government? What does that look like? I know of a couple examples of hyper-inflation, but does anyone have some examples of a hard deflation where prices go down because of government action? And if that actually happens, you would be getting paid more value anyway, so it’s really not a bad thing. If you are putting money in gold as a worst case scenario, then a deflation is the better of the two outcomes. If you invest into gold to make your living, then that’s a different story.

    1. Jonathan Finegold Catalán Post author

      Regarding “deflation:” What Simon and I mean is a reduction in the price of gold stocks (and all other stocks). The bursting of the debt crisis will cause a shock in the stock market, and will probably cause prices to plummet. I’m not saying that gold will not start to increase thereafter, but it’s better to avoid as much as the loss as you can and buy low — you’d make much more money that way.

      Also, there will be a reduction in the quantity of money. All that money that banks its existence on government debt will be liquidated, and with it might come an industrial shock as well — i.e. the liquidation of malinvestment. The liquidation of these bonds and loans is a monetary contraction.

      Whether there will be a hyperinflation depends on two things:

      1. Instead of declaring bankruptcy, there is direct debt monetization. Greece does not have its own currency, so it cannot do this.

      2. Because the government can’t borrow, further expenditure is paid through inflation. Greece does not have its own currency, so it cannot do this.

      Besides, what happens in Greece will only impact the U.S. dollar indirectly — it cannot dictate whether we will have inflation or not. What will dictate a drop in the price in the stock market is a loss in investor confidence. What will dictate inflation is an industrial shock (liquidation of malinvestment) and a loss in confidence in U.S. government bonds. I can guarantee you that the U.S. will not respond with direct monetization of government spending, although there will probably be moderate monetary stimulus.

    2. Jonathan Finegold Catalán Post author

      Also, I don’t buy the whole “buy gold as a worse case” thing. You are not really guaranteed any physical quantity of gold.


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