Misanthropic Gold Bugs?
Business Insider recently posted an article in reference to the reaction it got when discussing Warren Buffett's well-known – and quite flawed – views on gold. The article purports to explain why 'gold bugs are such thin-skinned misanthropes lashing out at critics'.
To this a little background: firstly, Buffett penned another one of his anti-gold/pro stock jeremiads, which we will discuss in more detail further below. It has to be noted that these hit pieces are rather irritating, as he consistently refuses to even remotely address the arguments thoughtful critics have forwarded on occasion of his previous rants against gold. Instead he trots out the same arguments he has used before over and over again, as though that made his line of reasoning any better.
The next point one needs to consider here is that Joe Weisenthal, the author of the above mentioned 'explanation' starts out his screed by mentioning the alleged 'absurdity of gold' in the very first sentence. In short, right away reveals his own bias. As it turns out, Weisenthal has been pining for a deflationary collapse for several years. In this context he's apparently been prognosticating tops for gold all the way up (we only did a cursory search for his past writings on the topic, so we may be in error – but we could not find any countervailing evidence – his editorials all appear to be biased in this direction).
Now, we don't deny that in principle, the possibility of a deflationary collapse certainly exists and has to be considered if one discusses the modern-day monetary system. Whenever a giant credit bubble set into motion by a fractionally reserved banking system culminates, a deflationary contraction becomes a viable option.
Central Bank Policy and Gold – 'N' = 0.000578034
The thing is however that we live in a fiat money system administered by a central bank that can theoretically print money in unlimited amounts.
In practice, the US true broad money supply TMS 2 has risen from $5.3 trillion at the end of December 2007 to $8.356 trillion at the end of December of 2011 – an increase of nearly 75% in a mere four years. This does certainly not constitute 'deflation' by any stretch of the imagination. Rather, it represents proof positive that a determined central bank is quite capable of staving off a genuine deflation, even in the face of a huge private sector credit contraction.
Readers should note that this is a time period during which gold has done exceptionally well, which is no coincidence.
Moreover, we can conclude from this that the question of whether we shall have inflation or deflation (we are using these terms in their original meaning, i.e., to denote increases or contractions in the money supply, not in the sense of a rising or falling 'price index' such as CPI) is not merely an economic one. Absent a Fed as 'lender of last resort' and an FDIC which insures deposits, we undoubtedly would have experienced deflation after the mortgage credit bubble burst in 2007/8. However, we did in fact not have deflation, but the biggest bout of monetary inflation in such a short time period in modern times. No other post WW2 period even remotely compares to this and one really has to go back quite far in US history to find periods of fiat money inflation on such a scale (usually these periods have been associated with war). A recent article at the Gresham's Law blog shows a detailed breakdown of the Federal Reserve's assets from 1915 (close to the date of its founding) to today. We only reproduce the long term chart here, which kind of speaks for itself:
The Fed's assets from 1915 to 2012. Let's just say it would be highly unusual if the spike in Fed credit implied by the growth of its assets in the most recent period had not led to monetary inflation – click for higher resolution.
In short, in a fiat money system, the question whether the money supply will be allowed to shrink or will grow even further after the bursting of a credit bubble is largely a political one.
The creed of modern-day central bankers is that their job is to provide 'price stability'. This erroneous and dangerous policy is at the root of the giant credit bubble edifice that has begun to totter in 2008. No matter how many apologias are written by the vast coterie of etatiste courtier economists directly or indirectly in the employ of the central bank or otherwise feeding at the establishment trough, this basic fact can not be wished away.
For newer readers who wish to learn more about why the price stability policy is mistaken and dangerous, we would point to a previous article of ours that is discussing the topic in great detail ('The Errors and Dangers of the Price Stability Policy').
In brief, it is first of all not possible to 'measure' the phantom of the 'general price level'. All the attempts of doing that (be it CPI, PCE or whatever 'index' one employs) are flawed. The primary reason why such measurements can not be undertaken is that there simply are no constants in economics (this is by the way also the reason why all econometric methods are a complete waste of time and effort; they will always fail to furnish what their purveyors think they should produce: namely, reliable predictions).
Money itself is subject to supply and demand just as goods and services are. There is therefore no fixed point, no constant that could possibly be used as a yardstick for such measurements. It is not possible to tell by way of looking at a price index if there has or hasn't been massive inflation of the money supply. Moreover, a price index 'adds up' the prices of disparate goods. This is mathematical and logical nonsense. Just consider this statement: 'Two apples and three movie tickets equals five'. Five what?
However, apart from the impossibility to measure a 'general price level', the entire premise – namely that 'price stability' is a worthwhile policy goal – is in fact mistaken. As we have pointed out in the article linked above, in periods when economic productivity rises strongly, many prices will have a tendency to fall fairly fast. The computer industry stands as a pertinent example for this phenomenon. The only way to keep final goods prices 'stable' in such an environment is by furthering unbridled growth in the supply of money and credit. This is precisely what central banks have done over the past four decades – hence the serial bubbles and busts, culminating in the 'GFC' ('Great Financial Crisis').
The GFC has indeed raised the specter of a deflationary collapse of the system. Given the conviction of Ben Bernanke and his colleagues that Milton Friedman was correct when he asserted that the proper way to stave off the Great Depression would have been monetary pumping on a grand scale, this is precisely what we got from the Fed in reaction to the GFC.
All in all, explaining the strong rise in the price of gold since then is not exactly rocket science. Savvy investors – a small fringe to be sure, but big enough to make a difference to gold's price – have recognized that this recent monetary experiment is even more dangerous than what went on before. In reality, the Fed's monetary bureaucrats don't know what they are doing and what the long-range effects of their actions will be. They erroneously hold that they will be able to pull just the right lever to set things right again should their experiment threaten to careen out of control. The 'potent directors' themselves are falling for the 'potent directors fallacy'.
When Jim Grant was once asked 'how should one value gold?', he remarked that this was a difficult question. However, he proposed that the value of gold probably is '1/N', with 'N' standing for the faith people have in the monetary authority. The more this faith declines, the higher the price of gold will go. The exact quote was:
“To me the gold price takes the form of a very uncomplicated formula, and all you have to do is divide one by ‘n.’ And ‘n’, I’m glad you ask, ‘n’ is the world’s trust in the institution of paper money and in the capacity of people like Ben Bernanke to manage it. So the smaller ‘n’, the bigger the price. One divided by a receding number is the definition of a bull market.
You’ll notice that this had nothing to do with security analysis. This is conceptualizing, brainstorming, nothing to do with price/earnings ratios, other valuation methods like cash flows. It is a proposition or a hypothesis on what is driving the gold market. So the gold market is necessarily a speculative piece of business. It’s not to be confused with the kind of investment that Ben Graham wrote about. Anyway, I happen to be bullish on it, but not for reasons that I can readily defend before a member of the fraternity of chartered financial analysts.”
There are of course a number of fundamental drivers of the gold market one can examine (a detailed list can be found in this article). Grant's witty remark certainly describes one of the major ones. Warren Buffett fails to understand this. More on this further below.
Grant's 'N' has become increasingly smaller over the past decade. At the beginning of the gold bull market, 'N' was 0.003921568. Today it is 0.000578034 – a quite remarkable decline. Of course the number as such is completely arbitrary. It's Grant's way of delivering a dig to the econometric faith - click for higher resolution.
Buffett and Gold
Warren Buffett remains the world's most renowned value investor, in spite of the fact that the return of Berkshire Hathaway shares has been nothing to write home about over the past decade (it was a positive return, beating the stock market at large by a considerable margin, but nothing remarkable - especially compared to previous decades when the stock had the wind of the secular bull market at its back). The return provided by gold over the past decade was a great deal better, that much is certain.
The reason why Buffett does not understand gold is probably that there is nothing for him to 'measure'. Value investors look at a company's discounted earnings and dividend streams, the value of their assets, the solidity of their balance sheets, and in cases where this is applicable intangible factors such as the power of their brands. Armed with these concepts, they can calculate whether a stock's price does or doesn't represent value to them.
Note here that the value judgment as such remains entirely subjective. For instance, Warren Buffett recently decided that he would rather own a big bunch of shares in IBM than hold on to $10.7 billion in cash. The decision that shares of IBM were valued more highly on his personal scale of values than the $10.7 billion was entirely subjective, in spite of the research that was presumably undertaken before he went ahead to buy the stock.
As an aside, this is an example of 'style drift' – Buffett never before invested in technology companies, claiming that he 'doesn't understand them'. Now he suddenly does? In any case, he parted with $10.7 billion in exchange for a stake in IBM near an all time high in the stock's price.
A long term chart of IBM's stock price, with the price point indicated at which Warren Buffett discovered that it represented 'value' - click for higher resolution.
In this sense, there is no difference between people investing in stocks and people buying gold: regardless of the calculations value investors undertake before buying a stock, their decision to buy is just as subjective as that of an investor deciding to buy or exercise his reservation demand for gold.
Now let's look at Buffett's arguments against an investment in gold. In the main, Buffett is saying: gold is not productive, contrary to for instance farmland or corporations. It produces no income stream. All it represents is an asset for the 'fearful', who are 'rightly', as he concedes, 'fearful of the future value of paper money'. He also cites an old canard that is really irrelevant to the gold price:
“True, gold has some industrial and decorative utility, but the demand for these purposes is both limited and incapable of soaking up new production.”
Gold's decorative and industrial utility is what created the pre-existing demand for gold before the market selected it as money many thousands of years ago. Ever since gold was chosen as the most suitable money commodity by the market, the bulk of the demand for gold is in fact monetary demand. The industrial and jewelry demand is actually easily high enough to 'soak up' annual mine production, but as Buffett himself notes, all the gold ever mined still exists, about 170,000 tons of it. It should be obvious that the price of gold does not depend on 'industrial demand'.
Buffett then says in the same breath:
“Meanwhile, if you own one ounce of gold for an eternity, you will still own one ounce at its end.”
That is actually the point. There is a decisive difference between owning a pile of dollars – $1,730 at present – or an ounce of gold. At the 'end of eternity', the ounce of gold will still be there, unchanged and if there are still human beings around, likely highly valued as a medium of exchange and store of value. We doubt anyone will even remember the dollar at the end of eternity. Buffett fails to make the connection between gold and money.
It makes actually very little sense to compare the investment merits of gold to those of stocks and bonds in this manner. Rather, as Steve Saville has recently remarked, gold should be seen as part of one's cash holdings. It should be compared to alternative currencies in which one might want to hold one's cash – dollars, yen, euros, and so forth.
When viewed through this lens, it becomes immediately clear that gold is the superior form of money, and is treated by the market as such. No central banker can print a single ounce of gold.
There are also other considerations which Buffett ignores. Very few corporations are there for 'eternity'. It is not even sensible to compare e.g. the 'long term return of the DJIA' (as miserable as it looks compared to gold over every time frame ranging from 30, 20, 10, 5 , 3 and 1 years one might want to pick at the moment) to that of gold under the assumption that this is a fair yardstick. It is not, as stock indexes contain a so-called 'survivor bias'. All the companies that have disappeared over the years due to bankruptcy no longer are represented in any index or average. What would the Dow's return look like if Eastman Kodak and all the other former member stocks that went belly-up were still included in it?
Similarly, farmland is not always the best investment. One very big drawback is that it is immobile. You can't bribe the border guards with farmland if push comes to shove. You simply can not take it with you.
Of course, as we know, gold is not always a good investment. It makes little sense to invest in gold when it is clearly overvalued and the central bank obviously implements policies aimed at putting a stop to the inflation of the fiat currency it is priced in. These were the circumstances under which the gold price topped out in 1980. Even so, the best investment one could have picked at the time in lieu of gold were not stocks, but bonds – if we consider the time frame 1980 to today. In the time frame 1980 to 2000, stocks were the superior investment.
In fact, which type of investment option is to be preferred depends not at all on any of the arguments Buffett makes about earnings streams and productivity – it depends mostly on valuation and the business cycle. There are times when stocks perform best, times when bonds perform best and times when commodities and gold (and cash more broadly) are the best performing assets. Right now it is evidently the time of gold, as Buffett could easily ascertain by looking at the gold/Berkshire ratio.
As we noted previously, gold is no longer a bargain. However, neither can one argue that it is egregiously overvalued, especially when considering the amount of fiat money inflation that has occurred over the past several decades.
Since no end to this rapid pace of inflation is in sight, gold remains a preferred asset. Note here also that rapid monetary inflation is very bad for the economy, and by extension is bad for stocks. Since inflation falsifies economic calculation, rapid inflation makes it impossible for entrepreneurs to correctly appraise the future. As a result, they pull back from productive investment and begin to hoard cash, precisely what we have observed in recent years.
This is also a time when the stock market tends to consistently apply lower valuations to stocks – this is to say, p/e ratios suffer secular declines during major economic contractions that are extended by loose monetary policy (note here that contrary to the mainstream view, loose monetary policy is not a good way of combating depressions. It makes them worse and lengthens them unnecessarily).
Lastly we should perhaps point out that we think Buffett still has 'daddy issues'. His father Howard Buffett was a conservative/libertarian businessman and Congressman of the 'Old Right', who advocated a return to the gold standard throughout his life. It is probably not too far-fetched that his son's support of a liberal-socialistic worldview and hatred of gold is connected to an ongoing rebellion against his father, even if this is probably only on a subconscious level. We can of course not prove this, but we suspect it plays a role. We have always been baffled by the dichotomy of Buffett's success as an investor and businessman and his support of socialism and all that goes with it in terms of regulations and taxes.
We must not forget that gold is also a 'political metal'. It is the money of the free market, and as such the major antagonist of welfare/warfare statism – precisely the system Buffett wholeheartedly supports. It should be no surprise that he often sees fit to denigrate gold.
Lastly, Buffett asserts that 'gold is currently a huge favorite of investors'. He probably deduces this from its high price, but there exists scant evidence otherwise. We know for a fact that the amounts allocated by institutional investors such as mutual funds and pension funds to gold and gold related investments are microscopic (estimated to be somewhere between 0.2% and 0.8% of the total of their investment allocation). There are still far more doubters than fans of the gold bull market. The fans are very vocal, but they are still a tiny minority.
As to Weisenthal's assertion that 'gold bugs are misanthropic', it is probably true that many gold bugs have a pessimistic view of the world at present. This is however no inherent fault of theirs – rather it is the result of the policies or vaunted political leaders and monetary bureaucrats are pursuing. How can one be optimistic in the face of massive deficit spending and monetary pumping? It would not be a very sensible stance to take. In fact, it is precisely because of these policies and the pessimistic outlook they demand that it is a good idea to invest in gold.
As an aside to Weisenthal's screed, he also publishes the twitter comments of one Jared Woodard of 'Condor options'. We reproduce the image below:
Talk about prejudice – Jared Woodard thinks he has pegged who the 'gold bugs' are and who by contrast 'supports humanity'
We would note that anyone who thinks that the 'theme of productive versus non-productive assets crystallizes an important difference for Keynesian/monetarist versus Austrian/tinfoil econ.' probably has neither read Keynes nor a single word of what the Austrians wrote. We rather regard this as an expression of economic illiteracy. Just to make that clear: Keynesians and their offshoots (we think monetarists are basically Keynesians in drag, we certainly would rather regard them as left fringe than anything else) stand for interventionism, socialism and an overbearing State.
Austrians are the only defenders of the unhampered free market economy.
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