Gold: Total Collapse in the Worth of the Dollar?

(April 6, 2016 - by Will Ebiefung - Gold and Precious Metals, Economic History)

Summary

• Gold investors need to be more strategic and less emotional if they want to succeed.
• Recession invariably leads to deflation, but the monetary supply has been so inflated that anything is possible.
• There is a bullish argument for gold here: total collapse in the dollar.

When it comes to precious metals, there are 3 distinct types of investors. First is the institution. This includes anything from central banks holding gold in reserve to quant funds using algorithms to protect themselves from inflation. These guys see no emotional value in gold, to them it is just a speculative tool to make money with. When they make their profits they dump.

The hysterical gold bug is on the other side of the spectrum, he is one of the most archetypal investors. These types are notoriously emotional, clinging to rigid dogmas and predictions. Gold buggery is often the predication of survivalists and conspiracy theorists.

The gold bug is a perfect example of the "true beliver" detailed in Erick Hoffer’s book The Nature of Mass Movements. What the true believer lacks in creativity is replaced with dogma, a feeling of "certainty" and group momentum. Investors like this rarely make money on gold or any investment.

The final and best type of gold investor is the one who looks at gold as an asset like any other. He appreciates its historical significance, beauty and value but does not become emotional about it. Most importantly he is not attached to any particular outcome or ideology. His only goal is to make money/retire comfortably/make a living.

This type of investor knows when to buy and when to sell. He doesn’t absorb a talking heads opinions and he doesn’t get sucked into an echo chamber. This is the sort of gold investor you want to be.

Will the dollar collapse in our lifetime?

In my last article I asserted that recessions are by definition deflationary periods and that if the U.S economy went into recession no amount of monetary policy would be able to reverse this. The main foundation for this view is the example given by Japan. A situation where an exponentially increasing monetary base has not actually resulted in increased consumer prices over a decade.

Nevertheless, there is one aspect of the gold/dollar issue that cannot be ignored. Even if the next recession does not result in consumer price inflation, it certainly will induce the fed to increase monetary base. What happens to all this extra money in the economy, surely this is not sustainable?

This next graph is the M2 money supply, the part we actually interact with. The growth from 2007-2010 is much more modest here.

If you look closely at the last 8 years at the top graph you see that the little spikes upwards where the result of quantitative easing by the Fed. This was how much monetary base expansion it took to prevent prolonged deflation during the great recession.

(For those that are unaware, it was this quantitative easing that led to the bubble in gold we saw back in 2011 and 2012.)

The value of this monetary base is currently sitting at around 4 trillion. All this money is being printed with little effect on prices and a second recession seems to be around the corner. I do not think it is possible for the U.S economy to avoid real measured deflation if we enter recession in the years to come and deflation is not bullish for gold or any asset.

P.S "The reason why the monetary base expansion has not resulted in significant inflation in M2 is because the money has not been given out to the public. The vast majority of it is sitting in bank accounts collecting treasury coupons, LIBOR interest and being used to create garbage like 3x ETNS (I may be the first person to draw a connection between 3x ETNS and dovish monetary policy)"

But there is actually a bullish argument for gold here:

All the explanations in the world are one thing, but simply looking at the above chart it is clear to anyone in their right mind that this sort of base money expansion is unsustainable. This is a monetary base that clearly does not represent wealth. It doesn’t represent economic activity or anything of real value. It is just funny money floating around in the economy liable to create bubbles and mal-investments. The law of gravity has to come in somewhere.

Total collapse of the dollar?

This is where I actually agree with the gold bulls. If things continue at this rate the dollar is going to collapse someday. And when it does gold will spike to the stratosphere. The only question is when, how and why? Will it even be in our lifetimes?

The central bankers aren’t stupid, they may be cornered and desperate but they are not stupid. A total dollar collapse benefits no one and I see no reason why China, Europe and the other nations that depend on global trade would let such a thing happen. Overall a total collapse of the dollar seems like an unreasonably extreme reaction to our current situation. But is it possible? Yes, but it is an extremely speculative position to invest on.

Either way, the next recession will be a turning point in economic history, many questions will be answered.