GOLD ...

A SOLUTION TO A NON-EXISTENT PROBLEM

Whats Driving Gold?

Written by: Dr. Scott Sumner

The Internet is full of apocalyptic stories about the US economy. If you believed everything you read you would think that
the US dollar is about to be dethroned, our debt situation
will get out of control, and hyperinflation will ensue. But as
Adam Smith once said, there is a great deal of ruin in a nation. What Smith meant is that economies can absorb quite
a bit of punishment and keep on ticking. Here Ill explain how
despite Americas very real and serious problems, investors
should be skeptical of get-rich-quick schemes suggesting
that gold is a good hedge for the turmoil ahead.

The Internet is full of apocalyptic stories

about the US economy. If you believed everything you read you would think that the US
dollar is about to be dethroned, ...

Lets start with the national debt, which by one measure is as

large as our GDP. If you look at the part of the debt actually
held by the public, however, its a bit over 70% of GDP, which
is not unusual for a developed country. The budget deficit,
which is the net increase in the debt over one year, has fallen
to about 3% of GDP, also similar to many other countries.
Even better for the Treasury, interest rates are relatively low
and likely to rise only modestly. This means the cost of financing the national debt is not too burdensome, and long
term rates will stay fairly low (about 2% to 4%) even as short
term rates rise.

Issue: May 2015

For instance, those who claim that hyperinflation is on the way

often suggest that the government will be forced to monetize the debt which means printing money to pay off government bonds. In the past, countries that have done this have
often suffered from extremely high inflation. Printing money
to pay for deficit spending largely explains the very high inflation suffered by places like Brazil and Argentina during
the 1980s and the more recent hyperinflation in Zimbabwe.
There are lots of good reasons to doubt whether this scenario will play out in the US. First of all, investors in 30-year
Treasury bonds obviously dont fear hyperinflation, or they
wouldnt be willing to lend money for such a long time period at 3% interest rates. Even better, those low interest rates
make a debt crisis much less likely as it means the national
debt can be financed at an interest cost of roughly 2% of GDP.
Second, there are other developed countries that have
dramatically worse public debt problems, measured as a
share of GDP. In Japan public debt is about 240% GDP, or
140% in net terms, double the US level. Yet the Japanese
continue to borrow money at very low interest rates, despite this large public debt. It would take many decades for
the US to reach the debt situation of Japan today, and not
only does Japan not have hyperinflation, theyre even falling short of their 2% inflation target. Chinas official public
debt is not too large, but the Chinese government is widely
seen as being responsible for a dramatic increase in debt
issued by state-owned banks and local governments. Total debt in China is higher than in the US as a share of GDP.

So we dont currently face a public debt crisis. On the other

hand, the retirement of baby boomers will soon lead to large
increases in spending on programs like Medicare and Social
Security. So there are some long-term issues that need to be
addressed, but in my view we will be able to adapt to the
changing demographics through a combination of a higher
retirement age, cost controls in healthcare, and slightly higher taxes.
Ive emphasized the public debt issue because many of
the other concerns are linked to this one key problem.

Photo Source Business Insider

As Adam Smith once said, there is a great deal of ruin in a nation.,

What Smith meant, is that economies can absorb quite a bit of
punishment and keep on ticking.

What about Greece? This is the example that people cite

who are concerned about excess debt. Greece actually has
three problems that are interrelated: excess debt, no ability to control their own currency, and a deep depression
that led to roughly 25% unemployment. This is nothing
like the situation faced by the US, where unemployment
is only 5.5% and trending downwards, and which has a
Federal Reserve that can print money if we are in a recession. Borrowers understand this distinction, which is why
countries with their own central bank have not suffered
from the sort of debt crises that hit the southern European
countries.
Some people claim that the US is only able to borrow so
much because the dollar is internationally recognized
as a reserve currency. The fact that Treasury bonds are a
preferred international reserve might allow Uncle Sam to
borrow at slightly lower interest rates, but its only a slight
advantage at best. For example, many other developed
countries, such as Japan, Germany, and France, have large
amounts of public debt outstanding and pay even lower
interest rates than the United States. The Australian dollar is not widely used as an international reserve, and yet
Australia has run trade deficits comparable to the US for
many, many decades.
And even if the US dollars reserve status does lower borrowing costs, there is no plausible alternative out there for
the foreseeable future. The euro is a mess and likely to be
plagued by periodic crises due to the decision to impose
a single currency on many vastly different countries. In
the first decade of the euros existence there was a modest
shift out of dollars, and the US dollar share of international
reserves fell from the low 70s to just over 60%. But in recent years the euro has slipped
back, and now comprises only
22% of international reserves,
while the dollars share has leveled off at over 60%. No other
currency is even close.
China is growing rapidly, but its
currency is still heavily regulated through capital controls. Because foreigners cannot freely
move Chinese yuan in and out

of China, it is not a very attractive option as an international reserve currency. While Chinas economic influence
will gradually increase over time, the US dollar will remain
the dominant reserve currency for many more decades.
In some respects the US is like Britain in the late 1800s; it
will still have the worlds most sophisticated financial markets even if Chinas total GDP is larger.

Some commentators had falsely hyped a

risk of high inflation due to quantitative easing and near-zero interest rates. In fact, there
was never much risk that QE would lead to
high inflation, ...
If none of these apocalyptic theories of dollar collapse are
true, then what does drive the international gold market?
Gold tends to do well during periods of extreme economic stress, such as very high inflation or depression, and also
during periods of very low real interest rates. (Real rates
are the actual market interest rate (nominal) minus the
rate of inflation.) This needs a bit of explanation, because
some people might recall that gold did very well during
the late 1970s when interest rates were high. Yes, but that
was due to high inflation; real rates were not high. Investors bought gold as a hedge against risk of high inflation.
When inflation is 13%/year, even a 15% nominal interest
rate means only a 2% real interest rate. Even though nominal interest rates fell in the 1980s, inflation fell even faster,
so real interest rates actually increased. Thats why gold
prices fell after 1980. With the Fed now targeting inflation
at 2%, its unlikely that well see a repeat of the highly inflationary late 1970s.
A better argument is that low real interest rates help the
gold market because they make other alternative investments such as bonds look less attractive. However, the US
is gradually moving out of the depressed period of the
early 2010s, and the Fed is expected to raise interest rates
sometime in the second half of this year. In my view, the
Fed rate increase might come a little bit later than some
people expect, but I do think interest rates will gradually
rise over the next few years, probably beginning in late
2015 or early 2016 at the latest. Higher interest rates take
away one of the factors that underpinned the bull market

but that factor is already priced in. From this point forward
rates are more likely to rise than fall.

Photo Source Thomson Reuters Datastream, World Gold Council

Over the long run, stocks have done far better than gold.
That doesnt mean gold is a bad investment; people care
more about just the average rate of return. Some people cite
gold as a hedge against risk. But gold is itself a very risky asset, with a price that is highly volatile over time. To make an
argument in favor of gold you need to show that gold does
well when other assets are doing poorly. Someone worried
about another Great Depression or double-digit inflation
might be tempted to invest in gold as a hedge.

in gold a few years ago. Indeed gold prices declined in

2013 on just a mention of the Feds intention to taper its In my view, however, the problems of the 21st century will
look different from those of the 20th century. Instead of depurchases of bonds, aka QE.
pression or hyperinflation, the risk is economic stagnation
Some commentators had falsely hyped a risk of high in- especially in countries with falling populations. And in that
flation due to quantitative easing and near-zero interest environment gold is not a particular good hedge. Stagnarates. In fact, there was never much risk that QE would tion will be less of a problem in the US due to factors like
lead to high inflation, because unlike previous hyperinfla- a growing population (immigration) and new technologies
tionary episodes, most of the new money went right into such as fracking which remove the previous fear that peak
interest-bearing bank reserve accounts at the Fed. The oil would inhibit economic growth. Again, gold does not
Fed was not dumping trillions of dollars of paper money do particularly well when there is low inflation and steady
directly into circulation. Economic recovery and higher in- growth.
terest rates in the US will also diminish any latent fears of
inflation. As interest rates rise the Fed will remove some This is not to say that gold prices wont go higher over time;
of the excess reserves from circulation and immobilize the the long-term trend has obviously been positive, and there
rest by paying a higher rate of interest on reserves. That is growing demand in Asia. But dont forget that much of
this merely reflects the effects of inflation. Gold prices are
policy did not even exist in the 1970s.
about 60 times higher than in 1900, but the cost of living
There might be some international factors pushing gold has increased roughly 30-fold. So the increase in purchasing
up in the short run, such as Grexit, which means Greece power of someone who invested in gold is about 2-fold, but
leaving the euro. Even if that occurs, and its not at all clear thats over 115 years! This is a much lower return than you
that it will, any effects are likely to be short-lived. Greece wouldve seen in alternative investments.
is less than 2% of the Eurozone economy. Back at home
there is a deadlock between the two political parties,
which some believe is actually good for growth as it stops
For more information contact
Congress and the President from greatly expanding the
size of government. The worlds key central banks (Fed,
RCW Financial at 800-347-3250
ECB, Bank of Japan, Peoples Bank of China), are focused
or visit www.rcw1.com
on maintaining steady growth with low inflation. As I indicated, the low interest rates, have been positive for gold
Disclaimer: This issue represents the authors opinion and should be used for

About the Author

Scott Sumner studied economics at the University of Wisconsin, and received a PhD from the University of Chicago.
He has done extensive research on the
role of the gold standard in the Great
Charles
Krauthammer
the
Depression
and ispredicted
currently on
a profesOctober
28
Fox
News
Special
Report
sor of economics at Bentley University,
with Bret Baier that ObamaCare is gonna
where he has taught since 1982. Sumncollapse on its own, saying the law will
er also writes a blog on monetary policy

continue to face problems beyond the

issues with its website.

informational purposes only. RCW expressly disclaims any forward looking

statements or particular outcomes. No communication by RCW to you should
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