Gold may now be in trouble but the collapse in its price is unlikely to last

Detlev Schlichter
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I recently took part in a debate on the Today programme about the direction of gold. I’m on record, on the morning preceding gold’s two worst trading days in 30 years, arguing that it’s still a good investment. Am I right? I believe so. The only questions that really matter are: has the direction of global monetary policy fundamentally changed, or is it about to change? And are quantitative easing and super-low interest rates about to come to an end?

The reason I own gold is not its chart pattern, but the diagnosis that the global fiat money economy has check-mated itself. After 40 years of relentless paper money expansion, dislocations in the system are so massive that nobody dares allow market forces to do their work – to price credit and risk according to available real savings, and the potential for real income generation, rather than according to the wishes of monetary central planners.

There are two potential outcomes: first, the central banks’ policy is maintained, leading to higher inflation and eventual paper money collapse; secondly, the policy is abandoned, and the liquidation of imbalances is allowed to unfold. Gold is mainly a hedge against scenario one. So far, I see little indication that central bankers will change course. But what is the evidence?

Events in Cyprus were not supportive of gold – not because the country might sell a smidgeon of its gold, but because the EU decided to go for liquidation rather than a full-scale bailout. Cyprus’s major bank is not being rescued, and depositors are being told that they can’t rely on money-printing or transfers from taxpayers in other countries to protect the nominal value of their deposits. This is a strike for monetary sanity and a negative for gold.

If this sets an example, gold is in trouble. But it seems more likely that Japan is the model for where other central banks will head: aggressive debasement, and a last attempt at throwing the monetary kitchen sink at the economy. Also, the EU may not be as principled when the patient is not Cyprus, but a big boy like Spain, Italy, or France.

But the central bank that really matters is the Fed. Monday was the worst day in the gold market since February 1983. Then gold was in a bear market because Fed chairman Paul Volcker had allowed short rates to go up and restored faith in the paper dollar. Volcker had the backbone to inflict near-term pain to achieve longer-term (although not lasting) stability, and to live with the consequences of tightening. Today, the consequences would be more severe, and there’s much less central banker backbone on display.

In the debate last Friday, my opponent made a very good point. He said that what causes problems for gold was the direction of travel of the economy and other markets. Equities are trading higher, while bonds are stable and inflation is (so far) not a problem. Gold feels like a dead weight. For most investors, it is hard to stand on the sidelines of a rallying equity market – they need to be part of it.

Central bankers are now enjoying a sweet spot, where their machinations boost equities sufficiently, but don’t yet affect inflation readings and don’t upset the bond market. This policy is not balancing the system. It is marginally adding to long-term problems. It feels good for now. But it won’t last.

Detlev Schlichter is author of Paper Money Collapse.

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