There has long been a disconnect between gold and institutional investors. The instincts of these managers of large sums are typically tied to the generation of cash flows to feed the monster — that is, the institution’s cash flow needs. Alternative emphasis is given to growth, especially if obligations are long duration and not fixed. This is usually true for pension funds, endowments, some insurance companies or individuals investing for retirement.
For these investors, the preferred investment habitat tends to be a blend of income-generating fixed income and equity type investments that are thought to contain the potential for growth. Because gold, as an investment class, provides neither steady income nor systematic growth, it succeeds in only providing emotional discomfort for these investors.
Warren Buffet’s recent article in Fortune is a reflection of this sentiment. First on the list of asset categories to consider are bonds or, more generally, fixed income. His analysis is instructive.
From his point of view, over the relevant time frame of the 47 years he has been at the helm of Berkshire Hathaway, continuous rolling short term Treasuries bills would have averaged 5.7% annually. But if an investor paid income taxes at a rate averaging 25%, the return is reduced by 1.4 points. Buffet then goes on to point out that the return is then further reduced in real terms by the invisible inflation “tax” which would have devoured the remaining 4.3%. Hence rolling short-term Treasuries would have yielded nothing in real terms.
If one held long maturity Treasuries over this period — which included 30 years of general Treasury bond price appreciation — the investment outcome is questionable if you take into account the declining purchasing power of goods in U.S. dollar terms. It is even worse when compared to a market basket of goods from around the world.
In Buffett’s terms, fixed-dollar investments have fallen a staggering 86% in real dollar value since 1965 during his tenure at Berkshire Hathaway. He points out that today it takes no less than $7 to buy what $1 did when he arrived in Omaha.
He concludes with the recommendation that fixed dollar income investments should come with warning labels advising you that they’re bad for your financial health.
What if contractual steady income doesn’t perform well? Asset categories outside the normal preferred habitat need to be examined. That’s where gold comes in, especially considering that for the first time in our monetary history the central bank has adopted positive inflation as a policy goal. Nonetheless, the institutional sale is a hard one, not just because it’s not been a member of the preferred habitat, but according to Buffet it has other fatal defects.
After conceding in a backhanded way that gold has performed well, with reference to its near $10 trillion in market capitalization, he argues that it doesn’t qualify to be in his preferred investment habitat because it doesn’t produce a growing revenue stream — and if it doesn’t grow, it doesn’t compound.
Rather, he states that his preference would be to employ his capital with growth commodities such as farmland or businesses that will continue to grow its bread-and-butter capacity that can be sold in real terms. That is to say, he rejects gold because it doesn’t produce gold sprouts. Gold is just inert, lying in neatly stacked bars in a subterranean vault. It has but limited use in electronics, jewelry, dentistry and few other applications.
Buffett then goes on to compare the rising price of the sprout-less gold to a Ponzi scheme, which depends upon finding a bigger fool to pay yet a higher price for the same subterranean inert matter. This is apparently proving easier to do by the day as the developed world continues to run outsized fiscal deficits and then compels its central banks to purchase its paper.
Instead, Buffett prefers investments such as Coca-Cola or See’s Candy, which have the ability to sell more candy in the future at the prevailing price level as a means to produce real growth.
That’s where I depart from the Sage of Omaha. While not arguing with the ability of See’s Candy to deliver and the American sweet tooth to be unaffected by the growing concerns for obesity, I believe he fails to see the new product that gold represents and its growing sales potential.
This is “the new calculus of gold.”
In a wealth-accumulating economy there is always demand for an ultimate store of value for wealth preservation. In finance terms, there is always a demand for some asset for which an investor takes no default risk, nor inflation risk, and can be obtained and sold on liquid markets.
For decades, U.S. Treasury debt took over from gold as the market’s preferred store of value. Treasury bonds mythically had no default risk and little inflation risk when central banks were not under pressure to be concerned about unemployment, lending to insolvent banks, or propping up the value of government debt. Moreover, U.S. dollar-denominated Treasuries served not only as the store of value but also sprouted interest payments.
But all that has changed, perhaps not forever but likely for the next four decades, as developed world democratic governments will be under pressure from their constituents to make good on the social contracts of social security and comprehensive health care to the bulging baby boomer population. And, if need be, they will recapture the central banks (by legislative changes if necessary) if they fail to support U.S. Treasury prices.
Given the debt and monetary growth ramifications of these pressures, investors will seek an alternative embodiment of a store of value other than fixed dollar denominated assets, especially sovereigns. With all other developed countries in similar straits and emerging market countries exposed to inflation generation from developed country central banks, their currencies and sovereigns also fail to qualify. Hence, gold has reemerged to play the role of the store of value, despite its sprout-less property. Sprouts are the icing on the cake but not the cake itself — and many gold admirers remember Mark Twain’s old saw: ‘I am more concerned with the return of my money than the return on my money.’
The New Calculus of Gold has much more to its story than merely the market-designated good for inflation and default protection, with or without sprouts.
We are at a historic point in time when both consumer and government debt have grown dramatically relative to income, which is our underlying economic problem (See Roadblocks to Recovery: An Interview with Dr. Lacy Hunt). In the great debt run-up of the last few decades, lenders or bond investors underwrote debt or loans based on either the borrower’s cash flow to service the debt or based on the borrower’s collateral, or both.
But debt has a maturity, and when the maturity is reached, borrowers seek to go back to the well and roll the debt over. From the easy lending days of the turn of the 21st century, the value of what has traditionally been accepted by the lender as good collateral has declined in market value as well as market esteem. That includes residential houses and commercial real estate for mortgages, mortgages for mortgage-backed securities, and mortgage-backed securities for CDOs. Even government securities and guarantees have been questioned especially from abroad when collateral value is set by the credit rating of the collateral. By that measure even U.S. Treasuries and government guarantees fail the test of good collateral given rating downgrades.
Hence, the great corollary of over indebtedness is the relative scarcity of good collateral to support the debt load outstanding. This imbalance of debt to collateral is impacting the ability of banks to make loans to their customers, for central banks to make loans to commercial banks, and for shadow banks to be funded by the overnight Repo market. Hence the growth of gold as a collateral asset to debt heavy markets is inevitably in the cards and is de facto occurring. Gold is stepping up to the plate as “good” collateral in a world of bad collateral.
As described in the accompanying news story (J.P. Morgan to Accept Gold as Collateral), gold is now being accepted (or more likely demanded) as collateral for bank loans, which increases the demand for gold. Furthermore the scarcity of collateral has spread to Europe, where debt is now being priced according to the value of its collateral, and clearing houses are accepting gold as collateral and for exchange settlement. Furthermore in this environment of collateral scarcity, clearing houses that service the shadow banking repo loan closures are closing loans despite the arrival of the collateral (prosaically called settlement fails) but it doesn’t stop the loan from being closed without any collateral, either good or bad and is now causing a regulatory backlash to tighten up actual collateral.
In addition to the demand for gold as collateral to back private debt, there are growing instances of commercial banks and central banks stocking up on gold as assets to meet the perception of depositors that banks or currencies are financially healthy. In this regard there is a shifting of foreign exchange reserves of world central banks away from foreign currency (dollars) into gold as shown in the Figure.
Most importantly, China, in its not so secret desire for the Yuan to be a world reserve currency, is accumulating domestically produced gold as it bans exportation, and at the same time it is shifting its foreign exchange reserves from currency into gold. If the Yuan has a chance to have reserve currency status it likely would require gold backing. A gold-backed Yuan would make a big dent in the U.S. market for the dollar and Treasuries as the world’s store of value asset. A gold-backed Yuan would be the equivalent of gold certificates in a warehouse and denominated in a currency that would be on the upswing and very desirable as compared to developed country sovereigns or currency. It might even be more appealing than gold certificates stored in a Swiss warehouse, denominated in a currency that is not allowed by its central bank to appreciate.
We have entered an environment with elevated debt to collateral and elevated currency to goods, and gold is again demanded by market forces to enhance the value of debt paper and otherwise fiat currency.
What we are witnessing is a sea change in which market forces are driving a de facto return to the gold standard. All that is missing for this to be a de jure gold standard is some regulatory and legal recognition and one has been proposed. The Basel Committee for Bank Supervision, the maker of global capital requirements is studying making gold a bank capital Tier 1 asset.
This implies banks would be regulatory blessed to operate with less equity capital than is normally required of banks if they held more gold as an asset. Basically, regulators would allow banks to be more leveraged, meaning the banks would not suffer as much equity dilution to recapitalize after sovereign and mortgage write downs. Not only would gold then be backstopping debt and currency but also be backstopping bank equity capital. So the realm of gold is expanding to fill the void of other “money good” assets and elevating its demand.
The world has gravitated from one gold-backed paper currency to another before, and it likely is happening again. It would depend on whether investors in liquid, default-free, inflation-free paper prefer gold-backed Chinese Yuan to Swiss warehouse receipts or deposits from large international banks with large gold positions that operate with lots of leverage. This is a market choice that will determine the gold linked paper store of value, but the point is that all the paper contenders derive value from the gold backing, and thereby expands the demand for the shiny metal. This is the new calculus of gold. This state of affairs is likely to remain until developed world governments no longer reach for the unreachable and pressure their central banks to finance it.
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