Why gold can go higher and higher

Paul Tustain
December 6, 2005

The number of zeros on formal statistics sometimes disguises their real meaning.

The US government currently borrows $5,000 a year on behalf of each US family, which it dares not tax for electoral reasons. This is the source of the budget deficit. That uncollected money remains in the hands of the family, which currently prefers buying foreign goods and spends $5,000 on them, producing the trade deficit. The foreign supplier sends the $5,000 back to the US by buying government bonds and American businesses. This money from abroad is the source of the fine-sounding US capital inflow.

Give or take $1,000 this same $5,000 deficit triangle is completed for each of about 100 million US households every year, and that is why there is a $500 billion budget deficit, and similar trade deficit and US capital inflow. It is tempting to assume that this is the way it has always been and that somehow it must be stable, but that is wrong. This is a wholly new way of arranging things.

The last four-year administration ended having increased the average US family's gross future tax debt by about $19,000. The family's total accumulated uncollected tax - i.e. its share of the country's public debt - grew by that $19,000 to about $74,000, three quarters of which has been built up since 1985. The demand which has sustained growth for twenty years has arisen from this money being spent twice, and this duplicated spending is the only explanation that is needed to understand the remarkable strength of the USA's economy. But the legacy of it is this $74,000 tax debt for each of just over 100 million families.

How serious is a $74,000 tax debt? We don't know because it has never happened before, but we do know that in Argentina in 2001 their sovereign public debt was about $12,000 per family, and at that level it triggered the capital flight which was the direct cause of their debt default and subsequent economic crunch. It is both extraordinary confidence in underlying USA economic robustness and an apparent lack of alternate options which appears to be preventing a similar US setback. But the confidence rests on the demand strength, which itself arises from the scale of the deficit triangle.

To resolve the US public debt problem safely is very difficult. Raising taxes to the required level is unthinkable - both electorally and because it would hurt domestic spending and feed back into a deflationary spiral of declining output and demand. Trade protectionism was tried before and it triggered tit-for-tat trade restrictions and global depression. Meanwhile formal debt default is unnecessarily dramatic, but it seems it can be effected without the same national loss of face by a policy which allows the dollar to bleed value: so serious inflation seems much the most likely result.

Assessing how severe the coming inflation might be is also difficult, but it is possible to get an idea by looking at the bond market. For twenty five years the bond market has been growing fast, to about 40 times what it was in the early eighties. Through most of that time interest rates and inflation were falling, so fixing a rate of return with a bond was an attractive option for a saver. As a result while borrowers were spending savers were diverting their cash out of the economy and freezing it in bond portfolios, until eventually US dollar bond markets have grown to contain 50 times all the dollars in current circulation.

This frozen money is up for redemption over the coming years so it will turn back into cash, and little of it can sensibly be re-invested in bonds with inflation threatening and rates turning up from long cycle lows. In any event much of it must be returned as consumable cash to the retiring boomer generation.

This suggests a possible cash glut in the medium term, and that indicates inflation too. Aggressive inflations do tend to follow an accumulation of official indebtedness. It would be unusual if the current US situation did not result in something similar.

Fear of this should have already caused a downwards dollar correction, but this has not happened because the alternate currencies have similar problems. The Yen is afflicted by an equally difficult sovereign debt problem, while the Euro looks politically unstable and can agree neither a constitution nor an ongoing budget. Commodities on the other hand have been rising in price - and gold particularly so.

Gold is famously useless in almost everything except that it cannot be made, and is reliably difficult to find. Even now if all the gold ever produced on Earth were formed into a single cube its edge would be less than 20 metres - 2 metres shorter than a tennis court. Annually mined production grows that cube by about 12 centimetres a year, and more than each year's production is used up by jewellers such that now 75% of that cube is fabricated in an art form worth several times its bullion value. Meanwhile after 15 years of consistent selling into private demand central bank ownership is now down to about 20% of the world's gold.

That 20 metre cube of gold would weigh about 140,000 tonnes and each tonne is worth about 16,000,000 dollars. So all the gold in the world is currently valued at $2.2 trillion, which compares to a US public debt of $8 trillion, and an unreserved US generational debt of $44 trillion. By contrast the US has the biggest gold reserve in the world which at 8,000 tonnes is worth only $0.12 trillion, enough, were it all sold, to stop the deficits growing for about 10 weeks.

Arising from this there are are powerful fundamental forces at work on the gold price which cautious savers understand intuitively - even if some cannot put their finger on what those forces are. The value of anything reflects its utility at the margin, which means it only needs a slight shortage to create price surges and a slight surplus to create price slumps. The utility of gold is simply that it is rare, and for 5,000 years people have used reliably rare stuff to store value for the future.

Often because of a local shortage of gold (which they might prefer because of its natural and unimpeachable rarity) most human societies have been able to arrange and enforce a respectable rarity of artificial forms of money, and so long as savers have been able to trust in this artificially created rarity the marginal utility of gold's natural rarity stays low. Paradoxically rarity is in surplus wherever artificial money is being reasonably well managed, and this makes gold's natural rarity less valued in those times.

But what savers are now realising is that official money is not being well managed and cannot in future be relied upon for rarity, and they believe their governments will soon be forced to create money in large quantities. Even if the underlying demand for the rare stuff required to store value stays the same then the value of the few naturally scarce things will go up. Much more likely is that the underlying demand for natural rarity will increase, and it's utility at the margin, where diminishing supply of rarity meets increasing demand, will continue to force up the price.

This is what is starting to happen to gold now. Arising from the scale of public debt the forced monetary issue which is being anticipated by savers is causing them to value the unimpeachable rarity of gold higher. More and more people no longer believe that the artificial rarity of bonds, or bank-notes, shares, or even houses are offering that same assurance of future scarcity, and until responsible fiscal and monetary management returns to government the outlook for gold is likely to remain resolutely positive.

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Paul Tustain

Paul Tustain edits Galmarley, the popular free research site on gold. He recently sold London based SAM Systems - the specialist banking and risk management systems provider which he founded in 1990. He consults on risk management within the financial sector and is well known as a writer, publisher and TV panellist both on gold and the workings of the financial system. In 2005 he launched the Bullion Vault service - to improve the accessibility, security and affordability of professional grade gold bullion for private buyers all over the world.

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