Why History Points to the Dollar Devaluing, and Gold Going Much Higher

First of all, I frequently write about gold, and right off the bat wanted to dispel the notion that I am a gold bug.  I haven't been sitting in my basement salivating over gold coins for the past 25 years, babbling about the imminent end of the world.  As most of you know, I am a contrarian value investor.  Stocks and Bonds,  distressed stuff.  Not gold.  Buying what others hate.  So its perhaps odd (to me even) that I would be buying gold a couple weeks ago, at it's near historical highs, around $1300 an ounce. 

It's extremely interesting to me also that I rarely get much reaction from people on gold.  The best, smartest investors in the world though love it:  David Einhorn, Marc Faber, John Paulson, Fred Hickey.  I pay attention because these guys are much smarter than even good money managers.  They are the best.  But most people's view is that gold is a quaint relic of economic history, one that wont be repeated.  "The gold standard? Not a chance, it caused the Great Depression."  Perhaps.  Perhaps not.

SOME HISTORY:
The history of gold is that it was the first monetary unit 7000 years ago.  Eventually, governments were created and established gold reserves.  That is, they issued paper money backed by gold. Think, the government owns $100 of gold, and prints $100 worth of paper money.  The money is redeemable for a fixed amount of gold.  So, net net, a government cannot issue more currency without owning more gold.  The government is hamstrung in terms of monetary policy. Not surprisingly, we have a long history of being on a legal or implicit gold standard in the United States.   

First, in 1900 the US passed the Gold Standard Act, and fixed gold prices at $20 per ounce.  You could literally take $20 of paper money, go to a bank and get an ounce of gold.  The US Treasury couldn't issue more printed dollars because they only owned so much gold. 

The problem was, after WWI, Germany owed huge war reparations to England and France.  Its gold reserves were plundered first, but then Germany had no economy left, and no means of repaying their debts.  The debts were so large, in fact, that all they could do was print money (exactly like QE today by the way). They issued what quickly became worthless paper to the British and French, and in the process created hyperinflation in Germany in the 1920's.  They eventually defaulted.

Taking it a step further, the British and French also were having a rough time, and continued to debase their currencies to improve their ability to sell worldwide.  The more you devalue your currency, the cheaper it is for foreigners to buy your goods.  The first Currency War of the century was underway in the late 1920s.

What you should understand generally is, when times are good, GDP grows.  But in times like the late 20's, early 1930's, GDP was suffering everywhere.  To back up for a sec, GDP we know is C + I + G + X.  Consumer Spending, Government Spending, and Investment Spending were all done, and dying back then.  The only thing left was X, or exports.  So currency debasement is the last effort to salvage a very weak economy.  Sound familiar?

So as the Depression was playing out in the US in the early 1930s, our economy got crushed too.  At the same time, we were about the only currency in the world still on the gold standard.  (The British went off the gold standard in 1931).  That meant that a strong dollar was also choking off exports, exports that we desperately needed.  So, to fix this, in 1933, we went off the gold standard.  Not only that, but the US Government went as far as to BAN all ownership of gold.  Your safety deposit box could not be opened at a bank without an IRS auditor present.  And if you had gold in your box, they gave you $20 per ounce for that gold and took it.

What did the government do with all that confiscated gold?  They built Fort Knox, literally, to house it all.  It opened in 1937.  Then they repriced gold at $35 an ounce.  Quite a killing for the government, taking in gold at $20, then upping the value to $35 an oz.  We then created a quasi-gold backed system.  Only 40% of US dollars had to be backed by gold reserve by the Treasury, instead of a full gold standard which requires 100% of gold on deposit.  After WWII, this system created quite a stable currency and the US experienced economic prosperity from 1946 until the late 1960's.

Then, fast forward to 1968.  Again, Currency War broke out.  The Pound broke down in 1967, and the French began to devalue the Franc.  A strong dollar began to be a problem for our exports.  Foreigners were redeeming dollars and demanding gold.  Our reserves were being depleted, and a strong dollar was hurting our exports.  So Nixon reneged on the gold standard in 1971.  Inflation, while running at only 1-2% per year in the late 1960's, then began to take off. 

In 1972 inflation was 3%.  By 1973 it jumped to 6%, then 11% in 1974.  Wow.  If you don't think inflation can move quickly, then just realize that inflation more than doubled prices in that decade.  (the index went from 39, to 82, up 112%).  So for all of those who say oil more than doubled in price, it didn't.  The value of the dollar just fell by more than 50%.  Gold, by the way, jumped from $35 an oz to over $800 an oz.  This was the era of terrible stock and bond performance, as interest rates rose, commodities did well, and precious metals shined for lack of a better word.

HISTORY REPEATING ITSELF
Fast forward again to 2011.  Its almost impossible to miss what is going on worldwide.  Its basically 1970 all over again.  The United States is so heavily indebted, that it's virtually impossible for us to repay our debts.  We are going the easiest route to repayment:  dollar devaluation and inflating our way out of it.  While this goes on, interest rates will go up, stocks and bonds will perform poorly, and commodities will rally.  The economy will grow anemically at best, the new normal.  I wouldn't be surprised to see $150-200 oil in 5-7 years.  In fact I would be surprised if it didn't get to those levels.  Gold can only go higher too.  Treasury Rates at 3.5% have very little room to go down.  Bonds get killed when you have inflation.

CREATING INFLATION IN THE US
So given our fiscal situation, Ben Bernanke and our government have no choice but to create lots of inflation, to pay off our debts with devalued dollars.  But the problem he is having with creating inflation is twofold.  1)  money velocity has slowed down dramatically.  What that means is that the Fed can only control M0, or BANK CAPITAL.  The banks take in capital, and lend them out 10x. So, you put $100 into a bank, and that bank lends out $90.  That $90 gets deposited into another bank, who lends out $80.  And so on.  So that at then end of the day, roughly $1000 in money gets created for every $100 deposited in a bank.  In theory, our $2 trillion of Quantitative Easing could mean $20 Trillion of additional money in the form of M2 (bank accounts plus money market funds).  THAT would be tremendously inflationary. 

For the time being though, banks have tightened lending standards following their recklessness in the bubble times.  And, bank capital requirements are actually going up.  Loans aren't being made, so the money supply isn't going up nearly as much as we would think.  M2, one of the more closely followed measures of the money supply, is only up 6.5% in 2 years in fact. 

The second problem Ben is having with creating inflation has to do with China.  The Chinese Yuan is pegged to the dollar.  So, when a Chinese company sells Widgets to the United States, they get dollars.  They take those dollars, convert them into Yuan at a fixed exchange ratio, and then the Chinese company pays its employees, bills, etc.  With the US printing SO many dollars, that means that Chinese companies are getting tons of dollars, which are being converted into TONS of Yuan.  What you get is a flood of Chinese Yuan, and then inflation there as our money supply grows here.  This is not only true of China, but many emerging market countries with currency pegs to the dollar.  This exported inflation though is keeping inflation at bay in the US.  Our flood of dollars is ending up in China. 

When will money velocity and exported inflation end?  I dont know exactly, but these are mean reverting metrics.  Velocity will return to normalized levels, and banks will lend as they used to.  Foreign governments will raise rates to slow their economies and halt their own inflation.  And after this happens, look out.  Inflation will come home.

As a side note, understand that the government in China is in a HUGE quandary.  Keep the peg to the dollar and keep the masses employed.  Or de-peg and let the Yuan revalue higher.  That would stop inflation, but then lead to much higher unemployment in China.  That would cause major political instability there, something the Communist leaders of China do not want to deal with.  I mean, there are 10mm people every year flooding into Chinese cities from the country looking for work.  What do you tell them???

GOLD IS MONEY
People have pointed out to me that the chart on gold looks like every other bubble.  And yes, it does.  Gold has jumped tremendously in the past 10 years.  But you have to understand that gold is MONEY.  Yes, it is money.  It has been for 7000 years.  Just because the US dropped the gold standard in the last 40 years doesn't mean gold is not currency.  And gold value versus any currency is merely a monetary phenomenon.  Fiat currencies are backed by NOTHING.  The US Dollar has no collateral to back it. Its fancy monopoly money.  If tons of dollars get created out of thin air, then gold, which is fixed in quantity, can only increase in value. 

I have a chart here though that shows the global money supply against the value of gold reserves over 40 years.  Money supply goes up, Gold does too.

THE RATIO OF US GOLD RESERVES TO DOLLARS
What I think is important to figure out is what is the RATIO of dollars to Gold.  If gold is forward looking, then perhaps it's ahead of itself?  That ratio clearly fluctuates greatly over time, and is the key to getting into gold at the right time.  The chart above clearly shows that gold got way ahead of itself in 1980, and was way too cheap in 2000.

So what is the ratio today?  Great question.  For decades the US dollar was 40% backed by gold (until 1971).  Other times 100% (up to 1933).  I don't think we'll ever go back to a fully backed dollar.  We need more monetary flexibility.  But to do the math, right now there is $3 Trillion in US dollars in M0.  We have $350BB worth of gold in Fort Knox (the US owns 8.1k metric tons of gold).  That is a ratio of 11% today.  Our US dollar is essentially 11% backed by gold.  That is pretty low, maybe US citizens have no clue about the risk to our currency.

On the high side, in 1980 at gold's last peak, demand for gold was high and inflation was running at 12% per year.  So much so that we actually had 100% of the value of gold in reserves against dollars in the money supply.  100%!  That is the time to sell gold.  11% today if it just goes to 20%, means that gold could easily double to $2500 an ounce.

I honestly have no idea if gold goes back to a 20%, 40% or 100% gold backed basis.  But as dollars get printed, for one I think even at a constant 11%, gold prices have to go higher to match.  But for two, I think eventually fear of a dollar devaluation will cause this ratio to go sharply higher. It may take years to happen.  But it always has in economies that create inflation and/or default on their debts.  Show me an example of a collapsed currency where gold didn't skyrocket.

DOWNSIDE IN GOLD
From a purely economic perspective, commodities tend to trade at a normalized return on investment compared to their marginal cost basis.  So, if it costs $500 to mine one ounce of gold, would you bother if gold were at $520 an ounce?  Probably not.  I would suggest that a target ROI is around 10-20%, so I figure that $550-600 it becomes worthwhile to mine more gold.  That is my downside.  To think what could make gold fall, I copied a note from David Galland at the Casey Report:

"Setting the stage, I think it’s safe to assume that in order for the gold bull to decisively reverse direction, the following general conditions would have to be precedent in the economy:

1. The financial crisis will have to have ended. Which is to say that…
   1. Unemployment would have to begin falling by significant numbers – with 300,000 jobs or more being added month after month, instead of being lost.
   2. The housing markets will be stabilizing. Foreclosure rates would have to fall to more normal levels (and not because banks are forced to postpone the process for legal reasons, which is the case now), and sales would have to accelerate in the right direction.
   3. Government deficits would have to be sharply curtailed and heading lower.
   4. All quantitative easing will have ended.
   5. GDP will have to be on sound footing and rise based on sustainable, private-sector growth – not based on the activities of government, which loom so large today in the calculation.
2. Real interest rates – the yields you earn over the actual rate of inflation (not the fabricated numbers ginned up by the government) – will have to be solidly positive. Which, of course, is a big problem given the sheer magnitude of the outstanding debt. Rising rates will only beget more debt.
3. The monetary base of the country will have to be contracting, not soaring as it has been in recent years. "

I read this and think: not terribly likely.

UPSIDE
But the upside is that the gold ratio could go to a 30-40% backing of the US dollar.  That would imply $4000 gold.  I know, sounds crazy.  It will take awhile to happen.  But net net, the beauty of owning gold is that, we can simply buy it, then watch the Currency Wars unfold.  Owning gold means I don't have to worry too much about who wins.  Because at the end of the day, gold will win.