The new calculus of gold
Here at The Real Asset Company we support gold’s role as money and often write of how its use as such is gaining in popularity through individuals, governments and central banks. In a new post in his Spellman Report blog, Professor Lew Spellman, a professor of financial markets, writes of ‘The new product that gold represents and its growing sales potential’. Despite it’s ‘sprout-less property’ investors are beginning to feel more concerned as to the return of their money, as opposed to the ‘sprouts’ or return on their money.
A return to good collateral: gold
He discusses what the market now perceives as good collateral; what was once, in the early days of the 21st century, perceived to be good collateral ‘has declined in market value as well as market esteem.’ Due to the increasing liabilities in government securities and guarantees, we are seeing a global movement towards the re-collateralisation of the system’s liabilities – governments, central banks and commercial banks are turning to gold.
As we know there is always a demand for an ultimate store of value for wealth preservation. Professor Spellman reiterates this; ‘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.’
It is these properties that make gold unique in the financial universe.
Previously, in the contemporary financial era US Treasuries were seen as 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.’
What the Austrians saw
However all this is due to change as governments find that over the next few decades (Prof. Spellman estimates four) they will have to run around mopping up the social fallout from this financial crisis, through social security payments, health care and growth policies. All of which will have to be financed through the central banking system.
Fixed duration dollar denominated assets will no longer remain attractive to investors due to the inflationary pressures eroding their value like the sea at a sand-castle, particularly such assets issued by sovereigns. Due to the intense incestuous nature of the global monetary system, emerging countries will also ‘fail to qualify’ as a form of international collateral.
Both banks and individuals’ debts have grown dramatically in comparison to income; in the UK we are the most highly leveraged nation in the EU. However for US Treasuries this is an even bigger problem :‘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.
Gold returns to the heart of the monetary system
Professor Spellman reminds us of JP Morgan’s recent announcement that they will accept gold as collateral. Clearing houses and commercial banks are also moving to accept gold as collateral. We recently described China’s surging demand for gold, as well as Iran, Russia, India and China’s plans to stop using the dollar in international payments. From payments for oil in gold, to using gold as money, the world is now witnessing a surge of gold being utilised as collateral.
Professor Spellman also reminds us of the growing demand for gold by central banks as foreign reserves, choosing the yellow metal over foreign currencies. We have seen this in recent World Gold Council reports and in recent Parliamentary debates in regard to where gold reserves are currently held. We ask, if governments and their central banks are returning their faith to gold why aren’t more Western investors? Many gold investors will remember the words of market heavyweight Jim Sinclair when he urges investors to buy gold bullion to “be your own central bank.”
In light of all this, Professor Spellman believes we are on the verge of returning to gold-backed paper currencies. He says ‘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.’ Regardless of what is chosen, the point is that the paper contenders will derive their value from the gold backing. This will, of course, drive up the demand for physical gold bullion and therefore its price.
There is little chance of this situation changing for as long as developed governments continue to pursue the impossible whilst expecting their central banks to finance it. The road down which this can may be kicked looks to be a long one.
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