Gold Mania. And Then What?
December 26, 2010
Eventually, people get it. The value of their currency is collapsing. It takes more and more … dollars, marks, yen, whatever … to buy an ounce of gold. The only apparent way to preserve financial value is to own gold, or some foreign currency that is stable in value. When the entire world is inflating, as was the case in the late 1970s, and there are no foreign currencies that are reliable, then gold is the only option. The “demand” for paper currency collapses, causing its value to collapse, and the “price of gold” soars.
To the typical speculator, this looks very much like a “bubble” or late mania stage of a bull market. It has many of the same characteristics, including the sudden widespread realization that owning a certain asset is a “sure thing.” However, fundamentally it is much different.
I say that, in early 1980 for example, there was no “bubble” in gold as classically conceived. Yes, there was a panic out of paper dollars, but gold itself was essentially unchanged in value. By “essentially” I mean that we could hypothesize that gold’s value varied by a little bit, maybe 10% or even 20% either way, but there isn’t really any conclusive evidence to back this up, and it doesn’t really change the situation even if it were true, so it is easier to just assume that gold is unchanging in value.
The essence of a “bubble” is some asset being driven far above its intrinsic value. Tulips. Real estate. Early-stage stocks. Eventually the mania passes, and the asset’s market price falls to its intrinsic value, or probably far below. The mania signals the end of the “bubble,” because the asset is finally driven so high in value that it can’t go any higher without fresh buyers, and all the buyers have already bought.
This does not apply to gold. In the last 500 years, I can’t find one example of gold doing anything else than serving as a stable measure of value. It never trades above its intrinsic value, or below its intrinsic value.
There is an interesting point here regarding 1980. Why did the gold bull market (i.e. dollar devalution trend) of the 1970s end with this apparent mania behavior, exactly like a classic asset bubble?
I say this was because, alongside the widespread public realization that the dollar was collapsing in value (the panic/mania), was the realization among policymakers that the dollar’s collapse had to be stopped — immediately — or there would be dire consequences. In slightly different terms, a new political consensus formed. In this new consensus, the government/central bank was encouraged to take any measures necesssary to stop the inflationary trend. This was a major change from the previous consensus of “accomodation,” in which the Fed would accept the inflationary trend because to stop it would mean a recession and unemployment (or so they imagined). The previous consensus was that “stopping the inflation is worse than letting it continue.” The new consensus was that “letting the inflation continue is worse than stopping it.” Volcker appeared on the scene, and had the political support to do what he did, which was to be a super-hawk to stop the inflation — something that was politically impossible until they had finally reached that panic/mania point.
I should say here that stopping an inflation doesn’t have to be a bad thing at all. The original Reagan strategy was to have a combination of tax cuts and a gold standard, which of course would have stopped the inflation. The gold standard would have probably led to lower interest rates, and the tax cuts would have led to a healthier economy. It was a win-win plan. The idea that inflation could only be stopped with high interest rates and “pain” was a bit of a fantasy of the time, but they believed it so much that they made it true. Volcker’s plan, the Monetarist Experiment, resulted in very high interest rates. Reagan’s tax cuts were mostly postponed until 1983, and watered down. The dollar not only stopped its decline, but rose explosively (deflation). The combination of deflation/high interest rates/no tax cuts produced the 1982 recession.
We saw previously that hyperinflation is very common. Just about every country in the world suffered some sort of hyperinflationary event during the 20th century, except for the Anglo countries of Britain, the U.S., Canada, Australia and New Zealand. I include not only the Weimar/Zimbabwe type hyperinflation, but also cases of chronic very high inflation (Turkey), or situations where the currency suddenly goes worthless (France in 1940). You could also include all sorts of currency collapses like Indonesia in 1998.
Happens all the time.
Imagine if you were in an incipient hyperinflation. Eventually there would be the mania/panic moment when even Joe Public understands that the real value of cash, bonds, and even stocks and real estate are collapsing, and the only way to survive is to get some gold. This would actually occur rather early in the hyperinflation, maybe when the annual CPI is around 12-15% or so.
Obviously, for a hyperinflation to occur, we must get to this mania/panic moment and then keep going. What would happen is that there would be a mania/panic, the currency’s value would drop dramatically, but, unlike 1980, there would be no adequate policy response. Volcker’s appearance was, in fact, rather flukey. The existing Fed Chairman, William Miller, was not a monetary specialist. He was the former CEO of Textron. His time at the Fed was characterized by “accomodation,” which was basically maintaining the status quo (inflationary policy), and not causing a recession. Miller wanted to be Treasury Secretary. So, Carter made him Treasury Secretary, opening up a vacancy at the Fed before the end of his term. A search was done, and Volcker was chosen as the replacement. Volcker was not, at the beginning, the hawkish anti-inflationist we remember today. He turned into one during the mania/panic phasse. So you see, we got a little lucky there. At the mania/panic moment, we had someone who could step up to the plate and deliver the appropriate (more or less) policy change.
But what if that moment passed? What if Miller remained at the Fed? What if there were other circumstances, such as the Fed was busy printing money to fund the government’s deficit, as it is today? (This was not an issue in the late 1970s.)
In that case, the classic “bubble” narrative would not apply. We would get the mania/panic, but instead of indicating the end of the “gold bull market”/episode of currency decline, things would probably accelerate still further. The public could see — there would finally be perfect consensus — that we were in a full-blown currency event, and they could also see, very clearly, that nobody is doing anything to fix the problem. At that point the mania/panic would reach phenomenal proportions.
At roughly that point, the government would no longer be able to issue debt, except perhaps for short-term bills at very high interest rates, like 20%-60%. We got close to that point in 1980. Why buy the debt of a government that is hyperinflating? Also, tax revenues would probably be falling in real terms, because tax evasion tends to soar during these times (the government loses all legitimacy), and also when taxes are paid at the end of the year, they are paid in a depreciated currency. Every effort is made to defer tax payments. When the government is no longer able to issue debt easily, and tax revenues are sagging, then the temptation to print money to finance the government is intense.
This is, I would say, the gateway to true hyperinflation.
Typically governments will do anything to maintain the “status quo” as they imagine it. From day to day, the political consensus will be that it is better to print the money, and keep the government operating for one more day, than it is to stop the hyperinflation (this would mean huge spending cuts, because the government would no longer be able to run a deficit). At least, that is my interpretation of the German experience. Eventually, things reach the point of absurdity. It becomes clear to all that hyperinflation cannot continue. People stop accepting these paper banknotes under any circumstances, no matter how many zeros are printed on them. Government employees can no longer buy food with their printed money, so the game comes to a halt. At that point, things enter the next stage. Ideally — as was the case in Germany in 1923, or Japan and China in 1949 — the government returns to a gold-linked currency. However, another common option is that the government abandons the market economy altogether, and begins to impose what amounts to a Soviet-style centrally-planned economy. If the farmers refuse to accept 100 trillion bills in for their food, then the military will stimply take the food from the farmers. Another option is “price controls,” which are a thinly-disguised form of confiscation. If you declare that farmers must sell wheat at $1 million per ton, and then you print up some $100 million banknotes on the laser printer to pay for it, the end result is exactly the same. Farmers then refuse to grow food, because the last crop was stolen from them. At that point, the govenrnment creates a forced labor camp (“commune”) to grow the food. Refusal to participate gets you sent to the concentration camp. This is, unfortunately, a common outcome at the end-stage of hyperinflation, whether that of the Roman empire or Zimbabwe not too long ago.
It can go on like this for decades, even centuries.
Ultimately, the government will collapse, because it no longer has an economic/resource base to draw from, and it is, shall we say, extremely unpopular by that point. In this case, the situation is resolved by the introduction of a new government, either some sort of home-grown entity, like a breakaway province that declares independence, a civil war with a new government taking control by force, or perhaps an outside power. Cooler, or at least different, heads prevail, and a new system is established.