02 August 2011

The coming goldbug civil war and your PM exit strategy

I recently received a question from a client regarding my three point staged approach to choosing a storage method, as per the Perth Mint website:

“1. While the world environment is benign, they hold unallocated. They do not incur ongoing storage costs and fabrication charges.
2. When the environment becomes uncertain and risky, they convert to allocated.
3. When the world is at a crisis point, they take delivery of their physical metal.”


By the way, I wrote that webpage text many years ago, well before the gold bull market and when the world environment was benign.

His question was “At a crisis point why would investors opt to take delivery of their metal, rather than sell it? Isn't that the whole idea of holding precious metal?”

I found it a very interesting question, because it indicated that the investor saw only one scenario developing, what I would call “Repeat of 1980”. This scenario sees the 1970s repeating with a bubble in metal prices driven by high inflation, recession and a “mild” financial crisis.

This exit strategy assumes that just like the 1970s, the current economic environment is just a cyclical phase and we will return to “normal” at some point, in which case you can deploy your increased wealth into other (hopefully) cheap productive assets. Selling your metal for cash certainly could be profitable in such a scenario.

However, my third point was addressing another scenario, one I call “End of the Debt Bubble”. This scenario in simple terms (and probably do the complex issues involved a disservice), is that we are at an “end of cycles” as the debt levels most Governments and individuals have accumulated will not be able to be paid back. The only acceptable political solution, it is argued, will be for Governments to inflate debts away, which given the scale of the problem, will lead to hyperinflation as people lose confidence in fiat currency’s ability to hold its value. Some consider this scenario will also involve confiscation. In the case of Australia I personally think this is unlikely and have covered it in detail in this post.

This is a completely different sort of crisis, possibly also involving societal breakdown, in which case investors would be looking to take delivery (in coin form) with the purpose of using their gold and silver as money to buy goods and services or simply because they feel more secure having the physical metal in their possession in such a situation. Selling your metal for cash in such a scenario could be disastrous unless you quickly convert that cash into some other wealth preserving asset.

This is the single most important issue precious metal investors must have a view on, because if you get it wrong it will potentially do significant damage to your wealth. You do not want to have held on to your metal if we will experience a “Repeat of 1980” as you will end up selling at a much reduced post-peak price. Alternatively you do not want to have sold your metal if we experience the “End of the Debt Bubble” as you will be left with worthless cash.

Whichever scenario you favour, I suggest you read this post of mine on Deflation or Inflation .

For those who believe in “Repeat of 1980”, this post summarises the key arguments why the US won’t be able to paper over its debt problems. For those believing in the “End of the Debt Bubble”, keep in mind that the text of the post was written 20 years ago. At the time the writer was sure that it was “the End” – how sure are you that it really is different this time?

It is not something you have to work out right now as you can wait for more "data" as economic events unfold, but unlike my questioner, at least be aware that there are alternative "futures".

As the gold price increases, you will also start to see a "civil war" developing in the gold internet community on this issue. All gold commentators you read have a view on this issue. It may seem that everyone is in the “End of the Debt Bubble” but a careful reading of many commentators tells me many hold a “Repeat of 1980” view. At the moment all gold advocates are united against conventional economists and investments advisers as they have been proven right with a 10 year bull market.

But once the gold price starts to get really high, you will see commentators who believe in the “Repeat of 1980” scenario start to recommend selling your gold. This is likely to result in “End of the Debt Bubble” commentators calling them "traitors" or "incompetent" for recommending holding soon-to-be worthless cash. The passion of the current debates in our little gold internet community will be nothing compared to this.

The key will be to keep your emotion out of it, weigh up the claims, and hopefully make the right decision.

10 comments:

Anonymous said...

Funnily enough, I'm not in either camp.. I'm in the 'things get bad, then worse, then we see some sort of global reset' camp. Not to say I'm not very open to the possibilities of either inflation or deflation. I just don't think they'll let it get that far before that change the rules..

And when I say change the rules, I don't mean anything sinister, I just mean they reform the whole damn system, write down debt, jail a banker etc..

I don't know though, I could be totally off base.

Kid Dynamite said...

Bron - you'll want to read this short quote on the difficulty of inflating away debts like ours which are largely short term in nature:

http://marginalrevolution.com/marginalrevolution/2011/07/our-short-debt-maturity.html

"Still, it’s precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can’t be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues. At that point, any shortfall in GDP growth or government revenues would result in a rapid spike in debt-to-GDP (as Greece and other peripheral European nations are experiencing now). Prior to embarking on an inflationary course, the first thing a government would want to do is dramatically lengthen the maturity of its debts."

Gordon said...

Bron,

Love your posts and look forward to them.

That said, this one - as intended no doubt - gives no real insights into your own thoughts.

It truly is an interesting question what with CB, Chinese and Indian buying, but can we truly believe that it is different this time? I don't think so, a thought supported by the fact that almost all gold-bug sites are heavily promoted and supported by gold dealers.

My personal solution (partially recommended by you in an email - thanks) is to hold a fair commitment in PM unallocated which I can sell at the drop of a hat. I also have a decent holding of physical, most for the long-term. My solution here is to sell 1/3 of this when the price approaches ridiculous levels, such that the remaining 2/3 essentially cost me nothing. Then I can comfortably sit back and relax even if, and when the 80's repeat.

Cheers

Pete said...

It's a good post Bron, I think you clearly articulated the point you were trying to make, whilst remaining fairly impartial.

I'll leave the speculating to the speculators.

Anonymous said...

Doesn't one's exit strategy all depend on one's reason for buying in the first place or continuing to hold?


If it's to make the most "money" surely one sells when one perceives it to have peaked, or one alternatively can no longer withstand one's losses.

If it's to survive Bron's coming goldbug civil war, would one not rather swap barbaric relics for goldbug exterminating chemicals

intuitivereason said...

I suspect that the intensity will be such that you can put a 'bob both ways' and come out ahead what ever happens.

Also, I wouldn't be surprised to see both circumstances happen consecutively (gold bubble peak, collapse, leading to debt bubble collapse and reset).

Anonymous said...

I think that the U.S. and perhaps U.K. and Australia will inflate away their debts. The bonds, social security payments and private creditors will all be paid dollar for dollar, pound for pound. This will make a lot of winners and a lot of losers. Two or three zeros will be dropped off by the governments and a "New" dollar/pound will be circulated.

Pete said...

What I don't understand is how people can be so indifferent to the idea of 'inflating away debts'.

I'd think that if they'd been through a depression that they'd be quite against it!

Inflation is not good! The rich get richer and the poor will get poorer. Think you're not poor? Unless you outright own a lot of assets you will be in that camp. If you need a job or Govt handouts to eat and pay for electricity then you're in the poor camp.

Can anyone think of an example of debt being inflated away that worked well and was entirely painless?

Michael H said...

@ Kid Dynamite,

While short-term debt is more difficult to inflate away, it is not impossible. All it takes is an *accelerating* inflation rate.

Like so:
- Period 1: short-term debt at 1%, inflation at 2%.
- Period 2: short-term debt at 2%, inflation at 4%.

etc.

In this way, the money printers can stay in front of the interest rates charged on the debt.

Grinners said...

Kid Dynamite said...
Bron - you'll want to read this short quote on the difficulty of inflating away debts like ours which are largely short term in nature:

http://marginalrevolution.com/marginalrevolution/2011/07/our-short-debt-maturity.html

"Still, it’s precisely that short average maturity that makes the debt problematic from a long-run perspective, because it can’t be inflated away easily. In the event of sustained inflation, the debt would have to be constantly refinanced at higher and higher yields. Contrary to the assertion that the U.S. can easily inflate its debts away, it is clear that sustained inflation would create enormous risks to our long-run fiscal condition by driving interest costs to an intolerable share of revenues. At that point, any shortfall in GDP growth or government revenues would result in a rapid spike in debt-to-GDP (as Greece and other peripheral European nations are experiencing now). Prior to embarking on an inflationary course, the first thing a government would want to do is dramatically lengthen the maturity of its debts."

How interesting to see that this is exactly what the Fed has done with operation Twist.