Thursday, June 27, 2013

Gold and the current economy

It's no secret that I like gold and silver.  In the 15 years (almost) that I've been in Canada, I've watched the dollar devalue about 1/3rd, as what cost $1 in 1998 now costs $1.34.  Here's the Bank Of Canada's Inflation Calculator to corroborate this fact.  

As seen in the media recently, gold has dropped about 35% from an all time high.  But what does this mean?

An ounce of gold is largely a static item in terms of what you can barter it for.  Historically, one ounce of gold should get you a decent suit.  About 400 ounces should get you a decent house.  But gold is priced in dollars - and this goes up and down.  The two main factors supporting currencies like the US dollar are how much faith people have in it and how much of it there is.  

The latter of these two is pretty simple to explain:  In short, imagine that you invent a new currency - your own dollar, for instance.  If it takes all the currency in the world to purchase everything in the world, and you only printed 1 million notes, then obviously the world would be worth $1m of your new dollars.  But when you start create 500,000 new dollars the old dollars become worth less.  Now it takes $1.5m of your dollars to purchase everything in the world.   

Whilst this is heavily oversimplified and somewhat incorrect, it gets the jist across about the fluctuations caused by printing (or as it's know now, "Quantitative Easing" or "QE").  Right now, the US Government is pumping some $85bn a month of new dollars into their economy.  The problem is the banks aren't lending this money out much.  Why would they lend out $100 in today's money knowing that if you pay back $120 with interest, it's only going to be worth about $80 when they get it back?

This is where faith comes in.  The government has to forge a sense of faith in it's currency, so it just announced that it's going to stop printing new money in the not too distant future.  This means that the perceived value of the dollar goes up as it's no longer going to be liquidated every month, and things priced in this currency (such as gold) should go down.  But prices in dollars shouldn't go down too fast, as that's deflation and they really want inflation, instead.

The gold price falling is not what it first appears.  People move money out of currency into gold as a store of wealth when faith in the currency is failing. Basically, when money is scared, it leaves the currency mechanism.  When the price of gold collapses, it means a spike in the value of the dollar.  Thus, gold acts a bit like a barometer.

The real test for this is still in Europe.  Everyone knows of the PIIGS (Portugal, Italy, Ireland, Greece, Spain) economic issues.  Since joining the Euro, they can't print more money, so they have to borrow it from other nations.  In the old days, they'd print money like Zimbabwe recently did - and look what happened there.  It's highly likely that in the next six months we'll see Italy ask for a bailout.  

When that happens, pandemonium will take hold and it's really anyone's guess as to what happens then.