The Barbarous Relic Expresses an Opinion
By John Gilbert
December 21, 2012
Gold has a long and varied history in economics and finance.¬† Otherwise sensible people lose rationality and logic when conversation turns to the subject, with some rising to passionate romance, and others to apoplexy.¬† It elicits neither for us, which allows us an attempt at a reasoned view.¬† That is more important today than usual, because there is a message in gold’s price behavior, and it is not an encouraging one.¬† That message is that not only are rates of return low at the moment, but they may remain there for some time.
Those who scorn gold for investment purposes do so because it has a negative net present value.¬† It produces little or no income, sits rather self-satisfied in a vault someplace, and charges its owner for storage.¬† The only hope of a positive return on such an asset is to sell it one day for more than it cost.¬† Gold will only rise in price if its relative disadvantage is falling.¬† We can, therefore, consider rationally its relative prospects, with an inference of some implied actual price return.
The price of gold has historically been affected by demand from two sources‚ÄĒmonetary and nonmonetary.¬† Nonmonetary gold is primarily for jewelry fabrication, and is price-sensitive.¬† Monetary gold, on the other hand, was the backing governments once held to support the roles of their currencies as stores of value.¬† Sometimes the difference blurs, such as in India, where gold jewelry’s traditional role in fact was a store of value.¬† A woman’s dowry was typically in gold jewelry, and remained her property even in divorce to avoid destitution.
Gold has often held a similar role as insurance against perfidy and bad faith by governments.¬† When Isaac Newton was finished musing on calculus and gravity, he was made Master of the Mint in London in 1699.¬† He was given the job to clean up the place, which was populated at the time by unimpressive characters.¬† He rebased the pound sterling to a metallic standard, adding gold to silver as the base of the currency and store of value.¬† Under such a standard currency was convertible into physical metal upon demand, with the metal coming from the government's reserves.
Most western countries adopted the gold standard at one point or other, and as the British pound became the dominant currency in trade it became the de facto monetary policy of the time.¬† Through the 19th century and into the 20th, monetary policy was generally conducted by targeting a price of gold in one’s currency.¬† It was often suspended during wartime, as prices usually rise rapidly during war.¬† But the gold standard was typically reinstated after war ended.¬† Prices of goods and services would then fall, often to something around their levels prior to the war.¬† This occurred in the United States, for example, in the American Civil War.¬† The gold standard was suspended during the war but resumed in 1879 at $20.67 per ounce, at which it remained until Franklin Roosevelt ended it in its pure form in 1933.¬† A modified form was resumed at $35 per ounce, with convertibility limited to governments only, and was finally thrown over the side for good by Richard Nixon in 1971.
In his famous epithet John Maynard Keynes referred to gold as a “barbarous relic” and objected to the rigidity of the gold standard as contributing to the Great Depression, about which he was correct.¬† It has been demonstrated that the sooner a country left the gold standard, the sooner it began to emerge from depression.¬† The U.K. left in 1931, the U.S. in 1933, and France later.¬† Their economic performance improved in the same order.¬† This finding includes in its ranks Ben Bernanke in his former life as a research economist.
So gold has a primary place in financial history, like it or not.¬† And while it has been demoted from the playing field to the stands, it continues to vote.¬†¬† Our purpose here is to consider that vote.¬† Gold rises in value when the returns on productive assets are falling.¬† Chart 1 shows the performance of American equities and gold after the elimination of the remains of the gold standard in 1971.¬† In the two decades that the stock market disappointed ‚Äď the 1970s and 2000s ‚Äď gold excelled.
Chart 1.¬† Gold and Equities Since 1971
Sources:¬† Bloomberg L.P. and GR-NEAM
These are returns after the fact (or ex post, as it is known).¬† Since we cannot know what they will be, we consider what expected returns are priced into markets at the moment in making investment decisions.¬† Expected returns are correctly considered in real terms removing the effect of inflation.¬† The price of gold is free to fluctuate with inflation, and thus contains an expectation of real return.¬† We can compare it to similar valuations, such as that of the stock market, since profits and dividends change with the prices of goods and services.¬† In Charts 2 and 3 we plot the dividend yield and earnings yield of the stock market, respectively, against gold.
Chart 2. ¬†Gold and Dividend Yields
Sources: Shiller, GFD and GR-NEAM
Chart 3. ¬†Gold and Earnings Yields
Sources: Shiller, GFD and GR-NEAM
After 1971 gold exploded in price as inflation rose and returns on business investment collapsed with rising interest rates and the contraction induced by the 1973-1974 Arab oil embargo.¬† Gold peaked in 1980, then went into a generation of decline as central banks attacked inflation, uncertainty receded and business returns rose, driving an exceptional period of returns on risky investments in general and stocks in particular.¬† Stocks peaked in 2000, and not coincidentally gold reached its price nadir in 2001.
Their respective performances since then are the point of this discussion.¬† With the sharp drop in stock prices in the 2008-2009 financial crisis, valuations fell and drove expected returns up sharply, directionally similar to what happened in the 1970s.¬† But central bank intervention in the form of quantitative easing drove stock prices back up again, reducing expected returns.
Gold differs in opinion.¬† Even as the earnings yield has been held below 5% and the dividend yield at a miserly ¬†2%, gold has continued to rise.¬† As the expected returns on more productive assets, such as business investment, remain modest, gold is rising because investors are suspect at the prospects for other risky assets.¬† Investors have, for the time being at least, not relinquished a role for gold as an insurance policy against financial misfortune.¬† Like it or not, it remains a monetary asset.
This is clearest when we compare gold’s performance to that of inflation-adjusted bond yields.¬† U.S. Treasury Inflation Protected Securities, or TIPS, adjust for inflation by adding consumer price inflation to the payments on the bonds, unlike conventional bonds that pay only fixed cash flows.¬† Similar securities exist outside the U.S. such as “linkers” in the U.K.¬† Chart 4 shows the two, with expected real yields on TIPS inverted to demonstrate the inverse relationship.
Chart 4. ¬†Gold and TIPS
Sources:¬† Bloomberg L.P. and GR-NEAM
There is growing evidence that the rising price of gold is a statement about the discouraging prospects for returns on productive investments.¬† If the price of gold should change in an inverse relationship to alternatives, its price behavior should look something like Chart 5, falling as productive investments rise, and rising as the opposite occurs.
Chart 5. ¬†Gold Price As Inverse of Other Asset Returns
Now consider the most recent episode.¬† In 2011 the Eurozone crisis spread from the most troubled countries, such as Greece, to Spain and Italy.¬† Demands for reductions in government spending imposed by the financial markets made it likely that returns on investment in those countries would fall as aggregate demand for goods and services did so.¬† Gold accelerated in price just as this occurred.¬† In Chart 6 we have superimposed the theoretical curve from Chart 5 upon the actual price behavior of gold.
Chart 6. ¬†Gold Spiked Upward As Europe Deteriorated In 2011
Sources: Bloomberg L.P. and GR-NEAM
We hope that this analysis is wrong.¬† We fear that it is not.¬† Returns on productive assets are falling as 30 years of debt accumulation, and government distortion of economic behavior, such as in China, depress expected future returns as growth slows in many parts of the world.¬† Businesses express caution by not making the investments necessary to improve productivity.¬† There are exceptions, such as emerging countries with favorable demographics, and falling natural gas prices in the U.S.¬† But it is not clear that those are enough to counter the forces depressing returns, nor is it clear that activist central banks can repeal gravity by encouraging investors to take risk anyway.¬† There will be a tendency to higher gold prices until that changes, and a risk of correction in risky assets to lower prices and improved expected future returns. ¬†¬†The barbarous relic has a long history, and its opinion is not encouraging.
Robert Barsky and Lawrence Summers (1988), "Gibson's Paradox and the Gold Standard", Journal of Political Economy (June 1988), 528-550.
¬©2012 General Re-New England Asset Management, Inc.
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