You don’t have to spend very much time poking around the financial side of the internet before you run into an internet economist. You probably know the guy (and it’s usually a guy). He’s very eager to point out that:
- The US is running a massive federal budget deficit, and as a result has accumulated an even more massive national debt.
- The US will eventually be unable to pay that debt via taxation, and will thus have to print money to pay it.
- This printing of money will cause massive inflation eventually turning to Weimar Republic style hyperinflation.
- If you want to protect your assets in this environment, you should buy gold because gold is real (as opposed to fiat) money that can’t be printed. So while everyone else is being inflated away, you’ll be safe and secure.
You’ll see a few variations on this argument. For example, the advanced internet economist might suggest to you that holding gold is not enough – it must be physical gold in your personal possession (as opposed to gold in someone else’s vault, gold futures, gold miner stocks, or a gold ETF). The reasoning here is that physical gold in your possession presumably can’t be easily confiscated or otherwise regulated by the government. Either that, or the internet is full of would-be Scrooge McDucks.
Now, don’t get me wrong. McDuck aside this argument is chocked full of indisputable facts and sound economic reasoning. It seems like it ought to be right. There’s only one problem: 1985 just called, and they want their bullet points back.
I’ll be 31 years old this summer. My very first memories of anything related to economics were when I was about four, and it was my dad having this exact same discussion with someone. In other words, this situation has been going on for over 25 years (essentially, since Regan took office). Since then, the publicly held debt has increased by about a factor of five (in inflation adjusted dollars). The money supply has likewise increased about fivefold. Having read the internet economists, you know what must have happened: massive inflation. There’s only one problem: inflation over that period has averaged about 3% – arguably the most stable period for the currency in US history (the other candidate would be 1950 through the mid-60s). It certainly hasn’t been fivefold, let alone the sort of hyperinflation predicted by the internet economists.
Gold’s price has moved largely independent of either the debt or inflation. Starting from a high of about $615/oz in 1980, gold fell like a rock for the next 20 years, eventually losing about 56% of it’s value on the way to a price of $271/oz in 2001. As dramatic as that number is, it’s more dramatic to note that during that period there was mild inflation. Adjusted for inflation, gold lost 4/5ths of its value. From there, gold made a dramatic U-turn, and over the next ten years ran up by a factor of over 5x – sitting today at a price of about $1550 per oz.
So here’s were we’re at: internet economics starts from one observation (the debt) and makes three predictions (printing of money, inflation, and the suitability of gold for asset protection). Of those three predictions, the printing of money is clearly true. But the inflation just as clearly hasn’t happened. And gold has behaved completely independent of the theory, varying in price by huge amounts in both directions without any seeming regard to the debt or inflation.
At this point, proponents of internet economics would likely argue that the predictions just haven’t happened YET – it’s coming soon, and you’d better buy gold to get ready. But eventually this becomes like the guy at your bar who argues every spring that this is the year the Cubs are going all the way. After decades of inaccuracy, you have to conclude his predictions stem from fanaticism rather than rational analysis.
So if internet economics has failed to deliver the goods so to speak, it’s interesting to ask why. And the answer isn’t necessarily clear cut. Economics is called the dismal science for a reason. But we have learned a few things.
If there’s one thing the financial blogsphere knows, it’s that debt is bad. The reason for this is obvious: interest payments. When you take on debt, you swap future money for current money, but not at one to one. Instead you have to put up more future money. Do too much of this and you run out of future money, and somewhere down the road end up eating ramen noodles and contemplating bankruptcy. Oops.
It’s worth thinking about what debt would be like if interest rates were negative. In other words, if you could borrow $100 today and only have to pay back $99 next year. Debt would no longer be such a bad thing. In fact, you’d be well served by borrowing as much as possible, burying $99 out of every $100 in a vault, and using the rest to buy yourself something nice. When the loan expires, you pay it off with the $99. Assuming your vault storage costs were zero, this would be free money, limited only by the size of the loan you could get.
What’s not quite so obvious is that you could in theory do the same thing with a positive interest rate loan, as long as the rate was less than inflation. Just take the $99 and buy a basket of physical goods that tracks inflation, bury those goods in the vault, and spend the $1. When it comes time to pay back the loan, sell the goods (at a now inflated price) and pay back the loan. Obviously it’s difficult to do this in the real world, but it is sometimes feasible. When possible, it’s called a “storage arbitrage”. Storage costs are one difficulty. But the bigger problem is that no one’s eager to give you a loan with a rate less than inflation. It’s like giving you money. Sure, you may get a zero percent car loan or whatever, but you can bet they added the cost of giving you a cut rate loan to the price of the car. As a straight loan absent some other kickback there’s no chance.
This is where the US Government’s debt gets funny. It all has an interest rate less than inflation. Inflation has been consistently around 3% for 30 years, and the 30 year T-bond (the highest yielding) yields 2.6% right now. It used to be only the first 5 years or so of the yield curve were below inflation. But thanks to moves in the bond market over the last 4 years, now all T-bonds yield less than expected inflation. In other words the Federal government, like our guy with the vault, is in a position to profit from debt.
Huh, what? It’s such a strange concept I have a hard time wrapping my head around it. But it’s an economic fact that the government’s debt is so cheap to finance (rate-wise) that they’re actually befitting by having it out there – effectively able to buy things “for free” now, and then paying the bond back for less (inflation adjusted) in the future. Every time the debt rolls over, new debt is issued and yet more free stuff acquired.
You can see this process of getting stuff for free occurring on multiple fronts. We’ve fought two massive foreign wars over the last 10 years, and the level of sacrifice requested of the average American as a result is roughly zero. This is not to diminish the sacrifice of those who served, but they were volunteers. No sacrifice, in terms of service or economics, was demanded of the country as a whole via draft or taxation. In some sense the wars were “free”.
Similarly, the US runs a persistent trade deficit. Other countries send us their manufactured goods. We send them pieces of paper (currency). Since we don’t really want that paper back (and would bid a bad price if offered it), they use it to buy other pieces of paper (T-bonds) that promise to offer yet more pieces of paper in the future. Oddly, this is an agreement acceptable to all parties. But you can’t deny that somehow we’re getting those manufactured goods more or less for free at least in a national sense. It’s profoundly weird, but it all stems from the incredibly low rates on T-bonds.
The question you ought to be asking, at this point, is why anyone would buy a T-bond that yields less than inflation. In other words, why would you give the US government a free ride? And therein lies the best explanation I’ve seen for the last 30 years.
Banking at the Treasury
A little know fact of finance is that the majority of those involved are abject cowards. Not that there’s anything wrong with their courage per se, but they’re incentivised to behave in the most risk adverse imaginable way.
Suppose you run a pension fund. You have to decide between two possible investments – a T-bond that yields less than inflation, and a corporate bond that yields more than inflation but has a chance of default. Which do you buy? The “rational” manager might compare the expected rate of default to the difference in interest rates, and decide which is the better deal. The smart manager buys the T-bond. Why? If the T-bond under-performs, it doesn’t matter. The pension is defined benefit anyways. If the T-bond under-performs even that mark, the company offering the pension has to make up the difference. Nothing bad can happen to you. But if you buy the corporate bond and it defaults, you can be fired. It’s a no brainer.
Now, imagine you’re the CFO of a company in Spain right now. You have cash on hand that you won’t need for a quarter. Which do you do – deposit it in a Spanish bank, or buy 13 week T-bills? Again, no brainer. If the Spanish bank blows up (as they’re slowly doing) you could lose everything and be fired. But there’s no risk to you if you buy the T-bill. So screw Banco Santander. You’re going to do your banking at the US Treasury. It doesn’t even really matter what rate you get on the T-bill vs. the bank, just that you can’t be fired for the T-bill.
These two related forms of economic cowardice generate a massive demand for T-bonds, especially the shorter duration ones. That’s why the Treasury can sell all the T-bonds it wants at rates everyone knows are below inflation – the people buying them have warped incentives. Money is inexorably driven towards T-bonds and also Japanese and Swiss government bonds for the same reason. But Japan and Switzerland are tiny compared to the US, so it’s really about the T-bond.
The Money Supply & Inflation
All this demand for T-bonds helps explain what’s going on inflation wise. The US has massively increased the currency supply, but inflation hasn’t happened. The reason is that the price of our currency is a function of both supply and demand. Yes, the supply of dollars has ballooned. But so has demand. If you want to “bank” at the US Treasury by buying T-bonds, you have to do it in dollars. We don’t take Uzbek bottlecaps. What’s happened is that all that extra currency has moved overseas and is essentially being used to facilitate buying T-bonds. Since this added demand matches added supply (more or less) the price of the dollar remains constant. Weird, but true. It wouldn’t be possible if everyone didn’t want the security of US investments, but that is unquestionably the situation we’re in.
So what’s up with gold? Anyone who’s been paying attention knows it’s near record highs. But it’s also suffered a massive price drop during similar economic circumstances in the 80s and 90s. Hmm…
The answer, as best I can tell, is that gold is about perception rather than substance. The source of gold is mining. Mine production takes a while to ramp up (or down) so it’s sort of fixed. Demand is based on three things: industry, jewelry, and hording. Industry uses a roughly fixed amount for electronics and chemicals. Similarly, jewelry is somewhat constant although demand drops and melt increases slightly at high prices. The thing that really varies is the hording.
To be clear, I’m not being judgmental when I say hording. I’m just describing the behavior of buying gold and buying it in a vault somewhere. Or perhaps hiding it under the bed. Either way, at current prices hording represents the majority of net demand for gold. And I think most people would agree that hording is an emotional behavior. People horde because they’re afraid of societal breakdown or inflation. They sell their horde because the want something more useful than a shiny object. Fear and greed. It’s no coincidence that gold price bottomed in the happy go lucky 90s, and is at a peak in these over-anxious days.
Why the long rant? The reason is that I want to make sure my readers understand that internet economics is completely separate from successful trading. Successful trading is based on a rational appraisal of facts and the application of proven theories. Internet economics is based on political conformity to a libertarian/goldbug ideal that for whatever reason has found a happy home on the web. Past data shows that the theory is far from proven. It’s possible that the internet economists will eventually be correct, and the US will experience notable inflation. But it’s been 30 years without a single year of inflation over 4%, so we may be waiting a while.
Don’t bet the farm on something that hasn’t worked very well. Politics is a lousy reason to lose money.
Full disclosure: I’m slightly long both gold and the long end of the T-bond curve, for reasons more or less unrelated to this post.