Gold: Safety versus Liquidity. Which side are you on?

“The use of information content has been extended to define the complexity of a system as the amount of energy needed to maintain it. For example, it has been employed to explain the collapse of societies, arguing that as societies become more complex, they require more of their energy (loosely defined) to maintain the status quo, and can no longer defend themselves against the many inroads toward decline.”
                                    Richard Bookstaber

Commentary & Analysis
Gold: Safety versus Liquidity. Which side are you on?

A saw a prediction today stating that gold will reach $5000 an ounce because of a global supply deficit. Sure there are some industrial applications for gold, but will gold be consumed (and hoarded) to an extent that future mine supply and production won’t be able to sate?

Some think so. But this $5000 per ounce prediction assumes growth in demand remains flat. Dang. But for argument’s sake, could demand growth increase?

Added to the argument for higher gold prices is demand from central banks. True, central banks have become net buyers of gold rather than sellers over the last decade or so. But it is the all elusive Chinese central bank that lurks in the shadows, waiting to surprise everyone by upping its gold reserves to the average 11% of foreign exchange reserves. In other words: China would buy 6,000 tons of gold to meet that average.

I think I’ve been hearing this argument cited by gold bulls for at least 4 years. Not much progress has been made.

So I wonder: now that investors are all fiat-phobic, will China finally make a substantial alteration to its foreign exchanges reserves by bringing in some “real” currency?

I would assume China is scared to buy at a gold market top, whether intermediate- or long-term. I would also assume China doesn’t want to sell at a US dollar bottom, since naturally it is the wretched US dollar’s China wishes to dispense.

Of course, if $5000 an ounce is on the way, then China would be wise to buy now. Likewise, with fiat currency on the imminent path of implosion, why not get out now? Does China know something we don’t? Perhaps the fact that a lasting slowdown, one that will exceed all expectations, is in order – what happens if this happens?

They probably assume the US dollar will catch a bid when worse-than-expected Chinese growth expectations sour the global growth mood. And considering the state of European periphery nations and the vulnerability of their banking system, perhaps they are worried that another contagion might spread across the globe and send investors fleeing for liquidity.

This brings me to the topic of the day: liquidity versus safety.

I devoted the main article of my Commodities Essential publication yesterday to how the eurozone crisis might influence gold prices. I believe it has the potential to create a rush to liquidity as it did back in 2008. That’s when we saw the price of “real” currency like gold and silver tank along with many other foreign currencies and risk assets.

There are some, however, who do not agree with me. They see a flight to safety rather than a flight to liquidity. And in such a flight investors would flock to gold because they just can’t trust that dang fiat stuff and the promises of indebted and indeficited of governments. (Ok, I made up that word.)

From James Turk:

A lot of people ask if we get another Lehman style collapse, will gold and silver fall like they did in 2008? I say no they won’t. The reason is back in 2008 the primary driver after Lehman collapsed was a rush by investors, hedge funds and everyone else for liquidity. Most people learned a very valuable lesson from that event. Consequently, this time around you are not going to see a rush for liquidity, you are going to see a rush for safety. The safest haven of them all is physical gold and physical silver.

More from Mr. Turk:

The sharp rally that occurred today off of those support zones suggests to me that the correction is over. In other words we are going to see silver back above $40 and gold above $1,550 within the next couple of weeks. Everything is all set for new record high prices in both metals this summer, which is going to surprise a lot of people. I just think that people don’t really understand what can happen this summer. We’ve spoken before about the summer of 1982 when the gold price rose 50% from June to September, propelled back then by the Mexican debt default.

Back in 1982 gold was trading at an historic low, after a steady and deep decline from its peak when Paul Volcker freed up interest rates to move higher. Right now gold is trading near an all-time high. Market sentiment is obviously quite different at major highs and major lows. And considering the financialization of the economy and the QE-driven support for financial assets, might we see a liquidity-flight again, Mr. Turk? Sure – many people have learned a very valuable lesson; I’m just not sure it’s those that matter in this case.

I’ll allude to Mr. Bookstaber, author of A Demon of Our Own Design, as I often do; this is from his blog:

Complexity can be either an annoyance or a boon, depending on one’s enthusiasm for tricky problems. We all know intuitively that complexity makes accidents both more likely and more severe. After all, any machine with many parts has more risk of having something go wrong, and with more interconnected mechanisms there is more risk that a single failure will propagate to cause the entire machine to fail. For markets, the accidents are market crises. I pointed to complexity and tight coupling as key components in the origin of market crises in my book, A Demon of Our Own Design.

The global financial system is complex – that is a lesson we learned after the 2008 financial crisis. But what has been done to sufficiently prevent the same (or similar) mistakes that sent markets reeling a few years ago? Tight coupling is an ugly, and often invisible, thing until you put your hindsight goggles on.

Are investors going to be seeking safety from a fiat currency implosion sparked by a eurozone periphery default(s)? Or are investors going to be seeking liquidity from a financial market meltdown sparked by a eurozone periphery default(s)?

You know where my money is … and I don’t think gold can escape a rush to liquidity unscathed.

  • Buckscoder

    If nothing would change, your analysis would be true. But while some things remain resistant, many things change. Financial markets change in cycles. In the long term as in the short term, people become aware that liquidity is nice for buying or speculation, but bad for safety. Gold is a known material for keep your value long term. Since a couple of thousand years. Because it can’t be printed, it is even more undestroyable as precious safe haven. That governments tried to inflate money for devaluing their debt is old news. This was common practice in the empire of Rome and other periods following. They devalued their money while mixing other metals into the silver and gold coins. Why should that fundamental behavior of governments change, suddenly? Politicians in such cylcles as now are there to give empty promises, make debt and devalue that debt via inflation.

    Beside all of those fancy theories: Look at what single currencies survived over a couple of centuries, look at the gold price for a hundred years, look at the price last decade and those are facts speaking for itself. If you look at the dollar side by side, you can see the opposite trend in the long run.

    Sure there are pullbacks as in every market. So, if you look at a monthly gold chart, does that pullback of 2008 look surprising in a super bull market? It’s “shaking out the weak hands” and a buying opportunity for the smart money, nothing else. Those setbacks are healthy for the trend.

    Debating something is nice to understand how things work, but at least somebody has to act to make (or keep) money (value). So, did you act back in 7 years or so to buy gold or did you just missed the trend and are searching right now for reasons why it was a good thing to miss that small false breakout of gold? Gold WILL go higher in the same sense as a rotten herring will be eaten by small insects. What is closer to that herring: Gold or the dollar?