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Quotable
“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.