Who is right? Warren Buffett and Charlie Munger and many more say you shouldn’t own gold. Ray Dalio, David Einhorn, Jim Rogers, John Paulson, George Soros, and I (among many others) own some gold—but that doesn’t mean you should own it.
Many people believe Warren Buffett is the magic Jesus of finance. He’ll be the first to tell you he is not. He’s made a lot of mistakes. He held on to Berkshire textiles for too long; he bought and sold Conoco Phillips for a $2 billion loss a couple of years ago, and more. But he’s avoided the really big mistakes, and he positioned himself to prosper in the wake of the financial crisis—irrespective of any taxpayer’s opinion about the methods. He also engaged in a huge successful silver speculation many years back. He might be right about gold today.
I own some gold as a hedge against inflation and currency devaluation, meaning—at the very least—that gold may lose less value than many other currencies, and that may include the USD. But looking at the future, there are a lot of moving parts, and there is an enormous amount of manipulation in the gold market.
If anyone asks you who says gold is money, you can point your finger my way. Money—and gold is money—has a price. A durable good has a minimum of two prices. One price is where it can be bought and sold, and the second price is that of the products or services it creates per a unit of time. Gold has purchasing power, the first type of price. The second price reflects gold’s utility as a store of value, the capital gain or loss as its purchasing power fluctuates.
There was a time when countries settled their payment imbalances in gold, and the metal traded at a fixed rate against respective currencies. You could convert dollars directly to gold as part of the Breton Woods system of international exchange. That time wasn’t very long ago.
Rome was beautiful on the holiday Ferragosto, August 15, 1971. I went to Europe for the summer, and it was my first time away from home alone. Rome was my last stop and I had a few more days in the Eternal City. I stayed at a charming hotel, and I was on a budget. I converted my dollars to lire (the Italian currency before the Euro), and vowed to spend only that much and no more in Rome for my hotel, meals, gifts for family, and general rabble rousing. My remaining dollars were held as an emergency reserve. I had planned for everything except Tricky Dick.
The U.S. knew for a long time—at least since the 1960’s—that she no longer had enough gold to back her dollars. So in 1971, when the U.S. got a demand she didn’t want to meet, President Richard Nixon cancelled the direct convertibility of dollars to gold. It wasn’t until 1976 that the dollar’s definition was changed to exclude any mention of gold and make it a pure fiat currency, but it was close enough for government work in August of 1971.
Suddenly Americans traveling abroad found that restaurants, hotels, and merchants did not want to take the floating rate risk of their dollars. On Ferragosto, banks in Rome were closed, and Americans caught short of cash were in a bind.
The manager of the hotel asked departing guests: “Do you have gold? Because look what your American President has done.” He was serious about gold; he would accept it as payment.
Half the hotel housed Americans, and he was worried. The staff looked worried, too. Americans filed by and their tension was palpable. No one had any idea how much the dollar would fluctuate in the next few days.
I immediately asked to pre-pay my hotel bill in lire, before other Americans could ask me to become their personal exchange agent. The manager clapped his hands in delight. He and the rest of the staff treated me as if I were royalty. I wasn’t like those other Americans with their stupid dollars. For the rest of my stay, no merchant or restaurant wanted my business until I demonstrated I could pay in lire. My budget had saved the day.
In 1978, I was in Iran when the Shah was deposed. The convertibility of toman (Iranian currency) to dollars was set at an artificial rate and was severely restricted. Some Iranians had hard currency and gold offshore. As people fled the country, they sold land, hand-woven carpets, and valuables for pennies on the dollar to anyone who could pay in hard currency or gold at their destination. Gold was trusted money.
India recently pulled a fast one on its citizens. Through restrictions and taxes, she made it difficult for people to buy gold. Soon convertibility of the rupee into stronger currencies ground to a halt, and the Indian government started to devalue (crush, actually) the rupee. A connected few got the memo before the rest of the Indian population.
I prefer to own productive well-managed assets that produce things people want and need and buy regularly. I want management of businesses to be honest and free from greed. I’d like the global financial system to be free from fraud and manipulation. I’d like to live in a country where present and future debt is a small percentage of GDP, and I’d like a balanced budget. I’d like the consequences of breaking laws to apply to those connected to Congress and the White House. I don’t want the Federal Reserve Bank to buy the banking system’s suspect assets or accept them as collateral for loans. I don’t want the Fed to buy a boatload of treasury bonds. (I also wish I could be invisible at will and fly like superman.)
Since I live in the real world, not a world of my preferences and wishes, I diversify. Gold is just one of many assets one can buy to diversify. Diversification doesn’t mean you won’t lose money. It just means it’s unlikely you’ll lose it all at once, and instead, you may do very well over time.
Gold will rise and fall in price, and it doesn’t generate any products or services. But it doesn’t pose credit risk, and unlike many U.S. stocks, it has never traded at zero. It’s a tangible asset at a time when there is reasonable distrust of many financial assets. There is also reasonable distrust in the managers of major banks and distrust of the representations of Central bankers and the IMF (more on that in Part 3).
According to former President Jimmy Carter, the U.S. no longer has a functioning democracy. He knows the U.S. is a republic, but he was speaking colloquially about rogue behavior.
Rule of law doesn’t seem to exist for financial criminals and other well-connected malefactors. The NSA’s surveillance violates our constitutional rights, and none of our branches of government seems to have the will to defend the Constitution. The IRS is being used for political ends. The U.S. has launched drone strikes, seemingly at will. The Treasury and the Fed seem to exist to serve the whims of U.S. banks.
In August, JPMorgan Chase, the U.S.’s largest bank by assets, halted new business with thousands of foreign correspondent banks. JPMorgan processes transactions and clears dollar payments with these banks, but it won’t do new business. JPMorgan also won’t take any new clients.
Capital controls are very inconvenient. Nothing, besides perhaps a war, gets a bank thinking about gold faster than an inability to process and clear hard currency (or what they thought was hard currency) payments. A time honored way around this is to buy and sell gold.
Speaking of war, General Wesley Clark revealed a post-911 plan for taking out seven countries in five years: Iraq, Syria, Lebanon, Libya, Somalia, Sudan and Iran. The U.S. may soon be at war with Syria. Wars tend to drive up the prices of oil and gold. This video is short, just over two minutes:
China is buying gold mines and is rumored to be buying gold. Conspiracy theorists say China has an endgame to supplant the dollar as the reserve currency, but maybe she just wants more gold reserves.
Gold has an advantage over other currencies, because it can’t be printed, and although it doesn’t pay interest, interest rates are relatively low at present. Rates can change fast, but for now, interest rates are below real rates of inflation.
The situation is fluid, and there are a lot of wild cards. It made me laugh that four gold invested fund managers recently used almost exactly the same words to me: “thinking about gold gives me a headache.” Let me sum up the causes of the headaches.
Gold prices are unstable. Under normal conditions, changes in mining output, demand, unpredictable behavior by governments that own gold, and unstable emotional expectations about future prices whip around the price of gold, especially in the short run.
The price is very volatile, and at any given time, you do not know who is buying or selling gold or why. It could be manipulation; it could be a fund tired of a long or short position; a Central Bank might buy or sell, someone could be covering a margin call, or a fund might massively deleverage…anything. When gold took a fast nosedive earlier this year, it displayed to me the pattern of a large investment being deleveraged, but conspiracy theories abounded.
Gold is also a tool for geopolitics. Consider recent remarks by a former CIA head. He made them at a dinner I attended at the Chicago Council on Global Affairs. In his opinion, it’s imperative that we break OPEC’s back.
He noted Saudi Arabia’s marginal cost of production of a barrel of oil is just a few dollars. Our marginal cost of production is much higher. The U.S. does not control the global price of oil—and never will, no matter how “energy independent” we become—because the marginal cost of production plays the tune to which we dance. Oil is a global market, and OPEC controls the price of oil.
We have sanctions against Iran, an OPEC member. If the U.S. wanted to put pressure on Iran right now, how would we do it? Iran’s currency was just extremely devalued, and she has been selling oil to Turkey in exchange for gold to convert to hard foreign currencies. If we destroy confidence in gold, we’ll kick Iran while she’s down (currency-wise).
Smashing the price of gold will help destabilize Iran, and destabilization is something the USA has done beforeto Iran. Gold price manipulation is not above us. That’s not to say we’re doing it, only that you shouldn’t put it past us.
Recently Venezuela, an OPEC member, repatriated her gold. She’s paying close attention to the price of gold, too.
It would be really awful if everyone invested in gold instead of producing things and investing in infrastructure to say, move food from farms to hungry consumers. It would also reveal the damage that the financial crisis did to the U.S. dollar and to confidence in the U.S. government.
In the most extreme scenario, the U.S. could criminalize gold ownership. President Franklin D. Roosevelt did exactly that on April l5, 1933. His excuse was that people were hoarding gold and stalling economic growth. You know, the way banks did by issuing value destroying securitizations and constipating sound lending. But we don’t punish financial criminals in the U.S. It’s easier to punish those trying to defend themselves from the consequences of that criminal behavior.
Anyone who tells you they know where the price of gold will be next year or next month is fooling you. No one knows. No one can tell you today whether diversification into gold is a good idea, a neutral idea, or a bad idea. But almost everyone will tell you that diversification is generally a good idea.
How much gold should be in an investment portfolio?
Warren Buffett and Charlie Munger may be correct. The right answer might be zero.
Greg Mankiw, professor and chairman of the economics department of Harvard University, wrote a recent New York Times article, wherein he states he no longer has an aversion to gold and thinks a 2% weight in the world market portfolio makes sense. Later he wrote that the “correct” answer based on “roughly plausible” assumptions is 4%. Mankiw imagines an uncorrelated portfolio of stocks, bonds and gold where stocks have a higher expected return than bonds, and bonds and gold earn the same return—for magic Chrissake, Greg!—and gold returns are three times as volatile (using standard deviation) as bond returns. To be clear, he made up those assumptions and didn’t provide a timeframe for their basis. In other words, he doesn’t know.
I met with a foreign fund manager with more than 50% of his assets invested in gold. He didn’t know the “right” answer either.
I don’t have the “right” answer, especially not for anyone else. But in in part one, I promised I’d tell you why reasonable people have diversified into gold.
This is part two of a four-part series. See also:
“Structured Finance: Sovereign Debt, Banks, and Gold (Part Three)”
“Gold Game Changer: J.P. Morgan Accepts Bullion as Money,” February 7, 2011.
Endnote August 31, 2013: Several of you asked for more about diversification. Prudent investors don’t invest in one or two assets, because the day will come when you will be wrong. I will write more about this in The Money Book. I do not yet have a publication date. Meanwhile, here’s a rule of thumb. If you invest in 15 assets, roughly a 6.7% weight for each, that will improve returns to risk by a factor of five. That’s five times the return for the same amount of risk, and they don’ have to be great assets, just good ones.
For those who asked when I will finish my next thriller, Vatican Gold, the sequel to Archangels: Rise of the Jesuits, I do not yet have a publication date.