When The Yellow Dog Barks

Since the inception of this blog, I've generally treated it as somewhat of a respite from my job, which is asset management. Thus, with occasional exceptions, most of my musings here have been only tangentially related to the economy, finance, the stock market, etc. But when I feel something is happening that's important for readers (particularly those not well-versed in economic issues) to understand, I've written about it. This is one of those times.

As I type this, the price of gold is currently at $521, its highest level since 1981. For visual reference, a three year chart appears here. Gold's rise has extremely important implications. As I've written before, while the Federal Reserve has been raising interest rates at a snail's pace since last year, it has also been hurling liquidity at the financial system and the stock market. Gold represents many things to different people, but essentially it's a proxy for excess liquidity. When there's too much money around, the price of gold generally rises as people try to maintain purchasing power against the effects of inflation.

I've been bullish on gold for several years because of the irresponsible fiscal and particularly monetary policy in Washington. For the past few years, the Federal Reserve has reacted to every minor bump in the economy or the stock market with a massive round of fresh liquidity. In the nanny state, economic weakness---or, God forbid, cleansing of overcapacity and malinvestment---can't be tolerated. This is particularly true during an unpopular war led by an unpopular president. Gold loves the nanny state. It adores offensive wars started by politicians who spend without considering the consequences. Regardless of what one thinks about George Soros, one of the all-time great quotes about politics and the financial markets belongs to him: "All of economic history is one lie and deceit after another. Your job as a speculator is to get on when the lie is being propagated and then get off before it is discovered." Gold is the ultimate polygraph machine. It stands as a silent sentinel, taking notes on what it sees and reacting accordingly. Thus, the fresh 24-year high in its price.

Alan Greenspan knows all this. Before he became an integral part of the nanny state's machine, he wrote the following in a 1966 essay titled "Gold and Economic Freedom":

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

Essentially, Greenspan's point is that gold enforces consequences. That's why Nixon officially decoupled the dollar from gold in the early 1970's; as the U.S. printed excess money to pay the debts from the Vietnam War, it sought to disguise the consequences. Greenspan refers above to the government making the holding of gold illegal. In 1933, Roosevelt outlawed the ownership of gold by U.S. citizens as the government tried to remove any constraint on its ability to reflate during the Great Depression (history buffs can view a copy of FDR's executive order here).

Unlike some of the moonbatty goldbugs out there, I don't see the sharp rise in gold as a sign that financial apocalypse is on the calendar for next week. Rather, it is an indication that stress is rapidly building under the surface. In this case, that can take several forms including the diversification away from dollar-denominated assets by foreigners. This is in fact happening right now, as Russia, China, the Saudis and others have been buying gold. And you've no doubt noticed the increasingly shrill hysteria about Hugo Chavez. Did you think that was just about "democracy"? Venezuela has been using its profits from oil to buy gold as well---unacceptable to statists who abhor consequences. When stress builds in the financial system, usually the results are not manifest right away. The real fallout from the 1987 stock market crash wasn't visible until the early 1990's. Similarly, the hangover from the 1990's stock market bubble hit after Clinton left office, and continues to this day. I suspect that the financial zealotry occurring right now in Washington will have a similar denouement, and gold is simply warning of its increasing inevitability and eventual magnitude.

I also think another recent event is contributing to the sharp rise in gold. On October 24, when Bush nominated Ben Bernanke to replace Greenspan, gold closed at $465. The next day it rose to $472 and has never looked back. Bernanke's nickname on Wall Street is "Helicopter Ben", a reference to a speech he made in 2002 in which he extolled the virtues of the printing press (i.e., dropping money from helicopters if needed). Gold adores a Fed chief who brags about his helicopter pilot's license.

What happens from here? The Federal Reserve can remove liquidity from the financial system, which would take the steam out of both gold and oil. That's not an attractive option for the Fed or the White House since it would also dampen the stock market, which in turn would restrict our ability to pay for this war, impair Bush's ability to rebound in the polls, and disappoint the business community and financial industry (and yes, I'm operating on the manifestly obvious fact that at this point the Fed has completely surrendered the political independence it is supposed to have). Or the Fed can continue to monetize each and every bump in the economy and the stock market, in which case gold will likely head towards $750 and oil for $80 with a concurrent and possibly precipitous rise in geopolitical tensions. That's the essence of the box the Federal Reserve has built for itself, and for us. In its role as sentinel, gold is indicating that the Fed has already chosen its course of action.

And in that regard, here's a bit of advice for the "no consequences" bunch as they prepare to explain away gold's rise. They've done an excellent job of perpetuating the "we're running out of oil!" meme in order to disguise the link between excess money creation and higher oil prices. With gold, start with the line that "gold is reflecting increased prosperity, so higher gold prices are a good thing." When that gets old, trot out "gold is an ancient, barbarous relic." As the desperation builds, try "it's unpatriotic to own gold." Eventually, establish a mantra that "gold is the currency of terrorists." And when there are no more pages in the script, conjure up FDR's spirit for advice on what to do next.