What Are Gold Bugs Afraid Of?

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Photo: Anthony Bradshaw | Getty Images

The price of an ounce of fine gold entered this Millennium at $271.1, one of the lowest gold prices in the previous 20 years. Since then, the price of gold has soared more than five-fold. Over the same period, the Dow Jones Industrial Average increased 16.5 percent. Corrected for inflation, gold returned a whopping 480 percent, while real returns on major stock market indices in the U.S. and in the euro area were negative - in double digits.

That was meant to be a "killer" opening statement of a friend of mine, a lawyer and a notorious gold bug, in a heated discussion about the investment allure of what the British economist John Maynard Keynes called the "barbarous relic."

My response was that these exceptionally strong gold returns were mainly due to (a) what is considered to be the most serious financial crisis the world has ever known, and (b) the ensuing Great Recession in developed economies, representing 60 percent of global output.

(Read More: Gold Must Hit This Level to Be a Buy: Futures Pro)

"Exceptional?" my head-for-the hills, gold bug friend laughed. "Don't tell me that the gold's nearly 50-fold return since Nixon slammed the gold window shut (putting an end to the dollar convertibility into gold) on August 15, 1971 was all 'exceptional.'"

I desperately tried to change the subject because I knew that he was not interested in "exceptional" circumstances caused by the collapse of the Bretton Woods system of fixed but adjustable currency values that served the world well for nearly 30 years. The inflationary bias of the regime of generalized currency floating that followed oil price shocks of the 1970s and stagflation were too arcane discussion arguments when the lawyer was rushing to "rest his case."

Like all gold bugs, and most traditional monetarists, my friend has an unshakeable and total lack of confidence in fiat money – the authorities' discretionary power to print money. That deep mistrust transcends the usual reductionist view that gold is merely an inflation hedge.

(Read More: Are Fiat Currencies Headed for a Collapse?)

Recent events confirm that gold's appeal as an investment asset stems from much broader considerations. Think, for example, about the events that led to the 2008 financial crisis, inadequate regulatory reforms to prevent a similar debacle in the future, and the political and social upheavals caused by the euro area's economic mismanagement. All these developments are legitimate sources of worry about the reliable stores of value in what many political scientists - and not just gold bugs - perceive as a rudderless world.

Excessive Credit Creation

One does not have to be a gold bug to worry about huge amounts of money being created by the U.S. Federal Reserve and the European Central Bank (ECB). Both institutions are correcting their own earlier policy errors – failure to properly supervise their respective financial systems – by throwing fresh money at reckless lenders and irresponsible fiscal policies. How credible a policy is that?

(Read More: Fed Stimulus Isn't Tied to the Calendar: Bullard)

And what confidence a prudent investment manager can have in these central banks' assurances that they know when, and how, to withdraw the monetary stimulus before it sets in train the next wave of accelerating inflation?

The Fed and the ECB are not even thinking of stopping and reversing the stimulus, even though inflation rates in a sluggish U.S. economy, and in the sinking euro area, are already at, or above, their medium-term 2 percent target. What will happen to inflation when, in the months ahead, the U.S. economy begins bumping against its physical limits to non-inflationary growth (GDP growth in the range of 3-3.5 percent), and when the euro area starts recovering later this year?

Looking further afield, one sees the Japanese government pushing its central bank to raise inflation from -0.2 percent to 2 percent. India is struggling with its double digit consumer price inflation, and Brazil's inflation is accelerating to nearly 6 percent at a time when its economy's growth rate is expected to more than triple by the end of this year.

(Read More: What Will It Take for India to Cut Rates?)

Expansionary monetary policies are also observed in Southeast Asia. Most major economies in that area are maintaining negative real short-term interest rates to shield their exporters, while paying no attention to rising inflation pressures.

Clearly, the stage is being set for a broadening inflationary flare-up.

Increasing Gold Component of Reserve Assets

The novel feature of the last few years is that central banks have joined private investors' gold rush. From being net gold sellers at the turn of the Millennium, central banks have become net gold buyers. Gold purchases were part of their response to instabilities caused by the financial crisis, growing public debt problems in the U.S. and the euro area, and a major cyclical downturn in Europe. Countries as diverse as Bangladesh, Bolivia, Mauritius, Mexico, Sri Lanka and Thailand have been adding large amounts of gold to their reserve assets, to say nothing of China, Russia and India.

Given the prospects of rising inflation and excessive public sector debt in the U.S. and in the euro area, it seems clear that the demand for gold as a reserve asset will remain firm for the foreseeable future. That will particularly be the case with some large players like China, Russia and India. Using the G-20 and their own BRICS (Brazil. Russia, India, China, South Africa) group as political platforms, these three countries are leading the call for a new international monetary system. One of the things they want is a system of several reserve currencies, where gold might play some as yet undefined role.

The U.S. is strongly opposed to this idea, but the BRICS countries are not giving up. They will probably have the issue back on the agenda of the G-20 meeting in St. Petersburg, Russia, next September.

Apart from an apparent desire to diversify out of the dollar and euro holdings, China, Russia and India will continue to increase the gold component of their reserves as an instrument of leverage in their quest for a more balanced power structure of the international monetary system. The buildup of their gold holdings can be deduced from the decline of their dollar assets while their reserves continue to grow (China), and from additions of dollar assets representing a declining fraction of their total reserve growth (Russia and India).

Global Security Threats

Gold bugs also like to talk about the "fear factor" driving the rush to the yellow metal. In that context, they understand that disagreements about the structure and the functioning of the international monetary system are emblematic of the emergence of new power centers that were either not present or not influential at the conference tables (in Bretton Woods in 1944 and at the San Francisco Peace Conference in 1945) where the post-war world order was set out.

(Read More: Even Gold Bull Jim Rogers Is Turning Cautious)

Incipient power shifts, and an increasingly contentious reality of a multi-polar world, are the political and security background to acute crises engulfing Syria and the rest of the Middle East, North and Central Africa, East and South China Seas and the Korean Peninsula.

In view of all that, gold bugs may be forgiven for dismissing optimism about human rationality in favor of less rosy scenarios. Indeed, armed conflicts are spreading, thousands of people are dying every day, and new sparks are ready to ignite intractable conflicts because reason is failing.

Take a case of Syria. Death, misery and destitution are mounting by the day because the world is unable - or unwilling - to stop the fighting and find a political solution to a political problem. Syrian people are caught in the middle because outside forces are pursuing their own agenda of irreconcilable differences. And these outside players know that Syria can easily light up the rest of a highly combustible Middle East and North Africa.

Or think of the Sino-Japanese conflict in the East China Sea, where neither side is ready to back down and compromise. Outside observers are warning about the risk of "miscalculation," when China and Japan consider the four islands (Diaoyu for China and Senkaku for Japan), and the surrounding waters, as part of their sovereign territory – and behave accordingly by using the islands' sea lanes and airspace as their own. Clearly, this is an "accident" waiting to happen, where the fighting will not be limited to China and Japan.

(Read More: Why US Arms Sales to Asia Are Set to Boom)

How big a step is there between the fury of the current economic and financial warfare that is exacting an increasingly high cost on the Japanese economy and a shooting war? One can only hope that Sun Tzu's wisdom will prevail: "The supreme art of war is to subdue the enemy without fighting."

Speaking about irrationality, France is getting involved in an open-ended ethnic and religious military confrontation in its former colony of Mali, instead of trying to find a peaceful solution to the conflict. A yet another case of failing reason at the time when the stagnating French economy and rising unemployment threaten the country's - and the euro area's -- fiscal and financial stability. The seven-month war in Libya in 2011 is estimated to have cost France about 300 million euros. A relatively small amount, but an important digression when France's public debt kept soaring to 100 percent of GDP (from 95.5 percent in 2010). This year, the French public debt is expected to exceed 105 percent of GDP.

No problem. The ECB will be providing unlimited lending to French banks, which will then pick up the government's ballooning IOUs.

Enough to send my gold bug friend screaming about a blatant case of inflationary finance. And he is right.

Those of you watching this post may have noticed that in my recent articles I was somewhat cool to gold purchases. I still am, because I believe that - at current levels - the gold price is a bit bubbly. But I also believe that economic and geopolitical risks - compounded by hugely conflicted global governance – bode well for gold as a long-term investment asset.

(Read More: Gold Above $10K? Don't Rule It Out)

Buy the "barbarous relic" on any major downward correction. It cannot be printed, and there is a limited amount of it: some gold watchers tell me that, as of 2011, only 171,300 tons of the yellow stuff have been mined in human history, and that it would all fit in a cube of 21 meters on a side.

Michael Ivanovitch is president of MSI Global, a New York-based economic research company. He also served as a senior economist at the OECD in Paris, international economist at the Federal Reserve Bank of New York and taught economics at Columbia