How Gold Rallied for Years on a 'Misunderstanding'

Source: World Gold Council

The rally in the gold market over the last several years has been based on a misunderstanding of the global economy's problems and a misunderstanding of what quantitative easing is.

Investors are just starting to realize that their framework for analysis can't account for what's happening in the world right now. They are gradually learning that the economics they learned from textbooks needs updating. That's why they are starting to throw in the towel on gold and why I expect the price to fall further.

The macroeconomic case for buying gold can be summed up by recent comments by John Reade, partner and gold strategist at Paulson & Co, who said: "federal governments have been printing money at an unprecedented rate creating demand for gold as an alternative currency. It is this expectation of global paper currency debasement which makes gold an attractive long-term investment." (Financial Times, April 15 2013). This analysis is based on a misunderstanding of quantitative easing. Furthermore, it fails to take into account the unorthodox behavior of an economy facing a "balance sheet recession."

Governments have indeed been engaging in quantitative easing. But can that be called printing money? True, the central bank's balance sheet expands, but on the private sector side, all that happens is that banks replace one asset with another – they sell bonds to the central bank and get reserves in their place. Are reserves money? This is a philosophical question akin to asking when life begins – at conception or at birth.

Bank reserves are in effect embryonic money that hasn't been born yet. The bank can give birth to new money based on those reserves, using the fractional reserve system to create money and lend it out. But until those loans have been made and the new money born, reserves are just potential money sitting in the central bank's womb.

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At the moment, this birthing process isn't happening. The money multiplier (the increase in broad monetary aggregates relative to the increase in base money) has collapsed around the developed world as bank lending stagnates or declines.

The reason central banks in effect can't even give money away for free is that we are in a balance sheet recession. So long as consumers and companies find that the value of their assets – houses, shopping malls or whatever – are below the value of the liabilities they took on to pay for those assets (a situation technically referred to as "bankrupt"), they will not be in a position to take on new loans no matter how cheap they are. They will only be interested in saving money and repaying their loans.

This is the aspect of a balance sheet recession that confounds people who have only experienced a typical recession caused by the central bank raising interest rates. In a normal recession, once the central bank lowers interest rates again, borrowers return and things go back to normal. In a balance sheet recession, such as took place in Japan, this doesn't happen.

(Read More: The Race to Cut Rates: Look What Japan Started)

The problem is compounded nowadays because governments, particularly in Europe, don't understand this difference. They run afoul of the fallacy of composition: it's impossible for everyone to save money at the same time, because one person's spending is another person's income. There has to be some borrower of last resort to ensure that the money is recycled. The government usually serves that role, but that goes against the trend in official ideology nowadays. On the contrary, governments are trying to save money too. The result is a downward spiral of declining spending, declining incomes and declining prices.

While the gold bugs wait for hyperinflation, the global economy slides first into disinflation and then – who knows? – perhaps deflation. Remember that in Japan, the real estate bubble peaked in 1991 but deflation didn't start until 1999. It's still early days.

As people hoarding gold in anticipation of hyperinflation gradually realize that they have things backwards, they are starting to sell and to put their money to work in more productive assets, such as stocks. The physical market may see today's prices as a fire-sale bargain, but investors holding gold in paper form are likely to be reconsidering the need for an asset to fill the role that gold currently plays in their portfolio.

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The risks in gold that people in the physical and the paper markets see are different. Many of the people holding physical gold can wear it, will never be marked to market, and if worse comes to worst can pass it down to their children. But many of the people holding paper gold get no particular pleasure from their investment, are marked to market at least every quarter and can lose their jobs (and thereby lose even their debased paper currency!) if their investments go wrong.

I expect more selling to come until the price falls well below the marginal cost of production, estimated to be around $1,100 an ounce, and supply starts to decrease.

The author is the Head of Global FX Strategy at IronFX, an on-line trading firm specializing in Forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously Head of the Forex Committee at Deutsche Bank Private Wealth Management.