Recipe For Disaster

Two tragic incidents struck us recently. While one was a sudden form of destruction by means of the serial bomb blasts that shook Mumbai, the other is akin to a ticking time bomb that is waiting to explode - the Quantitative Easing policy expressed by Ben Bernake, the U.S Federal reserve chairman, to add more stimuli in the US economy by creating further money through unconventional methods.

Both the events unfolded at around the same time and have caused equal damages. The blasts saw an immediate effect of the lives of citizens of Mumbai and the monetary policy decision by the Federal will have long term implications not only to the US but to the world at large.

A few relations can be made between the two incidents. As a post disaster move to the bomb blasts, the government will engage in stringent checks, arrests and a lot would be written about the spirit of the city. But soon, all will be forgotten until it recurs in some other part of the country. Each such incident evokes anger and fear amidst the people and would someday (hopefully) force the government to change their method of functioning.

In the same manner, Ben Bernanke expressed the possibility of increasing monetary stimulus into the US economy which is equal to a slow poison unveiling itself, with adverse consequences. He is of the opinion that a falling economy needs support for revival. But, have Mr. Bernanke`s earlier two doses of stimulus (QE1 and QE2) been of any help to the economy? The main concern with such stimulus is that it does not reach the desired areas; instead it increases inequality and leads to mal-investments which are a waste of scarce resources.

A reflection of the policymaker`s imprecision was evident in a fiery exchange that took place between Bernanke and Congressman Ron Paul after Bernanke raised the topic of QE3. Dr. Paul expressed his skepticism over the positive reports on the economy, highlighting the lackluster improvement in the economy despite the Federal infusing $ 5.3 trillion dollars. He noted that the national debt has grown by $ 5.1 trillion, while GDP has grown less than 1% and expressed uncertainty over claims that inflation was low, since the prices were up 34% over the last three years despite the weak economy. He observed that 7 million people were still unemployed, and that the average term of unemployment, had soared to nearly 40 weeks from 17 weeks. So, Dr. Paul criticized the idea of bailing out banks and corporations, and suggested that the economy would be better off if the policies were made directly for the people.

The Fundamental Question: Is Gold money?

During the hearing, Mr. Paul questioned Bernanke`s perception of Gold commenting that dollar`s value had fallen by almost 50% against the yellow metal. He went on to ask the startling question "When you wake up in the morning, do you care about the price of gold?"

To which, the chairman, Mr. Bernanke replied. "I pay attention to the price of gold. But I think it reflects a lot of things. It reflects global uncertainties. I think the reason people hold gold is as protection against of what we call tail risks, really, really bad outcomes. And to the extent that the last few years have made people more worried about the potential of a major crisis then they have gold as a protection."

Let us read the brief conversation that took place between Mr. Bernanke and Dr. Paul to learn why the Federal does not pay enough importance to gold.

Dr. Paul: "Do you think gold is money?"

The chairman paused awkwardly, before finally replying.

Mr. Bernanke: "No, it`s not money. It`s a precious metal."

Dr. Paul: "Even if it`s been money for the past 6,000 years, somebody reversed that, eliminated that economic law?"

Mr. Bernanke: "Well, it`s an asset. Would you say treasury bills are money? I don`t think they`re money, either. They`re an asset."

Dr. Paul: "Why do central banks hold it?"

Mr. Bernanke: "Well, it`s a form of reserve."

Dr. Paul: "Why don`t they hold diamonds?"

Mr. Bernanke: "Well, it`s tradition, long term tradition."

Source: Bloomberg

The question on diamonds as a reserve hit the spot. Paul asked Bernanke why central banks did not hold diamonds, criticizing the fiat money creation through the Quantitative Easing process, and it was unfortunate to hear misinformation and self-delusion from the Fed. By now, it shouldn`t surprise us that the current administration and the Fed are themselves unable to sort out fact from fiction. And even when they realize the errors, they are unwilling or unable to accept the inconvenient reality.

A Race to the finish: Gold vs. Currency

Money or currency is the economic medium of exchange against which all goods are traded. Gold, even in its physical state too can be used as a mode of transaction in an economy. Unfortunately, any other contemporary monetary system including gold, no longer passes the "money" test. This is because governments have removed gold from its role as a monetary form of trade, often using the excuse that a more flexible type of money was needed to prevent financial crises and economic downturns.

But instead of acting as a stabilizer, the debt levels have reached unmanageable levels due to blatant misuse of paper money. We can expect money (or its equivalent) to retain its worth over time as a store of value, but there will be situations that arise where money may not be valuable, while gold could be used. Here, the test of whether that equivalent is money involves asking the question: Is it the general medium of exchange?

• If you answered with a yes, then you choose money as a medium of exchange,
• If the answer is no, well done! You are smart enough to know that a better medium of exchange could exist.

Here is how money is being promoted in the economy: The US dollar passes the money test and therefore gains the status of being termed as "money" within the US and countries that use the dollar as their currency, but not elsewhere. Again, the euro is adopted as the "money" throughout much of Europe, but not outside Europe. If each country starts adopt its own type of "money", where does it leave gold, an economic good that was equivalent to money for thousands of years?

Recognizing that gold doesn`t perform the monetary role at this time doesn`t devalue the metal in any way. I have no doubt that we wouldn`t be in this economic mess if the general medium of exchange were gold or gold-like. The reality is that nowadays gold is sometimes used as a currency, meaning that there are certain situations where gold is used to purchase things, but gold is not the currency in general use throughout the economy. In other words, gold is not money, but it is occasionally used as a currency.

Looking ahead: Will gold be money again?

The answer is yes. Gold is better suited to be used as money today than at anytime in the past, since today`s technology allows simple and instant ownership of gold through ETFs and other means as compared to physically transferring physical gold. Also, most of the gold owned by the investors, would remain locked in vaults - from a few of a grams to several kilograms, depending on the amount purchased -- being effected electronically.

But, no matter how far the high efficiency of technology in making the use of gold as money, it is unlikely that it will ever be on the same rank unless there is a severe economic shock. This is because only a total economic collapse would bring about changes in the economy that would make "money" look like the ideal choice. How compatible is this "money" when the government has promised benefits such as social security, pensions, promised `free` medical care, deposit insurance, payments to bondholders, etc.? Implementing "money" and leaving everything else the same would be the same as trying to keep a Ponzi scheme going without getting in new investments.

Replacing money that the government can inflate at will, with money that has rigid supply limitations, could only occur in line with direct default on a massive scale and the shrinkage of the government to a small fraction of its current self. And as long as it remains possible to `kick the can down the road` a little further, this is not a realistic expectation.

It`s high time that we embark on a political revolution. Our elected representatives are currently changing laws at the cost of our misery. Political vision is increasingly turning short term and can not aim beyond the next elections. The endless money creation in order to buy time is worsening the debt issues, as the fact that you can`t solve a debt problem by issuing more debt remains far from realization. The only hedge against this political binge is to own gold until there`s order at the center of decision making. Unfortunately, we do not have any protection against the mishaps of terrorism and are compelled to live in fear unless we force the government to take measures to make our country, city and home a much safer place to live in.

At least hedge your financial risks... own Gold.

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The views expressed in this article are the personal views of the Fund Manager of Quantum Gold Fund. The views constitute only the opinions and do not constitute any guidelines or recommendation on any course of action to be followed by the reader. This information is meant for general reading purpose only and is not meant to serve as a professional guide/investment advice for the readers. This article has been prepared on the basis of publicly available information, internally developed data and other sources believed to be reliable. Readers are advised to seek independent professional advice and arrive at an informed investment decision before making any investments. Please visit – www.quantumamc.com/disclaimer to read scheme specific risk factors.