Europe and Washington’s debt ceiling squabble has seen gold breach $1600 per ounce. The financial media’s standard line is that investors are scared and gold represents a “safe haven”. But how? What are investors scared of that’s led some of them to bid the gold price higher?
First off, a little context. Over the last decade, US national debt has more than doubled, rising 138% in Dollar terms. That doesn’t account for inflation, however – and as we’ll see below, inflation is viewed by some as part of the ‘solution’ to the debt problem. Yet measured in terms of gold- the nemesis of Uncle Sam’s debt, apparently – US national debt has actually fallen for the last ten years:
Put another way, the average annual Dollar gold price has risen faster than Uncle Sam has been able to write his IOUs. Which is no mean feat!
The US now only owes the equivalent of 340,000 tonnes of gold – still more than the total sum of gold ever mined (twice as much, in fact, according to best estimates) and way above the 8,113.5 tonnes the United States Treasury says it holds between Fort Knox and the New York Fed.
But why would gold demand rise – pushing the gold price higher – in response to the growth of national debt?
Like money itself, debt – whether a personal loan or the kind racked up on our behalf by our elected representatives – represents a claim on resources, otherwise known as wealth. At some point in the future, the debtor is expected to hand some wealth back to his or her creditor, ideally the principal plus some level of profit. Trouble is, debtors don’t always follow the script.
Now, when it comes to resolving its national debt, the US government has five options:
#1. Economic growth – The economy produces more real wealth. The government, through taxes, takes a slice of this growing pie, and pays back the bondholders from whom it has borrowed in the past;
#2. Raise taxes – The economic pie doesn’t need to grow. Uncle Sam could simply raise the rate of taxation, and use that bigger sum of cash to repay its debt;
#3. More borrowing – As interest or debt repayments fall due, the Treasury simply goes back to the bond market and borrows from Peter to pay Paul;
#4. Default – Just don’t pay. Tell the creditors to get lost;
#5. Pretend to pay – The US Dollar is the world’s No.1 reserve currency, giving foreign central banks (especially in fast-growing Asia) little choice for where they might store their burgeoning savings. The US Treasury borrows in Dollars. The Federal Reserve has the power to create Dollars. The more Dollars there are, the less each one is worth – but when you’re handing them over to someone else, who cares?
The first option tends to be the one creditors bank on, in order to get back what they lend. Right now, however, the prospects for strong growth look bleak. Check out these scary numbers:
· The Congressional Budget Office reckons this year’s deficit will be $1.5 trillion;
· US national debt was an estimated $13.4 trillion in 2010;
· This implies a growth rate for debt of around 11% per year.
Economists may quibble at the margins about the data, the methodology, and so on. But a stark fact remains – the US will need to post some stellar growth rates just to stand still. Unless, that is, its government picks one of the other four options. Besides the highly contentious Option 2 of raising taxes, in fact, this is exactly what America’s been doing for years.
Option 3, more borrowing, has been exceedingly popular, leading to accusations that Washington is running a Ponzi scheme. The problem with a Ponzi scheme comes when you run out of new schmucks to help pay profits (or simply repay the principal) to early investors.
Is $14.3 trillion that point? Clearly not – the debt ceiling is an artificial, political construction, not a reflection of any financial reality. Investors remain willing to hold US sovereign debt, as shown by – and despite – the appalling rates of return it offers. (Bond yields fall when prices rise, and US debt has never paid so little in interest.) This may not always be the case, though, especially if creditors start to fear that Option 4 is on the table and a true default is looming.
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