Are Gold and Silver in a Bubble Market?

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We look at
the real estate markets in coastal cities and conclude, "these
are bubble markets." Yet they have not risen as far and as
fast as silver and gold have risen since 2001.

most recent first-time buyers of gold and silver give no thought
to what should be obvious: the moves of both metals over the last
four years are anomalies. Other than believing they are geniuses,
why should precious metals investors not be getting nervous?

Gold and silver
are inflation hedges. Yet the Federal Reserve System is sending
mixed messages regarding inflation. On the one hand, the FED has
been increasing the adjusted monetary base at double-digit rates
since late 2005. The other monetary indicators have followed. This
can be monitored here (and should be).

On the other
hand, the FED has also raised the federal funds rate by a quarter
of a point every time the Federal Open Market Committee (FOMC) has
met since mid-2004. This is the classic sign of anti-inflation policy.
The short rates have been rising faster than long rates, which has
now produced a flat yield curve. An inverted yield curve is a prelude
to a recession. The
yield curve can be monitored here (and should be).

So, which is
it: recession or accelerating price inflation?

Right now,
we are in "anyone’s guess" territory, which is why wise
investors had better monitor the statistics of these seemingly rival
policies on weekly basis. It is not clear which FED policy is dominant
today. A great deal is at stake.


The growth
of the U.S. government’s annual budget deficit is being matched
by the growth of the balance of payments deficit. Wise investors
look at these twin deficits and conclude: "This cannot go on
indefinitely." So, they ask themselves: "What is likely
to reverse these trends?"

The answer
to the payments deficit is a fall in the value of the dollar. Foreign
investors will cease buying dollars for purchasing dollar-denominated
assets. This will reduce international demand for dollars, which
will produce a falling dollar internationally. Prices of imported
goods will rise.

But if this
happens, how will the U.S. government persuade foreign investors
to buy its T-bills? The obvious response is to raise short-term
interest rates. This is what the FED is doing today.

Raising short-term
rates has a negative consequence: it produces a recession. First
the yield curve goes flat. Then it inverts. Then there is a recession.
We are halfway there today: a flat yield curve.

So, it is possible
to have simultaneously a falling dollar internationally (scenario
#1) and a recession domestically (scenario #2).

The FED today
seems to be moving to head off scenario #1. How? By raising short-term
interest rates. Yet it is also clearly trying to head off scenario
#2 by inflating the money supply. I am reminded of the Apostle James’

A double
minded man is unstable in all his ways (James 1:8).

If you have
been following the price of gold and silver, both seem to have topped
out. So, for that matter, has the Dow Jones Industrial Average.
I contend that the reason for this hesitancy on the part of investors
to buy or sell en masse is their confusion with respect to Federal
Reserve policy. Until the FED makes up its collective mind, marginal
investors will be hesitant to issue either "buy" orders
or "sell" orders. I cannot blame them.


The FED, beginning
in late 2000, saw what had happened to the yield curve: it had inverted.
That was when I predicted a recession in 2001. The FED saw this,
too. The FED began cutting the fed funds rate a quarter of a point
at a time.

Then came the
2001 recession: March. The FED continued to reduce rates. Then came
9/11. The FED continued to reduce rates. The housing market continued
to rise, and gold and silver at long last began rising. That was
when I issued a strong "buy" recommendation for gold:
the fall of 2001.

Gold in 2001
had been battered by 21 years of downward pressure. It had gone
to $840 in early 1980. Despite a doubling of the price level, 1980—2000,
gold declined to the mid-200s in 2001. I became convinced that an
anti-bubble process was at the end of the road.

Gold is not
a recession hedge. It is an asset that can be sold to raise funds
in a crisis. It gets sold in recessions because people want to raise
cash. Selling any asset is a way to raise cash. Gold is not under
any king’s-X safety umbrella.

Silver is even
less protected from recession-induced sales, which is why silver’s
price is more volatile than gold’s. It has no central banks buying
it during recessions. Meanwhile, demand slows because the economy
is slowing. Silver is an industrial metal and to a lesser extent
an ornamental metal. Demand for most metals falls when the economy
goes into recession.

There is a
longtime myth of gold that has been popular in every pre-recession
period. Recent buyers console themselves by saying: "Gold did
not fall during the Great Depression. It went up." In the 1930s,
the U.S. was still on the gold standard internationally. By law,
the U.S. government bought gold from gold mines at $35/oz. So, the
gold market had a legal floor.

That policy
ended on August 15, 1971, when Nixon unilaterally took the United
States off the international gold standard. So, the experience of
the Great Depression is economically irrelevant to today’s gold
market. Central banks may buy gold or they may not, but they are
not compelled by law to buy it. All we can say with confidence is
that they will not buy silver, which is no longer a money metal.

Gold fell in
the 1974/75 recession. Then it rose in the Carter-era inflation.
Then it fell by 50% in the 1980/81 recession. Then it fell in 2000
prior to the 2001 recession.

My point is
that gold, as an inflation hedge when price inflation exceeds what
the experts have forecast, should not be regarded by investors as
a universal solution to the gyrations of Federal Reserve monetary

Silver is even
less of a hedge. It has been de-monetized, so it is even more a
captive of the overall economy.

The FED is
trapped long-term in a policy of "inflate or die." It
is committed to the absurd premise that a committee of academic
economists (FOMC) is a better source of monetary policy than the
free market. The FED has created a boom economy — i.e., a universal
bubble economy — through the constant expansion of money. Like
addicts, investors, consumers, and debt-issuing governments demand
ever-more money from the Federal Reserve. Everyone has factored
in 2% to 4% monetary depreciation. If the FED fails to provide this,
the entire debt pyramid is threatened with collapse.

So, we find
that the FED does not stabilize money. It expands the money supply
at varying rates. Sometimes this expansion is insufficient to goose
the economy into more growth. The economy then falls into recession.
The FED’s response is always the same: create even more money.

This process
of varying rates of monetary expansion does not immunize gold and
silver from wide swings in price. In the case of the period 1980
to 2001, the contraction wiped out 90% of investors’ asset value,
if you factor in the 50% loss of the dollar’s purchasing power.


A new generation
of investors has arrived. It took them at least two years to believe
that a new bull market had arrived: 2001—2003. Then they hesitantly
began getting into the precious metals’ market. They have done well.

They are newcomers.
They don’t understand fully why they bought. They just understand
that their investment’s market value has risen. Remember: "Genius
is a rising market." They are tempted to regard themselves
as geniuses.

If the economy
goes into a recession over the next 12 months, the precious metals
are unlikely to continue their upward move. The pressure on asset-holders
to sell in order to gain cash is always a problem for asset holders
who choose not to sell. They see the value of their holdings fall.
Yet prices in general continue upward.

I do not expect
a fall comparable to what happened to gold and silver after January,
1980. That was an historically unique period in the post-World War
II era. The rate of price inflation under Carter soared. This, coupled
with Bunker Hunt’s silver play, created panic. Then the Soviet Union
invaded Afghanistan in December, 1979. The metals mania exploded
for one month: January, 1980. Then it ceased, overnight.

Still, there
will be selling pressure if the recession hits, as it looks as though
it will hit, if we take seriously the flat yield curve. This is
not written in stone yet, but the behavior of the metals markets
and the U.S. stock market does point to increasing doubts concerning
the continuation of the economic boom.


In a recession,
asset values tend to fall as people become desperate for cash. Fear
is a great motivator. So are margin calls. The marginal sellers
of assets are more active than the marginal buyers of assets.

I am issuing
this warning because I know how many of my subscribers have not
gone through a recession-induced fall in the precious metals markets.
I don’t want new investors to conclude that the boom, 2001—2006,
was a fluke, a bubble that will not return for decades, which was
the case after January, 1980. The gold and silver markets, unlike
the housing markets, are not driven by long-term government-subsidized
mortgage money. So, I do not call them bubble markets.

they are markets. They respond to supply and demand. Recessions
increase the supply of assets offered for sale and reduce demand
for these assets. The quest for ready cash in a recession is a universal
aspect of all recessions. Don’t expect the next recession to be

The FED stands
ready to inflate its way out of the next recession. It seems already
to have begun. This is the case for the precious metals. But it
is a long-run case, not a full-time case.

Be forewarned.

15, 2006

North [send him mail] is the
author of Mises
on Money
. Visit
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible

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