Don't dump gold yet, inflation is still alive

For gold to plunge in price in the way it has this week, at a time when leading central banks around the world are printing unlimited quantities of paper money and when warnings are being sounded loud and clear about the dangers of rising inflation in emerging economies, one would have thought the world had gone mad.

Gold has traditionally been seen as a classic hedge against currency debasement, and the fact that the bullion price has dropped so far at a time when money is being printed with total abandon means that the idea of "bad money driving out good" (Gresham's law) is regarded now as obsolete.

It seems to be assumed that the "dragon" of inflation is dead - at least in the so-called advanced economies - when in fact it is almost certainly just dozing, waiting to roar back into life when least expected.

Already it is beginning to breath smoke, if not yet fire, in Asia. It is as though the economics of the Bitcoin world had infected global investors, and financial logic had been turned on its head. But then the way in which markets are ignoring the perils of latent inflation and potential fiscal crises hardly suggests that sanity is prevailing.

The most rational explanation for gold's US$100 an ounce price plunge on Monday is that some potentially hideous losses are expected in suddenly very volatile bond markets, or in equally volatile currency markets - and that investors are dumping gold to cover these losses.

This week's events also suggest that there could be a stampede back into gold once the realisation takes hold that there are no longer any really safe havens in currency, equity or bond markets now that central bankers are near to papering their toilet walls with paper instruments.

Perhaps at the root of the problem is the fact that financial crises have become apparently painless since the time of the dot.com bubble in 2001 and the global financial crisis of 2008-2009. What does not hurt you you do not fear, and what you do not fear you do not guard against.

Alan Greenspan, then chairman of the US Federal Reserve, exercised his famous "Greenspan put" at the time of the dot.com debacle and flooded the US system with enough money to absorb most of the dot.com shock and to get the US economy moving forward again.

In 2009, Fed chairman Ben Bernanke went one (or more) better than Mr Greenspan and "monetised" the mountain of private and public debt which threatened to engulf the US (and the global) economy by printing even greater amounts of money, under quantitative-easing policies.

Inflation kept a low profile and fears of hyper-inflation were regarded as being akin to believing in vampires. European Central Bank governor Mario Draghi proved that he too was above such superstition and promised to buy up all the bonds in sight to counter the eurozone crisis.

Now, Bank of Japan (BOJ) governor Haruhiko Kuroda has thrown a cool 135 trillion yen (S$1.7 trillion) at Japanese deflation while ruling out the possibility that Japan's deflation could metamorphose into runaway inflation, or of a sudden spike in bond yields. All three governors may live to rue their rashness.

Perhaps we should not be too hard on the central bankers, however, since it was finance ministers who started the rot by bailing out distressed banks and other financial institutions after the 2008 crisis, by using money that was in effect conjured out of thin air.

Governments then got into such deep debt themselves that they had no option but to beg, bully and cajole their central banks to lend them limitless amounts of money, with scant chance of it ever being paid back. The debt will sooner or later have to be inflated away instead.

But the problem with shielding everyone from pain in this way is that no one believes any longer that such pain exists. As former Goldman Sachs (Asia) vice-chairman Kenneth Courtis put it, the BOJ appears to have "jumped off a cliff without a parachute. Fun, until you land".

The World Bank and the International Monetary Fund have sounded a warning note, however. Both cautioned this week that the sea of liquidity being created in the United States, Europe and now Japan is slopping over into Asia. Masking problems tends to make them go away for a time but then they crop up elsewhere and, by "exporting" theirs to emerging economies through massive liquidity creation, the advanced economies have almost guaranteed that inflation, asset bubbles and currency crises will appear elsewhere.

If emerging economies, in East Asia and elsewhere, learn their lesson from the West (as Japan has done) and decide to set their own money-printing presses rolling madly after they are hit by asset bubbles, the whole problem will be compounded massively.

Problems arising from the need for rising interest rates in Asia, allied with increased trade protectionism and the general disruption of financial systems and economic life in the region, would quickly wash back to the West like the tide of portfolio capital that has rushed out to Asia Financial markets need to wake up to the fact that they are living in never-never land and that they need to lift their gaze above a day-to-day search for a few extra points of yield on bonds, currencies or whatever, and to focus on the need for real hedges.

To (mis)quote William Shakespeare: "All that glitters is gold."

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