Financial Sense

Gold & the Flood of Cheap Government Money

by Paul Tustain, BullionVault.com | October 8, 2008

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"...If we allow governments to control finance, we give them extraordinary power over which projects are allowed and which are deemed inappropriate..."

The BRITISH PRIME MINISTER, Gordon Brown, says the current mess in world finance and credit is the fault of "irresponsible" bankers.

Well, he would say that, wouldn't he?

Let's not forget that Mr.Brown claimed the credit for 10 years of unbroken growth here in Britain. For those 10 years he copied Alan Greenspan – the ex-US Fed chairman – by holding interest rates unusually low, aiming to encourage investment and demand, which is a near-sighted economist's way of avoiding mild recessions.

But this low-interest rate medicine stimulates both the supply and the demand for those products which Mr.Brown now blames bankers for promoting. It leads directly to a world of crazy finance, because low rates punish caution.

In a time of state-sponsored easy credit all projects get financed by incautious banks with cheap, centrally supplied money. There is no market for cautiously lent money, priced correctly for the risk involved. Why would anyone pay more for funds from a cautious bank when cheaper funds are available from easier sources?

This is why the profits of incautious banks grew, and why their stock prices multiplied. Meanwhile careful bankers sunk. As Brown (and Greenspan) injected ever more money into the economy the cautious banks began to lose their customers, their managers, their share values, and their independence. This Darwinian extinction of caution is the direct result of a monetary environment which was hostile to cautious bankers, one which favored those banks with an appetite for cheap money.

So be in no doubt about the cause of the credit crunch. It was too much cut-price credit, and the blame for the supply of it rests squarely on the likes of Gordon Brown and Alan Greenspan.

So much for the blame. What now?

It seems almost everyone – from both the right and the left of the political spectrum – agrees that the world needs more government intervention in the form of bail-outs and increasing regulation. We're getting it, too.

Yet once we have grasped that the underlying cause of this disaster was credit creation by government itself, we should perhaps be a bit wary of putting governments ever more in charge.

Governments operate a cheap credit policy in order to defer pain, stay popular, and get re-elected. The US, British, Australian, Russian and now pan-European bank rescues are intended to create and promote a higher volume of cheaper and easier credit than the market really wants. They aim to supply yet more of the wretched stuff which got us here in the first place.

Is that really so wise?

If we allow governments to control finance through regulation, we give them extraordinary power over the direction of the economy. Because they can (and will) deny finance to some projects and grant it to other, more politically appropriate ones. Such government control has repeatedly shown itself to be much worse than our imperfect marketplace at handling the power of economic direction – both in this case, where their efforts at economic stimulation are the root cause of the fiasco, as well as in recent history, particularly with communism.

The new rush of bail-outs, and their associated tighter regulation, pushes us further towards the socialized "command" we thought the world had abandoned in 1989. That is bad – and there is a better way to rapidly re-configure our economies in the right way:

More than ever we need to trust the market. Let interest rates rise (without government interference) and allow the market to kill off those institutions whose functioning depends on limitless supplies of cheap credit.

Yes, there would be pain, but it would right a long list of wrongs. It would make houses affordable for younger working people. It would make saving worthwhile again. It would make borrowing less attractive. It would increase the use of equity in the financing of enterprises, and significantly decrease their use of debt, making all of them much safer in future downturns.

Each of these moves in the right direction are, sadly, the moves which yet another dose of rescue money will now suppress. This won't be understood by our politicians, however, so we will get yet more patched-up bail-outs – and lots more regulation besides.

Did you notice? While the United States, Britain, the Netherlands and Australia were banning short selling on their local stock markets, the Chinese were relaxing restrictions on it. This is enormously telling. Asians – suppressed by the command economy for decades – aspire to a world of free enterprise. Unlike us they are now prepared to accept the costly consequences of those repeated errors which the free enterprise system allows people to make.

When we finally wake up under the yoke of our new, improved and over-sized government regulators, we will have lost the privilege of benefiting from free and highly profitable financial centers. It's the turn of Hong Kong, Mumbai, Shanghai, and Singapore.

Oh well – it was nice while it lasted. And from an avowedly selfish point of view, I think it is almost certain that these tax-funded bail-outs will be good for me personally.

I believe we will now avoid the pain of a sharp correction. Instead we will get many years of miserable underperformance in shares, bonds and deposits – the classic backdrop to a strong bull market in Gold.

With no bailout, gold would probably rocket even faster than it has this week, and within a few months it would have fully appreciated. That would be time to exit gold and start buying bombed-out productive assets instead.

The speed of such an ascent in gold prices would be highly profitable for gold owners (including me), but it would probably prevent BullionVault from aggregating more than a few thousand new customers in total. My personal ambitions for the business would never be met.

Instead, as all this bail-out money seeps in, I anticipate some temporary relief for the stock market, followed by a long, slow, miserable slide in mainstream investment performance, accompanied by a steady rise in the value of gold bullion.

So – entirely hypocritically – I believe one outcome is required, yet hope for another! Knowing governments won't allow the incautious banks to fail, I can only look forward to helping more investors each day move a portion of their wealth into gold.

Copyright © 2008 Paul Tustain
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