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What Is the Gold Price Telling You about the Financial System?

Yesterday, we published a video interview with gold experts Shae Russell and Dan Denning. I hosted it and threw in

my two cents worth on the matter too. If you missed it, I’d urge you watch it, here.

That’s because it sets the scene for next week’s discussion. And what a discussion it will be.

This week, you’ve seen some historic moves in the global marketplace. Oil prices crashed by as much as 30%. The US 10-year bond yield collapsed to historic lows (again) around 0.4%. Aussie dollar gold surged to another all-time high at over $2,600 an ounce, at one point.

Overnight, the Dow Jones Index plunged nearly 6%. The main culprit was Boeing Co [NYSE:BA], which fell more than 13%. It announced plans to access its full line of credit, which is nearly US$14 billion. The news clearly spooked investors.

Futures point to a fall of around 3.5% on the ASX 200 today.

The extreme moves are reminiscent of the aftermath of the Lehman Brothers collapse in September 2008. The size of the fall was unnerving. You genuinely wondered whether the system would collapse.

It’s the same this time around. Can a debt addled financial system survive the twin shocks of a pandemic and a collapse in energy prices?

Or will it need the support of something much more solid than the paper money system it rests on?

I’m talking about gold. Throughout the recent panic, the gold price has remained resilient. Which is what you would expect. It’s why I (along with Dan and Shae) will continue to talk about it over the coming week.

We are at a critical time in global financial markets. The system is straining at the seams. It feels like it’s only a matter of time before governments and central banks do something extraordinary.

But as I said, gold has been a pillar of strength throughout this panic phase. It’s performed its role as a protector of wealth in times of global uncertainty and turmoil.

It begs the question, is the soaring gold price a signal that it’s preparing to play a bigger role in the global financial system? Could gold resume as the global monetary anchor that, relatively speaking at least, keeps things in check?

Today and for the week to come, we’ll try to answer that question, and plenty of others in relation to gold and the broader markets.

First though, let’s take a step back. I want to explain to you in simple terms why gold is such an effective protector of wealth. Hopefully, this will give you a clearer understanding of what’s happening in the market right now and the type of investments you could make to protect and enhance your wealth.

Let’s get into it…Put simply, gold is a monetary asset. That is, gold is money.

Not in the modern-day sense. You can’t readily pay for goods and services with gold these days. But that’s largely because it’s too precious. Why would you part with gold when you can get the same result with paper notes?

When I say gold is money, I mean it in a deeper sense. Let me explain…

The defining characteristic of physical gold is that it is a ‘no liability’ asset. That is, it is an asset without a corresponding debt. It is pure wealth.

In contrast, modern-day money is simply debt.

That cash you have in your wallet? It’s a liability on the banks’ balance sheet. That term deposit you hold earning a dwindling amount of interest? A liability on the banks’ balance sheet.

If you’re not familiar with the concept of double-entry accounting, that may sound a bit confusing. But the simple fact is that modern money is both an asset and a debt. It is someone else’s liability.

Gold is completely different. When you own physical bullion, it is your asset, and no one’s liability. If stored securely, no one else has a claim on it.

For that reason, it’s not a part of the official banking system. When you buy gold, you are swapping your fiat currency (money that is both an asset and a debt, created at will) for something that is a pure asset.

Put another way, physical gold is pure wealth. It is one of the few ways you can get your ‘money’ out of the financial system and store your wealth securely.

This is what makes gold so valuable in times of crisis, panic, and uncertainty. That is, it is not a part of the financial system. And, in my humble view, it’s unlikely to be again.

Sure, central banks own it and store it in their vaults. But whether they own it free and clear is another question. Who knows how much they’ve lent out? Who knows how many claims there are on it?

When you own and store your gold privately, you know it is one of the few ways you can store your wealth outside of the financial system. So why is gold unlikely to play an official role in the global financial system again?

The Great Depression is why. Back then, gold was money. It fulfilled the role of being the monetary reserves of the banking system. In the US at the time, people could still swap their paper dollars for gold if they wanted to. This provided the banking system with discipline not to create too much credit.That was the theory, anyway.

It went out the window in the 1920s when the US Fed, the Bank of England, and the German Reichsbank all colluded to help create the conditions for a global credit boom.

When it went bust in 1929, people rushed to the safety of gold. They started handing over their dollars and withdrawing gold from the commercial banking system.

Because gold was money at the time (it was the monetary reserve asset of the banking system), the run shrank the money supply even further. Gold left the banking system and went into the pockets of millions of individuals.

The US Fed responded by raising rates to support the dollar and entice the gold to come back. But it was a disaster. Thousands of banks went bust, people lost their life savings (at least those that didn’t swap their dollars for gold), and the economy suffered a deflationary collapse.

Gold got the blame of course. Keynes called it a ‘barbarous relic’. But it was the behaviour of central and commercial banks that created the bubble and the eventual bust.

Gold, eventually, imposes discipline. That’s why our politicians and monetary bureaucrats will never allow it to be an official part of the system again. You can’t inflate a system anchored to gold.

But that’s not a bad thing. It means the market will value gold rather than central banks and bureaucrats. And it doesn’t stop you accessing gold’s wealth protection attributes.

There are many ways you can gain exposure to gold. My colleagues Shae Russell and Dan Denning will discuss ways to do this in the week ahead.

Dan will also talk about price and value. Is gold overvalued? Is it still a buy after such a strong run?

We’ll look to answer all these questions and more in the next few days. But tomorrow, after reviewing the recent market action, I’ll look at gold from a purely Aussie angle. That is, why gold is especially important for Aussie investors to understand right now.

Greg Canavan, Money Morning Australia

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