We have a week to figure this out, and yet the government is stuck in a bi-partisan gridlock. Back in May, gold was trading at about $1,515/oz. Today, with just a week until a possible U.S. default, gold has swelled to a record high (nearly $1,615/oz.) and is likely to keep climbing. Is this coincidence? Is it gold’s time to shine (pun intended)? It’s a little more complicated than that. If it came down to a simple explanation, financial forecasters wouldn’t have jobs. Gold’s rise can be attributed to many factors, including the perpetually evasive notion of speculation and the abstract “economic vibe” of the country.
Gold is generally understood to retain its value better than currencies or riskier investments such as stocks, commodities, and U.S. bonds, during financial or political shocks. Accordingly, investors have flocked to the safer asset, shedding their riskier holdings that would be affected by the default. But what happens to gold if the government defaults? It thrives when Uncle Sam hits tough times. The bond rating agencies would downgrade the U.S. government’s debt, and a lower debt rating for Treasury securities gives them a lesser value in bank portfolios. Since banks carry securities as assets, they will then have less money to loan, which consequently reduces economic activity.
But what if the debt ceiling is raised? Does this mean the end of gold’s glory days? Not if past precedent has anything to say about it. Generally, governments deal with large deficits by one of two ways—increasing inflation or increasing taxes. However, a debt of mammoth proportions (like the one the U.S. is looking to take on), will make it impossible for the nation to tax its way out of the problem. So that leaves us with inflation. Inflation decreases the real value of money, which makes debt repayments easier, yet devalues the U.S. dollar. Tangible assets, like gold, play on the weaker currency and score in this environment.
The government may also employ a “take one for the team” strategy. If they drastically cut back on spending over the next few years to pay off the debt, it could make the economy drastically worse. The Federal Reserve, which has already kept interest rates near zero since December of 2008 and has injected trillions of dollars into the bond markets, would have to take even more drastic steps to keep the economy from crashing. The result—great for gold, terrible for the dollar.
Lastly, one mustn’t forget about the repercussions of Europe’s debt problems. After all, traders view gold as a currency alternative. And with the dollar and euro both mired by increasing fiscal problems, it’s just another reason gold shines.
Next week will pale in comparison to the post-Lehman Brothers bankruptcy and failure to pass the bank bailout by the first deadline, so please remember that it’s all relative. I’m not suggesting you should jet over to your nearest bank and surrender your holdings for gold bars, but be aware that it’s a serious issue that extends far beyond our national borders.