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Gold bug Merk: The risks of gold

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Axel Merk has written a book lamenting an undependable dollar and his funds designed to manage currency risk include a gold ETF — so it would be disingenuous to count him as a critic of gold.

But in the same way that a scientist might first look at the weaknesses of his hypothesis, the fund company executive’s latest commentary takes a critical approach to gold as a means of better appreciating its investing risks and rewards.

It was the chastisement of gold bugs objecting to the currency manager’s comment in a recent interview that gold is not “risk free” that prompted Merk to lay out what he sees as the risks of owning a metal long favored by investors distrustful of other investments.

The first issue he raises is physical storage. Whether one keeps his gold at home, in a bank deposit box or in the vault of a specialized custodian, it nevertheless remains possible for the gold to be stolen.

So in contrast to those who claim gold has no counterparty risk, Merk maintains that the burglar is the counterparty one needs to worry about. And were one to insure against loss, then the counterparty risk lies in the insurance company.

For those who assign gold storage to a financial institution, Merk highlights the distinction between allocated versus unallocated ownership. In the former case, the gold is held on behalf of the client so that if the custodian defaults the investor maintains title to the gold, whereas in the latter case the investor has but a paper claim against the institution.

The point is that there are shades of varying risk, however small they might be, in how investors choose to keep their gold.

With storage of gold thus addressed, the second issue Merk raises is gold’s safety as a storage of value.

For many investors, U.S. Treasuries serve as a benchmark of safety.

Merk points out the inherent circularity of the case for Treasuries — they can always be returned (assuming continued congressional authorization) for dollars, which the Treasury itself prints, and he quotes former Federal Reserve Chairman Alan Greenspan admitting: “We can guarantee cash, but we cannot guarantee purchasing power.”

Indeed, continuing with the case against the dollar (he will return to a balancing criticism of gold), Merk explains that a system of financial checks and balances involving a separation of fiscal and monetary policy is more theoretical than actual since “central banks have a very difficult time [preserving] the purchasing power of a currency when unsustainable fiscal policies are pursued.” As Exhibit A for this claim, he cites the dollar’s loss of 95 percent of its purchasing power vis-à-vis the consumer price index (CPI) since the establishment of the Fed over a century ago.

All this is classic gold bug rhetoric — the claim that gold, which cannot be printed, is a superior store of value to cash, whose debasement is essential to government’s historic drive to spend beyond its means.

But counter to this rhetoric, with which Merk seems to heartily agree, the currency funds manager raises an insightful and honest problem for owners of gold’s assumed safety.

And that is, since our daily expenses are priced in dollars, owning anything other than dollars makes us into de facto currency speculators. Or as Merk puts it, “anything that fluctuates in value versus the U.S. dollar is inherently not ‘safe.’”

Yes, an ounce of gold is enough to purchase a suit today, just as it was 100 years ago, reflecting the stability of gold as a store of value. But in the short term, its value fluctuates wildly against our dollar accounts.

“If I know I have to spend $1,200 a year from now, I can put the cash aside or buy one ounce of gold. The cash will pay for my obligation. The one ounce of gold may or may not,” he writes.

The case for gold’s risks — in terms of storage and safety — thus established, Merk returns to his familiar pro-gold perspective that frames gold as a tool in an investor’s toolbox that can be helpful in managing the risk of holding dollars.

So if gold can be accused of being unproductive, with a zero yield, Merk points out that dollars at a time of negative real interest rates are worse — they are destructive. Expressed arithmetically, zero is higher and thus more attractive than a negative interest rate.

Moreover, to Merk, unproductive gold’s annualized 8.3 percent rate of return since 1970 only makes sense if inflation is higher than reported by the CPI.

But gold doesn’t merely fluctuate against the dollar; it also has a low correlation to equities. That is why, for example, gold fell 28 percent in 2013, while equities roared. That negative correlation proves gold’s value as a diversifier, but should also imply favorable prospects for gold to those concerned about equities’ ability to deliver positive future returns.

Gold skeptics may still be holding back out of concern the Fed will go forward with its oft stated intentions to raise rates, which would make cash more competitive with gold. But in Merk’s analysis, “the U.S., Eurozone and Japan may not be able to afford positive real interest rates [even] a decade from now.”