Portfolio 002 – Poor Demographics Point to Higher Gold Price

Initially published at Seeking Alpha on Thursday, July 2, 2009.

The question about owning gold should not be ‘why’ but ‘how much’. At the very least, gold should be considered a form of insurance against either financial collapse or rising inflation. It is pointless therefore to ask ‘why’ if you generally believe in the merits of owning insurance on anything. You don’t buy insurance for your house as an investment, but as a hedge against the low-probability scenario of it burning down or being destroyed by a hurricane or flood.

The only caveat to this analogy is if you don’t believe gold is a suitable form of insurance. But then what is? One scenario where gold may fail the test would be a deflationary economy. However, considering the amount of pump-priming that central banks are engaged in, the likelihood of deflation has receded compared to six months ago. Furthermore, the scenario of a Japanese-style deflation is unlikely for the American economy because our financial system (unlike Japan’s) is hard-wired to domestic economic growth and any deflation would quickly result in renewed systemic stress which would in turn lead to more investors buying gold.

The market recovery since March has alleviated many concerns, but only the most optimistic analysts would say today that the economy is out of the woods. To the rest of us, the risks of either another bout of systemic distress or of accelerating inflation are very real. In light of the steps taken by the Obama administration and by the Fed, the greater of the two risks is now that of accelerating inflation. The economy will likely see rising prices brought about by the very large government budget deficits and by a weakening dollar.

Underlying this picture is the overall demographic picture of the United States. Starting in 2005, and for the first time in 30 years, the size of the most economically active population (the 30 to 60 year-old segment) is stagnant at around 121 million souls. Between 1975 and 2005, this segment grew every single year, from 87 million to 121 million, contributing to economic growth. Due to a decline of the birth rate in the past thirty years relative to the preceding thirty, we are now in the fourth year of a fifteen-year period (2005 to 2020) when this segment will flatline at 121 million. The last period which saw the size of this bracket stagnate was the 1970s when the 30-to-60 group remained at 89 million (dipping to 87 million in 1974-75).

(If we redefine the most active bracket as the 25 to 67 year olds (instead of 30 to 60), the size of that bracket will continue to grow until 2017, which is good news for a resumption of GDP growth. However, the weakening of the economy since 2007 suggests that the inflection point has already been passed and that we should focus on the narrower 30 to 60 bracket. Most people who are younger than 30 don’t have a lot of money to spend and most people over 60 cut back on their spending.)

This suggests that the assumptions of economic growth for 2010-11 and beyond made by the Fed and the Treasury will prove too optimistic if they are premised on a demographic context such as we have seen in the last three decades. Lower-than-expected growth will mean lower tax receipts and greater demand for subsidized services, making it difficult to reduce the budget deficit. The bond vigilantes are already back in action and we can expect long-term rates to rise, the dollar to weaken and inflation to accelerate. It is very likely that gold will break through its March 2008 high and that it will see a price of $1,500 or even $2,000 per ounce before the Presidential election of 2012.

While its overall effects on the economy are clearly negative, inflation has one benefit which is to reduce the burden of excessive debt. Rising wages mean that households with fixed-term debt (fixed-rate mortgages, credit-card debt, etc.) will service that debt more easily since monthly payments will be falling in real terms. And real estate prices would see a recovery, though probably only in nominal terms. The same is true at the national level with rising inflation reducing the debt and entitlements burdens borne by the Federal and state governments, but also damaging in the process many social services as well as our relationships with our country’s creditors.