Why Gold?

There's an old wives' tale that says if you put a frog in a pot of cold water and slowly increase the temperature to boiling, the frog will die in the water before it realizes that its environment has suddenly gotten very, very dangerous.

The unfortunate parallel for investors in today's economy are that we are the frogs and the central banks and misguided fiscal policies of western governments are the chefs, slowly turning up the temperature on an inflationary stew that, sooner or later, will become lethal to our financial well-being.

You'd be forgiven for not noticing, what with all the economic turmoil we've experienced over the past few years, but well before the Great Recession of 2008 began, the U.S. Federal Reserve had been applying ever larger doses of loose money as the solution for any and all problems.

It's been said that, if all you have is a hammer, everything begins to look like a nail. And that's what the Federal Reserve has been doing over the past decade — trying to fix a broken economy with ever larger hammers.

The problem with this strategy is two-fold.

First, as we are all painfully aware, it creates asset bubbles. From the Dot-Com bubble in the 1990s to the real estate bubble in the 2000s to the current equity bubble on Wall Street, this extended period of easy money has caused one investment sector after another to balloon and then burst.

The second problem, which I've already alluded to, is inflation. And it is this problem in which our dilemma is much like the hapless frog of our anecdote.

For well over a decade, the Federal Reserve has been pumping money into the economic system with reckless abandon. During this period, the governments of the U.S. and Europe have taken on huge debt loads. Bank bailouts, auto bailouts, huge new entitlement programs…all have been put on credit cards, thus putting in question the full faith and credit of those governments.

Cheap goods from China have largely kept us from feeling much of the inflationary pain from these reckless monetary and fiscal policy decisions. Occasional spikes in gas and energy prices have provided us with ominous signs of impending calamity, but for the most part, retail price inflation has not been on the general public's radar screen.

But it sure has been on the minds of the smart money that sees trends and makes trades to maximize their return on them. And the smart money is going one place: gold.

The currency of last resort

As the West's governments and central banks have used cheap money and truckloads of debt to prop up an ailing global economy, their fiat currencies have weakened when measured against gold.

Gold boasts a four-millennia-old track record as the only protection against the inevitable corruption of currencies. And thus, there has developed an inverse relationship between fiat currencies and the price of gold. Simply put, the more dollars, euros, yen and other such currencies that are created, the greater the relative worth of gold.

For proof of this fact, one need only look at recent experience. In 2000, gold was trading around $250 an ounce. But after that cyclical low, the yellow metal enjoyed an explosive bull-run, carrying it to a peak of over $1,900 an ounce (a more than seven-fold increase) in 2011.

Along the way, the seasoned and recently-minted gold bugs that played this trend became enormously wealthy. The question now, of course, is where do we go from here?

Well, with gold having experienced a steep correction, one could argue that the bull market is no longer in play. One could, but one would be wrong.

I can say that with confidence because all those "frog boiling" policies are very much in place (and look likely to accelerate). Does anyone really believe that the political leadership in Washington will take the steps necessary to address the country's debt problem? Does anyone really believe that the Federal Reserve can truly raise interest rates to "normal" levels?

Make no mistake. As long as these policies are in play, they will keep turning the temperature up on inflation, devaluing the dollar and making gold the only bastion of safety for investors.

Another factor: There's an ocean of liquidity that U.S. banks have been holding onto in the form of excess reserves. As the economy slowly improves, the taps will get turned on that money. And when it begins to flow, the multiplier effect ensures that inflation will become rampant. In that environment, even the impressive gains we've seen gold make over the past decade could seem tame by comparison.

The bottom line is that, over the long term, far higher gold prices seem not only likely, but inevitable.

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