Gold prices are dropping like a rock and what this means

The price of gold was almost $1800/oz at the beginning of October.  (Short time high: $1791.75 on 10/4/2012).  As recently as 12/12/12 it was at $1716.25.  But since then it has continued to drop and is now (12/21/12) at $1651.50.

It is unlikely to go below $1550/oz, as there is support at that level.  But still, this raises the interesting question - why would people abandon gold, which has intrinsic value, and just hold cash, which the Treasury and Federal Reserve can create at will?

The answer I think has 2 parts.  First, this is a signal that another recession is happening.  The drop in the price of gold is similar to that which happened in 2008.  On 3/7/08, gold was at $1011.25/oz.  It was still as high as $903.50 on 10/8/08, just after the financial crash.  But then it quickly dropped to $712.50 on 10/24/08.   So in just over 2 weeks, it dropped 22%.

But still, why would people abandon gold?  Long-term it obviously is a very good investment, but in the short-term, people would prefer to hold cash.  They can always shift back to gold once the threat of a recession is over.

But can't the Fed just print money at will to offset the demand for cash?  Again in the long-term they can and will kill the dollar.  But again we are speaking of the short-term.

So the second part of the answer is that the Fed cannot create enough money in the short-run to head off a recession.  I've studied this question extensively, and I don't necessarily want to repeat my thinking, but the main way that money is created is through deficit spending.  And because of the fiscal cliff, deficit spending will be reduced.  This doesn't necessarily mean that the money supply will be reduced, but it does mean that the rate of increase will slow.  The economy is so sick that the main thing keeping it afloat is the spillover from government spending, and now that "crutch" will partially be taken away from it.

But isn't the Fed printing money at the rate of $85 billion/month?  Supposedly yes, but that isn't enough.  Any new money that goes to purchase Treasury bonds doesn't help at all, because Treasury bonds are already treated as a kind of money.  (I account for this in my M4 measurement).  The $40 or $45 billion that they are spending to purchase mortgage-backed-securities does increase the money supply, but almost all of this goes to banks that already have excess reserves, so the money won't find its way into the general economy (M2).

So cash, for which there is a huge demand (not to spend but to hold onto) is becoming more valuable in the short-run.  That is called deflation.  We are heading into the Great Recession, Part II.

So what is the solution?  It depends on your point of view.  As a country we are very divided.  If you have a neo-Keynesian point of view, like Paul Krugman, then we need more government spending to offset the oncoming recession to kick the can down the road some more.  But if you are a fiscal conservative, then there is no problem at all.  Bring the recession on.  It is inevitable, and is needed to cleanse some of the waste.

Yesterday, the fiscal time bomb went off, as was predictable far in advance.  It will take a little time for this to be apparent.  But a recession is now inevitable.  So sell that gold and hang onto cash for about the next 6 months.  It will be a wild ride, but we will be better for it later.