How high can gold go? Just watch

Anyone buying into the thesis that gold represents an asset bubble about to burst should look at the balance sheet deterioration of the U.S. and Europe.

“As long as you look out to the future a few years and see debt to GDP is still rising in the U.S., stay with the gold market,” said Kevin MacLean, vice-president and senior portfolio manager, mining and metals, at Sentry Investments.

The Congressional Budget Office has projected a 65.6% increase in revenues between 2010 and 2015, with expenditures rising by 21.2%. If this scenario plays out, the U.S. federal deficit would contract by 53.1% to $607 billion.

There’s a catch, though: that 65% increase in revenue.

“That’s not impossible, it has happened once in history,” said MacLean. “In the late 1970s, when we peaked up to 13% inflation, we got this kind of receipt increase. Perhaps they are unwittingly forecasting 13% inflation.”

He points out that any announced spending cuts would not reduce the deficit, but simply come off of the planned increases in spending.

“There will be no cuts,” he says. “This whole balance sheet issue with be a theme for some time to come.”

There’s another problem with the CBO forecast: it relies on economic expansion to the tune of between 4% and 5%, with no allowance for recession.

“The IMF is saying maybe 1% this year, and 1.5% next year. These [CBO] numbers are already wildly off course, less than 12 months after being written down.”

This doesn’t take into account the affect of government spending cuts on GDP growth. Statistically, a 1% cut to government spending reduces GDP by 0.75%, and increases unemployment by 0.25%.

“When you try to fix the problem, you get a little sand in the gas tank.”

Meanwhile, the Federal Reserve has been massively expanding its balance sheet in a so-far futile attempt to kick-start the American economy. The last time the Fed acted anywhere near this scale was, again, in the 1970s, in response to the oil shocks.

MacLean says that if the response today was in proportion to the response of the 1970s, the price of gold would be $15,000 per ounce.

“Let’s assume that the last half of the gold run-up in 1980 was because Russia invaded Afghanistan: the gold price today should be $7,500.”

And if the U.S. were to revert to a partial gold standard, with 25% bullion reserves backstopping the dollar, gold would be priced at $10,000.

If that sounds far-fetched, he shared a conversation he had with a San Francisco hedge fund manager, who told him that “serious” investors would love to place more money in gold, but cannot because the sums they are interested in would move the market.

With roughly 5 billion ounces of gold currently on the global market in one form or another, the market value is roughly $9 trillion U.S. This hedge fund manager told him the market would need to be between $30 trillion and $50 trillion to satisfy institutional demand.

“Its not comfortable watching the gold price bang around by a hundred bucks, but the gold price, in my mind, is very, very cheap.”