The Story Of Gold – 1
“In nature, gold is not a currency.
In human society, gold is the natural currency.”
My summary statement above reverberates the thinking of many of the greatest minds in economic history. However, since the US abandoned the gold exchange standard in 1971, there has been a concerted effort to discredit the function of gold and even demonize it. “Gold is not anything.” “Gold is useless.” “Gold is not an investment.” And the best of all: “Gold is the vestige of human savagery.”
What is gold, then? When J.P. Morgan was asked, he answered simply: “Gold is money.” On the other end of the spectrum, Karl Marx said of gold: “It is the foundation of money. When all money is suspect, gold is money.” What do the Rothschild bankers have to say about gold? Typical of their extremely low-key style, they said nothing. But the founder of the House of Rothschild, the patriarch Mayer Amschel, was a goldsmith! Since its founding in the 18th century, the Rothschilds network dominated, if not monopolized, the world’s production of gold. Today, the Rothschilds and their affiliates (many of them are actually blood relatives) still control the world’s gold and diamond mines, through a web of companies. They also dominated the control of copper and iron ores. Their actions speak louder than words. (By the way, through its complex web of companies, trusts and other vehicles, it pulls the strings of the US Federal Reserve, and probably other central banks in Europe — invisibly. The family PR men would like us to believe they are genteel aristocrats in the pursuit of fine arts and vintage wines! In fact, it was one of the Rothschilds who said: “Let us control currency, and we don’t care who makes the laws.”)
Back to gold. In various periods and countries, gold has served as currency. In other periods, gold may be replaced by other metals, such as silver, and paper money (or “fiat currency”, or legal substitute for actual commodity), or used simultaneously, as currency in a society. Even if gold is not a currency, it is always money; whereas fiat currency, such as paper money, is not always good money. (I will explain the differences between currency, money, wealth and riches another day.)
Most importantly, as human progresses, economies grow to a size and activity that require a much larger volume of currencies than the amount of gold in circulation can accommodate. Therefore, the creation of legal tender in the form of sovereign credit, such as fiat currency in the form of paper or electronic money, became necessary. The problem is that, once a government can create fiat currency, history has repeated itself over and over — governments could not resist the temptation and eventually created more and more currencies with no additional reserve backing, until they have not sufficient credit or value behind them.
That is why gold still has a vital role. It is the policeman on central banks. When governments and central banks behave responsibly in their function of controlling and regulating the supply and demand of money and credit (“M&C”) , gold the policeman can take a good afternoon nap or go on a leisurely stroll. But when governments and central banks (“G&C”) start abusing M&C, gold the policeman will be out in force, patrolling the activity of M&C, and punishing G&C until discipline and balance are reinstalled. There is no organization or enforcement agency as such. Gold is the natural currency, and shines the brightest when other forms of currencies and M&C look pale and smell rotten. In good times, when M&C are healthy, gold entertains humanity as jewelry. Its economic function is largely nonexistent. We are not in such good times.
The Story Of Gold – 2
G&C and M&C
In 2005, I was beginning to worry about the volume of M&C (money and credit) allowed in circulation by the US G&C (Government and Central bank, or Federal Reserve). US money supply was sky-rocketing.
After the Fed increased the money supply in order to calm the markets in 1997 in response to the Long-Term Capital Management crisis, I had expected the increase in money supply to be temporary. However, the Fed did not reduce nor slow down the increase in money supply after 1997. Instead, with the internet bubble bursting in 2000 and the 911 market slump in 2001, the Fed continued increasing the money supply, particularly in M-2 and M-3 (the broader measure of money, which includes money-market funds and large time deposits held by private individuals & institutions). At the same time, hedge fund managers were using leveraged money (i.e. credit) and derivatives to reap profits from securitizations in the US, and from currency speculations in Asia and Russia in 1997, and the UK in 1999. The increasing leverage amplified money supply and we entered the age of money & credit, or M&C Age.
Since hedge funds and derivatives were unregulated (in substance meaning those who engage in such activities have no minimum capital requirements), the M&C Age ushered in an unprecedented period of money explosion. Money was not just supplied directly by the Fed, but the market amplified M&C in huge doses through the activities of securitization and derivatives trading. With off-balance sheet exposures, the financial institutions on Wall Street were routinely leveraged up to 60-80 times, as we ran up to the financial tsunami of 2008. When prices on assets fell and as credit counter-parties go under, the amount of “money” to be settled far exceeded the M&C then available to the Wall Street players — hence, G&C had no choice but to create more M&C, just to keep money-market instruments from collapsing in a domino and into a black-hole, resulting in an even more horrific scenario of money implosion.
Ducks Swimming In A Pond
Back to 2005, just when I was nervous that the stock market did not seem to make any meaningful correction, as money supply was chronically growing way ahead of GDP, M-3 suddenly shot up. Unlike M-2, which also increased sharply, M-3 included large institutional deposits and money-market balances. Without a doubt, there would either be high inflation (higher interest rate), or worse, an asset bubble bursting on the horizon. Obviously, it was time to get out of the equity market and stay with short-term cash instruments.
Then came the shocking move by the Fed in mid-2006 not to release any more M-3 figures! By then, many were scrutinizing the explosive growth in M-3 and trying to find an explanation. After the Fed stopped releasing the figures, many continued to ask for them. So, what did the Fed do? It finally said that it was no longer gathering the data! Therefore, go away!
With the benefit of hindsight (from the events in late 2008, in particular), the spike in M-3 corresponded with the frenzied creation of securitized money-market instruments and derivatives, many from subprime mortgages, as Wall Street was swimming in the seas of leveraged M&C and infinite AAA credit-ratings. These products flooded into money-market funds, and became additional M-3. To the extent these products were toxic, the ocean of money supply was being contaminated. It was no longer safe to swim at the beach. It was time to avoid taking risks in the market. (And for those living abroad, holding the US currency was an additional risk, since it was destined to be worth less, much less.)
That’s when I discovered that Gold was like a duck swimming safely in a peaceful pond, well onshore and far away from the ocean and the beachfronts where the tsunami would eventually hit.
Next, I will discuss Gold as the hidden treasure from 2005 to 2010, and as a potential bubble in the current period of serial quantitative easings.
The Story Of Gold – 3
Gold — A 25-Year Sleeper
I attach a 1975-2011(June) chart on USD/Gold prices for your reference.
Shortly before the end of WW2, in 1944, the Allies met in Bretton Woods, New Hampshire for a monetary conference to establish the new world currency system for post-war reconstruction. That marked the beginning of the US dollar standard, the replacement of the British pound sterling by the USD as the world predominant currency. Actually, the US introduced a gold exchange standard, by affixing the exchange rate of the USD to gold at $34/oz. The US Treasury will back up the US currency supply with the requisite amount of gold in its vault (at that time, the US had 80% of the world’s gold reserves). With USD fixed to gold, the rest of the member countries at Bretton Woods would have their individual currencies fixed to the USD. That began the fixed-rate currency period which lasted until 1971.
Stable currency rates and the gold exchange mechanism provided under the Breton Woods system helped propel the most spectacular global economic recovery and growth over the next 25 years. Miraculously, there was little or no inflation during this golden period!
In 1971, for reasons not to be enumerated here, the US announced the end of the USD gold exchange standard and the fixed exchange rate system. Gold was once again allowed to be circulated and traded (formerly, it was restricted to inter-governmental dealing). Currencies would float freely against each other. As a result, gold traded up from $50/oz to $800/oz, during a period of hyper-inflation and instability in the Middle East. In 1980, it crashed from the record high of $850 (equivalent to $6,500 today) and eventually stabilized at around $300/oz.
As the USD currency regime stabilized, gold price stayed at around $300/oz. It went to sleep for another 25 years.
Gold As Part Of Cash Management – A No-Brainer Since 2005
As the US and most of the Western countries lost their fiscal discipline for well over a decade, and the US Fed under Alan Greenspan flooded the economy with money and credit to accommodate the runaway appetite of Wall Street in “creating” virtual financial products, the monetary systems in the world have entered a structurally dysfunctional stage. To manage personal money, cash becomes a requisite component. But what do you do with cash?
Starting from approximately 2004 and 2005, for those financially astute and conservative, allocating a percentage (say 25% to 30%) of cash holdings to gold was sensible, both as a hedge against currency devaluation, and as a small bet with potentially big and sustainable return. Any tangible asset that had its price held unchanged for 25 years was potentially hugely under-valued. And gold is not just any old tangible asset. Relative to the amount of money and credit in circulation plus the amounts hidden behind off-balance sheet derivatives and contingent liabilities, the value of gold should automatically adjust in multiples, not percentage terms. Besides, it is as liquid as cash and, as the natural currency, an excellent storage of value.
Few looked at the world in an idyllic context. But once I perceived potential turbulence in the mainstream financial markets and decided to step away for safety, I found gold. As I said previously — like ducks swimming serenely in the quiet pond.
That’s the golden period of gold as the sanctuary, from roughly 2005 to 2010 (maybe 2011). It climbed from 350 to almost 1900. But in 2011, with the serial debt crises bringing on a general mistrust of sovereign “money”, gold is beginning to be denied its innocence.
Gold – A Bubble In The Making?
Currently, as a result of continual financial turmoil, there is more money chasing gold than there is physical gold out there. Most of the “investment” in gold is in “paper” contracts, legal claims on counter-parties who may or may not have the physical metal or the reciprocal claims against others, i.e., naked shorts. How many times the actual gold in the world do we have in financial claims denominated in gold? I suspect the number is huge. Central banks, including the US Fed, are supposed to hold the bulk of the world’s gold, but they had begun leasing them out for income (and in banking, the first principle is that you can lend the same thing out to many parties simultaneously, since the owner seldom comes back to claim it).
Then there is the Wall Street money machine. Without substantive regulatory reform since the tsunami of 2008, Wall Street grinds on as a creator of junk out of anything real and tangible, even intangible. It was real estate then, it can be gold, or oil, or something perceived to be real and tangible at the moment. For as long as you can make people chase after it, you can create money from it, even as it spits out garbage on the other end.
So the supply and demand for gold are extremely lop-sided. On the one hand, as more and more people want to park their money in gold, the more difficult it becomes for governments to manage their debt and currency bubbles. On the other hand, If one day, everybody starts panicking about their gold “holdings” and stampedes to sell, the amount to be settled will be staggering. The price of gold can plummet, as in any financial bubble, including the one in 1980 to 1982 which brought gold price from $800/oz to $280/oz. With it, many counter-parties may default and trigger a credit crunch.
Is that going to happen? In Greenspan-speak, I would say that the chance of that happening will at least stay on either side of 50%, approximating the standard deviations of past financial volatilities, and varies in accordance with one’s subscription to the Alpha or Beta characteristic of gold price behavior, and historical aberrations (meaning “I sure as hell don’t know, but I must pretend I know so that you are so confused that you will believe anything I say.”)
But what I do warn is that even gold has entered … the Twilight Zone.
Next, I will evaluate the risk of gold, at this extremely abnormal and critical juncture of financial and monetary history.
The Story Of Gold – 4
With the Suckers’ Rally going on this week, we finally find a breather to continue with our story of gold.
Diversification of Gold Holdings
Necessitated by their Debt Bubbles, the developed countries will have to continue to print more money for some time. The price of gold should go up higher, but in a far more volatile trading range. For example, as I have mentioned before, the inflation-adjusted record level of gold price should be around 6,000 today, and we are not anywhere close to that. Obviously, in investing, one should not look at peaks, just as one should not aim to fish bottoms. Instead, one should evaluate risks and explore opportunities in every price range.
Therefore, I remain bullish in my view that it is healthy to hold between 20% to 30% of one’s cash in gold and/or silver. However, we are at the price levels of 1600-1900, where it becomes critical to try to spot buying opportunities and selling opportunities in adjusting one’s cash allocation. This is because (1) the prices can fluctuate wildly (500 points in a couple of weeks) and (2) prices can get stuck in a relatively low or high level for months, while clearly not reflecting fundamental and incidental factors. In other words, gold is more risky. Its liquidity is compromised by pricing volatility (i.e., you don’t want to sell at too low a level, and you feel stuck in it if you had bought at a relatively high level). Those who already bought gold at much lower prices (which I did at average of $420) can just do nothing, since the trend is still on the way up.
However, as the Debt Bubbles threaten the safety of banks and general credit environment, it becomes necessary to evaluate the credit risks of one’s gold holdings. Most gold investments are in paper contracts with financial institutions and intermediaries, not insured as deposits. As such, they are merely a form of derivatives which ultimate risk lies in the default and/or bankruptcy of the counter-parties. In today’s financial atmosphere, even very large financial institutions may not survive the turbulence and catastrophe of the next few years. At a minimum, an investor should spread out its holdings of gold among several institutions, to diversify the credit risk. In addition, holding some physical gold bars and coins may not be a bad idea (but remember even gold bars can be fake).
No Longer “The Innocent Duck In The Pond”
As the global Debt Bubble enters the stage of contagion, gold’s prominence as a currency substitute and investment vehicle will continue to occupy center stage. Politically, this is not a good thing.
While the over-supply of all of the world’s major currencies makes the value of gold, the natural currency, intrinsically higher, the faltering governments and financial establishment will naturally view gold as both a threat and an embarrassment. As money goes chasing gold, the immediate objective of monetary easing is also counter-acted, at least to some extent.
Paper currencies or fiat money are founded purely on the issuers’ credit and credibility, when there is no gold or silver reserve backing them. Throughout history, governments and authorities always ended up issuing way too much fiat money, either because their incessant waging of wars made borrowing a necessity or they formed a habit of solving real problems with addictive injections of artificial M&C (money & credit). Like the emperor with no clothes on, the pretense can go on for some time, and the majority of citizens may actually believe the facade rather than their own stupid eyes. Harbingers of gold are like connoisseurs of fine fabrics and quality costumes, hard to be fooled. They become the thorns-in-the-eyes of the courtiers and plutocrats.
Before long, governments and monetary authorities will have to do something to discourage “gold hoarders”. What can they do? That’s what I have been researching. I will let you know when I reach my conclusion.