Hang on to Your Gold 20 comments
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Gold bugs are believers, that's for sure. The question is: are they wrong?
One must correctly perceive what is happening, and what is being done about it, in order to predict what will occur.
Recall, the initiating event for this crisis was a "credit crisis". What is a credit crisis? It is the disappearance of credit from the system. Credit is not cash money, and it is not capital, it is debt born of capital in a leveraged system. “Credit” then goes out into the system and acts like money.
Banks pursue leverage in a fractional reserve system at the rate specified by the Fed, 10:1. In other words, banks use capital to give birth to credit at 10:1. Unregulated financial institutions pursued leverages much much higher, 30:1, 40:1, and in the case of certain credit insurers, 180:1. These high leverages were used in "blowing a credit bubble", fueled by Fed easy money policies (borrow short and lend long) and by Congressional incompetence in their "oversight" of Fannie (FNM) and Freddie (FRE) leverage.
Now that credit has begun contracting, the bubble can no longer be supported and is collapsing. Leverage ratios are now unsustainable. Collapsing leverage is called "unwinding". Remember, the credit that is disappearing from the system is the credit that had been created at 30:1, 40:1, and even 180:1. This highly leveraged credit had gone out into the system and acted like money; people bought things with it. It is precisely this highly leveraged credit which is disappearing from the system. With all this "credit-money" vanishing, price pressures are vanishing as well. We see this as falling house prices, etc. Since these elevated prices were used as the basis for still more leveraged lending, prices must be supported by central bank and government policy to reignite lending and credit.
Here's the problem: there are no more "Investment Banks" that use high leverage, and Fannie and Freddie have just been put directly onto the US balance sheet. All of the major sources of high-leverage credit have disappeared. In order to reinflate the system, Bernanke is pushing new money (capital) into the banks in the hopes of getting them to lend it out at 10:1 in order to replace all the credit that has disappeared from the system at 30:1.
How much new money will Bernanke have to print in order to do this? Early estimates (April '08) of the amount of capital destruction ran in the $1.5 Trillion range. Roubini stopped estimating at $2 Trillion, so let's say that $2 Trillion of capital has disappeared. If that $2 Trillion blew a credit bubble at an average 30:1, you have an approximate estimate for the value of global economic activity, so the scale of this number is probably correct. Now, if $2 Trillion in capital has vanished, and if that $2 Trillion had been lent out to create "credit" at 30:1 ($60 Trillion worth of credit), how much new capital will Bernanke and the rest of the central bankers have to print in order to replace it at 10:1? Answer: $6 Trillion.
The central bankers have already done this "back-of-the-envelope" calculation. Bernanke has already, in two months (September '08 to November '08), expanded the Fed's balance sheet by $1 Trillion, from $1 Trillion to $2 Trillion total. He is nowhere near finished.
Final question, for extra credit: what will the net effect be of this increase in the supply of capital? After all, it’s easy to recognize that it’s not real capital, it was just printed up in the basement of the Fed. What is the dilutive affect of all this brand-new faux capital? As I have asked elsewhere many times, how long until a currency crisis is initiated? The central bankers, in my opinion, hope to mask this capital dilution and stave off a currency crisis by debasing all currencies cooperatively and equally; you can see this cooperation now in rate cuts and stimulus packages around the globe.
Disclosure: Long gold. I am not a professional money manager, so please DYODD.
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This article has 20 comments:
I don't agree with your conclusion about gold. I know that the debate is raging, but even if gold is the "right" way to play these events, you perpetuate the flawed logic without supporting your argument.
Gold bulls use classical liberal economic theories to conclude that government printing presses produce inflation. I believe that in this environment, the replacement of private capital, which has been destroyed, with public capital (the debt that we are taking on as a society) doesn't necessarily lead to inflation. It can lead to higher taxation, higher real interest rates and lower long-term growth instead. The world has changed since these theories were born - there isn't a country with a currency linked to gold any longer. Additionally, I don't believe that the theory addresses when all the developed world is in the same boat, as we are now. I have written previously and continue to believe that gold is a "sucker's bet".
One other comment.... I don't believe that your argument regarding $60 trillion makes a lot of sense. A lot of the leverage created was used by different entities who placed money on opposite sides of a bet (some were long commodities, others were short commodities). A lot of the higher leverage traders have voluntarily or involuntarily reduced their leverage dramatically already. You can see this in the declines of short-interest in stocks, and I would bet that open interest has plunged on commodities (though I am not sure). With that said, I remain very worried. I told a banker friend yesterday that banks with "only" 8-1 leverage still have about twice as much as they should in this environment. So, I don't disagree with your premise regarding the need for new capital, but I do take issue with the logic you employ (30-1 to 10-1).
So, I think we are both very pessimistic about the severity and duration of this economic crisis, but we are in stark disagreement about how to invest during it. Please keep sharing your thoughts!
Alan, sir, you have made an logical statement about inflation not always being the case when public capital is pumped into the economy. However, what perplexes me on that theory is that while gasoline is 1.60ish a gallon NOW, (we kinda know it will be 8 or 9 bucks a gallon soon, don't we?) which gets the CLH's of the world chanring DEFLATION, go into a grocery store and check the prices of goods. There is RAMPANT INFLATION, no? If not, what is it I should call it? I spend FOUR TIMES the dollars on grocery items than I do gasoline. Tell me whatever moniker you want to call it, I can evaluate it. I believe that this currency we have has turned to "funny money". That, to me Alan, gives me pause, and a reason to buy PHYSICAL gold and silver...Keep it coming. Thanks for your post!
On grocery store inflation, don't get hung up on the tail end of a trend. The input prices rising resulted in final goods price inflation, but that will end very shortly. The sellers locked in high cost commodities. I am not so sure that the prices will decline there per se, but they will stop rising. They could plunge though as the producers experience lower input prices and as consumers trade down. Remember though, groceries, unlike energy, aren't an area subject to deleveraging pressure. They also have less elastic demand, as food is about as basic a need as one can imagine.
Thank you for your very active participation. I always appreciate differing viewpoints. I came to SA and contribute here in large part as a means to bounce ideas off the community.
Nowhere in your reply do your address the issue of the "verity" of the new capital, and this issue lies at the heart of your dismissal of classical economics. You defend borrowing and printing as a means to get out of this morass, and so you obviously believe they will work. I do not believe that, and here are the reasons why:
1. If we could borrow our way to prosperity, there would be no crisis. Borrowing and not being able to service the debt is exactly how we got here. Inability to service mortgage debt was the trigger for the current crisis. If society at large cannot service the existing debt, how can we use more more debt to pay off the old debt? The global sources of "Six Months No Interest!" credit cards have dried up, leaving the only source for new money to be the printing press.
2. If we could print our way to prosperity, we would all be prosperous, and there would be no need to have debates on how to fund health care, education, the military, or anything else. Yet these debates rage. Why? Because printed "capital" isn't real, and everyone knows it. Your solution requires suspension of disbelief.
By the way, I've done some digging and have found references where Roubini and others have estimated capital destruction at close to $3 Trillion, so maybe I should redo my math.
Then let all buy and sell gold for US $ and keep that exchange rate fixed.
The USA must end the collapsing total of dollars available at once.
On Dec 07 08:35 AM Alan Brochstein wrote:
> SW Richmond, I am glad to see that you are publishing your ideas.
> There is no reason, in my opinion, for you to qualify yourself as
> "not being a professional" in a negative way! Yes, I am the same
> guy you called a coward and a sell-out regarding my belief that the
> government needs to provide capital to the auto industry to avoid
> liquidation and to ensure an orderly transition to down-sizing.
>
>
> I don't agree with your conclusion about gold. I know that the debate
> is raging, but even if gold is the "right" way to play these events,
> you perpetuate the flawed logic without supporting your argument.
>
>
> Gold bulls use classical liberal economic theories to conclude that
> government printing presses produce inflation. I believe that in
> this environment, the replacement of private capital, which has been
> destroyed, with public capital (the debt that we are taking on as
> a society) doesn't necessarily lead to inflation. It can lead to
> higher taxation, higher real interest rates and lower long-term growth
> instead. The world has changed since these theories were born - there
> isn't a country with a currency linked to gold any longer. Additionally,
> I don't believe that the theory addresses when all the developed
> world is in the same boat, as we are now. I have written previously
> and continue to believe that gold is a "sucker's bet".
>
> One other comment.... I don't believe that your argument regarding
> $60 trillion makes a lot of sense. A lot of the leverage created
> was used by different entities who placed money on opposite sides
> of a bet (some were long commodities, others were short commodities).
> A lot of the higher leverage traders have voluntarily or involuntarily
> reduced their leverage dramatically already. You can see this in
> the declines of short-interest in stocks, and I would bet that open
> interest has plunged on commodities (though I am not sure). With
> that said, I remain very worried. I told a banker friend yesterday
> that banks with "only" 8-1 leverage still have about twice as much
> as they should in this environment. So, I don't disagree with your
> premise regarding the need for new capital, but I do take issue with
> the logic you employ (30-1 to 10-1).
>
> So, I think we are both very pessimistic about the severity and duration
> of this economic crisis, but we are in stark disagreement about how
> to invest during it. Please keep sharing your thoughts!
>
On Dec 07 10:43 AM SWRichmond wrote:
> Alan,
>
> Thank you for your very active participation. I always appreciate
> differing viewpoints. I came to SA and contribute here in large part
> as a means to bounce ideas off the community.
>
> Nowhere in your reply do your address the issue of the "verity" of
> the new capital, and this issue lies at the heart of your dismissal
> of classical economics. You defend borrowing and printing as a means
> to get out of this morass, and so you obviously believe they will
> work. I do not believe that, and here are the reasons why:
>
> 1. If we could borrow our way to prosperity, there would be no crisis.
> Borrowing and not being able to service the debt is exactly how we
> got here. Inability to service mortgage debt was the trigger for
> the current crisis. If society at large cannot service the existing
> debt, how can we use more more debt to pay off the old debt? The
> global sources of "Six Months No Interest!" credit cards have dried
> up, leaving the only source for new money to be the printing press.
>
>
> 2. If we could print our way to prosperity, we would all be prosperous,
> and there would be no need to have debates on how to fund health
> care, education, the military, or anything else. Yet these debates
> rage. Why? Because printed "capital" isn't real, and everyone knows
> it. Your solution requires suspension of disbelief.
>
> By the way, I've done some digging and have found references where
> Roubini and others have estimated capital destruction at close to
> $3 Trillion, so maybe I should redo my math.
Thank you for your contribution with your reference to the “Thoughts from the Frontline” blog. I read it with great interest.
The article addresses the problem which I attribute to leverage as a problem of velocity of money. From my perspective they describe essentially the same thing; actually, velocity is a manifestation of leverage, isn’t it? Isn’t decreasing velocity of money an indication of unwinding leverage?
The author also takes some pain to point out early in the article that the Fed has not yet injected “capital”, but only liquidity. The word “capital” appears in the article only twice. He treats the entire episode as a monetary one and avoids the subject of capital dilution by hinting we haven’t done it yet; the subject never comes up again, and that’s too bad because it’s one I’d really like to read more about. He notes, though, that the Fed will monetize $800 Billion by buying mortgage-backed securities. And he includes a paragraph that ponders just how much monetization will be needed and then admits that no one knows and that there is no fancy equation to calculate an answer.
Clearly, the question I attempt to answer here is the right one for us to be asking. Clearly also, the numbers are huge; we have only begun the real crisis, and the Fed has committed $800 Billion to monetization. Interestingly, the US Treasury has committed Trillions of dollars so far to the “rescue” and various backstops that haven’t been funded yet and have yet to show up on any financial statement anywhere. These impacts will begin to be seen in 2009. I’ve pursued an admittedly crude methodology to arrive at an answer, and as far as I can tell the number fits. Time will tell. I may be even a few Trillion off, but when the Fed started last year with a balance sheet of $800 Billion, what’s a few $Trillion among friends?
The leverage number I floated here can actually be “backed into” another way. A Bloomberg article from July noted at that time that “About $11 trillion has been erased from global equities in 2008 as more than $460 billion in credit-related losses and accelerating inflation threaten global economic growth.” I think this can be viewed as a very crude measure of global leverage. 24:1 overall leverage equates closely to the 30:1 and 40:1 numbers reported for investment banks if you average in less-leveraged players like regulated banks. No respected economist would dare use these numbers, but they do provide a sanity check that gives an interesting result.
To date, all of the new money created is just replacing the write downs in the Banking system. There is no money available to lend, yet.
Free Reserves continue to be decidedly negative at Fed. Res. Banks, this indicates a tight monetary policy not an easy one. Ben is not printing money fast enough.
Barron's Federal Reserve Data Bank, definition of net free reserves.
Do not expect this to change anytime soon. And until Free reserves turn positive, deflation, not inflation will be the name of the game. IMHO
So hang on in gold and gold stocks in safe countries and you will be rewarded as it is inevitable. $1000 is not a bubble price in gold folks, maybe $10,000 will be the new high. And it hasn't fallen much, down to $756 or less than 25%-- if you had to buy gold in CN$ or EU or pound sterling, you'd pay a lot more with dollar up.
Long NXG, CEF, GFI, PAL, SWC
On Dec 07 10:43 AM SWRichmond wrote:
> Alan,
>
> Thank you for your very active participation. I always appreciate
> differing viewpoints. I came to SA and contribute here in large part
> as a means to bounce ideas off the community.
>
> Nowhere in your reply do your address the issue of the "verity" of
> the new capital, and this issue lies at the heart of your dismissal
> of classical economics. You defend borrowing and printing as a means
> to get out of this morass, and so you obviously believe they will
> work. I do not believe that, and here are the reasons why:
>
> 1. If we could borrow our way to prosperity, there would be no crisis.
> Borrowing and not being able to service the debt is exactly how we
> got here. Inability to service mortgage debt was the trigger for
> the current crisis. If society at large cannot service the existing
> debt, how can we use more more debt to pay off the old debt? The
> global sources of "Six Months No Interest!" credit cards have dried
> up, leaving the only source for new money to be the printing press.
>
>
> 2. If we could print our way to prosperity, we would all be prosperous,
> and there would be no need to have debates on how to fund health
> care, education, the military, or anything else. Yet these debates
> rage. Why? Because printed "capital" isn't real, and everyone knows
> it. Your solution requires suspension of disbelief.
>
> By the way, I've done some digging and have found references where
> Roubini and others have estimated capital destruction at close to
> $3 Trillion, so maybe I should redo my math.
i enjoyed the dialogues here in. i do appreciate the common tie of leverage v velocity, and the importance in understanding "what is really happening"in our current crisis. too bad it was necessary for us to have encountered the situation; i could have done without, but life is nothing but change.
as EVERETT DIRKSON said many years back--"...a bilion here, a billion there, it starts to add up.." given our intervening leverage[inflation], the Billions are now Trillions. we'll know how many when it's all over.
On Dec 07 02:49 PM SWRichmond wrote:
> fran,
>
> Thank you for your contribution with your reference to the “Thoughts
> from the Frontline” blog. I read it with great interest.
>
> The article addresses the problem which I attribute to leverage as
> a problem of velocity of money. From my perspective they describe
> essentially the same thing; actually, velocity is a manifestation
> of leverage, isn’t it? Isn’t decreasing velocity of money an indication
> of unwinding leverage?
>
> The author also takes some pain to point out early in the article
> that the Fed has not yet injected “capital”, but only liquidity.
> The word “capital” appears in the article only twice. He treats the
> entire episode as a monetary one and avoids the subject of capital
> dilution by hinting we haven’t done it yet; the subject never comes
> up again, and that’s too bad because it’s one I’d really like to
> read more about. He notes, though, that the Fed will monetize $800
> Billion by buying mortgage-backed securities. And he includes a paragraph
> that ponders just how much monetization will be needed and then admits
> that no one knows and that there is no fancy equation to calculate
> an answer.
>
> Clearly, the question I attempt to answer here is the right one for
> us to be asking. Clearly also, the numbers are huge; we have only
> begun the real crisis, and the Fed has committed $800 Billion to
> monetization. Interestingly, the US Treasury has committed Trillions
> of dollars so far to the “rescue” and various backstops that haven’t
> been funded yet and have yet to show up on any financial statement
> anywhere. These impacts will begin to be seen in 2009. I’ve pursued
> an admittedly crude methodology to arrive at an answer, and as far
> as I can tell the number fits. Time will tell. I may be even a few
> Trillion off, but when the Fed started last year with a balance sheet
> of $800 Billion, what’s a few $Trillion among friends?
>
> The leverage number I floated here can actually be “backed into”
> another way. A Bloomberg article from July noted at that time that
> “About $11 trillion has been erased from global equities in 2008
> as more than $460 billion in credit-related losses and accelerating
> inflation threaten global economic growth.” I think this can be viewed
> as a very crude measure of global leverage. 24:1 overall leverage
> equates closely to the 30:1 and 40:1 numbers reported for investment
> banks if you average in less-leveraged players like regulated banks.
> No respected economist would dare use these numbers, but they do
> provide a sanity check that gives an interesting result.
The Treasury issued XYZ worth of dollars but this wasn't enough for the Financials to work with so they gamed the system by leveraging the float by 20-30 times.
Because of this, any break in the system could cause the whole complex to selfdestruct. The Housing collapse started the unravelling of the entire structure. After that it was just like a row of dominoes. The Fed and Treasury are trying to replace the "Virtual" money with real money but they are also trying to reduce the amount they must replace at the same time by letting some of the Monopoly Money devalue.
Whether they will be successful is moot.
It took years to create the system which is unravelling. It will not be fixed overnight. More cockroaches will be revealed. IMHO
It would take a politician of outstanding courage and foresight to honesty address the issues covered in this article with the American public.
Hopefully, one day we will have someone acknowledge the fact that we have spent our future and that all we have to show for it is a mountain of debt that we will bestow upon our children and future generations.
Americans have a history of overcoming adversity if we truthfully confront the issues. Maybe someday, someone will honestly tell us that there are no simple solutions and that the government cannot painlessly cover all losses.
Maybe someone will explain to us that yes, there will be hard times, yes, we will need to be frugal and work hard together and yes, eventually we will solve our financial crisis and put our financial house back in order.
Maybe someday, we will learn that a sense of material entitlement, allowed by easy credit does not create prosperity.
So far, I have only heard about bailouts and "stimulation".