http://www.sprott.com/pdf/marketsata...

Allow us to preface this article by saying that we’ll be making no mention of the ‘manipulation’ of

the price of gold. Let’s put that issue aside for now because, in the long run, it just won’t matter.

We are in the midst of a financial crisis – not just any financial crisis mind you, but arguably the

worst and most pervasive the world has seen in almost a century (second only to the Great

Depression… thus far). In the sea of financial assets and currencies that are being decimated

the world over, the one true safe haven continues to be gold.

During these times, it is understandable that the prevailing investor sentiment is

fear. People

are fearful of their savings, fearful of their jobs, and especially fearful of risk, having just

witnessed how quickly a bear market can decimate portfolios. The other major factor currently

affecting markets is

deleveraging. As we all know by now, the 2002-2007 credit bubble was all

about leverage. Leverage in housing and real estate. Leverage in the banking system.

Leveraged hedge funds. As long as all asset classes continued to go up, then leverage was the

winning formula. Although such a myopic strategy paid handsomely in the short run, the

premise of the preceding sentence is, of course, false over the longer term. Thus, the winning

strategy of yesteryear is now a ruinous one, leading to a vicious circle of deleveraging that is

gutting the value of almost all assets. In this respect, gold is proving to be no exception. On the

flip side of deleveraging is the frenetic buying of what was on the short side of the leveraged

trade, namely, US dollars and Japanese yen. As currencies with low interest rates, they were

borrowed to effect the leverage and are now benefiting from what is essentially short covering as

leverage is unwound. This is another reason that the price of gold, in US dollar terms, is down

over the past month – albeit, not nearly as much as other assets that were on the long side of

the leveraged trade.

That said, we must confess to being perplexed (although far from discouraged) by the recent

price action of gold. It is not behaving the way one would expect it to behave during times of

financial crisis; namely, as the consummate safe haven asset of choice when all other assets

are being shunned. Mind you, gold isn’t performing badly by any means. In Canadian and

Australian dollar terms the price of gold is at or near all-time highs. Such is the case in most of

the world’s currencies. Even in Euro terms, the price of gold is within 5% of the high it reached

earlier this year. But gold has yet to catch a wind under its sails in all currencies. Is it really the

‘barbarous relic’, rendered obsolete by the stability and prosperity of the paper-based fiatcurrency

global financial system? Laughably, this argument was once used by anti-gold

proponents as the main reason not to own gold. How quickly things have changed! Today’s

financial system, with the institution of the central bank at its foundation, has proven to be

anything but as stable and prosperous as once thought. For the first time in a long while, the

very foundations of capitalism are being put into question. Once infallible central banks of

developed nations have become almost irrelevant. The financial markets, even the stock

markets, are completely ignoring them. Central banks have shown, to their chagrin, that they

can only solve one problem by causing another. The system is in such a state of disarray that

the leaders of many of the world’s developed countries, including the US, Britain, France and

others, are now proposing some sort of massive overhaul in the way the world does finance.

How it will all play out remains to be seen. Certainly it will involve greater government

involvement and therefore greater waste and inefficiency. But be that as it may, we would not

consider any paper-based asset as ‘safe’ right now. Especially not currencies, as we will explain

shortly. When the markets realize this, the outcome should be highly bullish for gold.

physical gold (not ETF’s, not futures), is

that it is one of the very few assets that has no one else’s liability attached to it. We believe this

point is particularly relevant today. At its heart, this financial crisis is all about the systematic

lack of trust in the liabilities of others. Everybody is worried about default/counterparty risk. One

example, yet to fully play itself out, is derivatives. The fallout in this area could be disastrous, as

we’ve written about several times in the past, adding fuel to the fire of the global financial rout.

But the problem, clearly, is by no means only relegated to derivatives. It’s the problem with

all

financial assets, even the traditionally safest ones. Banks don’t want to lend to each other

because they don’t want an asset that is another bank’s liability. The money markets seized up

because nobody wanted to own another business’s liability, even over the very short term. Even

bank deposits, traditionally one of the ‘safest’ assets around, is some bank’s liability and

therefore a newfound cause for concern. Like it or not, in the financial world everything is

someone else’s liability and every financial asset has default risk. Even cash under the mattress

is someone else’s liability… it’s the liability of the central bank. Which is why nobody should be

breathing a sigh of relief that central banks are now guaranteeing everything. They guaranteed

all bank deposits. They guaranteed money market funds. They guaranteed interbank lending.

But at what cost? As they are wont to do, they only traded one problem for another. For what

does a government guarantee really mean? It means they are the buyer of last resort for other

people’s liabilities. It means they are ready, willing, and able to print money in any quantity to

back the guarantee. It means they are trying to solve the problem of default risk by causing the

equally nefarious problem of purchasing power/inflation risk. (Conversely they could tax their

citizenry into oblivion, but this would be much less politically acceptable than printing money,

especially in a debtor nation such as the US.) During times of financial crisis, it is best not to

trust anybody, especially not the central banks. When even the safest counterparties can no

longer be trusted, gold should be the asset of choice. It is the only asset that has absolutely no

default risk whatsoever and, in our opinion, it is the only true safe haven asset.

For now (though we believe it a temporary state of affairs) the markets seem to believe that cash

is king. They are still content to own paper in times of trouble, particularly US dollars and US

Treasuries. But such confidence is misplaced, for many reasons. In the current environment,

deflation

à la the Great Depression is highly unlikely. Ben Bernanke, the head of the Federal

Reserve, is already on record as saying deflation cannot happen, using the helicopter drop

analogy to prove his point. Under a fiat currency system this is true enough, and made

abundantly clear with the central banks assuming the role of buyer and guarantor of last resort.

But regardless of what the central bank does, we believe the fundamentals have never looked

worse for the US dollar. On top of the money to be spent bailing out the financial system (at

least $1 trillion… likely $2 trillion and more), there is also the recession to deal with. Even during

the best of times the US government ran sizable deficits, in the worst of times these deficits will

go through the roof. Going forward they could easily exceed $1 trillion per year. Then there are

the social security and medicare payments the US government has promised to baby boomers,

that will begin to escalate exponentially as they begin to retire starting this year. The

present

value