The Remonetization of Gold?

Two forces collided head-on. Hundreds of people spent more than 30 years looking for the answer. The Higgs boson discovery? No, gold. After experimenting with fiat currencies, this flawed premise has collided with an equally bigger truth: Gold is finite, paper isn’t. Bankers now lie, even governments lie, and politicians always lie. Gold tells the truth. Gold is on the first step towards remonetization. Gold is money, it is a currency. Without gold to bind the system together we believe, like the Higgs boson, the financial universe will fall apart.

With the highest deficits since World War II, Mr. Obama and the Federal Reserve proved particularly adept at printing, borrowing and spending money creating one of the biggest financial bubbles ever. And the implications of the Fed’s promise to keep interest rates ultra-low by extending “Operation Twist” (QEII ½) is a tidal wave of liquidity with money created out of thin air. Since 2008, the Fed expanded its balance sheet by 250 percent with nearly $2 trillion worth of toxic securities. After two rounds of quantitative easing, debt to GDP stands at 100 percent and deficits run at 9 percent GDP. And as in late 2008, the Fed’s decision to keep Maison interest rates artificially low has caused short term stock market volatility, runs on sovereign debts, bank bailouts and a dash for cash.

Risk is back on again. In the eighties, government yields of 5 percent were considered low because they exceed both the inflation rate and equity returns. Today, the safe haven economies’ yields are negative and returns are less than equity. Investors were prepared to lock up their cash for the next decade at a record low yield of 1.459 percent for 10 year US treasury notes, less than the S&P’s 2.3 percent yield. As a consequence we believe that the forty year bond bubble peaked as investors in their quest for safety, flee crumbling Europe for government bonds backed by sovereign entities whose finances are similarly insolvent. Interest rates must eventually reflect this underlying fiscal insolvency and the quest for scarce capital will be accompanied this time by depreciating currencies, higher inflation and of course a collapse in overvalued bond prices. US bonds seem to be a good place to park funds for 30 days, not 30 years.

Meanwhile, at a time when markets and politicians are calling for the equality of tax rates, politicians naively ignore the role of capital in the production of wealth and of course jobs. A side effect is that investors have ignored risk as they seek safety of capital instead of the meager returns offered by central banks that collude to keep interest rates low. Higher returns are needed to assume risk today. Of course, one of the reasons that taxes are being raised is that cash strapped governments everywhere are desperate for new sources of revenues to close the financing gap. Some, like Australia, are soaking rich miners, and others their rich citizens. Even if America’s top 1 percent paid more taxes it would not be enough to get America going. Higher tax rates also increases costs and in turn reduces the availability of investment capital. In Ontario, a surtax will see capital move towards lesser taxed provinces. In France, Mr. Hollande who just assumed office has already raised taxes on wealth and capital, increased the size of the public sector and lowered the retirement age pushing the debt to GDP ratio close to 90 percent. France’s deficit will exceed 5 percent of gross domestic product and quickly assumes the have-not status of Spain or Greece leaving only Germany to shoulder the eurozone’s burden.

Debt Hangover

The problem is that there is just simply too much debt in the world. Our deregulated world financial system is supported by debt and its surrogates, over the counter derivatives (OTC). In the past decade, the notational value of derivatives according to the Bank of International Settlements (BIS) has grown from $100 billion to almost $6 trillion or 10 times the world’s GDP. Much of this is held by financial institutions, in particular, America’s biggest investment banks. Derivatives were supposed to hedge risk but instead concentrated risk so that the world faces too many too big to fail institutions. Debt on debt does not work because it mortgages future generations’ legacy. Governments eliminated the principles of moral hazard by rewarding the so-called risk takers in bailouts to Wall Street and Europe which recapitalized their underfunded banking systems with taxpayers’ money. Bankers, the central banks’ handmaidens, always seem to get the biggest bailouts and governments remain reluctant to nationalize the banks they have rescued. We seem more interested in coddling the banks than in fixing our banking system. In the United States, five banks, JP Morgan, Goldman Sachs, Morgan Stanley, Citigroup and Bank of America, hold assets more than half of America’s economy. This crony capitalism is counterproductive. The previous bailouts only made a bad situation worse.

And the price of bailouts keeps going up. Contagion has hit debt-ravaged Europe. However as always, the devil is in the details. In the fourth bailout, Spain was to receive a €100 billion credit line to recapitalize its banks which added 10 percent to its national debt already at 69 percent of GDP. Like Wall Street, it is all about the banks. The point of absurdity is that Italy is responsible for almost 20 percent of that €100 billion promise but must borrow those funds at almost 7 percent to lend to Spain who is paying 3 percent. This Lehman-like bailout, like the others, keeps getting bigger and will not work. Spain not Greece is the dividing line. To date, one quarter of the seventeen eurozone members have required a bailout. Moody’s, the credit rating agency left Spain’s bonds just above “junk” status. Nonetheless, the market will focus on the next domino, Italy for the next little while. Italy’s public debt of €2.3 trillion makes it too big to fail and too large for the ECB. Needed is a fiscal union not a political union nor the savings of Germans.

America Approaches the Tax Cliff

Despite the recent coordinated round of interest rate cuts, there is no question that another QEIII or IV is just around the corner both in Europe and in the United States. But like a drug, governments keep printing more and more money to keep their economies solvent but like an addict, they need more and more since the interest cuts and bailouts only bought time. And the latest cuts brought rates down to near zero anyway. If cheap money was the solution, our economies would be roaring.

A bigger problem is that Mr. Obama’s debt addiction has already racked up $5 trillion of debt in his first term, more than all the presidents before him. America is destined to pile up another trillion dollar deficit for the fifth year in a row regardless of who wins in November. With a $1.3 trillion deficit this year and almost $16 trillion national debt, the numbers are scary. If we add state and municipal bond debt plus the debt of Fannie Mae and Freddie Mac, the debt to GDP ratio in the United States easily exceeds the 100 percent danger zone when solvency risks mount. Federal spending as a share of the economy is higher than at any year since World War II. Of most concern is that the United States approaches a “tax cliff”, a yearend combination of tax increases and spending cuts equivalent to a fiscal squeeze of 5 percent of GDP. Amazingly both parties are not talking about the likelihood of a fiscal stalemate at yearend. Debt resolution should be a major plank of the presidential election campaign. It is about debt, stupid. Too often brinkmanship, the politics of blame and legislative gridlock has undermined confidence in our policymakers ability to make the necessary decisions to steer our economies. The lessons of history shows that profligacy eventually leads to economic chaos, capital controls, and devaluations and of course eventually hyperinflation. The world is charging to disaster like the Light Brigade, led by America’s addiction to debt.

Fiat Currencies Experiment Has Failed

The origin of today’s problems date back to the termination of the Bretton Woods Agreement when America, Japan and Germany agreed that their currencies would float against each other with the dollar replacing gold as the benchmark. This 30 year experiment with faith based currencies has now fallen apart. The 10 year decline in the dollar and the collapsed euro has raised the prospect of a currency war. The Americans continue to blame the Chinese for currency manipulation while America’s mounting debt has undermined the value of the dollar – even the Swiss are manipulating their currency.

The deepening problems of the eurozone and Europe’s experiment with a faith-based euro reveals the vulnerability of the fiat currency system. We believe that the dollar’s position as the world’s reserve currency and source of America’s financial power is being challenged. The dollar’s day as a faith based currency will be tested again this fall when America faces the fiscal cliff of big tax cuts and the made-in-Congress austerity cuts. History is littered with examples of broken currencies that failed to work, such as the Zimbabwe dollar, Russian rouble or the Weimar mark.

Who Can We Trust?

The decline in the market is no surprise. Nor is the decline in public trust in the “masters of the universe” or its institutions in the wake of Wall Street’s mortgage debacle, JP Morgan’s whale-like losses, Facebook’s implosion, MF Global’s demise, or Europe’s debt woes. That decline intensified when Britain’s largest bank, Barclays admitted that it rigged Libor, the benchmark rate for some $350 trillion worth of derivative financial products. And as the rate scandal deepens, it implicates as much as eleven other global banks, including the Bank of England. So too, has central banks’ credibility fallen as they have become the greedy creators of money, monetizing deficits to subsidize the spending of their respective debt ridden governments. Central banks were at one time independent stewards of taxpayers’ money. Today they are the alchemists, the creator of money. Fed Chairman Bernanke once said that under a fiat system, “the US government has a printing press that allows it to provide as many dollar as it wishes”. The printing presses are working overtime.

Political paralysis has shifted the responsibility of growth to the central banks which are using every available monetary tool in their toolbox. Even China has lowered its benchmark rate for the second time in a month emulating Bernanke’s zero interest policy. In printing record amounts of currencies in order to pay for their respective governments’ spending, central banks have been complicit, building the global monetary system foundation with debt. Central banks’ assets have grown much faster than their capital with the European Central Bank’s balance sheet topping $4 trillion, surpassing the Federal Reserve’s bloated $3 trillion balance sheet. Where does the central bank go to get its funding? The printing press of course. That’s the debasement of currencies. Since the collapse of Lehman Brothers, base money has more than tripled. It is no coincidence that after finding out that Libor could be rigged, so can currencies. As part of its dollar policy, Washington had the big derivative banks short bullion and other rival currencies in a last ditch effort to buoy the dollar. Crony capitalism is very much alive today.

However, history shows that without public trust, neither the governments nor our financial institutions can prosper.

Indeed with central banks’ balance sheets laden with the toxic paper of the world’s banking system, it is no surprise that gold has become a significant and important reserve asset that is both convertible and protects purchasing power. Gold has made new highs for eleven years in a row. Today central banks are the single largest holders of gold with the US, Germany and France among the largest holders along with the International Monetary Fund (IMF) and ECB. The International Monetary Fund reported that official reserves jumped from $2.2 trillion in 2001 to $10.8 trillion by October 2011. China’s reserves alone jumped 15 times from $0.2 trillion to $3.3 trillion. At the end of 2011, 22 percent of those reserves were in gold which could be used as collateral. Gold is becoming too important to the central bankers to be left aside.

Funding For Votes

Today, Europe is borrowing heavily from the IMF. The IMF was created in 1947 and recently Christine Lagarde passed the hat around, raising another $540 billion to replace funds mostly for Europe. The Europeans are pressing for another round looking to Canada and Asia’s deep pockets this time. However, any contributions must be in proportion to their respective voting blocs. China recently contributed $43 billion but is reluctant to contribute more without being allocated additional votes and a say in the decision making progress. Herein, politics has raised its head because the United States and the west are reluctant to give up their votes or dilute even for more funding. Ironically, America too has borrowed heavily but not from the IMF, but from China. Therein lays the next battle as we believe the IMF’s archaic quota system will give way to more funding but for votes.

America’s policymakers are slowly losing control over their institutions and their indebtedness will reshape that control. If the decisions are to be made by the IMF, will majority rule or will the west again insist upon its solutions. The second problem is the contributions themselves. Can America maintain its proportionate share if there is no political will to maintain their stake in this important institution. What if for example the IMF’s other members insist on a new currency to replace the greenback, backed by gold? Or what if the IMF decides to revalue gold upward? (The dollar, euro, and yen value would thus decline in value). Can America stop this?

The Remonetization of Gold

Although we expect significant volatility ahead as policymakers continue to look for quick fixes, the markets will discover that bailouts are unsustainable. We believe the road map to fixing our problems is based upon gold. There are two ways to ease the world’s debt woes. The first is for deflation which would lead to widespread failures and asset devaluation. The second option and most likely is inflation which devalues wealth, paying down debt with devalued dollars – a lessor evil. There is another way. For some time we have said gold is the antidote to our problems because we believe it is simply the default solution when faith in fiat currencies such as the dollar or euro disappears.

The solution is not outlandish nor the ravings of a very old gold bug. The solution actually builds upon existing arrangements and institutions. The IMF is the world’s third largest holder currently holding 3,217 tonnes of gold. Gold has always remained a key component of its official reserves. The IMF gold is owned by its member nations, some who are in trouble and revaluing gold upward would leave fiat currencies like the dollar or euro in the dark.

The proposal would involve linking currencies to the IMF’s own currency, the special drawing unit (SDR). The SDR consists of a basket of currency and gold. The second step then is a move to convertibility to the SDR and gold and the formation of a basket of currencies like a petrodollar, Asian yuan, a much weaker euro and diminished dollar.

After twenty years of selling gold, central banks have become net buyers. We believe that recent central bank purchases are a major step towards the remonetization of gold particularly as they lose confidence in paper currencies. China, Saudi Arabia, Russia, India and Mexico bought gold recently to diversify their reserves, which are largely denominated in US dollar. China has recently slowed its purchases of US treasuries and has less than 2 percent of its foreign exchange reserves in gold. If China were to bring this proportion in line with the western average of 10 percent, it would have to buy more than two years of gold production. The euro today has a 12 percent gold backing, not enough. We believe the global monetary order is about to change.

To unwind the huge build-up of debt or deleverage, the solution is not austerity or more growth. Instead of shouldering the debt of the weaker European economics, Germany for example has proposed mobilizing the eurozone’s vast gold reserves in order to back or use that gold as collateral to recapitalise some $2 trillion of loans to desperate euro nations. Similarly we believe that the issuance of new sovereign bonds backed this time by revalued gold (aka Giscard d’Estaing bonds) would prevent the financial meltdown and eliminate much of the world’s debt – not dissimilar to the time when FDR went off the gold standard to wipe out their huge debt through the devaluation of the dollar. Central banks could mobilize their huge gold reserves as an alternative reserve asset. We believe by revaluing gold upward and linking the value of currencies to gold, it better utilizes the world’s massive precious gold reserves.

The US holds 261 million fine troy ounces in its reserves valued today at $42.22 an ounce or $11 billion. On the other hand, revaluing those reserves at $1,500 an ounce, US holdings would be worth some $391.5 billion. With total public outstanding debt at about $16 trillion, a gold price of $41,000 would pay off US indebtedness. America could issue new bonds backed by their gold reserves, valued at the higher price and the debt problem would disappear as the dollar would be backed by gold. Noteworthy is that gold as a percentage of US foreign reserves stands at 74 percent and ironically among the highest but behind Portugal at 81 percent and Greece at 79 percent. While gold as percentage of foreign reserves is not necessarily a useful determinant of solvency, a revaluation would certainly help those insolvent economies, including the United States.

In effect gold would replace currencies. To restore confidence then gold becomes the default currency of the world. Gold is liquid and provides better returns than the debt of the governments that run the printing presses. Gold is simply the antidote to our problems.