Alasdair Macleod – 18 March 2010
Markets may be in the earliest stages of discovering that governments are insolvent, and that their fiat currencies are therefore set on a hyperinflationary course. The news-drift in recent weeks continues to indicate this may be so. Statistics are generally lacklustre, suggesting that the hoped-for economic growth, upon which governments are relying to rescue their finances, may not be forthcoming. Added to this is the new fear expressed by Keynesian economists, that the current trend of countries looking to cut public spending will jeopardise world-wide recovery, end the Keynesian experiment prematurely and guarantee a renewed slump.
These are the dynamics of momentous events, a continuation of extremes which started with the near collapse of the banking system, replaced billion with trillion in our every day language, and has seen governments speed up the printing presses. These events are universal and extreme; not the minor controlled events we normally expect as a background to our lives. But we continue to act and think in the small scale when we should expand our thinking to match the scale of what is actually happening.
A relapse into the next stage of the global slump – let us be blunt and not call it a double-dip recession – will have one over-riding consequence: the widespread insolvency of governments. Even those governments that have been relatively prudent are likely to be undermined by the profligate.
Whether or not a collapse in global government finances is imminent, it is time to consider its possibility, an event which should be marked by a dramatic reassessment of fiat currencies, not against each other (because they are all intrinsically worthless) but against the longer-standing store of value and medium of exchange, gold bullion. To get a sense of the scale involved, we should state how much paper cash and credit is being supported by one ounce of gold officially held for each of the principal currencies. Using broad money or its near equivalent, we get the following figures: USD 33,679, EUR 1,185,688, GBP 238,042, JPY 43,349,241 and CHF 20,339. The production of paper money and credit has been truly staggering since the end of gold convertibility.
The caveat that applies to the USD figure is that the Fed is commonly believed by independent analysts to overstate its gold reserves, in which case this figure is considerably higher. The EUR figure is based on official gold reserves held by the ECB and excludes the gold reserves held by individual member states, giving us an indication of how shaky the euro really is. The disparity between all these figures is substantial, which at some stage may be important, but for now these figures are purely a measure of the extent of the creation of fiat money, rather than a target for the price of gold.
In the days when the gold standard operated, central banks held sufficient gold to meet withdrawals against their paper money. In practice, so long as creditors felt confident that there was sufficient gold at the central bank for this purpose, they would prefer the convenience of paper money and credit. Today the situation is fundamentally different: foreign creditors can now expect more monetary dilution, the cash element of which will accelerate substantially if economic recovery fails, because of the consequences for government finances and the need to compensate for contracting bank credit.
Governments collectively are under pressure to reduce their fiscal stimuli, thereby precipitating the crisis they wish to avoid. The pressure comes from the markets, which simply cannot fund all the required deficits. The result will be to increase reliance on monetary inflation for funding purposes. The more the borrowers are forced to print, the more reluctant the lenders become, and the cost of refinancing the already high levels of government debt escalates as well.
The US, UK, Europe and Japan, representing together nearly 60% of the world’s GDP are already in this debt trap. So far, markets have given them all the benefit of the doubt, accepting quantitative easing as a policy option, on the basis that it may foster economic recovery. This explains the eerie calm since the aftermath of the Lehman failure. However, a renewed economic decline can now be expected to trigger a flight out of fiat money; into – what? Property is a mess still to be resolved. Company shares will be over-valued because of the deteriorating economic outlook. Other fiat currencies are little better. And industrial commodities will see a fall in demand as the global economy slumps. There is no obvious alternative to bullion as a store of value.
This is why we need to be aware of the scale of events. Analysts who forecast a gold price of $1,300 or even $2,000 by the year end are ignorant of these greater forces, as were the dinosaurs before their extermination. The gold bulls usually recommend a five or ten per cent portfolio exposure to gold, when they should be considering five to ten per cent exposure to everything else. If governments are bust, it is time to hoard, not speculate.
So much for economic theory, but what is the market position? In a nutshell there is very little physical bullion supporting substantial gold liabilities. At its heart is the London Bullion Market, whose banking members operate large but undisclosed unallocated accounts. This means as much as 95% of customer-owned gold in the LBMA is subject to counterpart risk, and these customers actually own no more than an IOU from a bank. We do not know how much bullion is actually held against these IOUs, but it is unlikely to be more than a few per cent: the fractional reserve banking model even extends to the bullion banks. And remember: gold bullion does not pay a bank any interest, but it costs interest to fund its possession.
The same bullion banks are also short of a further 700 tonnes on Comex, which together with the shortage of physical bullion in London suggests the conditions exist for the greatest bear squeeze since the Hunt brothers cornered the silver market in 1979. More detail on the shortage of physical gold was covered in my note issued on 8th January.
Supply and demand have also altered fundamentally, with mine production falling, mines no longer hedging, central banks turned net buyers, and investors hoarding through ETFs. Furthermore, it is a store of value for the Chinese and Indians who are becoming middle-class, out-populate Westerners many times over, and have never studied Keynes.
By the time Western investors realise the mistake of having no gold (or at best have five to ten per cent of their portfolios invested “just in case”) and are weaned off their love for inflationary central banking practices, gold and silver prices are going to be much, much higher. Indeed, decades of price distortion by central banks has led to an extraordinary mispricing, which will benefit those who see the insolvency of governments early and act accordingly.