Here’s Jim Grant, who recently gave a talk to the Fed regarding his take on the harm the central bank is bestowing on the world economy.
When a country finds itself in the same situation as that of the U.S. – too much debt – there are basically three ways to resolve the situation:
- Get lucky. That is, if the country is lucky enough to grow their way out of the debt by having a healthy economy with low unemployment and a steadily rising GDP, the country could easily pay its debt over time.
- Default. The country simply refuses to pay its debt.
- Financial Repression. Inflating the country’s monetary system to the degree in which the debt becomes relatively meaningless.
So far, the U.S. economy has not shown significant improvement in employment and GDP growth, so option #1 is out. A default would be too unpopular for politicians wishing to keep their offices of power. So even though option #2 would be beneficial long-term, it’s off the table as well.
In the middle of 2011, Bill Gross, managing director of PIMCO, referenced a paper on Financial Repression written by Carmen Reinhart and revealed his fund was going short U.S. Treasuries. Since that time, the fund has lost value due to this call because the U.S. Treasury market bubble has still not burst. But Mr. Gross was not wrong – perhaps his timing was off. The U.S. is indeed embarking on some form of Financial Repression in order to address its debt burden.
So, what is Financial Repression?
Simply put, the goal for the U.S. under this strategy is to sustain a modest level of inflation. For example, if a 4% inflation level can be kept up over a period of 10 years, with compounding, half the debt can be melted away. Of course, the U.S. Federal Reserve will not publicly state that rate, but instead declare the target of around 2%. Nevertheless, the inflation rate doesn’t have to be that high, just kept consistent over time.
According to Reinhart’s paper, there are 3 mechanisms which serve to sustain a certain level of inflation. The first is caps on interest rates. With rates at or near zero, it’s rather obvious the Fed has been successful in keeping rates low. And in mid September, 2011, the Fed initiated Operation Twist, which rolled maturing short-term bonds into new long-term bond purchases having the affect of pushing longer term interest rates lower.
The second mechanism is to ensure there’s a market for U.S. bonds – that is, make sure someone is available to buy the securities on offer by the Treasury. With interest rates so low, this is a difficult task. The Fed was supposed to be the buyer of last resort. But recently, they’ve overtaken China as the largest holder of U.S. debt. However, during the bail-outs of 2008, the banks received a lot of money in order to keep their capital ratios up. So far, that money has been parked in accounts at the Fed earning some interest. When called upon, these banks will use that money to buy U.S. Treasuries.
The third mechanism is to have capital controls in place that ensure there is no banking competition. All the banks in the system are banks in line with the Federal Reserve System. There can’t be any rogue banks out there deciding not to play the Treasury game as planned.
Under this strategy, the U.S. government debt can be inflated away. But there are losers in this game. First, people who save their money see their savings eaten away – they get little to no interest on their savings and as inflation rises, the value of their money decreases. Second, those purchasing the Treasuries lose as well for the same reason – low interest rates. Understood in this manner, the inflation sought under Financial Repression is a hidden tax.
Another interesting point Reinhart makes in her paper is that in order for Financial Repression to work in the long run, investment in gold needs to be discouraged or even prohibited. Investors cannot have any alternatives, but to invest in the target securities. But thankfully, that’s not the case today. People are able to buy gold and silver and thus protect themselves from this inflationary strategy.
September 18, 2011
With gold in a 10-year bull run and the price relatively expensive, every investor must ask themselves if gold has reached its top. And with recent highs above $1,900/ounce followed by severe volativity and price plunges sometimes near $100/day, the question becomes more pertinent.
It’s interesting to recall back in January, 2010 at the Annual World Economic Forum in Davos, Switzerland, George Soros claimed “The ultimate asset bubble is gold.” At that time, the gold price was at $1,100/ounce, down from a high of $1,225/ounce a month prior.
Of course, at the time, the main-stream media only picked up on the “bubble” reference and did not take into account the context in which the reference was given. So, obviously most investors began to question their faith in the continuing rise of gold.
Soros’ reference was that asset bubbles form when interest rates are low. Easy money provided by the Fed’s policies drive people to use the money to buy all kinds of things. The more buyers there are in relation to sellers makes the prices of things rise. This is the simple logic behind all markets – supply and demand.
Gold is the “ultimate bubble” because it is the asset that serves as a barometer for the measurement of how well the central banking monetary policies are (or are not) working. In this sense, it is literally the bubble to end all bubbles. As the central banks around the world print ever more paper money without any substantial backing, gold’s price rise is sustained. Until this kind of policy is reversed, gold’s “bubble” will continue to grow.
So, back to the question, how high can we expect gold to rise? There are many different theories, some of which will be discussed below. But keep in mind that as long as gold is denominated in fiat paper money in order to establish a price, the relation with the true gold asset gradually loses its psychological connection as fiat becomes worthless and gold becomes the real money.
Consumer Price Index
to determine Gold’s Possibilities
Using the Bureau of Labor Statistics CPI inflation calculator, we can determine what something would cost in today’s dollars versus what it cost at some time in recent history (as far back as 1913, when the Fed was created).
Plugging in the average price of gold in 1913 ($18.92/oz), we get a price of $432.95/oz. That’s interesting! Is gold over-priced today at $1,800/oz? Or is there something special about gold or fishy with CPI statistics?
After President Franklin Delano Roosevelt confiscated Americans’ gold in 1933 in return for $20.67/oz, he immediately re-pegged the dollar at $35/ounce. Using the same numbers in this CPI calculator, we come up with only $25.61/oz for 1934, about $10 less than the President’s price peg. So, it is becoming evident that the CPI calculator is not historically keeping up with the price of gold.
Furthermore, after 1933 citizens were prohibited from owning gold bullion. So, there wasn’t a free market available to establish a real gold price. It wasn’t until 1975, after President Gerald Ford signed a bill legalizing private ownership, was gold put back into a free market.
In 1975, the average price of gold was $160.86. Using this CPI calculator, the price in 1975 should be only $102.82/oz, again under-stating the price of gold by about 38%.
From an historical perspective, then, it seems this CPI calculator cannot be used to determine the price of gold. In fact, the tool is geared to specific data points, like those of this table, which excludes any precious metal.
Further still, the CPI measurement methods themselves keep changing. The reason for the constant changes is because CPI attempts to sustain the strength of the dollar and reduce the claims agains unfunded liabilities like social security. If the government can show that inflation is not rising as much as it is, they don’t have to increase pay-outs to social security recipients. Of course, this ends up hurting those individuals dependent on their ss checks because they’re getting hit harder at the grocery stores and their income isn’t increasing enough to compensate.
The CPI calculation method, therefore, is more of a tool to prop up the value of the dollar rather than to accurately measure the price of a commodity such as gold.
to determine Gold’s Possibilities
As this Seeking Alpha article from April 25, 2011 explains, the Gold Standard Act of 1900 tied the value of a dollar to 1/20th of an ounce of gold. This meant that the U.S. treasury needed to keep one ounce of gold in their vaults for every $20 of currency in circulation. (Note: Precise value was $20.67.)
Back in the early years of the 20th century, if one were to divide the amount of U.S. dollars in circulation by the ounces of gold held in reserves, one would consistently arrive at a value close to $20. But as the century progressed, with economic depressions, wars and central bank interference, the value fluctuated both up and down. But as shown in the table in the article, the ratio has historically tended to be an accurate predictor of the higher prices that eventually came to pass.
As the article goes on to describe, the currency supply of the U.S. has been inflating at the average rate of 8.5%/year between 1913 and 1971, and an accelerated 11.5%/year since 1971. As of April, 2011, there was about $949 billion worth of currency floating around. This is the M0 money supply, which represents all the paper bills and coins in circulation. Note: it is reported by the government not as M0, but as the column headed “Currency(1)” in the Components of M1 table on this page.
Next, this M0 amount must be compared with the reserves of physical gold held by the U.S. Treasury. According to The World Gold Council via Wiki, the U.S. currently has 8,133.5 tonnes (approximately 261 million troy ounces) of gold in its reserves.
So, using the currency/gold ratio for April, 2011, we have $949 billion divided by 261 million ounces = $3,636/oz.
1980 Peak of $850/oz
to determine Gold’s Possibilities
In January of 1980, gold hit a record price of $850/oz. Granted, the peak of 1980 concluded with a huge price drop back down to the $300’s because of the responsible actions taken by the Chairman of the Federal Reserve, Paul Volcker – he raised interest rates as necessary to reduce the easy money available, thus taming inflation and bringing the gold price down. But we see no such effort by those in power today. They’re faced with a declining world economy, making it difficult to make the unpopular decision to raise rates. Indeed, our current chairman, Mr. Bernanke has told us to expect interest rates to remain near zero through mid 2013.
Today, with gold over $1,800, one can say that we’ve already surpassed the 1980 peak. But this would not take inflation into account.
Now, we’ve already dismissed the Bureau of Labor Statistics CPI calculator above as a valid tool for establishing the price of many assets because it showed a tendency to under-state inflation, hence under-state prices. However, using that calculator and the government’s own data for measuring inflation, we see that it correlates the 1980 peak of $850/oz with a price of $2,336.93/oz today. As of this writing, we have not yet achieved such a price, thus the peak of 1980 still holds in even the weakest inflation-adjusted terms.
But is there another source of inflation data which describes the inflation situation better than CPI. In fact, there is such information available, thanks to John Williams’ ShadowStats. Data from ShadowStats indicates that CPI inflation measurements have traditionally under-stated inflation significantly. “The problem lies in biased and often-manipulated government reporting.”
This site also has an inflation calculator, which compares inflation adjusted prices using both governmental CPI and ShadowStats measures. Unfortunately it’s subscriber protected. However, here’s a Bullion Vault article from January, 2011 that references ShadowStats data and indicates that gold would need to reach $5,467/oz in order to match the 1980 peak! And here’s an older “Flash Update” from Mr. Williams in November, 2007 stating that the “Peak Gold Price is $6,030/oz.”
Run-up to the 1980 Peak
to determine Gold’s Possibilities
Again, using this list of annual average gold prices it can be seen that in 1971 the price of gold was at a low of $40.62/oz. After 1971, the price began to surge to its peak in 1980. The average price for 1980 was $615/oz. That represents a 1,414% increase.
On this current bull-run that started in 2001 when the average price was $271.04, in order to achieve a similar 1,414% gain, the price would have to climb to $3,833/oz.
Using the actual bottom-to-top numbers ($37.39/oz in 1971 to $850/oz in 1980), the percentage gain was a whopping 2,173%. The absolute low of 2001 was $255.95/oz. A 2,173% increase from that low would be $5,563/oz.
U.S. Gold Reserves Versus U.S. Monetary Base
to determine Gold’s Possibilities
Here’s an interesting “chart-of-the-day” from Bloomberg. This method tries to establish a “fair value” for gold by mapping U.S. gold reserves against the M1 monetary base. The theory tries to map every dollar in existence – currency, checks, certificates & any other instrument exchangeable for currency such as traveler’s checks – to the amount of gold held in U.S. reserves that could possibly provide backing for the currency.
The interesting thing about this theory is not that the fair value for an ounce of gold last June was $10,000/oz, but that as a percentage of the monetary base, gold is sitting at historic lows – 18%. Even during the $850/oz peak of 1980, the U.S. had such a relatively small M1 monetary base that if everyone who had any form of an exchangeable dollar instrument suddenly demanded an ounce of gold for it, the U.S. would be able to cover it – no problem! At that time, as a percentage of the U.S. monetary base, U.S. gold reserves amounted to 120%. But now, due to the ever-increasing monetary inflation, the U.S. would be completely drained of its gold and still have 82% of its dollars outstanding with absolutley no backing!
If you didn’t get that last paragraph…. it’s an eye-opener, so go back and try again!