|
Analysis,
investment ideas and strategies to encourage dialogue about the global
economy involving gold and silver, energy and monetary
issues....
|
Historic Reports
Larry
Myles Reports
There are approximately $200 trillion in
total global financial assets that are
even now, in the process of turning
their attention toward the $1.5 trillion
in market-available gold. If even a
fraction of this attention is
manifested, the price of gold will go
parabolic.
|
February,
2012
This
month marks the first time since the inception
of my monthly report that I have passed the
reins over to a "guest writer".
Most of us are in agreement that the fiat
currency system in its present form cannot last
much longer. Personal gold ownership is only a
part of the answer; an individual's prudent
personal response to the real time collapse of
the Keynesian system of economics. It is
time to take consider what could turn out to be
the next step. To that end, I am
pleased to welcome the views and ideas of
Keith Weiner.
Gold Bonds: Averting Financial
Armageddon
© Jan 24 by
Keith Weiner
After the near-collapse of the financial system
in 2008, a growing number of people have come to
realize that our monetary disease is terminal.
It is that group to whom I
address this paper.
I sincerely hope that this group
includes leaders in business, finance, and
government.
I do not believe that my proposal herein is
necessarily “realistic” (i.e. pragmatic).
There are many interest groups
that may oppose it for various reasons, based on
their short-sighted desire to try to continue
the status quo yet a while longer.
Nevertheless, I feel that I must
write and publish this paper.
To say nothing in the face of
the greatest financial calamity would go against
everything I believe.
***
It seems self-evident.
The government can debase the currency
and thereby be able to pay off its astronomical
debt in cheaper dollars.
But as I will explain below, things don’t
work that way.
In order to use the debasement of paper
currencies to repay the debt more easily,
governments will need to issue and use the gold
bond*.
I give credit for the basic idea of using gold
bonds to solve the debt problem to Professor
Antal Fekete, as proposed in his paper: “Cut the
Gordian Knot: Resurrect the Latin Monetary
Union” (http://www.professorfekete.com/articles/AEFCutTheGordianKnot.pdf).
My paper covers different ground than
Fekete’s, and my proposal is different as well.
I encourage readers to read both papers.
The
paper currencies will not survive too much
longer.
Most governments now owe as much or more
than the annual GDPs of their nations (typically
far more, under GAAP accounting).
But the total liabilities in the system
are much larger.
Even worse, in the formal and shadow banking
system, derivative exposure is estimated to be
more than 700 trillion dollars.
Many are quick to insist that this is the
“gross” exposure, and the “net” is much smaller
as these positions are typically hedged.
But the real exposure is close to the
“gross” exposure in a crisis.
While each party may be “hedged” by
having a long leg and a balancing short leg,
these will not “net out”.
This is because in times of stress the
bid (but not the offer) is withdrawn.
To close the long leg of an arbitrage,
one must sell on the bid (which could be zero).
To close the short leg, one must buy at
the offer (which will still be high).
When the bid-ask spread widens that way,
it will be for good reason and it does not do to
be an armchair philosopher and argue that it
“should not” occur.
Lots of things will occur that should not
occur.
For example, gold should not go into
backwardation.
This is another big (if not widely
appreciated) piece of evidence that confidence
in the ability of debtors to pay is waning.
Gold and silver went into backwardation
in 2008 and have been flitting in and out of
backwardation since then.
Backwardation develops when traders
refuse to take a “risk free” profit.
That is, the trade is free from all risks
except the risk of default and losing one’s
metal in exchange for a defaulted futures
contract.
See my paper (http://keithweiner.posterous.com/61392399)
for a full treatment of this topic.
The root cause of our monetary disease has its
origins in the creation of the Fed and other
central banks prior to World War I, and in the
insane treaty signed in 1944 at Bretton Woods in
which many nations agreed for their central
banks to use the US dollar as if it were gold,
and this paved the way for President Nixon to
pound in the final nail in the coffin.
He repudiated the gold obligations of the
US government in 1971, thereby plunging the
whole world into the regime of irredeemable
paper.
The US dollar
game is a check-kiting scheme.
The Fed issues the dollar, which is its
liability.
The Fed buys the US Treasury bond, which
is the asset to balance the liability.
The only
problem is that the bonds are payable only in
the central bank’s paper scrip!
Meanwhile, per Bretton Woods, the rest of
the world’s central banks use the dollar as if
it were gold.
It is their reserve asset, and they
pyramid credit in their local currencies on top
of it.
It is not a bug, but a feature, that debt in
this system must grow exponentially.
There is no ultimate extinguisher of
debt.
In my paper on Inflation (http://keithweiner.posterous.com/inflation-an-expansion-of-counterfeit-credit),
I define inflation as an expansion of
counterfeit credit.
I define deflation as a forcible
contraction of counterfeit credit, and the
inevitable consequence of inflation.
Well, we have had many decades of rampant
expansion of counterfeit credit.
Now we will have deflation, and the
harder the central banks try to fight it by
forcing yet more expansion of counterfeit
credit, the worse the problem becomes.
With leverage everywhere in the system,
it would not take many defaults to wipe out
every financial institution.
And there will be many defaults.
One default will beget another and once
it really begins in earnest there will be no
stopping the cascade.
Another key problem is duration mismatch.
Today, every bank and financial
institution borrows short to lend long, many
corporations borrow short to finance long-term
projects, and every government is borrowing
short to fund perpetual debts.
Duration mismatch can cause runs on the
banks and market crashes, because when
depositors demand their money, banks must
desperately sell any asset they can into a
market that is suddenly “no bid”.
In two papers (http://keithweiner.posterous.com/fractional-reserve-is-not-the-problem
and http://keithweiner.posterous.com/falling-interest-rates-and-duration-mismatch),
I cover duration mismatch in banks and
corporations in more depth.
Most banks and economists have supported a
policy of falling interest rates since they
began to fall in 1981.
But falling interest rates destroy
capital, as I explain in that last paper, linked
above. As
the rate of interest falls, the real burden of
the debt, incurred at higher rates, increases.
Related to this phenomenon is the fact that the
average duration of bonds at every level has
been falling for a long time (US Treasury
duration began increasing post 2008, but I think
this is an artifact of the Fed’s purchases in
their so-called “Quantitative Easing”).
Declining duration is an inevitable
consequence of the need to constantly “roll”
debts.
Debts are never repaid, the debtor merely pays
the interest and rolls the principal when due.
As the duration gets shorter and shorter,
the noose gets tighter and tighter.
If there is to be a real payback of debt,
even in nominal terms, we need to buy more time.
At the US Treasury level, average
duration is about 5 years.
I doubt that’s long enough.
And of course the motivation for building this
broken system in the first place is the desire
by nearly everyone to have a welfare state,
without the corresponding crippling taxation.
It has been long believed by most people
a central bank is just the right kind of magic
to let one have this cake and eat it too,
without consequences.
Well, the consequences are now becoming
visible.
See my papers (http://keithweiner.posterous.com/the-laffer-curve-and-austrian-economics
and
http://keithweiner.posterous.com/a-politically-incorrect-look-at-marginal-tax)
discussing what raising taxes will do,
especially in the bust phase like we have now.
In reality, stripped of the fancy nomenclature
and the abstraction of a monetary system, the
picture is as simple as it is bleak.
Normally, people produce more than they
consume.
They save.
A frontier farmer in the 19th
century, for example, would dedicate some work
to clearing a new field, or building a
smokehouse, or putting a wall around a pasture
so he could add to his herd.
But for the past several decades, people
have been tricked by distorted price signals
(including bond prices, i.e. interest rates)
into consuming more than they produce.
In any case, it is not possible to save in an
irredeemable paper currency.
Depositing money in a bank will just
result in more buying of government bonds.
Capital accumulation has long since
turned to capital decumulation.
This would be bad enough, as capital is the leverage on
human effort that allows us to have the present
standard of living.
We don’t work any harder than early
people did 10,000 years ago, and yet we are
vastly more productive due to our accumulated
capital.
Now much of the capital is gone, and it cannot be
brought back.
It will soon be impossible to continue to
paper over the losses.
The purpose of this piece is not to
propose how to save the dollar or the other
paper currencies.
They are past the point where saving them
is possible.
This paper is directed to avoiding the
collapse of our civilization.
If we stay on the
present course, I think the outcome will look
more like 472 AD than 1929.
We must solve three problems to avoid
that kind of collapse:
1.
Repayment of all debts in nominal terms
2.
Keep bank accounts, pensions, annuities,
corporate payrolls, annuities, etc. solvent, in
nominal term
3.
Begin circulation of a proper currency before
the collapse of the paper currencies, so
that people have something they can use when
paper no longer works
I propose a few simple steps first, and then a
simple solution.
All of this is designed to get gold to
circulate once again as money.
Today, we have gold “souvenir coins”.
They are readily available, and have been
for many years, but they do not circulate.
A gold standard is like a living organism.
While having the right elements present
and arranged in the right way is necessary, it
is not sufficient.
It must also be in constant motion.
Gold, under the gold standard, was always
flowing.
Once the motion is stopped, restarting it is not
easy.
This applies to a corpse of a man as well as of
a gold standard.
The first steps
are:
1.
Eliminate all capital “gains” taxes on gold and
silver
2.
Repeal all legal tender laws that force
creditors to accept paper
3.
Also repeal laws that nullify gold clauses in
contracts
4.
Open the mint to the (seigniorage) free coinage
of gold and silver; let people bring in
their metal and receive back an equal amount in
coin form.
These coins should not be
denominated in paper currency units, but merely
ounces or grams
Each of these items removes one obstacle for gold
to circulate as money, along side the paper
currencies.
The capital “gains” tax will do its worst
damage precisely when people need gold the most.
At that point, the nominal price of gold
in the paper currencies will be rising very
rapidly.
Any sale of bullion will result in a tax of
virtually the entire amount, as the cost basis
from even a few weeks prior will be much lower
than the current price.
This amounts, in the US, to a 28%
confiscation of gold.
This tax will force people to keep gold
underground and not bring it to market.
It will contribute to the acceleration of
permanent backwardation.
It is important
to realize that gold is not “going up”.
Paper is going down.
There is no gain for the holder of gold;
he has simply not lost wealth due to the
debasement of paper.
Current law forces creditors to accept paper as
payment in full for all debts, and there are
also laws that nullify gold clauses in
contracts.
Repeal them, and let creditors and
borrowers negotiate something mutually
agreeable.
Finally, the bid-ask spread on gold bullion
coins such as the US gold eagle or the South
African krugerrand is too wide.
If the mint provided seigniorage-free
coinage service, then people would bring in gold
bars and other forms of bullion until the
bid-ask spread narrowed appropriately.
One of the attributes that gives gold its
“moneyness” is its tight spread (even today, it
is 10 to 30 cents per $1600 ounce!)
But currently, this tight spread only
applies to large bullion bars traded by the
bullion banks and other sophisticated traders.
This spread must be available to the
average person.
As I said earlier, these steps are necessary.
Gold certainly will not circulate under
the current leftover regime from Roosevelt and
Nixon.
But it is not sufficient to address the debt
problem.
Accordingly, I propose a simple additional step.
The government should sell gold bonds.
By this, I do not mean gold “backed”
paper bonds.
I mean bonds denominated in ounces of
gold, which pay their coupon in ounces of gold
and pay the principal amount in ounces of gold.
Below, I explain how this will solve the
three problems I described above.
Mechanically, it is straightforward.
The government should set a rule that, to
buy a gold bond, one does not bid dollars.
One bids paper bonds!
So to buy a 100-ounce gold bond, then one
could bid for example $160,000 worth of paper
bonds (assuming the price of gold is $1600 per
ounce).
The government retires the paper bond and in
exchange replaces it with a newly-issued gold
bond.
The government should start with a small tender,
to ensure a high bid to cover ratio.
And a series of small auctions will give
the market time to accept the idea.
It will also allow the development of
gold bond market makers.
With gold bonds, it would be possible to sell
long durations.
With paper, there is no good reason to
buy a 30-year bond (except to speculate on the
next move by the central bank).
The dollar is expected to fall
considerably over a 30-year period.
But with gold, there is no such
debasement.
The government could therefore exchange
short-duration debt for long-duration debt.
At first, the price of the gold bonds would
likely be set as a straight conversion of the
gold price, perhaps adjusted for differing
durations.
For example, a 100 ounce gold bond of 30
years duration might be bid at $160,000 worth of
30-year paper bond.
But I think that the bid on gold bonds will rise
far above “par”, for several reasons I will
discuss below.
The nature of the dynamic will become clear to
more and more people in due course.
In the present regime, there is a common
misconception that the yield on a bond is set by
the market’s expectation of how much consumer
prices will rise (the crude proxy for the loss
of value for the dollar).
But this is not true.
Unlike in a gold standard, in an
irredeemable paper standard, people are
disenfranchised.
They have no say over the rate of
interest.
The dollar system is a closed loop, and if you
sell a bond then you either hold cash in a bank,
which means the bank will buy a bond.
Or you buy another asset.
In which case the seller of that asset
holds cash in a bank or buys a bond.
This is one of the reasons why the rate
of interest has been falling for 30 years
despite huge debasement.
All dollars eventually go into the
Treasury bond.
The price of the paper bond today is set by a
combination of central bank buying, and
structural distortions in the system.
But it is a self-referential price, in a
game between the Treasury and the Fed.
The price of the bond does not really
come from the market.
And this impacts every other bond in the
universe, which all trade at varying spreads to
the Treasury.
An alternative to paper bonds would be very
attractive to those who want to save and earn
income for the long term, pension funds,
annuities, etc.
Not only will the price of gold continue
to rise (i.e. the value of the paper currency
will continue to fall towards zero), but also a
premium for gold bonds would develop and grow.
The quality asset will be recognized to
be worth more, and at the least people would
price in whatever rate of the price of gold they
expect to occur over the duration of the bond.
This dynamic—a rising price of gold, and a
rising exchange value of gold bonds for paper
bonds—will allow
governments and other debtors to
use the
devaluation of paper as a
means to
repay their debts in nominal terms, but
affordably in real terms.
This is impossible under paper bonds!
This is because the process of debasement
is a process of the Treasury borrowing more
money.
Debt goes up to debase the dollar.
This path leads not to repayment of the
debt cheaply, but to exponentially growing debt
until a total default.
So we have solved problem number one.
With a rising gold price, and a rising
exchange rate of gold bonds for paper bonds, we
have set up a dynamic whereby every paper
obligation can be met in nominal terms.
Of course, the value of that paper will
be vastly lower than it is today.
This is
the only way that the immense amounts of debt
outstanding can possibly be honored.
This also solves problem number two.
If every financial institution is repaid
every nominal dollar it is owed, then they will
remain solvent.
To be sure, pension payments, bank
accounts, corporate payroll, and annuities etc.
will be of much lower real value.
But there is a critical difference
between smoothly losing value vs. abruptly
losing everything, along with catastrophic
failure of the financial system.
I want to address what could be a misconception
at this point.
Does this work only for governments that
have gold reserves in the vaults?
No, this is not about gold reserves.
While that may help accelerate a gold
bond program, the essential is not gold stocks
but gold flows.
The government issuer of gold bonds must
have a gold income (or a credible plan to
develop one quickly).
And this leads to problem number three.
Gold does not circulate today.
Who has a gold income?
That is where we must look to begin the
loop.
There is one kind of participant today who has a
gold income: the gold miner.
Beset by environmentalist lawsuits,
regulations, permits, impact studies, fees,
labor law, confiscatory taxes, and other
obstacles created by government, these companies
still manage to extract gold out of the ground.
The gold miners are the group to which we must
turn to help solve the catch-22 of getting gold
to circulate from the current state where it
does not.
I think there is a simple win-win proposition to
offer them.
In exchange for exemptions from the
various taxes, regulations, environmentalism,
etc. they have a choice to pay a tax in gold
bullion.
There are other kinds of entities to consider
taxing, but the problem is that they all would
need to buy gold in the open market in order to
pay the tax.
As the price begins to rise
exponentially, this will be certain bankruptcy
for anyone but a gold miner.
And now, look at the progress we’ve made on the
problem of getting gold to circulate.
We have gold miners paying tax in gold to
governments who are making bond coupon payments
in gold to investors who now have a gold income.
We can see how gold bond market makers
will enter the scene, and earn a gold income to
provide liquidity for bonds that are not “on the
run”.
These bond market makers could pay a tax in gold
also.
And we have released other creditors from any
restriction in lending and demanding repayment
in gold.
And anyone else in a position to sign a
long-term agreement involving a stream of
payments over a long period of time, such as
landlords, can incorporate gold clauses in their
contracts.
And if the tenant has a gold income,
perhaps from owning a gold bond, he can manage
his cash flows and confidently sign such a
lease.
Note that the lender, unlike the employee, the
restaurant, or most other economic actors, is in
a position to demand gold.
While everyone else would like to be paid
in gold, they haven’t got the pricing power to
demand it.
The lender can say: “if you want my
capital, you must repay it in gold!”
If enough gold bonds are issued soon enough, we
may reverse the one-way flow of gold from the
markets into private hiding, that is inexorably
leading to inevitable permanent backwardation
and the withdrawal of all gold from the system.
One of the key points in my backwardation paper
is that the value of the dollar collapses to
zero not as a consequence of the
quantity
of dollars rising to infinity, but because of
the desire of some dollar holders to get gold.
If they cannot trade paper for gold, then
they will trade paper for commodities without
regard to price and trade those commodities
for gold.
This will cause the price of the commodities in
dollar terms to rise to levels that make the
dollar useless in trade (and collapse the price
of commodities in gold terms).
If we reverse the flow of gold out of the
markets, we may be able to prevent this disaster
from occurring.
The dollar will then continue to lose
value in a continuous (if accelerating) manner,
as people migrate to gold.
This is the best outcome that could possibly be
hoped for.
If it occurs along with a reduction in
spending so that spending does not exceed (tax)
revenues, we will avert Armageddon and be on the
path to a proper and real recovery.
To be clear, times will be hard and the
average standard of living will decline
precipitously.
But this is infinitely preferable to total
collapse.
It is now up to farsighted leaders, especially
in government, to take the first concrete steps
towards saving Western Civilization.
* Whereve I refer to gold, I also mean
silver. For sake of brevity and readability, I
will only say gold in most cases.
For my part I am working through the due
diligence process of a Canadian listed gold
junior that will be operating out of Ghana. I
expect the company will be cleared to trade
later this month.
|
Larry Myles
Larry Myles Reports
604-408-7600
1-877-405-7600
Receive Larry Myles Reports
Larry Myles is neither a geologist
nor a financial analyst. I do not purport to offer
personal investment advice nor recommendations.
While all statements of fact are derived from
reliable sources, and are believed to be accurate, I
make no warrant that they are so. You must do your
own research and check statements of fact for
yourself. My opinions are precisely that, my
opinions. I do not accept any responsibility for any
gains or losses you may experience resulting from
actions taken based on my opinions. If not otherwise
qualified, you should consult with your own personal
financial advisor before engaging in any investment
activities. Larry Myles Reports does not provide
individual investment advice, act as an investment
advisor, or individually advocate the purchase or
sale of any security or investment. Larry Myles may
actively trade in the investments discussed in this
publication. Larry Myles may have a substantial
position in the securities recommended and may
increase or decrease such positions without notice.
I do not know your personal financial
circumstances. I am not your personal financial
advisor. You must do your own due diligence. By
entering this web site, or reading LMR reports, you
acknowledge and accept the foregoing.
larry@larrymylesreports.com
|