Tuesday, September 8, 2009

Comments for Tuesday September 8th

Gold and silver pushed higher in early morning trading, as the dollar broke to multi-month lows. However, after pushing above $1000, gold fell in New York trading, with the price closing at roughly the point where it opened. Silver and the HUI gold equity index had similar action with strong advances followed by a fall in price into the close. Usually, this type of action can indicate a price top, particularly after a strong run-up in prices. However, I am still of the opinion that there is more strength in the market, and that this will later appear as a false top. It would be particularly noteworthy if a break to new highs occurred during the Asian trading hours tonight or tomorrow night.

I have gotten a late start on the article I intended to write on dollar devaluation, but I will give my argument in a nutshell now and expand upon the argument tomorrow. I will begin by citing 2 historic cases of devaluations (America 1933, and Argentina 2001) and then compare these cases to the current situation. In both of the previous cases, the money being devalued was "pegged" to the money it was devalued against. In the case of America 1933, dollars were pegged to gold, and in the case of Argentina 2001, pesos were pegged to the dollar. Currently, the dollar is not pegged to gold or any other currency. The dollar is pegged to an ephemeral substance called faith. Therefore, any devaluation will occur due to a shift in faith.

However, this does not make an overnight devaluation any more difficult. In fact an argument can be made that such a devaluation was already announced on March 18th, 2009, when the Fed announced purchases of $1.75 trillion in US treasuries, agency debt, and mortgage backed securities. The difference lies in that the meaning of the devaluation is more difficult to gauge, and takes longer to have an effect because it must first work through the perceptions of the market.

The reason the devaluation of 1933 had an instant effect was because it allowed the holders of gold, both foreign and domestic, more purchasing power for everything else that was priced in dollars. This higher purchasing power included the price of labor. In fact, there would have been much the same effect if the government had simply confiscated gold and then ordered by decree that all prices in the economy, including labor, were to be cut by 40%. One problem with that solution is that people's perception of their worth is often tied to the number on their wage statements, and so a devaluation of the purchasing medium (gold) was more practical, more easily enforced, and more politically savvy.

Fast-forward to today. Today, people still attach a great deal of psychological value to the number on their pay-check. "5 figures, low 6 figures, high 6 figures, etc." And that number has lost all formal pegging to gold, so most Americans are oblivious to that relationship. Additionally, Americans seem to accept that there is a 2% decrease in purchasing power every year; I think that most don't realize or don't care that the depreciation acts as a seigniorage tax that benefits the government. The honest truth is that most Americans don't care simply because life is so good! The loss of purchasing power is subtle, and many of the side-effects of money debasement are confusing and can't be understood without honest and diligent study. The ultimate example of confusion came with the housing bubble in the last few years. People were buying houses that were worth 15 times their yearly salary with no money down. This to me is the best example that Americans have accepted that the relationship between money and what it can buy is esoteric. It is because of this that I think it is unlikely - very unlikely - that the dollar will debase from within because Americans are too busy and too happy to lose their faith in the dollar. The debasement of the dollar will come from abroad, as foreign countries lose their faith in the future value of the dollar. The foreign countries that matter, China, Japan, OPEC, and to a lesser degree Russian and Brazil, will want a store of value. Since they are opposed to letting their own currencies appreciate, they will look for an alternative that is not a currency. Gold is an obvious choice, as well as oil, copper, or any other commodity that can be inexpensively hoarded for long periods of time. In the long run, gold and silver will return as the most logical choices because their of their inherent monetary properties. Oil is another possibility even though the storage and transportation is much more difficult.

The productive capacity of the US is below where it needs to be in order to maintain the faith of the world. Ultimately the buck stops here: by the amount of goods and services that foreigners can purchase from Americans with their dollars. Our productive capacity has been decimated by mal-investment in houses, cars, and domestic services. Thus, the foundation for a loss of faith.
When debasement comes, it won't come as an announcement from the POTUS. It will come as foreign holders of dollars slowly and silently abandon ship.

One final note. The larger the deflationary contraction the US experiences in the near future, the better for these foreign holders of large dollar stashes. Ultimately, the worth of the dollar is tied to the productive capacity of the US. But in the short term, if holders of dollars can exit by purchasing assets on the cheap, so much the better for them. The worst possible outcome for the US as a nation would be another round of devaluation, allowing China et all to buy even more assets in their exit from the dollar. I believe that our current predicament is best characterized as a dance between the Fed and foreign holders of the dollar. The Chinese try to goad the Fed into tightening money and credit, to ensure another wave of deflation and increase the purchasing power of the Chinese hoard yet more. The Fed tries to pretend as though they might tighten money and credit in order to head off any abandonment by the Chinese and others. I think the Chinese understand the strategy of the game, but the Fed only sees the tactics of the game.

In 1933, shortly after being elected, FDR called for a bank holiday, simultaneously passing an edict that made it illegal to hold gold bullion. This type of event is highly unlikely simply because the dollar is not pegged to gold anymore. Holders of gold are seen as a curiosity but not as a force of deflation in the economy. Some sort of announcement by foreign powers is even more unlikely. After firing a few shots over the bow, foreign powers will speak with their feet and leave the dollar quietly.

I'll end today with the executive order given by Roosevelt to confiscate gold. I found this to be a fascinating historical record, even if I don't see anything similar happening during present times.

Executive order: By virtue of the authority vested in me by Section 5(B) of The Act of Oct. 6, 1917, as amended by section 2 of the Act of March 9, 1933, in which Congress declared thata serious emergency exists, I as
President, do declare that the nationalemergency still exists; That the continued private hoarding of gold and silver by subjects of the UnitedStates poses a
grave threat to the peace, equal justice, and well-being of the United
States; and that appropriate measures must be taken immediately
to protect the interests of our people.

"Therefore, pursuant to the above authority, I herby proclaim that such gold
and silver holdings are prohibited, and that all such coin, bullion or other possessions of gold and silver be tendered within fourteen days to agents of the Government of the United States for compensation at the official price, in the legal tender of the Government. All safe deposit boxes in banks or financial institutions have been sealed, pending action in the due course of the law. All sales or purchases or movements of such gold and silver within the borders of the United
States and its territories, and all foreign exchange transactions or movements of such metals across the border are hereby prohibited.

"Your possession of these proscribed metals and/or your maintenance
of a safe-deposit box to store them is known to the
Government from bank and insurance records. Therefore, be advised
that your vault box must remain sealed, and may only be opened in the
presence of an agent of The Internal Revenue Service.

"By lawful Order given this day,
the President of the United States."

After confiscating gold and silver, he then changed the underlying relationship between gold and the dollar, from roughly $20/ounce to $35/ounce. This was a devaluation of roughly 40%.

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