SEMI-MONTHLY FISCAL/MONETARY UPDATE – A COMPELLING ARGUMENT FOR GOLD ABOVE $10,000
The following is an excerpt from an excellent article published recently by Myrmikan Research. We warn you advance that it is more technical than most investors like to deal with, but nobody ever said it is easy to maintain wealth. The following provides a logical and compelling case why a much higher price for gold, and gold mining stocks, is inevitable. Enjoy !!
The following is republished with the permission of Myrmikan Research LLC
Gold Past $10,000
Gold in 2019 finally burst through the $1,350 ceiling that had been established during the crash of 2013. Gold’s current price of $1,550 may be materially higher than where it has traded over the past six years, and it has returned most gold miners to profitability, but it is nothing compared to where the price of gold is headed. For the benefit of new readers and to jog the memories of long-time followers, let us work through the admittedly circuitous but conceptually simple reasoning behind the reason why the dollar price of gold is heading well above $10,000 per ounce
In 1915, the Federal Reserve’s assets were 77% gold, 7% commercial bills, and 2% government bonds (the remainder a smattering of various “amounts due” from other institutions). By 1923, those figures had shifted to 61% gold, 22% commercial bills, and 3% government bonds. There was no possibility that the Federal Reserve’s liabilities (i.e., the dollar) could decline in value when they were so backed: the Federal Reserve’s assets had almost no credit risk nor interest rate risk. Those who held dollars could at any time demand that the Federal Reserve redeem their dollars into gold, but few would want to given that the dollar was more liquid than gold and so solidly backed.
During the credit collapse of the 1930s, asset prices crashed against real money (gold) as malinvestments liquidated. Roosevelt made holding gold a felony, but there was little need: the dollar, backed by gold and commercial bills, remained relatively constant. Gold, in fact, flooded into the central bank from Europe: by 1940, Federal Reserve assets were comprised of 85% gold, 0% commercial bills, and 9% government bonds.
Contemporaneous economists understood that the dollar had not become “too strong” in the 1930s; it was asset prices that had been too high in the 1920s. But then the age of Keynes arrived, and the Federal Reserve embarked its new mission of funding the government instead of liquefying trade. By 1971, the Federal Reserve had increased its assets and liabilities by five times and lost over half of its gold to European governments (which retained the right to redeem dollars into gold): its balance sheet shifted to 12% gold, 0% commercial bills, and 71% government bonds. The Federal Reserve was no longer a liquidity provider in the mold of the Bank of Amsterdam, but a credit creator for the state.
In 1971, Nixon closed the gold window, and U.S. physical gold reserves have remained nearly constant since. But the Federal Reserve bought enormous amounts of government bonds in the 1970s to keep interest rates low to prop up government spending and financial market excesses. By the end of 1980, the Federal Reserve had increased its liabilities (i.e., the number of raw dollars) by 76% by buying government bonds. The dollar’s value collapsed.’
Under the quantity theory, a 76% increase in the number of dollars should have produce a 44% declined in its value. Or, if we look at M2, which increased by 125%, the dollar should have fallen by 55%. Instead it fell against gold by 96%.
The chart below shows what happened: as the government printed more money, interest rates rose, and the bonds the Federal Reserve holds to back the currency fell in value. It wasn’t that there were too many dollars chasing too few goods—as the monetarists claim—it was that each dollar was stripped of that which gave it value. It would as if the Bank of Amsterdam had suddenly announced that half of its gold reserve had been stolen: the value of its paper currency would immediately fall in half.
The surging price of gold—really the devaluation of the dollar—exactly tracked the increase in nominal interest rates. Note that the first surge in rates occurred when the price of gold was still fixed—instead of the price of gold rising, the U.S. lost 15% of its gold reserves to European governments.
The next chart shows the Federal Reserve’s balance sheet in terms of its gold backing. It shows clearly what happened when the Keynesians took over economic power in the 1940s and stuffed the Federal Reserve full of Treasury bonds. Then, in 1971, the reaction set in: interest rates soared and as did the the price of gold until the Federal Reserve’s existing stock backed Federal Reserve liabilities by over 100%.
Then they did it again from 1981 to today (only this time they called themselves monetarists). The Federal Reserve bought government bonds to fund the growth of the state and keep interest rates low to stimulate industry artificially. Leading up to the 2008 panic, gold increased to a price that caused it to backed Federal Reserve liabilities by nearly 30%. But then the Federal Reserve issued dollars to buy Treasuries and mortgage-backed securities, massively expanding its balance sheet and saving the malinvestments.
By the time QEs were complete, the gold backing of the dollar had fallen to just 6% (as opposed to 12% in 1969). In other words: in 2016, with gold trading at $1,050 per ounce, the price of gold was half what it had been in 1969 in terms of the Federal Reserve’s balance sheet. And, as the chart below shows, the composition of that balance sheet in 2016 was much worse than it had been in 1969 (the dip in bond holdings in 2008 was due to temporary swap lines with other central banks and other short-term extraordinary bailout programs).
In the 1970s, the duration of the Treasury bonds on the Federal Reserve’s balance was only a few years—now it is over a decade. Plus, the duration of mortgage-backed securities is inverse to the movement in rates: few borrowers refinance in a rising interest rates environment. Unlike at the Federal Reserve’s founding, when its assets were virtually immune from interest rate risk, its assets now are highly sensitive.
At the moment, when the Federal Reserve prints money to buy bonds, the result is rising prices and falling interest rates, which keeps the government funded and financial markets aloft. The end of the dollar will begin when this dynamic flips, as it did in the 1970s. At some point, the market will demand a premium to protect against the weakening position of the Federal Reserve’s balance sheet. The more the monetary authorities print, the higher rates will go, the more money the government will need to print to cover its interest payments and deficit, the lower the dollar will sink, and the higher gold’s nominal price will be.
The question is when will the dynamic flip? The great economist Ludwig von Mises argued that psychological factors are determinative:
“Finally, the public becomes aware of what is happening. People realize that there will be no end to the issue of more and more money substitutes—that prices will consequently rise at an accelerated pace. They comprehend that under such a state of affairs it is detrimental to keep cash. In order to prevent being victimized by the progressing drop in money’s purchasing power, they rush to buy commodities, no matter what their prices may be and whether or not they need them. They prefer everything else to money. They arrange what in 1923 in Germany when the Reich set the classical example for the policy of endless credit expansion, was called die Flucht in die Sachwerte, the flight into real values.”
Mises’s description of what happens after the panic begins is undoubtedly accurate, but there is no need to rely on psychology to determine when panic sets in: the cause is the collapse of cash flows from business projects due to overcapacity, which is what ended the canal boom of the 1830s, the railroad boom of the 1850s and 1870s, the stock market and real estate booms of the 1920s, 1960s, and 2000s.
After the last panic, the Federal Reserve managed to lower structural interest rates by around 4%. Existing projects looked more valuable, and the lower rates stimulated industry to build all the marginal projects that suddenly appeared to be profitable. Instead of a thorough liquidation of the financial and economic systems, the Federal Reserve engineered a new boom.
The next panic will similarly require not just a bailout of the banks but also a structural lowering of rates in order to avoid complete liquidation. This is why Bernanke announced earlier this month from his perch at the Brookings Institute that “new policy tools can provide the equivalent of 3 percentage points of additional policy space.” These new tools include: “the future use of negative short-term rates, both because situations could arise in which negative short-term rates would provide useful policy space.”
Negative interest rates that (adding the commercial banks’ spread) result in near-zero rates for large industry might well serve to keep the economy and government from complete collapse for a time. The consequences, however, would include providing gold with a positive carry as against government bonds and further deterioration of the composition of the Federal Reserve’s balance sheet.
At some point, whether it is during the next panic or the following one, the market will discover that much of society’s wealth has become entrapped in non-cashflowing malinvestments. Tax revenues will plummet, and the assets that our central bank holds will be shown to be near worthless. That is when gold will shoot into the multi-thousands of dollars per ounce.
History allows us to make some projections: The average gold backing for Bank of England liabilities from 1720 to 1900 was 33%. Private banks in the U.K. maintained a similar percentage of gold backing during this time. This percentage was set more by the market than by policy-makers: until World War I, anyone could deposit gold and demand paper or vice-versa. The composition and size of the Federal Reserve’s balance sheet requires gold to trade above $5,000 to reach one-third backing.
Looking at American history, Federal Reserve notes were freely exchangeable for gold until 1933, and the average gold backing of the Federal Reserve through that time was 54%. To reach that level of backing would currently require a gold price above $8,500.
Recall, however, that the above figures occurred when the non-gold assets on central bank balance sheets were nearly all commercial bills. Given the current composition of the Federal Reserve’s balance sheet, the market will demand more backing than one third or even a half.
The panic in 1980, for example, sent gold to a price that caused Federal Reserve liabilities to be gold backed by an absurd 135%—to achieve the similar figure today would require gold to trade over $20,000 per ounce. That was the peak of a dollar panic, not an equilibrium price, but it shows how crazy the gold market can get.
The nominal figures above assume that the Federal Reserve will keep the size of its balance sheet constant. But, of course, as Bernanke has telegraphed, the central bank will start printing as soon as recession looms. The Federal Reserve has, in fact, already starting printing to support the repo market, the primary funding mechanism for both the state and real estate loans.
Bernanke claimed on 60 Minutes: “We could raise interest rates in 15 minutes if we have to. So, there really is no problem with raising rates, tightening monetary policy, slowing the economy, reducing inflation, at the appropriate time.” This is exactly what Federal Reserve governors thought would happen in 1979 when they boosted rates to 21%. Instead, the dollar went into it final swoon as the Federal Reserve’s bond portfolio collapsed in value.
The money to push gold over $10,000 per ounce has already been printed. And now they are going to print more. The bubble economy is already teetering. No doubt strong fiscal and monetary intervention may extend its life for a time, but then the ultimate price objective for gold will then be markedly higher. The gold miners will do even better.
The above article excerpt is republished with the permission of Myrmikan Capital LLC
Roger Lipton