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Welcome to USAGOLD's "Gilded Opinion" pages. We invite you to browse our index of outstanding gold-based commentary.
Real Money, Funny Money and
YOU -- Part 2.
by Professor von Braun
May 26th, 2005
Could the US dollar collapse? As most of us know there never has
been a fiat currency that has continued in existence ad infinitum.
All previous experiments have failed, which suggests that the
current fiat game can not last. However never before has the game
involved so many players, not all of whom are willing, it seems,
given ongoing noises about central bank diversification.
During 2003 and into early 2004 the Bank of Japan 'created' some
35 trillion yen which found its way into the MOF and then into
the foreign exchange markets. It was used to purchase some $300
billion of US government bonds. The MOF purchased more US dollars
than it had done in the previous 10 year period, and Japan's foreign
exchange reserves increased dramatically. This increase provided
support for a falling dollar and in and of itself displays the
vested interest that other central banks have in supporting their
reserves, which are mostly US dollars. The magnitude of the move
is substantial (it resulted in an increase in Japan's foreign
exchange reserves of 75%+) and demonstrates the capability of
a fiat monetary system to 'reflate' itself.
With the stroke of a pen the creation of 35 trillion yen led to
a massive increase in foreign reserves and the US dollar decline
was 'supported'. Obviously there exists a willingness on the part
of the BOJ to hold US dollars and, as a result of their recent
purchase, an ever greater willingness to continue to support it.
By virtue of the reserve increase the BOJ has 'married' the US
dollar. Most other central banks are in a similar situation and
are likely to act to support a declining dollar, since they really
have no choice. That's the problem with fiat -- once you own it,
you have to accept more to support the original acceptance --
in a sense, a marriage with no divorce allowed, which is why talk
of diversification is just that, talk. Realistically it can not
be done, since the disease is too widespread and the cure, gold
reserves, are not readily available.
It is interesting to note the reported value of the "total
notional value of all gold derivatives at year end 2004 at $369
billion" as reported by the BIS, who obtained this information
from banks and dealers within the G-10 countries. This number
had increased by $51 billion during the second half of 2004. These
numbers equate to 28,000 tonnes of gold and collectively the G-10
countries, (actually there is eleven of them, which suggests that
bankers can't count), hold as 'reported' gold reserves, by the
respective members, 20,295.4 tonnes. Whether the BIS numbers include
all OTC markets as well I do not know, but why would banks and
dealers within the G-10 countries be so keen to increase their
exposure to the barbaric relic of days gone by? And whose gold,
if any, is being used as the basis for these contracts being written
in the first place?
One would like to believe that the BIS would ask the question
as to how one would settle these contracts and if it involved
gold held by the respective member countries then that gold should
not be classified as a reserve. But then again this is the age
of the paper contract and in most cases, the reality of those
contracts has yet to be tested. Counterparty risk is a term that
we hear little about at present, but is one that could begin to
be more commonly well known as time goes by.
If gold has no apparent role in the modern financial world
then why are banks and dealers operating in the G-10 countries
so keen on increasing their exposure to the metal, an increase
based on an exposure to something that could not be delivered?
While speculation in commodity markets is not unusual, what exactly
could be behind a substantial increase in the notional value of
gold derivative contracts? Most commodity markets have an end
user, whether it be for gasoline, wheat, cotton, corn, rice, etc.
Perhaps the number of jewelers in the G-10 countries has increased
dramatically and their desire to obtain large amounts of physical
metal has created this 4000 tonne equivalent increase in new contracts.
Is this to say a combination of a declining dollar, a rising gold
price and an overvalued euro would have had nothing to do with
this new found interest in gold derivatives? That would suggest
that gold, the barbaric relic, was being used as an alternative,
a hedge to the declining dollar.
As mentioned in Part
1, gold is not a promise to pay a promise to pay a promise,
it is what it is and as such is the neutral ingredient when it
comes to paper currencies. If you hold assets these assets are
denominated and 'priced' in the coin of the realm; in the US its
dollars, in Japan its yen and in Europe it's the euro. The market
price of the assets provides the owner with a sense of wealth
and allows balance sheets and net worth statements to be prepared.
Business obviously is transacted in these currencies and the source,
the central bank, as evidenced by the BOJ and statements by Ben
Bernanke of the Federal Reserve, has the ability to create unlimited
numbers of these instruments.
You, as an owner of an asset, are at risk from an over supply
of these instruments should there ever come a day when these instruments,
whatever they are, are deemed to be oversupplied. Now this
may never happen, but it has happened before, perhaps the best
example being Germany in the 1920's. Unlike the Bank of Japan
or the Federal Reserve you do not have the ability to increase
the money supply in your checking account simply by adding a digit
or two.
At present, as evidenced by the BOJ's recent acquisition of US
dollar denominated paper, simply by increasing its own money supply,
via the stroke of a pen, the collective power of all holders of
US dollars is immense. The collective vested interest in maintaining
the dollar as the worlds reserve currency is not to be under estimated.
Obviously if the dollar goes, then it would have a domino effect
as the value of other central banks reserves declined accordingly.
As a nation the US is faced with some inherent problems, Social
Security being one, rising health care costs being another, under
funded pension plans being another, a declining manufacturing
base being another and last but not least, a rising percentage
of the population nearing retirement age. Combined these suggest
a near future increase in government payouts and a decline in
the taxable income base which is where the income to pay interest
on the government debt comes from.
That's apart from the gorilla in the financial markets called
the derivatives market, an unknown entity that from small beginnings
now seems to have become the largest of all. While Mr. Greenspan
sees no need for regulation of these markets, he does see the
need to remove some of the players, in particular Fannie Mae and
Freddie Mac, perceiving them as a threat to the US financial system.
"As Fannie and Freddie grow ever larger, their ability
to quickly correct a misjudgment in their complex hedging strategies
becomes more difficult," Greenspan said. "We are thus
highly dependent on the risk managers at Fannie and Freddie to
do everything right."
"Without the needed restrictions on the size of (Fannie and
Freddie's) balance sheets we put at risk our ability to preserve
sound and safe financial markets in the United States, a key ingredient
of support for housing," he said. (How about the rest
of the financial world -- as in hello BOJ?)
Now both these entities already have serious problems involving
how derivates were accounted for and now have the need to restate
earnings to the downside. One would hope that the risk managers
Mr. Greenspan referred to are not involved in these debacles.
Given the rest of the worlds dependence on the soundness of US
financial markets, the mere fact that Greenspan can isolate and
comment on a potential threat to the soundness of this market,
from within the US itself, should convey the potential inherent
unstableness of the derivative markets themselves and send a warning
to holders of US dollar denominated assets.
What guarantee do you have that an event outside of the
control of any monetary authority won't occur and have repercussions
for the entire system, including your own holdings, whatever they
may be? Is it possible? Obviously Greenspan thinks so!
Now if your assets included, in part, gold in physical form, and
you have taken delivery, then any potential meltdown in the paper
markets will be of a lesser impact.
The Prof can be contacted by email at profvonb2@aol.com
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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