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Page IV Index

ORO (02/08/2001) The Error of Supply-Sider Jude Wanniski...Failing to See the Gold Market's Big (Paper) Picture

The Stranger (03/02/2001) On Bonds versus Gold

ORO (03/05/2001) On Oil and Gold

miner49er (02/16/2002) The New Alchemy -- "Financial Arbitrage Socialism" -- Wringing More Life Out of the Dollar

miner49er (05/30/02) Providing a perspective on gold through analogies

ORO (02/08/01; 22:45:10MT - usagold.com msg#: 47834)
Wanniski's error
Wanninski is correct in his uderstanding of gold serving as the price guide for real goods and services on the international markets. The problems he does not address are those of disproportionate international debt and interest rate allocations on the one hand, and of the paper gold inflation and deflation cycles.

Thus, while dollar debt in America is serviceable by dollars created through fresh borrowing and by Fed "printing" liquidity, dollars are available abroad only from exports to the US and countries with a net positive financial dollar cash flow (holders of US and other dollar assets) and by creation of fresh dollar credit. There is no "printer of last resort" to replace dead dollars while dollar debt is paid down.

While he is right that the gold price is indicating a strong deflationary aspect of the dollar sector in the internaitonal monetary scene, he does not see the other side of the picture, that of a paper gold inflation ongoing since the dollar went off the gold standard in the progression 1968, 1971 and 1973. Which dates mark the following events, respectively, gold pool closes, dollar debased to 42 per oz instead of 35 and the exchange window closes, and finally, the dollar goes off the gold standard altogether.

Additionally, he does not see that the paper gold inflation is the result of the operation of central banks and is similar to the dollar inflation preceding the crack up of Bretton Woods - the "floating" of the dollar when no further dollars could be issued without a drain of gold reserves that would eliminate the reserves quickly and completely. Just as the gold pool operation drawing down gold reserves was hidden for over a decade, thus the draw down of bank's (and central bank's) reserves ongoing since 1980 is not being addressed by any of Wanniski's papers.

He does not see the artificial low gold lease rate set by central bankers as causing a gold lending expansion greater than that of the 1920s, and that the gold credit bubble it created -- where paper gold assets (both official and "black") have expanded to the point of setting a gold market price devoid of supply and demand effects for the metal itself. A system where dollar-gold contracts have expanded and displaced gold assets held by the global public with paper gold.

As a result of this, he does not see that the paper gold world is undergoing the initial stage of a bank run, where gold reserves are being spent quickly to supply gold for redemption of paper. This while fresh paper gold is still issued for liquidity purposes.

While real world pricing is adjusting to the gold price induced by paper gold inflation, there is a concurrent dollar deflation outside the US, which was strongly exacerbated by the initial Euro expansion displacing the normal dollar expansion, and the inability of the US consumer to absorb the product of new export production capacity in SE Asia, S America, and E Europe at the prices prevailing when the contracts to build this capacity were negotiated, financed (in dollars) and signed.

The main stumbling block to Wanniski's vision is the past paper gold inflation that is below his radar. Had central banks not caused it by supplying gold liquidity to support it, the paper gold bubble would have never occurred, and gold prices could have reflected the actual overall inflation of the dollar as it happened. Another and FOA, join Murphy and Veneroso in warning that the paper gold banking system has become unstable, and we are all awaiting the event of the gold bank run, the day when the last available gold in reserve is tapped and remaining reserves are locked up. When the event happens, no amount of tightening by the Fed will have an effect on the dollar-gold exchange rate, and with gold prices reflecting actual supply and demand at a time when demand for gold to replace defaulted gold paper is higher and supply is limited by low grading practices in the mines, the shock to general prices will be horrendous. Not only in dollar terms.

The Stranger (3/2/2001; 9:48:35MT - usagold.com msg#: 49230)
Bonds versus Gold
Bonds have two kinds of risk. First there is credit risk. That is the risk that the bond issuer's ability to repay will diminish over time, perhaps to zero. This would reduce the value of the bond accordingly. Credit risk is not usually a factor when buying treasuries, but it is always a consideration when choosing municipals or corporates.

The other kind of risk facing bonds is interest rate risk. If you buy bonds at currently prevailing rates of return, and then the economy experiences a general rise in interest rates, your older, lower-yielding bonds will no longer be as attractive to new investors. You will have to mark them down in price to sell them.

Interest rates are always a function of prevailing inflation expectations. U.S. wholesale inflation for the past twelve months (Feb.1,2000 to Feb.1,2001) was 4.8%. Currently, investors in 30-tear treasuries are content with just a 5.35% rate of return. No doubt this is because they believe the current recession (if that is what we are in) will drive inflation, and thereby interest rates, down. But what if they are wrong? What if inflation rises from here? Soon, the rate of inflation would exceed the rate of return on their bonds, making their investment a poor one indeed. Under such a circumstance, the bonds would most assuredly decline in price.

As it stands now, the AFTER TAX, AFTER INFLATION return on 30-year treasuries is already negative for many investors (depends on tax bracket). So, there is no justification for buying them unless one believes inflation rates are about to decline. This raises doubts about the advisability of owning most other bonds as well, since most bonds are subject to the same valuation influences.

Bonds are poison when inflation rises. For this reason, they are often considered the investing antithesis of gold.

ORO (03/05/01; 12:31:44MT - usagold.com msg#: 49417)
Oil and Gold
Oil does not need to settle purely in gold, only the portion "saved" by the powerful few needs to be. Thus the bulk of funds and barter assets used to settle oil payments do not need to be gold.

As for the WWII methods of converting the excess portion of dollars and pounds sterling into gold, I suggest you look to the Jiddah gold market of the time, where gold traded at double the official US dollar rate. Obviously, someone was massively converting dollars to gold.

What the gold savings rate is for the Saudi Royals and their hangers on, or for their neighbors, is not answerable with certainty. But rest assured that it would be somewhere around the 8% minimum, or above. Also, you should not be surprised to find gold traded at different prices to different sellers and buyers, as was the case many times in the past, be it at Jiddah or in London after the gold pool closed.

The involvement of central banks in the bullion banking business is similar to their involvement elsewhere in the financial markets. Their role is only as "insurance"; to provide liquidity to the markets as lenders of last resort, and to dictate the interest rate (lease rate) from below. They lower the percieved risk in lending out gold and lend it out when tapped in order to maintain market confidence in the paper gold outstanding. As prices are derived at the margin, so is the gold interest rate. Only when gold liquidity is lacking at the lease rate dictated by the central banks, are they tapped to lend out bullion. Even then, they are only required to provide just enough to keep prices and gold interest rates from rising above the point threatening the solvency of "important" market players that are short.

The role of the central bank is to induce gold credit, not to provide it. The central banks do so by undercutting market rates; promising (rather than actually delivering) gold at a particular interest rate, quantity, or price. CB promises (and gold miner's gold obligations) are used by the bullion banking system as a reserve, and are leveraged by the routine 2.5 to 4 times, at the least. The paper they print up is used to replace the physical gold holdings of some, who then provide that gold to the markets. When you buy a gold call or futures contract and put the rest of your dollars in a treasury note, you have substituted paper for physical gold. Thus your demand for cash gold is eliminated from the bullion market, and moved to the paper arena where it is provided by the simple printing of a contract.

The banker or hedge fund selling you the contract needs only to hedge as dictated by the delta calculated from models. Therefore, your purchase of paper gold removed the whole of your demand from the gold market, and replaced it with a contingent demand derived from the need to hedge. The hedges themselves, are mostly derived from the obligations of other banks and the promises of CBs and gold producers. The only portion that must be provided in bullion is that which only physical supply can settle; demand for jewelry, bar, coin, and industrial gold. Since investment demand is answered mostly by paper obligations, all that is necessary is to prevent the markets from moving into physical. The only reason the markets would move into physical would be that there is fear of the gold contracts not being filled. Propaganda is sufficient to prevent loss of confidence most of the time. The rest of the time, minor amounts of physical gold (relative to outstanding paper) must be provided to the markets so that defaults do not occur when a gold delivery obligation is due but the indebted party has insufficient gold. At this point, only the shortfall need be covered, and there is also the possibility of buying out the creditor with an alternative that is sufficiently attractive.

Thus the system may remain stable so long as gold can be displaced from current holdings, on the one hand, and demand for physical displaced with paper supply on the other. The danger is that of escalating growth of gold obligations, and the loss of confidence in solvency of those printing them. The cures are (1) restructuring of gold delivery obligation schedules to fit within available fresh supply, (2) the sale of gold by holders who value the stability of the system more than their gold (i.e. central banks) and are willing to lose some or all of what quantities they lend, (3) exchanging certain delivery obligations with contingent ones (replace futures with calls), in the hope that they expire unexercized.

We have seen all three strategies followed, confidence in the availability of gold to fill obligations is still high, and general default is still considered unlikely anytime soon. The gold deficit, at an official 1000 tonnes per annum, and my estimate of over 2000 tonnes, is being filled with only minor fluctuations in price by displacement of private gold holdings with paper backed by central bank lending promises (1/4) and by CB sales (1/4); the balance being backed by producer forward selling of their gold production many years into the future.

New paper gold demand has dried up as discussions such as our own on this forum have brought many to buy physical rather than paper. However, many of the prior paper buyers had not the cash on hand to buy the whole amount at the market price, thus the amount of paper gold that can be bought posting 10% margin is not equal to the amount of physical gold that can be purchased at 100% cash payment. The few who have the whole cash balance on hand, can do so, the many who don't will buy 1/10 to 1/5 in physical relative to what they would otherwise have bought in paper. Thus for each 10 ounces diverted from paper, one would expect 3-4 ounces to be bought in physical (using the 20 80 rule).

This will continue so long as the international markets are short of dollars. When the moment arrives where these markets receive more dollars than needed to cover debt obligations, the portion of global buyers having dollars on hand will grow, as will the demand for physical gold over the demand for paper.

miner49er (02/16/02; 18:49:51MT - usagold.com msg#: 70211)
Financial Arbitrage Socialism ­ the next New Deal
In a speech to the Euro 50 Group Roundtable on November 30 (http://www.federalreserve.gov/boarddocs/speeches/2001/200111302/), Fed Chairman, Alan Greenspan, discussed the Euro as an international currency. One of the requirements that an international currency must have is efficient utility as a vehicle in cross-border transactions. In this, a combination of robust payment and communications systems, depth and liquidity, make the complexities, volume and frequency of the immense international money flows of global commerce possible.

In considering the usefulness of a currency through both time and space, this would be considered as "through space."

Yet, what is the most important attribute of a currency that makes it attractive as an international settlement currency? "First and foremost," according to Mr. Greenspan, "an international currency must be perceived as sound. To be acceptable, market participants must be willing to hold it as a store of value."

This would be considered as "through time."

There is an awful lot in this speech that makes interesting commentary regarding the fierce and quiet struggle between the U.S. dollar and the euro for premier status in this role, but I want to focus elsewhere today. It should come as no great revelation that in order for a currency to function satisfactorily it should be able to maintain a predictable value in terms of goods and services throughout the timeframe considered by the participants in the transaction. Lent currency, when paid back in depreciated units, makes the creditor whole nominally, but his real return suffers. Likewise, appreciating units are harder for the debtor to come by, and so the lender risks non-performance and default. Predictability, hence stability, allows both borrower and lender some room for confidence in forecasting, and helps ensure follow-through at par.

Herein lies the heart of the above-mentioned struggle, and the great contrast between these two fiat currencies: each claims its worthiness as a store of value; yet each has very different reasons for alleging that claim.

The dollar, once defined in terms of gold and silver, has seen several critical leap-points in its evolution. First a break from silver, then its gold-backing replaced domestically, then devaluation of the dollar in terms of gold, and finally default on its gold-backing internationally. Untethered, it began a campaign to demonstrate its undervaluation in terms of the potential capacity of the U.S. economy to produce. This process was aided by a combination of cheap oil, and technology only then beginning to uncover and develop the possibilities of petroleum by-products.

Mr. McGuire: I just want to say one word to you... just one word.
Benjamin Braddock: Yes, sir.
Mr. McGuire: Are you listening?
Benjamin Braddock: Yes, sir I am.
Mr. McGuire: "Plastics." (from, of course, The Graduate - 1967)

Several variations on this productivity theme have been performed since, with choruses of the hedonic multiplier ushering out the end of the century. Overlapping this denouement was another phenomenon that gave further life to the dollar -- the stupendous increase in the purchase of financial arbitrage products. This wave, ascending in phase with the unprecedented increase in credit financing, found its footing in a different kind of use for the dollar. The nature of these instruments, being very short term, lessens the importance of the currency vehicle as a store of value. Rather its liquidity, and the ability to transact enormous amounts of the currency instantaneously, permit the razor-thin spreads traded to be profitable, and allows participants to capitalize on the fleeting, almost imperceptible mis-pricings they arbitrage. The colossal volume of these instruments has influenced greatly the economic engine for nearly a decade now. But, alas, this too is coming to an end.

The steadfast repudiation of gold as an instrument of globally recognized wealth by the U.S. dollar faction has come to the point of self-destruction. If one denies the law of gravity, and steps out of an airplane, there is a period in which there is no penalty suffered for breaking this inalterable law. Certainly these few moments are quite thrilling. Reckoning will arrive however. Even should there be a rescue, it must come by some force that is itself not breaching the law, but advantageously utilizing it unto deliverance.

The euro on the other hand, takes a decidedly different tack. While giving assent to the necessity of improving economic productivity and employment within its currency bloc, it is determined not to allow itself to become bogged down in this political quagmire. The ECB has one chartered objective in maintaining the integrity of its currency -- inflation targeting. As a backing it has quietly, yet forcefully, used its gold reserves to advantage by marking them regularly to the market price of gold. Thus a rising gold price is a boon to their asset mix (in contrast to the U.S., which maintains its reserves at an outrageously undervalued constant). As for the "sale" of gold by the member banks -- I am not an insider, but I am also not naive -- these guys assuredly still have most of their gold. The owners of these banks are not 30-year-old kids. They are old money. Old money knows the value of gold. They play hardball. And they are not stupid.

The euro, in its marketing efforts, downplays the economies that use it, and advertises its emphasis on the integrity of the store through convertibility to the entire commodity panoply (gold included) in the free market. (In other words, don't look at what others might foolishly do with a good tool - instead this is what the euro can do for you.) The concept of non-interference actually enhances the ability of potential euro buyers to forecast their businesses. A currency that either fixes or manages its exchange rate to any particular commodity or other currency always stands to blow-up unexpectedly. So its players are buying a period of very determined stability, but always at the risk of a cataclysmic failure of the system. A currency that can be freely exchanged in a free market for any commodity or currency offloads the risk to the buyers of the instruments. But it allows the risks to be managed by traditional forecasting methods -- not burdened with the surreal illogic of politicization.

So we have a black-and-white, day-and-night contrast between these two competing units. The dollar has committed itself to its ability to hold its own without a use for gold, and with it the implication that it can ever pull out of its hat something that will give it use as a value store. The euro, structured to emphasize gold, stands poised to benefit from a revaluation in its price. And by avoiding political entanglements, gains flexibility to manage the currency more soundly.

A new breed of rabbit... (designer-cloned especially for hat-pulling...)

In another speech by the Fed Chairman (thx Randy), this one before the Greenlining Institute on January 10th (http://www.federalreserve.gov/boarddocs/speeches/2002/20020110/default.htm), there is a noteworthy discussion on the need to emphasize "savings." Considering the target audience, attention is given primarily to economic development and methods to get the financially "underserved" portion of the population, plugged in.

Amid the discussion is mention of a concept called "individual development accounts." These are basically tax-favored savings instruments for those who qualify, with matching-fund sweeteners, for the purpose of "saving" for things that improve a community's development: home-buying, business-starting, and education, for example.

What we have here is "targeted savings." Not a new idea by any stretch, but perhaps there is some new twist to extrapolate. Let's build on this a bit. First let's put the notion of savings into proper perspective. Savings as discussed here, is not savings. It is a loan to the bank. It is an investment (and investments are not savings, they are risk-taking ventures). You elect to become creditor. In return you expect them to yield back to you a portion of the profits they plan to make with the money you lent them -- and enough to make it worth your while to forego alternate marginal opportunity. You may have used your "savings" to loan to them, but it is a loan nonetheless. Deposit is a terribly misleading term.

Second, this concept, as mentioned, is really no different than other incentive-providing instruments. The premium you pay for the additional benefits (tax favored treatment, matching funds, etc.) are that you have time and usage constraints. Upon maturity of the obligations, you must still obtain goods and services -- even the targeted ones -- at current prices. Your bet is that the marginal benefits of preparing for these expenses, via these vehicles, will be greater in relation to alternative possibilities. Your risk is that the vehicle you are using -- a dollar denominated instrument -- will hold its value according to the prediction you have made in tying up your funds in this instrument at the expected rate of return.

In the case of the U.S. dollar, the onus for sustaining this value is a function of the sweat and grunts of yourself and your fellow taxpayers. (But I'm already dancin' as fast as I can...! Work smarter, not harder! Just hold hands and buy an SUV -- the gas guzzlin' kind have a greater effect on the hedonic multiplier...). You get the picture.

If I'm reading between the lines correctly, I perceive the U.S. Central Bank is quite well aware that they have wrung all the blood and plasma out of this stone, and are beginning a shift to a "new alchemy." (Not the old bricks-and-mortar alchemy, stupid... this is a new-alchemy...)

Traditionally, we have tried to instill the currency unit itself with value by way of commodities, or people's productivity, or even hyper-efficient transaction utility (the use value required by big money arbitrageurs, et al.). We then hope that the currency unit can hold its value by these mechanisms in terms of future procurement of goods and services.

What if we could promise the goods or services, deliverable in the future, at today's prices, instead of guaranteeing the accounting instrument? There are a couple of ways to look at this. The first is more conventional, sort of like a forward contract / lay-away hybrid. The second is more intriguing. First, let's examine the more conventional mechanism.

If we take the forward concept away from the framework of corn and pork-bellies, and the lay-away concept away from Walmart and Target, and apply the thinking to the purchase of old-age care, medical expenses, college tuition, and the like, we do have a new variation on a theme. Indeed, the accounting instrument will assume, of its own, stability vis-à-vis the things it is contracted to buy. (Ah, the wonders of fiat...)

Let's look at an example. A contract to purchase a year of tuition in 2020 at MyState University begins with a standard loan account. I lock in my 2020 tuition at 2002 prices, say $15,000. Between now and 2020, I make payments on a scheduled basis, and in 2020 I use the balance accumulated in this account to purchase my tuition. Several characteristics should be observed.

I will not receive interest on this account, as the obligation is not "savings" as such, but pre-payment installments for an actual good or service purchased today, with delivery deferred to the future. Money paid into this account is not mine. I am not able to borrow against it, or withdraw it. What I own is a contract. The contract is negotiable, and transferable. I can sell it on the open market.

While there are others also interested in 2020 enrollment at MyState U., the contract on its own is generally illiquid. To protect both parties from undue risk, funds and trusts would emerge to buy these contracts and transform them into marketable securities. (No doubt AAA and high yielding, too...) Immediately you incur all the dynamics of the current environment, with all its temporary advantages, and reliance on an asset structure built upon promises. Once balled up, these new instruments would function much like a financial currency in the contract marketplace, and among arbitrageurs. And as currency is want to do, its notional backing would face constant debasement. Practically speaking, the quality of the tuition eventually received would not be what we expected.

Why would people enter into such arrangements? Because, unhappily, people are possessed of the good and bad quality of child-like trust in their governing institutions. They want to believe the best. In the face of everything beginning to crumble around them, they would be ready to receive this financial lifeline, as a means of procuring anticipated future needs at current prices. They have been effectively discouraged from saving gold. They sense a need to hoard in the face of escalating prices, so why not provide them something to hoard, that is still yet defined in terms of a financial asset? Governments would buy the idea as it serves to remove much of the financial burden from a whole host of social programs. Yet it does so without causing the bureaucracy to relinquish their coveted control of these same programs. Financing companies would welcome the idea, as it would provide both a new game to play, and a fresh fix of funds to play with.

The concept provides a notable shift form the traditional tax-and-redistribute socialism of the 20th century, and launches us into a brave new high-tech world of pay-to-play socialism. A socialism for the new millennium. As in all socialism, the end product is still less than what the recipient hoped to get at the outset, but in this permutation, it is oh so much more efficient! We have now taken the next step forward from Doug Noland's "Financial Arbitrage Capitalism." We have moved on to "Financial Arbitrage Socialism."

S. Patrick: You who are bent, and bald, and blind,
With a heavy heart and a wandering mind,
Have known three centuries, poets sing,
Of dalliance with a demon thing.

[...]

Niamh: Then go through the lands in the saddle and see what the mortals do,
And softly come to your Niamh over the tops of the tide;
But weep for your Niamh, O Oisin, weep; for if only your shoe
Brush lightly as haymouse earth's pebbles, you will come no more to my side.

[...]

Oisin: The rest you have heard of, O croziered man; how, when divided the girth,
I fell on the path, and the horse went away like a summer fly;
And my years three hundred fell on me, and I rose, and walked on the earth,
A creeping old man, full of sleep, with the spittle on his beard never dry.

From "The Wanderings of Oisin," W.B. Yeats

I mentioned there was another less conventional way to approach the financing of this concept. Let's look at it now. In the contract concept just mentioned, the contract still ultimately depends upon the fate of its denominating instrument (the dollar). The funds used to purchase the contract disappear immediately into the world of whithersoever-they-will, no longer coupled to the future deliverable. In contrast, this second approach attempts to maintain this coupling. In doing so, the possibility exists to create a new "special-purpose" currency vehicle altogether. Instead of the buyer effectively buying forward a future deliverable, he instead sets up an account somewhat similar to an IRA conceptually. The goal is again targeted savings. Only this time the deposited funds belong to the depositor, and remain associated to the deliverable.

Why targeted savings? Two reasons. First, this helps ensure these funds stay under the control of the financing institutions -- as they remain financial assets, and do not find their way into real goods and services purchased currently. This would cause the fated exposure of the tenuousness of the financial assets relative to escalating consumer prices. Second, (really the same thing, just another way of expressing it) it transfers the feared unknowns of where these currency units may ultimately alight as value stores in the public's mind (commodity and goods hoarding), and polarizes them to a defined future deliverable (which is still presently negotiated as a financial asset).

The nature of the deliverables must be such that they can readily be redefined. They must also be in high and inelastic demand. Services such as health care, old-age care, and education suit these purposes quite well.

In this method, since the originating funds still belong to the depositor, these funds effectively become part of the financial institutions reserves. Since these funds are earmarked for the purchase of an appreciating asset, at a fixed price, they acquire extra value, and can be lent at a premium. Such accounts can also find liquidity by being rolled up together with similar instruments, and diced-and-spliced according to the wants of the marketplace. The service ultimately provided, as in the method above, will be inferior to what the buyer hoped for, but he will most likely receive it nominally anyway.

What is different here is that the funds involved take on a life of their own so long as they are traveling in this new savings vehicle. As long as the funds are tied to an inelastic and high demand future deliverable, they, like Oisin above, in a land of eternal youth, retain their youthful vigor.

Do we not now have a new "virtual asset" backed currency that can travel side-by-side with our other fiat currencies, including the old and mortal dollar? Could this new currency not be used as tender in our daily transactions (bread, butter, and beer), and thus add new life to the entire U.S. dollar regime? By providing a confidence of a value store to a daily use currency issued by the U.S. dollar faction, is not the incentive to move to gold taken away yet again from domestic participants? And, hopefully, could this not entice global speculators to stay for one more drink and one more dance, too?

As far as complicating restrictions on the premature withdrawal or termination of these accounts, perhaps no more would be required than that they would be nominally exchanged for old-fashioned mortal dollars. And like the tragic Oisin, once so much as haymouse brushing earth's pebbles, these special-vehicle dollars, suspended in youth, would return to their proper age and strength, to purchase whatever they may command in that day.

Will people actually go for this? For all the reasons listed earlier, yes of course. Will they accept an inferior future product - the inevitable outcome of such schemes? They already do with traditional socialism - for which they still clamor - even with its track record of inefficiency. Would people not be likely to accept a more efficient, cost-effective way to get the same thing? Especially, if they feel they have more "control" of the outcome... They "save" today in tax-deferred retirement accounts for all its worth because they believe unquestioningly in the integrity of the unit that accounts their "savings." Even as they watch their so-called savings evaporate before their eyes. Very few have any knowledge at all about what they are doing. Why would I expect people to behave any differently here? Cynical perhaps, but pragmatic...

So, welcome to the "New Alchemy." But if you have a choice, I suggest you reject alchemy altogether and just buy gold -- the real thing -- while it's still selling at give-away prices.

A few thoughts... maybe interesting, maybe way off base... but thoughts nonetheless...

Good weekend all,
miner

miner49er (05/30/02; 09:56:43MT - usagold.com msg#: 77006)
Providing a perspective on gold through analogies

In a somewhat similar way to the association of a booster rocket, and its final payload, so is this current environment. For a season the booster and the payload both track the same trajectory, and move in tandem, the payload being driven by the booster. There comes a time, however, when the booster is no longer needed (it is also spent), and suddenly the payload, without a hitch, breaks away from the booster, and continues on its course. The booster equally suddenly becomes lifeless, and falls gracelessly to Earth. Indeed, it could not continue. It was designed to do what it did, and if it were to remain, would only destabilize the payload, bringing both to ruin. It was not designed for this leg of the mission.

While the analogy is clearly not perfect, it can be used as a launching point (awful, awful pun...) to illustrate what many here have discussed over the years. The present contract-based environment will not be able to contain a price of gold that begins to fulfill the mission of expressing the true market valuation of the physical metal, itself. It is really better viewed perhaps, that the payload portion is instead pulling the booster, and the booster is somehow retrofiring for all its worth to keep from going any further at all. It is hard to know all the complex physics that come into play which address the velocity, changes in atmospheric pressure, how the construction stands up to the heat, vibrations and other stress, or how much fuel it has left. As such, the casual (and even decently informed) observer can only guess at what point the two will separate. Certainly some on the ground insist there will be no separation, others anticipate such a break, and each hazard their own opinion of the day and the hour.

Each of us will lie in the bed we have made. It has never been my contention to foster an "us vs. them" atmosphere regarding paper gold vs. physical gold ownership. Such a temper on the forum leads only to fruitless salvos being lobbed back and forth. The fruit in this discussion is born when each opinion is presented with the deferential humility that goes with the one thing each one of us is all too painfully aware of: none of us knows everything. (And I certainly wag the left tail of this bell curve myself.) Nonetheless, I try to always present here that which has become clear and convincing to me, and with a sober demeanor; for I never know what a day will bring forth.

That said, I will voice again my caution about the future of the paper-based environment. When it ultimately reaches critical mass, it will just suddenly break. Those who are carefully (and knowledgeably) observing may have some lead-time, as there may be a little warning. However, let me switch analogies for a moment.

When I was driving an old junker, sometimes I would know that it needed work of some sort, maybe the fuel pump was going, or the clutch, or whatever. At first I would be very conscious of any little strange noises, or sensations in the way the car was handling, and so forth. After driving it awhile, I would tire of this constant vigilance, as other things would distract me, and after all the car was going along fine. Maybe my worries were blown all out of proportion. After all the pump was only replaced recently, and I just had it in for a full checkup -- the mechanic pronouncing a clean bill of health...

And so I became less cautious about how far I drove it from the house, or how fast I would take it on the highway, or how much stress I might put on the system accelerating from a full stop, etc. Sure enough, I have had to have my car towed a couple times in my life.

Most of us have no inside knowledge of what's taking place geopolitically, or in the financial arena. We hear of wars and rumors of wars. We know a little bit about how derivatives work, and have some sense that they can really blow up. We know (like Maybury's CHAOSstan) that many parts of the world are woefully unstable and given to unpredictable volatility (yet we own many shares that have significant, if not total, exposure in these places -- places where many of us don't even know who runs the country, or how it's run...). Yet we insist we are investing. (Now if you do perform due diligence, you know who you are. I am not really addressing you folks, although, for the macro reasons concerning this market environment, I still humbly offer my cautions.) For the rest, it is important to be honest with ourselves, and realize that this is not investing. This is not even speculation. This is a high-risk gamble. Moreover, how much do you know about the due-diligence efforts of the broker/promoter who sold you these things?

This contract market environment exists for 3 main sub-purposes, which all ball up into one overriding, unequivocal manifestation. They are used for the traditional commodity purpose of supply/cash flow hedging. They are used by the commercial players in their suite of risk mitigation processes. And they are (ab)used by certain political and financial forces, each for their own designs.

This has been covered on countless occasions here. The bottom line to all of this is that each faction desires the price of gold to be stable or declining. Speculators fulfill their role in the grand scheme by betting on anomalies, and aberrations upon which they believe they can capitalize. Some specs maintain realistic horizons, and do (and have) made out on the occasional trend changes that go with the ebb and flow of any market. Others (IMHO) mistakenly hold that this contract-based market is THE single means the world will ever have of gold price discovery.

If this is true, then it must be able to satisfy reasonably most claimants for delivery. But it won't. It simply cannot sustain the prices now being commanded by snowballing volume in the physical markets. And when it breaks, it is not going to send its price to the moon and bring satisfaction to the long participants -- those in it for the gold or the cash payout. It is going to hurtle gracelessly to the ground, while the payload of actual physical gold will continue on unabated.

The true commodity players will leave because there will be no physical for those who want delivery. There will be no need for cash flow hedging by true sellers, because they will sell directly into the spot market at much higher prices, that won't ever return to previous levels anyway. The risk management types will be gone because the presumed stability upon which they hedged will be gone, the markets lastingly discredited as a means to price discovery. And the political purposes will have ended or evolved. Some aims achieved, others failed.

You own unhedged mines? Predatory takeovers by hungry hedgers will keep you up at night.

A rising POG, but no increase in miner wages = strikes and labor unrest.

Good property in Argentina? Government confiscation to claim it as a "state asset" to sell for dollars to bail starving debtors. (Perhaps not only starving for dollars.)

You own only US mines? If a dollar crisis comes (which is in large part why people are buying these mines -- to offset potential dollar problems by leveraging to a POG increase), the grand profitability of the mines will be tempting prey to rapacious taxation. And... even though some don't think the mines might be "nationalized" here (because of the foregoing, i.e., it is more profitable to just tax them), consider that immense quantities of gold may well have been promised to a number of players who have the ability to enforce delivery (oil, Europe, China(?), e.g.). 1933 style confiscation will not bring in enough, and is too cumbersome to enact. It is much easier to demonize gold (like oil in the 70s), and go after them... even if this doesn't mean the typical, clumsy 20th century style nationalizations that were common among socialist/communist states. It may not be labeled as such, but the practical considerations will be directed output to pre-selected channels at prices that will at that time be far below market (and the mines will still get taxed...).

Euro Breakout and a Rising POG in the Currency War...

As long as gold was on a chain around the original market-marking price of the euro reserves, the euro could be kept down. As long as the dollar price of gold was kept down, a rising euro would devalue their POG reserves and hurt their balance sheet. Consequently, a weak euro kept the dollar strong, and assured of its continued role of world reserve currency. So POG-on-a-leash = Euro-on-a-leash. This link refers to a speech by Alan Greenspan from last November. I quote an excerpt here:

"Because the attractiveness of any vehicle currency grows as its liquidity increases, an international currency has a tendency to become a natural monopoly.

"If the underlying demand for one of two competing vehicle currencies falters for a reason not clearly perceived to be transitory, and its bid-ask spreads, accordingly, increase relative to its competition, demand will shift to that competitor. But that shift, in turn, will widen the bid-ask spread of the faltering competitor still more, inducing a further shift of transactions to the alternative currency. This process ends with the demise of the weaker currency as a competing vehicle and the stronger of the two becoming the sole surviving vehicle."

This was the hope and dream of the dollar faction. As long as they could keep gold down, they could keep the euro down (since the ECB could not afford any contraction of their balance sheet). They would then wait it out, advertising the dollar's superiority in facilitating global settlement (i.e., EZ munny), and still maintaining the benefits of price stability, until Europe ultimately blinked...

The dollar would sacrifice its manufacturing sector, as the euro would battle high oil prices and other imports (in strong dollars) and the political pressure it brought in their sagging economies. (Also, steel tariffs on our part were just an indiscreet effort to further damage Europe by off-setting the one benefit of a cheaper euro: competitive advantage in export pricing.) The major participants whose interests aligned with the ECB could not just go into the market and bring relief by bidding gold, as their buy signals would cause a rupture in the market(s) as the dollar infrastructure would quake as money went to gold in torrents -- not necessarily benefiting the euro in this kind of move. It appears they had to just let fundamentals take their course, as the buying pressure had to come from beneath. And it would. And it is.

This type of pressure is slower and more manageable, and more easily apprehended (and thus assimilated) by people. But once in motion, cannot be reversed. The pressure valve can still be regulated for a while, and it will be upon the dollar faction to perform this. Once physical buying pressure overcomes the ability of paper interests to manage the price of gold down, there is no longer any need to keep the euro down (those ECB balance sheet concerns...). As long as the POG appreciates more rapidly than the euro (and it will for sure), the balance sheet is enhanced.

A strengthening euro increases euro confidence as it decreases the cost of dollar-priced oil (and other imports) and thereafter encourages euro priced oil, which benefits euro zone economies, which encourages euro investment, which means more euro debt, which increases liquidity, and stresses the international currency status of the dollar. This causes further dollar devaluation, which pressures dollar-priced gold up, which encourages more global physical off take which further pressures POG up generally, which damages any currency that is structured to compete with the POG, and benefits those that are designed to go with a rising POG.

This finds public acceptance on an increasing scale, as more general-public participation in physical gold ownership (clearly being encouraged by every corner of the planet -- except dollar-aligned areas) causes those with euro holdings to indirectly benefit by its appreciation along with gold. The converse anticipation of dollar export pricing advantage due to its new weakness is more than offset by now-realized big increases in dollar costs as dollars are dumped mercilessly. So the shin bone's connected to the knee bone, and suddenly Mr. Greenspan's statement is realized in the euro.

This is not meant as an advertisement for the euro, but instead attempts to illuminate the critical role this currency plays in the ultimate unshackling of gold from the constraints of a world currency system built around a relatively fixed gold price. And this is the planned outcome... Throw into this the prospects of the ever-feared "exogenous event," and the hair-trigger possibility of a sudden paper market reversal is compounded. Wars and other catastrophes always loom. And a derivatives crackup is always possible. And it most likely would not occur in a JPM/Chase or some other visible entity. They will be taken care of. And it would not occur most likely around some convenient time frame, like contract expiration, since it would probably involve some unknown parties (remember LTCM was once an obscurity), in some one-of-a-kind exotic that will trigger the grand chain reaction. No one without intimate knowledge of the specific problems will ever, ever see it coming...

So, all of this is not meant to be confrontational to paper investors. NOT AT ALL, believe me. I have no interest in seeing you fail. I hope you all make all you can make, and most of all have happy lives. I do (very thankfully). I also realize that some of you trade for a living, and need to engage paper to generate your cash flow. Understood. My aim is to maintain a detached analytical perspective, and hope that comes across here (although, I'm probably a bit more passionate here than usual). Physical gold ownership does not carry with it any guarantees either. But it has all the positive properties so thoroughly expounded here, and is still the premier wealth asset, and store of value.

A bird in hand is worth two in street name...

miner

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