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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 firstname.lastname@example.org
Copyright by Professor von Braun. All Rights Reserved. Reprinted at USAGOLD by permission.
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