Saturday, May 28, 2011

When Will the Rapture Come? Trying to Predict Inflation and Gold Price Performance

Problem:  Everyone now knows the bull case for gold, silver, precious metals, and even uranium and rare earths.  However, for all the gold bugs predicting the demise of fiat currencies - both crusty curmudgeons and suited hedge fund managers - no one is offering insights as to when and how much gold will appreciate.  And thinking 3 moves ahead, no one is talking about how difficult it will be to time their exit from these investments.

Mainstream news media and stock discussion boards have now fully caught on to the investment thesis for precious metals.  Government money printing, via bailouts, QE, and bond buying will destroy the value of fiat currencies over time.  Ok, got it.  No need for another college dorm stock blogger to give me the 101 lecture. (If you'd still like to review these cliches, will be happy to oblige.)

But when is this going to materialize? Over what time frame?  Or can a fair argument be made that it already has materialized, with gold up 500% over the past decade?  After all, we've only tripled the US dollar supply, but gold has run up 5x.  Have we overshot?

I knew that the fiat currency inflation argument had come in to the mainstream-minority when a brilliant hedge funder who I've long debated the issue with joined me in the summer of 2010 in ridiculing the notion that the deflation trade would bear fruit.  Clearly 2010 was not the first time since the 2008 crash we heard about deflation.  But even within the deflationary talk, there are periods of increased or decreased fear.  The deflationary scare, already in full force among the central bankers and monetary elite, manifested in to a mini-scare among professional investors in 2010.

August 2009:
May 2010:

Coming from a Wall Street background, I can tell you that America's financial elite have long dismissed the gold thesis (and I was among them).  Wall Street, for all that you deride it as a den of foolish thieves, is genuinely home to some of the smartest people.  They, rightly, don't view gold as an "investment" per se.  Gold doesn't produce anything.  And so they default to their Keynesian brainwashing from their university days, telling them gold is simply a trinket for jesus-freaks, akin to the Coke bottle from The Gods Must Be Crazy.

[More on this in:  They Don't Do Anything:  Marx on Buffet, and Buffet on Gold in June on]

So a funny thing happened last summer.  The brilliant hedge funder with little fanfare told me the deflation trade was widespread in the Wall Street community and that many would end up regretting it.  He stopped short of agreeing inflation was coming.  But he had accepted the premise that money printing was not compatible with ongoing deflation.  That basic acceptance will lead to further acceptances over a longer time span, but it was a basic rejection of Keynesian fears that recession and inflation  must occur together.

[More on this in: Tearing Out Pages: The Soviet Encyclopedia Approach to University Economics Classes, coming in June on]

So what does the "mainstream-minority's" acceptance of the fundamental fiat currency thesis tell us about the timing and magnitude of inflation and gold prices?  A few things, albeit indirectly:

1. For those who, as Jim Dines would say, have a "hyper-need to be right", hedge fund & Wall Street validation of the gold thesis will provide the first-mover excuse they need.  They're the "influencers", if you're in to the whole Tipping Point thing.

2. The game is on to calculate a "value" for gold.  Wall Street loves quantitative valuations as much as a daytrader loves playing connect-the-dots and calling it "technical analysis".  As more Chinese middle-class and American E*Traders trickle in to gold, the challenge of quantifying fundamental values and exit points will begin in earnest.  Expect research from major investment banks calculating gold prices as a multiple of fiat currency money supply at some point.  (This may actually signal a top in the market, as these pseudo-scientific calculations will simply justify capitulation to rising gold prices when they finally come out.)

Ok, some hedge funds accept gold, and neurotically try to calculate value. Does that help us?  George Soros is selling.  Isn't he an influencer?

Yes, he is.  He was one of the big ones.  But he got in early and made his money.  The entry of new players, including retail investors, has made the game harder for him.  More volatility.  And likely being a Keynesian at heart, he's afraid the Tea Party movement to balance our checkbook will take the wind out of his golden sails.  But influencers do not agree all the time.  In fact, just as hipsters caught on to Greenday and polo shirts early, and jumped out before the crowd got on board, Soros made it cool but was uncomfortable doing something a lot of other people starting doing.

The reason the American mainstream is important is that they are finally lending credence to the idea that the real bubble is in the US dollar.  The US dollar bubble took decades to build.  It will not pop overnight, and it may feel slow when it happens, but when we look back it will be clear how quickly it all happened.  The hedge funds caught on early and the herd piled in.  But we're back to Fiat Currency 101.

How do we quantify all this, and understand when it will happen?

I have found a few worthwhile commentators.  I'll be clear right now:  None of this will provide Harold Camping-like accuracy as to the date the world will end.

1. Milton Friedman -- In Monetary Mischief, Friedman performs the only systematic analysis I have found reviewing not just the correlation but the timing of increases in the money supply with increases in inflation.  In fact, Chapter 8, The Cause and Cure of Inflation is worth the price of the entire book.

We hear that there is a "lag" between money creation, and the resulting inflation.  We understand from the numerous gold pundits that there is some correlation between money printing and inflation.  Friedman weighs in on both these issues:

On pages 194-195, after having discussed a litany of cases such as banana republics like Chile, Brazil, and the United States, he writes:
"These examples also show that the rate of monetary growth does not have a precise one-to-one correspondence to the rate of inflation.  However, I know no example in history of a substantial inflation lasting for more than a brief time that was not accompanied by a roughly corresponding rapid increase in the quantity of money; and no example of a rapid increase in the quantity of money that was not accompanied by a roughly corresponding substantial inflation."
Friedman is being a bit modest.  In earlier chapters, he's already highlighted that the very concept of inflation is subjective.  Its just not possible to capture a Platonic concept of "inflation" that fits the real world.  The price of everything goes up separately.  And not everything goes up in line.  Friedman demonstrates that inflation inherently favors certain groups (leveraged farmers in the late 1800's; leveraged real estate owners in the 1990's and 2000's).  So I argue that he should have been more detailed, as well as more circumspect, in his statement that there was not a "one-to-one" match.

We could nitpick here and point out that during the Black Plague, inflation was rampant even without an increase in the absolute money supply.  The problem was, with everyone going and dying, the same amount of money was chasing fewer goods & services.  The result was inflation, without a sustained increase in money supply (but perhaps an increase in the per capita money supply).

Later in the same chapter, on page 230, Friedman graphs a case study of Japan from 1960 to 1990.  Having not found a version of this graph online, and not wanting to insert a manual snapshot of the page, we'll put it this way:  Friedman graphs % increases in the money supply against % increases in prices (ie, inflation) with a 2 year lag.  So the graph for one is right on top of the other, time-shifted two years out.  The inflation percentages are lower than the the money supply increases, but the two graphs track each other - not always exactly, but often exactly.  For the period in the mid-1970s, inflation capped out at 20% exactly two years after monetary growth capped out at 25%.

Friedman writes:
"...with a two year lag, inflation tended to mimic even the minor wiggles in monetary growth after the policy change."
Does this analysis apply today?
Friedman's book was written in 1992, and I do not attempt to track all of his writings since then.  However, there are factors that seem to have increased the complexity of monetary flows over the past 20 years, which are not specifically addressed in his analyses:
  • Asset bubbles and complexities in calculating Platonic "inflation".  (Housing and gas already tripled, before food prices even budged.)
  • Complex definitions and measures of money supply
  • Government damping adjustment cycles.  For example, supporting real estate and bond values, preventing capital from flowing in to other asset classes, thereby evening out inflation.
  • Global factors, such as dollar hoarding by China and Japan, as well as safe-haven seekers everywhere, that have changed the patterns of dollar flows through the economy.  
  • U.S. corporate and bank cash hoarding may also be impacting dollar flows.
  • All of the above factors applied to the Euro and Pound.
  • The globalization of currency flows coupled with the psychological value of the dollar resulting in inflation being reflected in other currencies.
China functions in the global currency market like anyone cornering a market - controlling a significant portion of total supply, and a huge % of daily trading volume.  Right now, our government can conveniently transfer newly printed dollars in to bank accounts in China (and Japan).  And China, not wanting to tank the value of its own dollars, will dribble out the dollars over time in to other assets.  To the extent this thesis on Asian dollar hoarding is legitimate, Friedman does not address it as a factor in his book.

2. Jim Dines -- Jim Dines has long argued that gold will go to $3,000, and for a short time, spike to $5,000 on frenzied buying.  And to be fair, despite his track record of horrible investment recommendations rife with conflicts of interest (Clearly Canadian, CCBEF, and Mega Uranium, MGA), he has called a few things right - and even noted that it will be necessary at some point to sell gold.  He's called the bond market a bubble for years - years before Pimco caught on to this idea (and later dropped it). 

I see at least two valuable insights from Dines.

First, the image entitled "Mass Mind" (of flock of birds in flight), with a photo by Gianfranco Basili, in the inside cover of Mass Psychology (1996).  The herd mentality is nothing new.  But as I watch flocks of crows and seagulls from my balcony, it always reminds me that I cannot predict when the flock will change course - but when it changes, the entire flock will quickly reverse course.  Quite the opposite of trying to help you predict the timing of inflation:  This reminds me of the importance of having stamina to hold well thought-out investments for a long period of time, so that you end up still holding them when the flock does change course.

Second, Dines offers the antidote for the metals buyers who confidently claim "I never sell gold (or silver)".  Dines fully acknowledges that the point will come when we should sell, because the market will be spiking in a final, glorious burst of panic buying.  A true mania.

The hard part is to know when.  There are always pundits claiming the last gasp on the gold trade is here.  Soros' recent exit has refreshed such claims.  However, at some point there will be a last gasp.  It would be great to predict when that will be, or realize it as it happens.  With a hat tip to Nassim Nicholas Taleb, I will be modest and say I have absolutely no idea.  I might know it when I see it.

If that feels like a letdown conclusion, perhaps it is.  However, what it implies for me is this:  I will not try to sell at the top of the market, and I will not look back when I do sell.  I will rely on some level of fundamental insight to support my ongoing gold and commodities holding, but I will recognize when the market overheats.  I had this sense in the silver market in April, 2011. I got out, perhaps "too early".  As I write, silver is trading below where I sold SLV, so perhaps it wasn't too early.

I remain in gold right now precisely because most of the world has not yet reckoned with the fundamental catastrophe that will result from easy money and the Keynesian debt trap.  When the world, led by the influencers in the hedge fund world, begins piling out of the dollar and in to metals or oil or whatever else, it will be time to start the exit from gold.

I would like to hear the readers of weigh in with their own views on what will signal the final spike in gold.  Will it be 5 years from now or 15?

For now, it continues to rain dollars, and the rivers are starting to rise...

Sunday, April 10, 2011

Let's Legalize Competing Currencies

By Ron Paul
Before the US House of Representatives, February 13, 2008

I rise to speak on the concept of competing currencies. Currency, or money, is what allows civilization to flourish. In the absence of money, barter is the name of the game; if the farmer needs shoes, he must trade his eggs and milk to the cobbler and hope that the cobbler needs eggs and milk. Money makes the transaction process far easier. Rather than having to search for someone with reciprocal wants, the farmer can exchange his milk and eggs for an agreed-upon medium of exchange with which he can then purchase shoes.

This medium of exchange should satisfy certain properties: it should be durable, that is to say, it does not wear out easily; it should be portable, that is, easily carried; it should be divisible into units usable for everyday transactions; it should be recognizable and uniform, so that one unit of money has the same properties as every other unit; it should be scarce, in the economic sense, so that the extant supply does not satisfy the wants of everyone demanding it; it should be stable, so that the value of its purchasing power does not fluctuate wildly; and it should be reproducible, so that enough units of money can be created to satisfy the needs of exchange.

Over millennia of human history, gold and silver have been the two metals that have most often satisfied these conditions, survived the market process, and gained the trust of billions of people. Gold and silver are difficult to counterfeit, a property which ensures they will always be accepted in commerce. It is precisely for this reason that gold and silver are anathema to governments. A supply of gold and silver that is limited in supply by nature cannot be inflated, and thus serves as a check on the growth of government. Without the ability to inflate the currency, governments find themselves constrained in their actions, unable to carry on wars of aggression or to appease their overtaxed citizens with bread and circuses.

At this country's founding, there was no government-controlled national currency. While the Constitution established the Congressional power of minting coins, it was not until 1792 that the US Mint was formally established. In the meantime, Americans made do with foreign silver and gold coins. Even after the Mint's operations got underway, foreign coins continued to circulate within the United States, and did so for several decades.

On the desk in my office I have a sign that says: “Don't steal — the government hates competition.” Indeed, any power a government arrogates to itself, it is loathe to give back to the people. Just as we have gone from a constitutionally instituted national defense consisting of a limited army and navy bolstered by militias and letters of marque and reprisal, we have moved from a system of competing currencies to a government-instituted banking cartel that monopolizes the issuance of currency. In order to introduce a system of competing currencies, there are three steps that must be taken to produce a legal climate favorable to competition.

The first step consists of eliminating legal tender laws. Article I Section 10 of the Constitution forbids the States from making anything but gold and silver a legal tender in payment of debts. States are not required to enact legal tender laws, but should they choose to, the only acceptable legal tender is gold and silver, the two precious metals that individuals throughout history and across cultures have used as currency. However, there is nothing in the Constitution that grants the Congress the power to enact legal tender laws. We, the Congress, have the power to coin money, regulate the value thereof, and of foreign coin, but not to declare a legal tender. Yet, there is a section of US Code, 31 USC 5103, that purports to establish US coins and currency, including Federal Reserve notes, as legal tender.

Historically, legal tender laws have been used by governments to force their citizens to accept debased and devalued currency. Gresham's Law describes this phenomenon, which can be summed up in one phrase: bad money drives out good money. An emperor, a king, or a dictator might mint coins with half an ounce of gold and force merchants, under pain of death, to accept them as though they contained one ounce of gold. Each ounce of the king's gold could now be minted into two coins instead of one, so the king now had twice as much “money” to spend on building castles and raising armies. As these legally overvalued coins circulated, the coins containing the full ounce of gold would be pulled out of circulation and hoarded. We saw this same phenomenon happen in the mid-1960s when the US government began to mint subsidiary coinage out of copper and nickel rather than silver. The copper and nickel coins were legally overvalued, the silver coins undervalued in relation, and silver coins vanished from circulation.

These actions also give rise to the most pernicious effects of inflation. Most of the merchants and peasants who received this devalued currency felt the full effects of inflation, the rise in prices and the lowered standard of living, before they received any of the new currency. By the time they received the new currency, prices had long since doubled, and the new currency they received would give them no benefit.

In the absence of legal tender laws, Gresham's Law no longer holds. If people are free to reject debased currency, and instead demand sound money, sound money will gradually return to use in society. Merchants would have been free to reject the king's coin and accept only coins containing full metal weight.
The second step to reestablishing competing currencies is to eliminate laws that prohibit the operation of private mints. One private enterprise which attempted to popularize the use of precious metal coins was Liberty Services, the creators of the Liberty Dollar. Evidently the government felt threatened, as Liberty Dollars had all their precious metal coins seized by the FBI and Secret Service this past November. Of course, not all of these coins were owned by Liberty Services, as many were held in trust as backing for silver and gold certificates which Liberty Services issued. None of this matters, of course, to the government, who hates to see any competition.

The sections of US Code which Liberty Services is accused of violating are erroneously considered to be anti-counterfeiting statutes, when in fact their purpose was to shut down private mints that had been operating in California. California was awash in gold in the aftermath of the 1849 gold rush, yet had no US Mint to mint coinage. There was not enough foreign coinage circulating in California either, so private mints stepped into the breech to provide their own coins. As was to become the case in other industries during the Progressive era, the private mints were eventually accused of circulating debased (substandard) coinage, and in the interest of providing government-sanctioned regulation and a government guarantee of purity, the 1864 Coinage Act was passed, which banned private mints from producing their own coins for circulation as currency.
The final step to ensuring competing currencies is to eliminate capital gains and sales taxes on gold and silver coins. Under current federal law, coins are considered collectibles, and are liable for capital gains taxes. Short-term capital gains rates are at income tax levels, up to 35 percent, while long-term capital gains taxes are assessed at the collectibles rate of 28 percent. Furthermore, these taxes actually tax monetary debasement. As the dollar weakens, the nominal dollar value of gold increases. The purchasing power of gold may remain relatively constant, but as the nominal dollar value increases, the federal government considers this an increase in wealth, and taxes accordingly. 

Thus, the more the dollar is debased, the more capital gains taxes must be paid on holdings of gold and other precious metals.
Just as pernicious are the sales and use taxes which are assessed on gold and silver at the state level in many states. Imagine having to pay sales tax at the bank every time you change a $10 bill for a roll of quarters to do laundry. Inflation is a pernicious tax on the value of money, but even the official numbers, which are massaged downwards, are only on the order of 4% per year. Sales taxes in many states can take away 8% or more on every single transaction in which consumers wish to convert their Federal Reserve Notes into gold or silver.
In conclusion, Madam Speaker, allowing for competing currencies will allow market participants to choose a currency that suits their needs, rather than the needs of the government. The prospect of American citizens turning away from the dollar towards alternate currencies will provide the necessary impetus to the US government to regain control of the dollar and halt its downward spiral. Restoring soundness to the dollar will remove the government's ability and incentive to inflate the currency, and keep us from launching unconstitutional wars that burden our economy to excess. With a sound currency, everyone is better off, not just those who control the monetary system. I urge my colleagues to consider the redevelopment of a system of competing currencies.

When Private Money Becomes a Felony Offense

The popular revolt against a declining dollar leads to a curious conviction. 

From the Wall Street Journal - March 31, 2011

The next chapter in the struggle over sound money may be the case of a newly minted felon named Bernard von NotHaus. Mr. von NotHaus was convicted this month of counterfeiting money by issuing silver coins called Liberty Dollars. His company's website says it's been taken down by court order, and absent a successful appeal he could spend years in jail.

Mr. von NotHaus was convicted under a section of the United States Code that makes it a crime to manufacture or pass "any coins of gold or silver or other metal, or alloys of metals, intended for use as current money, whether in the resemblance of coins of the United States or of foreign countries, or of original design." The law was enacted during the Civil War, soon after the Union began issuing the paper scrip known as greenbacks.

It is too soon to say what Mr. von NotHaus's grounds of appeal will be, but it is not too soon to say that his case will be one to watch at a time when so many believe our economic troubles are tied to the fact that the dollar has become a fiat currency, and when leaders world-wide are calling for a new reserve currency.

So alarming has been the collapse of the dollar that the legislatures in as many as a dozen American states are considering using their authority—under Article 1, Section 10 of the Constitution—to make legal tender out of gold and silver coins. Lest the ghost of Friedrich Hayek or any other advocate of privately issued money get any bright ideas, however, the von NotHaus verdict will stand as a warning.

The warning is contained in paragraph 33 of the indictment handed up against Mr. von NotHaus in a courtroom at Statesville, N.C. It said:

"Article 1, Section 8, Clause 5 of the United States Constitution delegates to Congress the power to coin money and to regulate the value thereof. This power was delegated to Congress in order to establish a uniform standard of value. Along with the power to coin money, Congress has the concurrent power to restrain the circulation of money not issued under its own authority, in order to protect and preserve the constitutional currency for the benefit of the nation. Thus, it is a violation of law for private coin systems to compete with the official coinage of the United States."

Yet a curious thing happened in the courthouse on the day before the jury went to deliberate. According to Aaron Michel, Mr. von NotHaus's attorney, the judge granted Mr. Michel's request to delete paragraph 33 from the indictment.

"That is a statement of law that, if it were to be put before the jury at all, should have been a matter of discussion between the parties as to the court's instructions to the jury on the law," Mr. Michel quoted the judge, Richard Voorhees, as saying. "In any event, it does not appear to the court to be a factual predicate that is supported by the evidence in the case."

The judge then asked one of the federal prosecutors, Jill Westmoreland Rose, whether she had "any comment on that." "No, Your Honor," Ms. Rose replied, according to Mr. Michel. So the copy of the indictment that went to the jury contained white space where paragraph 33 once was.

Yet after Mr. von NotHaus was convicted on March 18, the government issued a press release trumpeting the verdict and repeating the part of the original indictment that the judge had struck out. The release also went further, asserting that Congress's power to coin money under the Constitution was also meant to "insure a singular monetary system for all purchases and debts in the United States, public and private."

It again asserted that it is a violation of federal law for individuals—such as, it added, Mr. von NotHaus—"to create private coin or currency systems to compete with official coinage and currency of the United States." So much for the judge's view that the paragraph was unsupported by evidence in the case. The U.S. Attorney's office did not respond to a request for comment.

To be sure, there are advocates of sound money who believe that, while Mr. von NotHaus's scheme may have been visionary in principle, he made some mistakes under American law. He put a "$" sign on the silver he was issuing, and he denominated the units in dollars (albeit Liberty Dollars, or Liberties). Such facts may have helped convince the jury to find him guilty of counts involving the counterfeiting of coins.

It may also be, however, that the government has overreached in the von NotHaus case. It is indisputably clear that the power to coin money and regulate its value is one that the Constitution delegates to Congress.

 It's an enumerated power, and one of the big ones. It's also clear that the Constitution bars states from making coins other than gold or silver legal tender. But it is not clear that there is a constitutional basis or a logic for prohibiting individuals from making and selling pieces of gold and silver and using them, on a voluntary basis, as money—i.e., to "compete with" the official coinage of the U.S.

Certainly it's a loser's game to suppress private money that is sound in order to protect government-issued money that is unsound. For, as was once said by the same Abraham Lincoln who brought in the greenback to finance the great cause of the Union, you can't fool all of the people all of the time.

Mr. Lipsky is editor of the New York Sun.