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Sunday, June 14, 2009


Why gold?

Clearly it is not always right to be buying gold. Often - in fact, usually - it is better to go in search of business growth.

Right now we can look back over 25 years where the conditions have generally been very good for growing businesses. Unsurprisingly in those 25 years gold has underperformed business investments - by as much as 20 times.

But nobody makes money today from yesterday's price moves, and now there are many indicators which suggest things could soon turn very bad for investors seeking growth.

The list of dangers is getting longer. Here are a few:-

Budget deficits
Trade deficits
Asset bubbles
Financial systemics (open derivatives held on margin accounts etc)
The bond market overhang
Sovereign and corporate default risk
Accounting holes (e.g. corporate pension liabilities)
Foreign central bank currency mountains
Social program bankruptcies (medicare / medicaid / state pensions)
100% consumption, 0% saving

Whether directly or indirectly most of these problems ultimately resolve to a single form. The savings of the developed world have been bound up in promises to repay, and it looks less and less likely that repayment is possible. The level of debt is the central problem threatening the wealth of today's investor, and keeping all that debt under control is becoming impossible.

The difficulty is that as economies move from a low debt to a high debt environment the self correcting nature of the economy changes. Overindebtedness seeks to correct itself either with rapid inflation which devalues savings indiscriminately, or with a deflationary squeeze, which kills specific businesses, and their creditors, through default. The current wild swings in interest rates demonstrate our monetary authorities trying with increasing desperation to prevent first one and then the other.

Economies rarely return to stability in an orderly way, and late moving investors usually get caught. Once even one or two percent of savers go in search of protection - to things like gold - prices change to the limit of what is acceptable to the rest, and they hold out stubbornly.

There is never enough room in the lifeboats of financial markets.

A three way bet
The world's oldest investors can just about remember the Great Depression. In America, from 1929's top to the bottom in 1932, the price of business assets fell by 90%. The purchasing power of gold, in terms of business assets, rose about seventeen-fold. The key during the deflation was to avoid default - i.e. your savings being lost to a failing financial institution unable to meet its obligations.

In the 1970s gold's price rose from $42 to $850. The price of business assets stayed approximately the same in money, with stock markets opening and closing the decade at broadly similar levels. Gold's business purchasing power rose about fifteen times. The 70s were a decade of worldwide inflation and stagflation, and this time the key was to avoid your money losing its purchasing power.

More inflations
The following illustration shows just a sample of hyperinflations from the last hundred years.

In each case once the currency tipped over the edge the journey to worthlessness was rapid and painful. Gold stored offshore protected its owners from the consequences of these inflations. But in every case the local deposits and bond portfolios of the sensible saver were destroyed.

What caused these inflations?
Underlying these hyperinflations there has been more than one root cause, and both lost wars and financial corruption have contributed. But the single most common factor was a failure to contain debt. When countries lose control of their public finances they can generally look forward to watching the value of their currency evaporate.

BullionVault's view is that the demands of modern democracy have caused the public finances of the USA to fall into the early stage of the same sort of death spiral while - tragically - its government and many of its people are distracted. At the same time in terms of fiscal irresponsibility Japan and the UK are not far behind, and Europe as a whole is far from healthy.

Our view is that the correction from this very high debt situation will directly cost a large percentage of savings. It will also deprive the world of the previously insatiable American consumer (we British are almost as bad, but there's not so many of us), and for a long time overcapacity in the world and a shortage of customers willing and able to pay will make productive business a painful and unrewarding pursuit.

Is this delusional? It is a bit embarrassing to be so publicly pessimistic, but we know for certain that we share these thoughts with more and more shrewd people, on whose behalf BullionVault now stores more than 1.8 tonnes of gold - mostly in Switzerland.

Debt, debt, and more debt
Argentina collapsed in 2001 when its sovereign debt hit $12,000 per family. The world's lenders had realised it would never be able to raise the taxes to pay back this debt, so they refused to fund it with ever more of their money.

This year the United States official public debt hit $83,000 per household. This public debt was only $20,000 in 1985, but even that was widely considered an irresponsible level and described mockingly as "Reaganomics". It has since then quietly quadrupled, which is the hidden cost of promising "no new taxes" while continuing to spend; both of which appear to be necessary to win modern elections in the USA. Currently each household's debt is growing by $5,000 a year.

These figures are straight off the official public debt site at :
The conventional view is to believe the US household capable of paying back this money through economic expansion, because apparently this will generate more tax. But this view makes little sense. Encouraging economic expansion is all very well when people are spending money they have previously saved, but in the USA saving has declined steadily from an already low figure in 2002, and turned negative in 2005. New spending will therefore need more credit, and if it is to be state sponsored the US Treasury will be adding to the $450 per month of increasing indebtedness every US family currently contributes to the US Government's public debt. Only bankrupts and gamblers think borrowing more is the solution to high indebtedness.

Since the options are so painful it is quite likely nothing significant will be done, and the public debt will continue growing in the meantime at about $5,000 per year per family. It will probably not be paid off until normal everyday banknotes have got one or two more zeros on them.

Would anyone in the US Federal Reserve sanction such inflationary money printing? It is unlikely, but it can be taken out of their hands. The market itself could take charge; it usually does.

One day we will hit the tipping point. Some small event will probably end up being identified as the direct cause and will knock the markets surprisingly hard. Whether it's a hedge fund implosion, a bank failure, a political crisis, or perhaps even a natural disaster, it will trigger the re-evaluation which will correct 20 years of overconfidence in the ability of borrowers to repay. It will be impossible to identify it as the beginning of the long slide back to reality until 10 years later, by which time it will be too late to be useful.

The bond glut

The US dollar has for a long time been the reserve currency of choice. The result is that for each US household there is now a total of about 440,000 in dollar denominated bonds spread out across the world (this includes commercial bonds denominated in US dollars). The size of this debt mountain has grown about 40 times in 25 years.

A big chunk of this debt falls due for re-financing every year, which places many billions of dollars in the hands of global investors, who are not especially loyal to the US dollar and must decide whether to re-invest in dollar bonds, or buy something else.

This $44trn aggregation is easily the largest stockpile of debt ever, and keeping it off the market requires near zero inflation. Once this frozen stockpile starts to melt it will be self-sustaining, and a trickle could turn quickly into a flood.

This is the conundrum at the heart of the world's monetary system. People will steadily realise that without inflation the US cannot pay its public debts and must default. Yet with inflation the overhang of bond money will flood the world with worthless dollars. Which is the way out? Default and deflation, or glut and inflation?

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