Tuesday, July 5, 2011

The Future of Physical Gold (Part V - An Imperfect World)

"It is dangerous to be right when the government is wrong." -Voltaire

The first four articles in this series (Dialectic Foundations, The Evolution of Value, The Final Realization and Deflationary Canyons and Caves) used theories, facts, data and general observations to explain why the dollar price of physical gold would most likely take a significant hit over the next decade. It was also consistently argued that the global financial system would not be "re-capitalized" through the revaluation and monetization of physical gold reserves, as argued by the theory of Freegold. That, in turn, means that physical gold is very unlikely to reach valuations as high as $40-100K in current purchasing power per ounce, either in the near future or, for all practical purposes, ever.

Much of this series has focused on the Federal Reserve, U.S. Treasury and the U.S. Dollar as THE key influences on future monetary developments in our global financial system. Freegold advocates would take issue with this focus, because they believe the "rest of the world" (ROW) will be much more instrumental in leading the physical gold-based re-capitalization process, such as Europe, the Middle East, China, Russia and India. The problem for them is that such a conclusion is not supported by either sound theories of complex systems' evolution (i.e. evolution of the global economy) or straightforward empirical evidence. Let's return to a passage from Part IV:

[Deflationary Canyons and Caves]: We could even see several large institutions, such as central banks and governments in Asia, Europe or Japan, flood the markets with (sell) a portion of their gold holdings to temporarily relieve pressure from their dire private and public funding situations. The sheer momentum of financial capitalism will lead them to conduct their "re-capitalization" efforts through established fiat currency and debt mechanisms, rather than through an ongoing revaluation/monetization of gold by central banks such as the ECB (as argued in FOFOA's Reference Point: Gold - Update #1 and Update #2).

A complex and dynamic system relies on "central hubs" to keep itself functioning at anything close to its current scale, and therefore the "peripheral" branches of the system are more flexible and can deteriorate much faster. Accordingly, fiat currencies existing in the "periphery" of our global economy should be expected to fall first. For example, Belarus recently experienced the initial stages of HI as their currency lost 36% of its purchasing power in one month. However, the value of alternative mediums of exchange within the economy (i.e. dollars, gold, silver) can be suppressed in spite of such events as long as there are significantly bigger countries (currencies) willing to backstop the smaller ones, which will be Russia in this situation (with conditions of privatizing national assets, of course). [1], [2].

The countries on the periphery of the EU are in a somewhat similar position, but the Euro, as an accepted and stable currency, is obviously much more important to the system than the Ruble of Belarus. Even as the PIIGS continue to repeatedly experience public financing problems, the Euro has managed to maintain its value through various financial and political charades by the national governments, IMF and ECB (i.e. sovereign bond monetization, "credible" austerity plans, the prospect of labeling a default as "voluntary reprofiling", etc.). At every juncture, however, it became more clear that these efforts had increasingly less impact on public bonds and derivative instruments tied to their value.

At the end of every excruciating day, there must be a white knight in shining armor waiting in the shadows, ready to spring to action and prevent a complete European financial (Euro) implosion in the event of a PIIGS default. Countries such as Russia, Japan and China are simply not big enough to provide any credible backstop to the entirety of Europe, so we once again return to the operations of the U.S. Treasury and the Fed. In addition to various USD-Euro swap programs, it was revealed just yesterday by a report on Zero Hedge that almost all of the dollar flows generated from the Fed's QE2 Treasury monetization program have gone directly to European banks (~$600B to date).

The Federal Reserve Building in D.C.

Implication #3 explains why the US dollar has been as week as it has since the start of QE 2. Instead of repricing the EUR to a fair value, somewhere around parity with the USD, this stealthy fund flow from the US to Europe to the tune of $600 billion has likely resulted in an artificial boost in the european currency to the tune of 2000-3000 pips, keeping it far from its fair value of about 1.1 EURUSD. [3].

It conveniently turns out that major financial institutions in the Western world, whether technically classified as "American" or "European", repeatedly stop at the U.S. Treasury and USD markets and collect their "Go" money. The abridged reason is that the world has been flooded with dollar-denominated debt over the last few decades, and that debt, unsurprisingly, gives the institutions of dollar hegemony extreme leverage over the ROW when the liabilities come due and there is very little cash to go around. That has been a central theme of this series from the very beginning, and when you understand that, you start to understand what can happen to the value of physical gold.

The point has always been to maintain power structures of the system by transferring larger and larger amounts of resources and capital to its central hubs. When the PIIGS inevitably default on their sovereign bonds, EU citizens will realize that they were forced to sell their precious assets (including gold) for pennies on the dollar, while the major creditors who initially put them into debt were largely "re-capitalized" by the ECB/Fed and are set to absorb initial losses on any remaining debt-assets with ease. The Euro will experience a major sell-off relative to the U.S. dollar, when investors realize that the ECB is nothing more than a shell subsidiary of the Fed.

Gold may benefit a bit from capital flight out of Euro-based holdings over the next few months or year, but it will be difficult for it to maintain any marginal increases in value as financial contagion spreads and massive debt obligations come due. The latter are typically not payable in physical gold due to the system's evolutionary design, and so it will merely serve as a temporary and relatively illiquid repository of wealth for many investors. The debt-dollar system of "cash" and liquid bonds, on the other hand, will greatly benefit from capital flight, and that will also serve to suppress the value of gold on international exchanges.

Towards the end of Part IV, however, I explained that the shell game between the USD and Treasury markets cannot last forever. After a prolonged period of dollar appreciation and relative gold devaluation (~10 to 15 years), the central hub institutions would have concentrated and centralized too much wealth for their own good, just as predicted by Marx well over a hundred years ago. What both Marx and predictors of Freegold (Another and Friend of Another) really failed to understand, though, was that the complex global economy would not quickly rebound after this period with a drastic shift in property relations or systemic re-capitalization via physical gold.

In stark contrast, physical gold will become valuable mainly because it serves as a convenient and accepted medium of exchange in certain locations after the global financial architecture has crumbled into tiny bits and pieces. Ironically, the central hubs that were most dependent on that architecture will witness the most dramatic reversal, during which physical gold becomes a very important constituent of survival. For example, private communities in U.S. states have relatively small amounts of physical gold compared to those in Latin America, Africa, Asia and Europe. This lack of general availability will help to elevate its value in trade, as well as physical silver to a lesser extent.

In addition, at even smaller scales, black markets for trade in specific goods will inevitably become entrenched within "first world" countries over time as more and more people are displaced from the broader currency system. That trend is already prevalent in many poorer regions of the world, and it will simply expand to encompass those in the former "middle-class" who are living in densely-populated communities. For example, relatively poor neighborhoods in cities such as Detroit, Chicago, Los Angeles, New York, etc. will likely develop such markets over the next 20 years. Physical gold and silver, along with various other barter items, will become quite valuable in these locations.

It is also true that communities in the developed world have significantly less ability to sustain themselves through local food production, water procurement/treatment (more negatively impacted by shortages and impurities), efficient energy utilization, cooperative organization, ethnic/racial tolerance, etc. All of these physical, political and social deficiencies make it more likely that people will need to engage in extensive and reliable (trusted) trade to procure the things they need to survive, protect existing wealth and maintain bearable standards of living after HI occurs. Once again, this fact speaks volumes for the value of both physical gold and physical silver in the future.

On the other hand, locations with a lengthy history of gold or silver-backed currencies may find themselves re-instituting those monetary systems in the future at relatively smaller scales. States in the Indian sub-continent are a good example of those which may adopt a "gold standard" as the Rupee falls apart, and that would mean holders of gold are likely to gain a considerable increase in purchasing power. Alternatively, communities in Latin America may have a stronger affinity for silver-backing due to their historical paths of economic development. It is also possible that bimetallic currency standards are adopted at relatively small scales of organization in some parts of these regions.

It is perhaps most important to remember that a prolonged period of dollar deflation will be an extremely destructive process for general confidence in the global, regional and national structures of human society. Capital investments and revenues in every field of industrial economic activity will dry up in this self-reinforcing process, and that will in turn affect every aspect of our lives, including our ability to obtain adequate food, water, energy and shelter. By the time the central structures (the U.S. Dollar) of our system completely give out, the value of any official or unofficial monetary system will be constrained by the basic needs of people to survive in many regions.

Instead of hoarding physical gold for purposes of securing wealth or trading in a hyperinflationary environment, then, one may be better served by skipping directly to physical preparations that satisfy such needs. That is especially true in the developed world, where a relatively liquid and available means of exchange still exists and critical supplies are still somewhat affordable, but where self-sufficiency also requires a lot of effort. Once you are comfortable with your specific level of preparation, then you should begin looking for places to store excess currency wealth long-term. There is little doubt in my mind that physical gold is the place that generally towers above all others.

Some readers may feel that this article series has not delivered what it "promised", in so far as they were expecting an extremely detailed account of physical gold's future. While there was certainly no intent on my part to deceive, the series was organized to place significant emphasis on the role of complexity and uncertainty in our global economy as financial structures deteriorate. It is much more feasible, and therefore more important, to understand the broader foundations of how we got to this unique point and how the value of our wealth is likely to evolve from here. As explained in Part IV and above, the latter heavily depends on our localized circumstances of existence.

There is a well-known saying by Voltaire that "the perfect is the enemy of the good", and it's one of those cliches that should probably be tattooed on the palm of one's hand. Some people recite it as "we should not let the perfect be the enemy of the good", and that may be true, but it's just not as comprehensive as the original quote. The perfect is the enemy of the good, always. Perfect knowledge, perfect information, perfect monetary systems, perfect investments, perfect theories, perfect arguments... these things are all our enemies. What made me think of that quote was the following comment from a reader of the articles posted to a recent comment thread on FOFOA's website (emphasis mine):

"Anonymous": I offer profound thanks to FOFOA for giving me better insight into the economic events unfolding. I have become pretty much convinced about Freegold and hyperinflation.

But I have wished for an intelligent critique of FOFOA's writings because you can never be sure of a perspective until you understand the good arguments against it. So I thank Ash too, and look forward to reading the next installments of his series on the future of physical gold, at TAE. Perhaps it will undermine my tentative conclusion that FOFOA is right. Perhaps it will only lead to a more tempered version.

Reading all this stuff is a hard slog, especially when I have to work, and maintain a family. It is always a struggle to see the world aright.

I can only hope that other readers also find my series good enough to stand as a critique to the ever-insightful arguments of FOFOA and Freegold. Advocates of the latter would be the first to tell you that it is not meant to be predictable with certainty or a perfect monetary system by any means, but one cannot help but wonder if it's vision still flirts with perfection way too much. Even those who initially "exposed" the alleged trail towards Freegold (A / FOA) are depicted as the modern-day Messiahs of global finance; the Insiders among insiders who, sometime in the 1990s, managed to crack the code of financial elites around the world. That code was, of course, inked and cast in physical gold.

They wrote about their "revelations" from 1997-2001, during which time they preached the near inevitability of the global capitalist system being enveloped by a Freegold monetary paradigm. I could have trimmed around the edges of Freegold with quoted analysis/opinions, financial market data and/or questions about "why it hasn't happened yet", but that would not have been the way to critique such a fundamental argument about where we are headed. Instead, I believe this series has firmly established a well-researched argument that Freegold's foundations of socioeconomic evolution and its views of economic "value" in our global financial system are deeply flawed.

The empirical evidence to back up those theoretical arguments was later provided in the form of economic data and analysis of that data. It then follows that Freegold's strict predictions against prolonged dollar deflation are very questionable, as well as its views regarding the ECB (and the ROW) and its implications for the purchasing power of physical gold in the near future. This series was obviously not designed as a general argument against investment in physical gold. I simply ask that readers remember there is usually a vast chasm in our minds between owning physical gold and understanding the influences guiding its potential future. The time to narrow that chasm is right now.

"Doubt is not a pleasant condition, but certainty is absurd." -Voltaire


  1. Ash, another really thought-provoking post and I love the quotes from Voltaire. I'm really surprised your blog isn't more popular - I am so bored reading articles (talking here about non-mainstreamers) that are yet another re-hash of common non MS ideas.

  2. Andrew,

    I must take blame for this blog not really getting a lot of traffic, since I decided to "team up" with The Automatic Earth (theautomaticearth.blogspot.com) and publish most of my articles there first, as well as link back to TAE on other sites. I felt that was a better path to getting my views out to a wider audience in a shorter amount of time (as I'm sure you know, things are progressing rapidly these days), and I still very much feel that way. Of course, I still post all of my articles to this blog, and I appreciate everyone who still visits and reads. Thank you.

  3. I don't like the format of TAE blog, looks messy. It's much easier to read the standard blogspot format

  4. I never really had a problem with it, but I can see what you're saying. I do know that TAE is upgrading to a new site design (.com address I believe), and have even hired a computer graphics/design guy to help them with that. It will most likely have multiple sections by topic, and will also allow us to post articles more often than they do now.