The Path to $10,000 an Ounce Gold, Revisited

The Federal Reserve’s stock market wealth effect is getting stale. As investors contemplate the risks of the Fed losing control of long-term interest rates, stocks may start incorporating reality on the ground — not just Fed actions…

This week, we saw the spectacle of the most anticipated Fed meeting in recent history. In the end, the decision (surprise, surprise) was made to continue the Fed’s stimulus plan, to the tune of $85B a month.

However, most traders, obsessed with the tiniest tweaks to the monthly rate of Fed printing, are missing the big picture: Credit growth has outpaced the economy’s productive potential, both here and around the globe. Each successive growth spurt in money and credit has a weaker marginal impact on the real economy; this requires permanently easy monetary policy, and perhaps, eventually, a formal devaluation of paper against gold.

Excess debt is like kryptonite: Each new wave of printing has less impact on markets.

In his latest Gloom Boom & Doom Report, Marc Faber argues that the Fed has lost control of the bond market. Treasury note yields have doubled from the summer 2012 lows — a development that surely wasn’t part of the Fed’s stimulus playbook. Stock market bulls beware. “Having lost control of the bond market,” Faber writes, “it is likely that the Fed is also going to lose control of the stock market.”

Faber recommends investors reduce their equity positions. He sees the market at risk of an abrupt decline. Faber concludes: “The only asset classes that stand out as being oversold and of relatively good value are industrial commodities and mining companies.”

I agree. Value is scarce. Investors have bid up the prices of even the lowest quality companies far beyond any conservative estimates of value.

Today, I want to republish a year-old essay on gold and the paper dollar-based monetary system. Its core message still applies to what we’re seeing this week (and will apply a year from now.)

Much trouble can come of a monetary system that enables growth of unreserved credit beyond an economy’s ability to service that credit. It looks like the global economy is at this point, so it’s worth thinking about how the system might adjust.

[Ed. Note: The following was first published in summer of 2012. With the Fed’s announcement to continue $85B in monthly stimulus, we thought it worthwhile to revisit the fragility of the paper dollar-based monetary system.]

There’s a plausible path to $10,000 an ounce gold. And it doesn’t require a breakdown in civil society…

Speculators see central bankers as modern-day superheroes, able to push markets around with a single phrase. The image of Ben Bernanke, Mario Draghi and Masaaki Shirakawa in tights, masks and cape enriches the dreams of speculators worried that they might have overpaid for stocks or bonds. “Surely the next round of easing will allow me to sell!” they hope. Maybe… maybe not!

Lately, speculators have had more nightmares than dreams. Fears abound that the eurozone is going to dissolve. The ensuing chaos and bank runs could short-circuit the global banking system. German Chancellor Angela Merkel plays the villain in this scenario. “If only Merkel caves and agrees to euro bonds or a banking union,” the thinking goes, “we’ll be off to the races. Once Merkel gives into a fiscal union, ECB President Mario Draghi can unleash the powerful weapons of the euro printing press.”

Not so fast. The powers of Mario Draghi and other central bankers are waning. Excess debt is like kryptonite: Each new wave of printing has less impact on markets. As the popular phrase goes: “This is a solvency problem, not a liquidity problem.” In other words, new money supply cannot restore health to sick loans and government bonds. The only way to restore solvency to the system is to deflate the economy or slash the amount of debt in the system through mass bankruptcy.

Or is there another way? Is there a “reset button” that central bankers can push (with the approval of political leaders) that would restore balance to the system?

We know central bankers would never want to deflate the economy or crash the value of debt, which would destroy the banking system. So how about inflating the money supply to dilute the value of debt? All in one fell swoop?

Right now, central bankers are diluting the value of debt very slowly by pushing interest rates below the rate of inflation. Some call this “financial repression.” It’s an unspoken policy that has many negative consequences. Plus, the current set of central bank policies seek to subsidize exporters with weakened currencies. This only invites retaliation. Such an environment is hardly conducive for investments that improve living standards.

What is an alternative, since all attempts to “fix” the current system with more borrowing and printing are failing?

How about the classical gold standard, which stands out as the least flawed of all the systems we’ve tried (if you agree with this, I assume you don’t buy the tired Keynesian fallacies about the gold standard). Each nation could choose to peg its local currency to gold at a price that allows for enough growth in bank reserves to greatly reduce the burden of public- and private-sector debts.

Repegging a currency like the U.S. dollar to gold at the current price (about $1,550) has its pitfalls. Most notably, it would not deleverage an overleveraged banking system. Banks are overextended because at current values for houses and other collateral, the system is constantly balancing on the knife edge of solvency. Put another way, the claims of depositors far exceed the amount of cash held in reserve.

So if and when bank runs occur, banks must discount loans and assets to the central banks’ collateral standards and borrow against them to generate cash to satisfy depositors. At the end of this process, the bank is no more liquid (since the depositor left with cash to deposit at one of the system’s stronger banks) and it owes a liability to the central bank secured by overvalued collateral. Then it’s only a matter of time before the collateral stops yielding cash, or gets impaired, and the bank must look to other resources to satisfy its loan to the central bank. Ultimately, when the insolvent bank is liquidated, depositors would lose money.

This is a long-winded example to explain just how much trouble can come of a system that extends unreserved credit beyond an economy’s ability to service it. It looks like the global economy is at this point, which is why it’s worthwhile thinking about how the system might adjust, and how our superhero central bankers might play a role.

Hedge fund managers Lee Quaintance and Paul Brodsky from QB Asset Management wrote a fascinating outline on the potential reintroduction of gold into the monetary system, while simultaneously implementing what one might consider a debt jubilee. I recommend reading the entire outline. Here is a summary, starting with QB’s diagnosis:

“Public-sector debts and deficits are increasing. The global economy is rapidly approaching the point where neither the public sector nor the private sector can service debts to the degree required to maintain asset prices, which, in turn, removes incentives to borrow further. The temporary benefit of growing debt obligations supporting ever-increasing nominal assets prices is now prone to reversal.”

One can argue forever about whether we’ve reached the point of debt saturation, but the recurring market spasms since 2008 point in that direction. After all, who will bail out Germany after it bails out the PIIGS? Who will bail out the U.S. government? These are questions that few are asking right now, but they will. QB proposes a “policy-administered asset monetization.” Here’s how it would work:

“Remonetize gold as the asset against which newly created central bank liabilities (base money) are created.

  • Gold purchases would serve to promote deleveraging in two manners:
    1. via base money (bank reserve) creation, and
    2. by providing the currency proceeds to fiscal agents to retire existing debts.
  • The threat of waning confidence in the currency unit in response to expanding central bank balance sheets would be arrested by a gold price peg in the aftermath of the base money expansion
  • Any future operations to expand the base money stock would require additional purchases of gold
  • A gold peg would thus act both as a deleveraging agent today and a fiscal/monetary policy discipline looking forward.”

QB explains the mechanics of how it could work in the U.S.:

Central bankers would no longer be viewed as superheroes! Just meager servants, pegging the money supply to gold and letting the free market determine the price of money.

“Using the U.S. as an example, the Fed would purchase Treasury’s gold at a large and specified premium to its current spot valuation. The higher the price, the more base money would be created and the more public debt would be extinguished. An eight-to-10-fold increase in the gold price via this mechanism would fully reserve all existing U.S. dollar-denominated bank deposits (a full deleveraging of the banking system).”

Below is what the remonetization of gold would look like in chart form. The blue line would rapidly approach the yellow line. And the yellow line will keep rising as we see further growth in the money supply. QB’s “Shadow Gold Price” divides the U.S. monetary base by official U.S. gold holdings. Policymakers, who always feel the need to manage something, would appreciate that this is the same formula used during the Bretton Woods regime to peg the dollar at $35 per ounce. In other words, the Shadow Gold Price is the theoretical price of gold after the Fed inflated the supply of dollars to a level that would cover systemic bank liabilities and then repegged the dollar to gold. Behold the path to $10,000 gold [Ed. note: after QE3, the Shadow Gold Price is even higher, and rises with each incremental dollar printed by the Fed]:

The case for 10,000 gold

This path would weaken of the economy-sapping effects of debt created since President Nixon closed the gold window. It would transform a debt-based currency into an asset-backed currency. No longer would one ask the unpleasant question “What backs the dollar?” and come away with even more questions (and a headache). Right now, the dollar is backed by Treasuries held on the Fed’s balance sheet, which are in turn backed by dollars, which are…Wait a minute!

QB’s monetization scenario would impose losses on certain parties as the reset button is hit, but unlike most of the policy prescriptions we’ve seen lately, it seems to solve more problems than it creates. Most notably, politicians could argue that this reset would involve “migration of value, in real terms, from leveraged assets to unleveraged goods, services and assets.” Wage earners would be winners relative to asset owners, because “stable to higher nominal asset prices would require even higher nominal wage and consumable pricing looking forward.”

This scenario argues for holding some shares in producers of physical commodities (especially gold miners), even if it feels like we’re in a deflationary environment. A gold standard, after a one-time debt monetization, would make for a more-balanced, efficient global economy less prone to violent booms and busts.

As an added bonus: Central bankers would no longer be viewed as superheroes! Just meager servants, pegging the money supply to gold and letting the free market determine the price of money. After all, when in history has central planning worked better over time than the free market?

We can hope the central bankers of the world stumble their way to a solution like that proposed by QB Asset Management before they inflict even more damage to the foundation of the global economy. Unfortunately, conditions may have to get much worse in financial markets, banking systems and economies before such “outside the box” ideas are considered. A defensive portfolio with exposure to gold and other real assets seems like the right mix in today’s environment.

Best regards,

Dan Amoss, CFA
for The Daily Reckoning

Ed. Note: The debate over a gold-based monetary system will never go away. And whether or not it gains traction over the next few years, you should be prepared for whatever happens. The best way to do that is to be informed. Subscribe to The Daily Resource Hunter and start learning specific ways to profit no matter what the market throws at you. It is completely free, comes straight to your inbox each morning, and gives you with the chance to discover specific actionable plays that will help you make money. Don’t wait. Sign up for free, right here.

Original article posted on Daily Resource Hunter