Faith in Faith
The Daily Reckoning PRESENTS: This week’s drop in the price of gold has a lot of investor’s questioning their belief in the precious metal. Even self-proclaimed gold bug, Bill Bonner’s faith is a bit shaken…but not for long. Read on…
FIAT CURRENCY: FAITH IN FAITH
Gold investors who had been holding their breath for weeks had it knocked out of them this week. On Tuesday, the price fell $44, enough to put speculators in a tailspin. Even your editor – usually a rock of unproven opinions and a fountain of imperturbable prejudices – began to wonder.
What if we’re wrong? What if sophisticated, modern financial instruments have reduced gold’s role in modern finance? Wouldn’t gold act exactly as it has – that is, as a commodity? It went up with lead…and came down with it, too. But what kind of commodity has no industrial use? We wondered then why it had bothered to go up in the first place. After a while, we had wandered so deep into the forest of conflicting and ambiguous thoughts we needed helicopter rescue.
Daily Reckoning readers might be wondering…and getting lost, too. Today’s reflection is meant to provide them with some breadcrumbs.
We begin with two questions:
If we have a faith-based monetary system, what do we have faith in?
When this, too, passes, what will take its place?
That second question is the mischievous one. So, we will answer it first: we don’t know. But it is the question itself that is most revealing. Were monetary systems permanent and immutable, there would be no need for them. The present financial system could sit there as unchanging as a harbor light – a sturdy guide to the prudent and a warning to the reckless. Instead, monetary regimes come and go, like the lanterns of Cornish pirates, luring ships onto the rocks to be looted.
The financial history of Argentina is instructive as well as entertaining. There, hardly a single generation got through life without washing up – either on the rocks of inflation, the shoals of devaluation, or the soft mud of recession. One system brought inflation rates of 2,000% per year. When that sank, in came a peso as strong as the dollar. And then, when the new peso crashed, a new, new peso, with a new monetary regime behind it.
Just when people had learned how to get around the rocks, the rocks were moved. Along came another regime with another set of standards. Out on the pampas, people finally got used to financial change. They learned not merely from the record of the dead, but from their own living experience: don’t put your faith in any financial system; it won’t last.
But Americans can’t have learned much from their mistakes; they haven’t made enough of them. American paper currencies went bad in the Revolutionary War (“not worth a continental,” was the expression that recorded the mistake), and again in the War Between the States (when Lincoln spent more than he could honestly steal from the taxpayers). The Great Depression, with its devaluation of the dollar against gold, might have taught them a thing or two as well. But there is hardly a single person still alive who learned from it directly. No, in matters of financial calamity, Americans might have been born yesterday. Soft and dewy, they are ready to believe anything – even that their financial system might last forever.
That brings us back to our other question: exactly what faith is it that undergirds our faith-based system? It is faith, surely, in the dollar, is it not? The dollar is the unit in which Americans measure their wealth. If the dollar were called seriously into question, so would the system itself. Everyone knows that the dollar is manmade, of course. Like all man’s creations, they accept that it is not without its flaws and is subject to improvement.
Man’s automobiles get better every year. And although a man may be happily married, still, walking around a dreary college campus or on a sunny beach…he can still imagine how things might be better with a newer model. In the case of the greenback, it has lost 95% of its value since the Fed was established. It lost 80% of its value while the present financial system has been in effect. That is, since 1971, when the Bretton Woods system, with its limited connection to gold, was abolished by White House decree. But while everyone knows the dollar gives ground, few believe it is unreliable. It is not the ruination of it that disturbs people; it is ruination at an unforeseen rate. Like the Argentines, Americans have learned to live with a greasy dollar. What they’re not ready for is one that slips away from them too fast. Or even less – one that doesn’t budge.
Their faith is broad. How deep it is, we won’t know until it is tested. For the present, “You gotta believe” is the national anthem. Americans believe that their financial leaders have triumphed over sin and science, too. An Argentine recognizes that government will destroy its own currency in order to win votes and power. An American readily agrees that the Bank of Argentina would do such a thing, but of the Bank of Ben Bernanke, he can’t believe it. His faith stops at the metal detectors.
Yes, theoretically, government and its central bank may be tempted to try to create more liquidity than necessary, but no, they won’t give into it. Why not? Because the markets won’t let them, comes the unwavering reply. Ah yes, their faith stretches to cover free market speculators as well as government bureaucrats. Should the feds create too much “money,” it is believed, investors will dump treasury bonds and force up interest rates, thereby reducing liquidity naturally. But for the last 10 years, a huge tide of cash, credit and credit derivatives has flooded the world without a word of complaint from the speculators.
Instead, they got rich and built gaudy houses in Greenwich, Connecticut. They figured out how to snooker the system…shuffling and reshuffling money, slipping an ace up their sleeves when no one was looking. Liquidity – money in all its forms – was lapping around them, but who was going to complain? House prices rose. Stocks rose. Bonds rose. What’s not to like? And finally, the head of the most successful money shuffler of all time – Goldman Sachs – has just been invited to Washington to take charge of national finances. Could anything be clearer? The speculators are not watching over the feds; they’re watching out for them…and for themselves.
Meanwhile, in the popular imagination at least, great strides in the science of central banking have been made since the days of John Law. Asked what exactly those strides are, the modern economist shifts uneasily in his chair and mumbles something about improvements in data available to policy makers.
And this is where we begin to make faces. Our eyes roll toward the heavens.
We think of the improved “data” itself – of job numbers perverted by seasonal adjustments and changing definitions of employment that flatter the policymakers…of inflation figures shrunk by taking out inconvenient prices for food and energy and then hedonically act as a prestidigitator, so that they practically disappear from the stage of GDP calculations that have undergone so much cosmetic surgery that they no longer resemble anything familiar or even human. And we wonder what kind of jackass would take it seriously, let alone rely on such conniving rubbish to formulate public financial policy.
In the past, the detailed information wouldn’t have been of much use to bankers, even if they had had it. Their job was simpler. All they had to do was to make sure they could pay their debts – in gold. When they couldn’t, they went broke. If they were central banks, the whole nation went broke. As simple as the job was, many still couldn’t do it. Shady countries in sunny places routinely went belly up. Even in America, during the Great Depression, 10,000 banks went bust.
The Bank of the United States of America, run by the former chairman of the Princeton economics department, needs data because its mission has crept far beyond policing the value of the dollar. Expectations have inflated, too. Now, the Fed is expected to control the rate of decline of the dollar – a decline of about 2% per year is considered optimal. And if that weren’t hard enough, the Fed is also asked to control the economy itself – regulating the availability of credit so as to avoid serious downturns. That is why the Fed lowered interest rates to 1% following the deflation scare of 2001. It had nothing to do with protecting the value of the dollar and everything to do with avoiding a deep recession.
Not only do central-bank scientists have more data at their fingertips, they have more theories, too. Liberalism. Keynesianism. Monetarism. There’s one for every purpose under heaven. It doesn’t matter that they are contradictory. The banker is merely expected to choose the one that suits the situation and use it like a socket wrench. Crank. Crank. Problem solved.
And so, drawing on twisted data and convenient theories, the banker adjusts rates by quarter points. The prevailing theory in all the Western nations is that centralized planning is ineffective, troublesome, unethical and stupid. There’s hardly a serious economist over the age of 18 who will not point to the former Soviet Union and sneer.
“The market,” they will tell you with a superior tone, “does a better job of regulating supply, demand and price than bureaucrats.” And yet, the operating theory of every central bank is that a group of civil servants, working with government data, can fix the price of the key set of components in the entire economic system: credit.
The economists may have their theories, their insights, their models, we allow, but how do they know that what the world needs is a fed funds rate of 3.75% rather than one of 4.0%? And how do they know whether they should be tamping down on inflation…or goosing up a business downturn? They may have mountains of data, but they are still lost on the slopes. They cannot tell us what the price of oil will be tomorrow…or the price of sugar…or the price of gold. They take their guesses along with everyone else.
Because the numbers are corrupted, the theories are a hodge-podge of wishful thinking, myth and delusion. And the practice is that both officials and speculators collude to take advantage of the corruption and the delusion. Speak the truth to this kind of power? You might as well save your breath…and buy gold.
The Daily Reckoning
June 16, 2006
Editor’s Note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of The Wall Street Journal best seller Financial Reckoning Day: Surviving the Soft Depression of the 21st Century (John Wiley & Sons).
In Bonner and Wiggin’s follow-up book, Empire of Debt: The Rise of an Epic Financial Crisis, they wield their sardonic brand of humor to expose the nation for what it really is – an empire built on delusions. Daily Reckoning readers can buy their copy of Empire of Debt at a discount – just click on the link below:
At the end of another week, we reiterate our simple investment formula for your benefit, dear reader, but this time, with a new twist: Buy gold! Sell Goldman!
Goldman Sachs stock slumped again on Tuesday, although the company had just announced record profits. Goldman is top dog in the “dog and pony” show. But its latest profit report establishes not only a new record for Goldman, but also a record for the whole breed. Net income doubled to $2.31 billion for the second quarter. Based on results for the first half of the year that makes Goldman the most profitable firm in the history of the financial industry.
And yet, its stock fell.
We are keeping an eye on Goldman these days, because we think it will tell us something: something about the economy, and something about the times we live in. Every dog has his day. Goldman has had a month of them. We wonder: what kind of world is it that Goldman would be on top of?
It is one that rewards money mongers. Previous American economies rewarded people who drilled for oil, built bridges, or made mattresses. This one gives its blessings, its honors, and its profits to people who deal in money itself. Goldman deals in money like a Vegas card dealer. Its shuffling is so smooth and so sure that the White House has invited its top shuffler to Washington, hoping he’d bring some of that financial razzamatazz along with him.
Yesterday, we tried to get to the bottom of the Goldman mystique.
Laboring as always to better serve our dear readers, we happened to travel to Germany, where we ran into an old friend who is a professional investor and a heavy user of hedge-fund products. We put our conundrum to him.
“Here’s a question,” we began. “Trading is supposed to be a zero-sum game, right? Well, how is it possible that a company like Goldman – with thousands of traders – can make 75% of its revenues from trading? You’d think their lucky trades would be balanced out by their unlucky trades. They can’t all be lucky. And they can’t all be geniuses. As Buffett says, there aren’t that many geniuses around.
“Or to put it another way, here’s a company making billions, mostly by trading. Who’s on the other side of these trades? Who’s losing? Where does the money come from? How is it possible for so many traders to have a result that is so far beyond equilibrium…it seems to defy gravity.”
“Yes, it is a curiosity,” said our friend. “You’re right about hedge funds. I mean, what you wrote about them. The average person will do no better in hedge funds than in mutual funds. In fact, he’ll do worse, because of the fee structure. As you noticed, if he gets lucky, the manager will stand right there beside him, with his hand out, when the payoff comes. If he’s unlucky, and the fund loses its bets, he’ll be in line alone. The manager won’t share the losses.
“‘The average man doesn’t wish to be told that it is a bull or a bear market,’ wrote the legendary Jesse Livermore once. ‘What he desires is to be told specifically which particular stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.’
“You’re right, too,” continued our friend, “that there aren’t 8,000 geniuses running hedge funds. The average return will not be very good. But you’re wrong to tell investors to stay away from them. I’m invested in several hedge funds. In every case, the manager has figured out some special little sweet spot in the market. Usually, it’s some little thing that most people don’t know about. For example, one fund I’m in is run by a guy who just makes a point of catching the ‘earnings surprises’ before Value Line.
“Value Line figured out that you can do well by buying companies whose earnings are better than forecast. After the earnings come out, it takes Wall Street a while before it adjusts its view of the company to the higher earnings. But it also takes a while for Value Line to get the news and update its rates. This manager uses the same simple idea; he just moves faster. And he consistently beats the market.
“There are anomalies out there. Good hedge fund managers find them and exploit them. And good investors find the hedge funds that do that and negotiate their own fees to a reasonable level. But the average investor has no idea. He picks up a hedge fund like he buys a bottle of wine – because someone told him it was good. And then, he pays fees that are so high it is almost impossible for him to make any money.”
“But what about Goldman?” we asked.
“Goldman is said to be the largest hedge fund in the world, but in fact, it is, the largest collection of hedge funds in the world. It has hundreds of them. It has a great reputation…and it has its hands in more deep institutional pockets than anyone. So, it get so much money under management that it makes a fortune, even when its results are not spectacular. And in a sense, it is also the bank. It is not just playing in the casino; it is the casino. Goldman is trading so much money for so many people, it makes money no matter which way the markets go.”
The question for investors is this: Is the casino getting bigger, or is business falling off? Investors answered yesterday: they sold Goldman. For once, we think they were right.
Dan Denning, reporting from Melbourne, Australia:
“There is a larger issue here and it is the destruction of all this paper wealth, the fictitious economy, 10 years of misallocated global capital that must be liquidated.”
For the rest of this story, see The Daily Reckoning’s blog.
Bill Bonner with more views…
*** Poor George Soros. He tried to get the France’s highest court to overturn a conviction for insider trading, dating back 20 years. The Cour de Cassation upheld the lower court. Poor George still has a rap sheet. Maybe he could use some advice from Goldman.
*** And what about our favorite metal? Will we have to live through another long, dark teatime of the soul, when gold falls for 20 years as it did from 1980-2000? Or, are we merely enjoying a correction in a major bull market?
Gold is now officially below our buying target. We’re not too sure where we left the last buying target, but wherever it was, gold is comfortably below it. Buy. If the price drops below $500, buy more.
But wait. How do we know that this is not a trap? Why can’t gold just slide back down to $250?
As usual, we can give you no sure answer. We know no more than you do. All we have is faith. And a theory. We have faith in our fellow human beings. Given enough temptation, they will yield to it. That temptation, for a central banker, takes a predictable form: it is the temptation to create “money” out of thin air. In this, the U.S. Federal Reserve has led the way for the last four decades. Tossing off the last vestiges of gold-backing in 1971, it has sprinted toward temptation like a dipsomaniac to a free drink. Vast increases in the world’s supply of money and credit have been registered, while the world’s supply of gold barely increased at all.
You can easily forget to notice…amid all the noise of share prices, Fed policies, economists’ apologia, analyst reports, charts, graphs, and new headlines. The essential truth is hard to hear. You have to hold your hands over your ears and let it whisper to you: all the world’s paper currencies have been inflated. But if paper currencies are to lose value, they must lose value against something. That something, by tradition as well as convenience, is gold.
A few weeks ago, we yearned for a substantial correction. Now, we have one. We guessed that the bottom would come between $550 and $650. We gave ourselves plenty of room, but maybe not enough.
In the bull market in gold, so far, the yellow metal has risen along with its base metal cousins. In the bull market still ahead, it will shoot up like a plume of vapor. Investors have been shocked by how much gold can fall at this stage. In the next stage, they may be shocked by how much it can rise.
*** One man tries to involve himself in the gold rush in an interesting way…
Sixty-three-year-old Norm Enrique of Montclair, California got a bit “carried away” when his gold detector reported a positive hit in his front yard. He dug a 60-foot-deep hole, in search of the yellow metal.
The AP reports:
“Fire officials called to the scene Tuesday found two men that Enrique hired were inside the un-reinforced hole, using a bucket and rope to remove dirt.
“‘We told him, ‘You’re done,’ said Montclair Fire Capt. Rich Baldwin. ‘It’s amazing no one got killed.'”