Monday, November 26, 2012

J.P. Morgan on Gold and Credit - What did he say?

I have seen quotes from J.P. Morgan used to support the Gold/Silver is money meme. Sound bites such as:
"Gold and Silver are money. Everything else is credit." or "Gold is money. Everything else is credit."
These have been thrown around for a while now. The quote comes from testimony in front of congress (1912) only 3 months before Morgan passed away at age 75. The real quote that the modernised versions originate from is:
Money is gold, and nothing else. 

If a man had the credit, and I had the money, his customer would be badly off.
Apparently a silverbug added the Silver reference which is definitely not in the original transcript. You can read the transcript in full here. Even the above two lines (as they appear above) were taken separately from different answers and pieced together in the 'Morgan Epigrams', so are not necessarily in context.

The comment on credit came from the following question and answer:
Q. If a man controlled the credit of a country, he would have a control of all its affairs? A. He might have that, but he would not have the money. If he had the credit and I had the money, his customer would be badly off.
One might consider the position of China and the US at the moment, with the US having Gold reserves approximately 8 times the size of China, while China holds well over a trillion dollars in US Debt. Who holds the credit and who holds the money? The reports of the United States death may have been greatly exaggerated.

Other interesting snippets epigrams include this nugget:
I think manipulation is always bad. 

I never sold short in my life that I know of, but I do not see how you will get along without it. It is a principle of life, I think.
Most amusing given the activities of the modern investment bank that JP Morgan is today:
As a result of Chilton’s  public statement,  several individual investors  brought lawsuits against JP Morgan and HSBC, claiming  they lost money on positions they took in silver futures on  the Comex. One such suit claims that in  August, 2008 JP Morgan and HSBC controlled over 85% of the commercial net short position in COMEX silver futures, and that this represented a short interest of 169 million troy ounces of silver, equal to about 25% of annual world mine production. Forbes
Something to keep in mind when considering these quotes is that the US was on a Gold standard when the comments were made. Would Morgan make the same comments today? I wouldn't be drawing any conclusions from a 100 year old quote from a bygone era.

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Tuesday, November 20, 2012

Freegold: Gold bubble or new monetary paradigm?

Freegold, not FREE Gold (sorry to disappoint!). Freegold (or Reference Point Gold, RPG) is an environment where Gold is set free from the bounds of a fiat price, where it is used solely as a store of value and reference point for all other currencies. The 'price' of Gold floats freely in all currencies or as defined on Wikipedia:
Freegold derives its name from a monetary environment where gold is set free, and has no function as money. Gold is demonetized, and has one function only: a store of value. The function of legal tender changes only slightly: it is a medium of exchange and unit of account, but stripped of the store of value function. In this environment, currency and freegold will coexist to supplement each other, without interacting with each other.
Posts I've made on this blog tend to revolve around Gold remaining within the confines of the monetary system that it sits in today, that is, Gold will continue to remain priced in US Dollars and cycle in value against other assets resulting in a "bubble" which will pop (assumes that central banks will be able to restore confidence in fiat currencies). However, there is a very real possibility that the monetary and financial system that exists today may be overhauled in the near future given the unsustainable path that central banks are taking.

Greg Canavan of the Daily Reckoning posted a reasonable summary of recent monetary history in 2010:
After WWII the Bretton Woods international monetary system came into being. This was a fixed rate currency regime with the US dollar as the global reserve currency. But to ensure stability and financial discipline, the major currencies were fixed to the US dollar and the US dollar was fixed to gold at the rate of US$35 an ounce.

This is where the Triffin Dilemma kicked in.

The US soon understood that reserve currency status allowed them to run large deficits. The deficits were 'paid' for by issuing US dollars. When the excess US dollars began showing up in global central banks, they began converting their dollars into gold. This lowered the value of the US dollar in relation to gold.

At first the authorities tried to manage the Dilemma. In 1961 they established the 'London Gold Pool' in an attempt to keep the US dollar price of gold to $35 an ounce. This system worked for a while but fell apart by 1968 when France withdrew from the Pool.

The various nations then attempted to preserve the Bretton Woods system by maintaining a two-tiered gold market; one operating at the official US$35 an ounce price while another traded gold at the market price, which was well above $US35. Of course such a policy was completely unsustainable and it too failed.

Bretton Woods was on its last legs. President Nixon ended the system once and for all when in August 1971 he suspended the convertibility of US dollars into gold. From that point on, the US dollar was without an anchor and the global monetary system went from a fixed to floating regime.

What followed was a decade of monetary instability and record high inflation.

Perhaps surprisingly, the US dollar maintained its role as the world's reserve currency throughout the decade. Due to its economic and military might, the reserve currency status of the US dollar actually grew in acceptance throughout the next few decades.

But Triffin's Dilemma never went away. It did remain out of sight though as parties on both sides of the equation enjoyed the mutual benefits of the US dollar's reserve status.

The US benefitted by paying for imports with essentially costless US dollars. In turn, the US' main trading partners enjoyed robust demand for their products, creating employment and income growth.

The huge deficits brought about by excess US consumption produced a massive amount of liquidity throughout the global economy. While Triffin's Dilemma would have predicted a collapse of the dollar because of the glut of dollars in the system, such an outcome didn't eventuate.

This was primarily because the beneficiaries of US consumption didn't want it to end. So they reinvested their excess dollars back into US asset markets, notably US Government debt. Such actions supported the dollar, kept interest rates low, and perpetuated the imbalances.

Some commentators called this apparent happy state of affairs 'Bretton Woods II.' As the saying goes, markets make opinions and this was a flawed opinion born out of an ignorance of what brought the first Bretton Woods system undone.
The article continues (I would recommend reading in it's entirety) and concludes on the following note:
But as we told you last week, the IMF is already holding discussions about making changes to the financial architecture. Very few people understand the magnitude of what is going on, but it hasn't been lost on the gold market.

Gold will be one of the major beneficiaries of change. Back in the 1960s Robert Triffin warned about the dollar glut and the fact that it would bring the Bretton Woods system undone. He was right.

The rising gold price was the first warning sign of the system's weakness. Now, the gold price is again warning of monetary instability. It has been rising along with the US dollar. Gold is again being viewed as a reserve currency.
Where in the past a new or significantly changed monetary system has been considered a wet dream of the tin foil hat brigade, following the global financial crisis and central bank reaction to it, the expectation for such has become almost mainstream (at least in financial circles, prepare for blank looks if you tried to explain any of this to the common man on the street).

There has been a lot of speculation about what the monetary system will look like post Bretton Woods II. A former world bank chief had this to say in 2010:
World Bank chief Robert Zoellick said in an article the Financial Times that leading economies should consider “employing gold as an international reference point of market expectations about inflation, deflation and future currency values.”

Zoellick made the proposal as part of reforms to be considered at this week’s G-20 meeting in Seoul.

“Although textbooks may view gold as the old money, markets are using gold as an alternative monetary asset today,” said Zoellick.

He said such a reform would reflect economic realities and should be considered as a successor to the existing global currency paradigm known as “Bretton Woods II.”

Bretton Woods II refers to the system which began in 1971, when U.S. President Nixon ended the dollar’s link to gold as established under the Bretton Woods agreement.

Zoellick said a return to some sort of currency link to gold would be “practical and feasible, not radical.”

“This new system is likely to need to involve the dollar, the euro, the yen, the pound and a renminbi that moves towards internationalization and then an open capital account,” he said. Market Watch
Coming changes to the global monetary system have not gone unnoticed by the world's savviest and richest investors, with Jim Rogers (billionaire) recently making the following comments in a video interview with Lauren Lyster of Capital Account:
(From 7:20) Lauren Lyster: Do you think there would have to be another viable world reserve currency before that happens (for the united states to go bankrupt)?
Jim Rogers: Our bankruptcy may lead to another viable world currency. The problem is there is nothing on the horizon right now. The Euro as it stands now is not properly constructed to serve as a world currency. We don't have an alternative right now, it can't be the Yen, can't be the Renminbi yet. We're in trouble.
Lauren Lyster: So you think potentially the United States could have a huge event in the foreign exchange market or some huge bond market collapse before there is another world currency?
Jim Rogers: Ms Lyster, don't say could... will, let me tell you it's going to happen, whether it's the next recession in 2013/2014 or the one after that, it's finished. Our debt is sky rocketing.

The IMF has proposed the use of Special Drawing Rights (SDR) as an interim solution:
After substantial market depth has been established, which would require very substantial amounts to be issued, and if the perceived safety of other global assets were to decline, Fund-issued SDR securities could be a potential anchor off which to price risk throughout the system (assuming the SDR valuation method ensured the SDR were representative of economic weights in the IMS). In the even longer run, if there were political willingness to do so, these securities could constitute an embryo of global currency. Of course, this longer-term vision is highly hypothetical and support for the nearer term steps need not imply commitment to the longer-term ones. IMF
With a possible longer term plan for a one world currency:
From SDR to bancor. A limitation of the SDR as discussed previously is that it is not a currency. Both the SDR and SDR-denominated instruments need to be converted eventually to a national currency for most payments or interventions in foreign exchange markets, which adds to cumbersome use in transactions. And though an SDR-based system would move away from a dominant national currency, the SDR’s value remains heavily linked to the conditions and performance of the major component countries. A more ambitious reform option would be to build on the previous ideas and develop, over time, a global currency. Called, for example, bancor in honor of Keynes, such a currency could be  used as a medium of exchange—an “outside money” in contrast to the SDR which remains an “inside money”. IMF
The IMF goes onto explain:
Why bancor? A global currency, bancor, issued by a global central bank would be designed as a stable store of value that is not tied exclusively to the conditions of any particular economy. As trade and finance continue to grow rapidly and global integration increases, the importance of this broader perspective is expected to continue growing.
But assuming that these monetary changes (either SDR or global currency) came in during systematic duress there is no guarantee that the market would accept another fiat substitute in place of a real store of value such as Gold.

If BRIC counties have a say in the new monetary system,  there is the strong possibility that any interim (or the final) new monetary system would involve Gold with Russia having voiced support for Gold to be included in basket of currencies/SDR (Reuters):
Russia supports expanding the IMF's Special Drawing Rights (SDR) to include the rouble, the yuan and gold, but sees no chance of the G20 Summit accepting a new reserve currency, a Kremlin aide said on Saturday, agencies reported.

Dvorkovich said he sees no chance of the G20 accepting a new reserve currency next month, but his comments suggest the issue will be in the spotlight at the meeting, where world leaders will discuss ways to combat the global economic crisis.

"We could also think about more effective use of gold and gold and forex reserves in this system," Dvorkovich said, RIA reported. For its part, he added, Russia would support the broad use of the rouble and the yuan as reserve currencies, Itar-Tass reported.
And actions speak louder than words (BullionVault, 2009):
China, the largest producer and private consumer of gold in 2009, has announced that it wants to build up its Gold Bullion reserves. And by how much? Ji Xiaonan, who chairs the supervisory board for the Chinese State Council's biggest state-owned companies, said Monday the country should look to add a massive 10,000 tonnes in the next 10 years.

Is China going crazy after gold? It would seem so if the recent statements coming out Chinese government officials is any indication. In fact, its Bullion reserves began to make big news in April this year when China announced that the country had increased its gold holdings to 1054 tonnes from 454 tonnes in 2003.

Since then, many other fast-rising nations – India, Russia, Brazil, even Sri Lanka – have been making news by announcing that they all want to build more gold reserves.
Another recent discovery (by Warren James at Screwtape Files) has been the lack of (ANY) Chinese refined Gold bars in major Gold ETFs:
The fact remains that (despite looking) we haven't found even one Chinese-Refined LBMA gold bar in a major ETF, which still lends support to the idea that China is holding onto its gold refinery output. This is supportive of Freegold theory, and also any other 'Chinese are keeping their Gold' narrative.To put it in perspective, this is a massive hurdle for anyone who still maintains that gold is just a commodity like the others - China has stuff pouring out of factories like a river including silver bars and other metals, so why should LBMA gold bars appear be absent from the list? (especially since we can safely assume they are being produced).
When the country with the world's second largest economy (by nominal GDP) and highest Gold mining output starts hoarding almost every ounce it can, you'd best pay attention.

Many commentators who think Gold will play a role in the changes ahead suggest a return to a Gold standard in the United States, but a Gold standard (in the traditional sense) wouldn't necessarily be feasible as explained by Victor the Cleaner in this post:
The book Currency Wars by James G. Rickards quickly became a bestseller not only in goldbug circles. One of the main theses presented by Rickards is that the United States ought to return to a Gold Standard.

Have you ever wondered whether this would be possible? The answer is No. But why not? The reason we give might strike you as rather unexpected, but it leads you right into the question of what will be the future international monetary system. The answer is that it is the existence of the Euro that prevents the United States from returning to a gold standard.

The Euro zone is set up in such a way that it values gold at its free market price. Since the Euro zone is a major global trade hub, they are in fact in a strong position to block any attempt by the United States at returning to a gold standard. They can rather force the US to value gold at its free market price, too. Any attempt at linking the US dollar to a fixed weight of gold is futile in the long run because this would eventually lead to an under-valuation of gold in US$ and thereby irreversibly drain gold reserves from the United States. In the present article, we explain these ideas in greater detail.
Probably one of the simplest explanations I've seen for how Freegold would work came from the "Flow of Value" blog by Blondie, but it appears posts have been removed, the explanation is available from a PDF version of some posts:
Freegold is a gold-based currency valuation system where the currency is not tied to fixed amount of gold.
Under a Freegold system gold would value all currencies individually and the exchange value of each currency would still be relative to every other currency.
Eg. Gold gram = Euro 1
Gold gram = Yuan 1.5
Therefore Euro 1 = Yuan 1.5
It's a triangulation. As long as the exchange rate between physical gold and currency is established, the relative value of all else can be objectively ascertained.
If there is too much money printing then the exchange value of one unit of a currency will decrease, and as governments quantitatively tighten the exchange value in gold of a unit of currency will increase.
To put it simply, the rate of exchange between all fiat currencies and physical gold is set free to float. The quantity of debt able to be cleared by a given weight of gold would vary, in accordance with the needs of the market. Gold, in its role as the ultimate extinguisher of debt, would be the clearing mechanism for the marketplace. Sovereign entities (whether individual or state) would have a net outflow of gold when consuming more than they produce, and vice versa. Thus every entity is required, by the free market, to live within their means. When not living within their means, they are forced to live by consuming their savings.
Freegold gives the market a real point of reference, physical gold, from which to assess the relative values of everything else. This is the point of reference originally chosen by the natural evolution of money, over thousands of years. Nobody invented money. It evolved naturally from our desire to exchange goods and services. Evolution! is an excellent description of this process.
In practice, Freegold is a separation of the functions of money. Physical gold resumes its rightful position as the store of wealth par excellence. Fiat paper continues in its role as the medium of exchange par excellence. The numeraire, or unit of account function of money, would be either gold or fiat, depending upon ones time preference.
These diagrams may help clarify:
The first diagram shows the present arrangement. It should be noted that currently the vast majority of entities use fiat currency as a store of value. This is a major reason why this "store of value" is always being "invested", seeking a "return on investment". Because it is not storing value. It needs a ROI to maintain its value (buying power). Fiat is not a good store of wealth.
The second diagram shows what happens when we introduce the context of time, which ultimately creates the resulting situation, illustrated in this third diagram:
The three monetary functions are now each being performed by the best "tool" for the respective "job". Which tool is best for which job is a subjective decision, best left to the sovereign entity (whether individual or state) evaluating their own money. The criteria used in making this subjective assessment may be infinite, but the most important of these is time: how long does one anticipate holding this money? If the answer is short term (ie. "spending money", used for current expenses), then the best form to hold it in is a fiat currency. If the answer is longer term (ie. "savings", a surplus over and above what is required as shorter term "spending money"), then the best form is gold, to protect ones buying power.
A lot of the arguments I have seen presented for Freegold make sense, but whether a practical application of the theory would be viable I don't know for sure. One interesting thing I have noted over the course of the last month as I've read up on the subject is the stubbornness of many Freegold advocates. They are often critical of Silver as an alternative and they raise many good points (such as pointing out central banks are showing the way to the new monetary system via their buying and holding Gold on their balance sheets and not Silver). However, their argument that one should hold only Gold because it is the end game seems to me as foolhardy as the suggestion that one should be all in on Silver because at the current rate we will run out of reserves in X number of years. 

What they don't seem to understand is that what happens between now the the end game could be as important as the endgame itself. Even if we are on the road to Freegold in the not too distant future, there is no reason that a Gold bubble in the conventional sense (of a parabolic rise and crash) couldn't play out before hand. Or there is the possibility that the IMF gets to play out their role with an SDR in the interim with Freegold coming a decade or two down the track.

There seems to be little critical thinking occurring in the most popular discussion spots for Freegold (such as on FOFOA's blog), it's almost like a religion or cult. Those who don't agree with the consensus are often labelled trolls, silverbugs or even gamblers.

I worry that many are sucked into the Freegold concept based on the lottery winning like appeal of a Gold revaluation to the heights expected by some Freegold supporters (below from FOFOA):
It won't take much for this deal to fall apart. And when it does, we'll see the price of gold go up to probably $5,000 an ounce and then all trading will stop. No market will exist for gold at it's true value. For those that have all the gold in their possession are only buying, not selling. Oil will skyrocket too... if it flows west at all. This is coming, and soon. Buy gold. Hold gold. It only has to meet it's true price once in a lifetime and that will be more than worth the wait. I believe this is not a once in a lifetime opportunity right now, but possibly a once in the history of the world opportunity. Silver, platinum, commodities... they may all do well. But nothing will come close to the true value of gold. $50,000 an ounce may even be low.
Major changes to the monetary system have almost always come about at a time of crisis, rather than with the foresight to adequately plan and implement them. Chances are the next time things change it will be swift and while anticipated by many, it could come with little warning.

Although the majority of my precious metals holdings will likely be traded into other assets when reaching ratios which suggest Gold is in an overvalued state (comparative to what we've seen over the past 100 years), there is the chance that the price keeps moving higher and rather than bursting in a bubble it becomes the one exception to the rule, the one asset which truly is heading toward a new paradigm and plateaus at a price that blows even my mind.


That said the shift to Gold as the sole reference point for the monetary system, if it does come, may be tomorrow, 10 years from now or after our lifetimes. I certainly wouldn't be putting all my eggs in that one basket.


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