Debt Crisis

I recently wrote a piece on the world’s economy ... see: World Economic Growth ... in which I predicted that the continued stimulus of many countries’ economies through the generosity of their central banks would not work out well. And today I read that China has been propping up its economy with enormous debt ... see: CNBC Article ... with its total debt at 300% of its GDP.

Now, to me it is understandable that China has dug this hole for itself ... after all it’s new to this capitalism thing ... so it has a lesson to learn about debt. But, what about the rest of the world? It is not our first rodeo! Yet, central banks around the free world are encouraging enormous borrowing with effectively zero interest rates ... or below. What can be wrong with this if this stimulates a vibrant economy?  OK maybe “vibrant” is much too strong a word given that Germany is in an economic contraction with negative half-point interest rates.

So then what are the “dark days ahead” of what I have suggested? Well, it seems obvious to me that, if it costs nothing to borrow money, countries, corporations and people are going to borrow money ... lots of money ... money that they cannot possibly pay back.

This eventually spawns a “debt crisis” which will be a banner headline in the few newspapers that are still publishing when this event occurs. How soon will this occur and what will be the consequence? Boy, I have bitten into a big Pennsylvania hoagie on this question! Honestly, I don’t really know, but I suspect a bit of lunch-meat indigestion will be involved. These events, from the little I have gleaned are a social-psychological phenomena ... where lending logic and rational rules go out the window. ... like they did in the sub-prime mortgage crisis of 2008 ... which actually was the genesis of our current predicament. Somehow large amounts of debt gets erased by the courts and by fiat ... and the lenders generally end up the losers. So, be careful lending money ... but borrowing might not be a bad idea.

Many banks around the world will disappear as will some governments I suspect. Maybe the US will be forced back on the gold standard. But, after a great deal of dislocation and pain, things will normalize and we will start lending and borrowing again. Sorry, that’s all I got at the moment. I’ll muse on it some more later.

Good as Gold

Just about a year ago, when the price of gold hit an all-time high ($1,900/ounce), I wrote a blog entry discussing this price and the United States' gold reserves relative to the U.S.'s money supply (see: Gold Bug). Now that the Republicans are considering reinstating the gold standard if Romney is elected (see: CNBC Story), I believe my previous analysis deserves to be updated.

Primarily due to the strength in the dollar relative to other currencies, the price of gold has dropped to $1,670 per ounce and Bernanke’s printing press has expanded the U.S. money supply over the last year by 8%+ to slightly above one trillion dollars. Assuming that the U.S. stock of gold still stands at 8,965.6 tons (I can’t seem to find an updated number), this would value our gold reserves at $479.1 billion … less than one half of what would be needed to fully back our current money supply at parity … if we were to go back to a gold standard.

What are the implications of the U.S. re-adopting the gold standard? I can think of three possible impacts:

1) In order to back our money supply at parity, the price of gold could double to almost $3,500 per ounce … and continue to grow at the rate of the United States’ currency expansion. (I think this is result is quite unlikely.)

2) The U.S. might chose to back its currency with a fractional conversion rate … say one ounce of gold could be purchased from the Treasury for $8,000. This option might also be restricted to U.S. citizens or institutions. Even though this would effectively be a gold backing of our currency, very few rational investors would exercise this option. But countries, like China, with huge dollar reserves might be so tempted … only they would have convert their dollar reserves to actual currency and to go through U.S. proxies … and thus would be selling their dollars at a very steep discount.

3) The U.S. dollar would then have the most solid backing of any currency in the world. I could easily see the Euro exchange rate fall to 2 Euros to the U.S. dollar. And China would also be hard pressed to keep its own currency from inflating greatly (a good thing). This should dramatically drive down the price of gold (and oil) … resulting in a continued positive feedback loop. A strong dollar, of course, could impact U.S. exports adversely but this could be offset, balance of payments wise, by our much lower payments for foreign oil … and a stronger Chinese yuan.

Going to a gold-backed dollar would clearly engender very complex financial cross-currents and I’m certain that I have just scratched the surface of possible outcomes. However, it is clear to me that the hay days of United States’ economic hegemony have corresponded to periods of a strong dollar. This might be an easy template to apply to a move back to the gold standard.

Gold Bug

The price of gold hit $1,900 per ounce yesterday ... the highest in history.  And many ads on current cable TV and talk radio focus on selling this metal to gullible consumers.  I say "gullible" despite the fact that many who bought this yellow metal last year have cleaned up.  But those speculating on gold must note that the buyer's price and the seller's price can often differ by as much as 20% and the only possible gain from gold is a capital gain, no interest or dividends ... plus there are often selling and buying commissions and margin fees ... plus, if one buys in quantity, there are hefty shipping or storage fees.  And don't forget that old adage: "you can't eat gold."

This all aside, gold has had a remarkable run ... I bought some for my grandson when he was born five years ago at about $550 per ounce ... it is higher now by more than a triple ... quite a run.  The question then present themselves: Why such a run?  And, how high might gold go?

The answer to the first question has a lot to do with the decline of the U.S. dollar.  Obviously, the price of gold in euros or in yen has not had such incredible price inflation.  Also, worldwide political and economic uncertainty causes many to seek a safe haven for one's assets.  The U.S. dollar had been such a haven in the past, but this is rapidly changing due to irresponsible fiscal policies in the U.S. over the last ten years.  Thus, gold moves to the fore for nervous investors.  But some pundits believe that this may be a dangerous strategy currently ... see: Danger in Gold

The second question is a lot more difficult to answer.  It mostly depends if one believes that the U.S. will listen to Ron Paul (and others) and return to the gold standard ... and what one believes will happen to world inflation rates over time.   To see if a U.S. return to the gold standard is viable, one has to inspect the level of its gold holdings relative to its supply of currency in circulation, see:  World's Gold Reserves and Money Supply Statistics A number of years ago I remember hearing that the total amount of gold in the world would only fill a small barn.  I suspect that, today, it would fill a big barn (with a very strong floor).  The slide show referenced says that there are currently 30,160 tons of gold in the world ... of which the United States owns 8,965.6 tons (29.7%). At $1,900 per ounce, these U.S. holdings would be worth about $598 billion while the amount of U.S. currency in circulation is $974.8 billion.  This suggests that, to justify a return to the gold standard at parity would require that the price of gold to rise by at least 79% ... to about $3,400 per ounce ... just to back the existing currency in circulation.  Backing the entire M1 money supply (including demand deposits), but probably not needed, would require our gold to price-inflate to about $6,375.

Do I think that this is going to happen?  No.  First, I don't think Ron Paul will be elected President and I don't think that we will return to the gold standard ... Fort Know would be emptied in a trice.  And I am always skeptical of listening to and acting on sleezy TV and radio ads.  But it sure seems that the current rate of inflation in the price of gold seems to be trying to get us there.