Eurobonds - does Gold have a role?

A politician up a tree is a very resourceful creature. Ditto for central bankers! So in this vein, yet another proposal is being trial-ballooned with the aim of saving Euroland from its debt mess while off-loading some of the responsibility from Germany who so far has stridently resisted becoming its one and only financial backstop. The idea is to attract bond purchases and at low rates (similar to Germany's but without Germany becoming the guarantor) by getting European nations to pledge their gold as collateral for these bond issues. It must have been difficult for some of these bankers, finance ministers and heads of state to admit a possible role for that "barbarous" relic, gold.
The problem is that, at current prices, the Euro nations' gold stash is worth "only" about $2.3 Trillion. That just happens to be about the size of Italy's debt alone! So, It might look like a heady sum at first but let's take a look at what the gold price would need to be to back the debt of some of the countries at the centre of the debt fiasco using each nation's stated gold reserves. I've added a few others in for comparison as well. Source data is from the World Gold Council, the World Bank and Eurostat.

From the chart it is readily apparent that gold prices would need to be between $20,000 and $100,000 per ounce to back the debt of any of these countries. Of course, some of the proposals to date suggest backing only some of each nation's debt (maybe half, say). But on the other hand, some of the gold in the reserves is likely already pledged or leased and therefore "encumbered". Nevertheless, the true scale of the problem becomes evident when even the United States with its supposedly unencumbered gargantuan holdings of  8,133 metric tons of gold would need a $60,000 price per ounce to cover its $15 Trillion debt.

J.P. Morgan and the Zero Sum Game

It's interesting to observe the performance of the Fed's and Wall Street's favorite sons. They have all the connections and insider info that most of us could only dream of and they routinely make lots of money, quarter by quarter. But are they really so smart?
If money supply and growth were constant, investing should be a zero-sum game. That is, if someone is making money, someone has to be losing money. But in these times of rampant money creation, it is possible for most of us to win most of the time, at least in nominal inflated dollars. The part that I find interesting is that every time the money creation machine slows down a bit (we are awaiting QE3/4, no?) and markets waver a bit, folks like Jamie Dimon often start tripping over their shoelaces, even though the odds are seemingly so stacked in their favor. It happened with Lehman and AIG a few years ago. Maybe Morgan won't go that way. But I can't help thinking that these mega-remunerated CEO's could not run a real business in the real world without being back-stopped by bailouts when things go wrong, without counting on huge money creation off which they can skim almost risk-less profits and without their priveleged connections and information sources. After all, who runs the Federal Reserve?
Yes, in spite of the supposed odds, they still manage to make mistakes, really big ones, sometimes. Sometimes big enough to bankrupt the company. How long can the world's central banks accelerate their printing and backstopping operations to keep these guys and our supposed economy afloat? Methinks that the zero-sum game will return with a vengeance one of these days.

How well are foreign holders of US$ debt doing?

Folks have fretted over the possibility of a huge U.S. bond bubble for a long time. In particular, some have warned that China, in particular, might suddenly begin dumping large amounts of accumulated Treasuries. In fact, China has been dumping US Treasuries and the Federal Reserve has been forced to compensate by printing up the difference (quantitative easing) to a good degree. See here. But so far this exit from the US$ has been controlled. Partly this may be because other major currencies are also having trouble so that the US$ is seen as the best of the worst. Since the 2008 crisis, Central Banks around the world have been pumping - buying their own debt - see here. So, while the US debt infrastructure may slowly be crumbling, a fast look at the recent performance of US$ denominated long-term debt (30 year Treasuries) from the perspective of foreign holders shows that for the time being everything looks pretty good.

The above chart depicts the performance of 30-Year US Treasury Bonds in terms of the US$ index. Typical foreign holders make money in their own currencies if 1) the US$ rises and 2) the Bonds themselves rise. By charting the US$ index divided by the bond yield, we get an approximation of the combined effects of bond price and US$ price relative to other currencies.

Thus, while many participants may be nervously glancing at the EXIT doors to spot an incipient mass exodus which would precipitate an implosion of the so-called bubble, those exiting now are actually doing very well from an investment perspective. Anyway, the current focus is still on Europe - Greece, Portugal, Italy, etc. But markets will eventually turn to the biggest debtor of them all - the U.S.

Backing the U.S. Dollar with Gold

There has been a lot of speculation regarding the resurrection of the gold standard to address a possible crisis of confidence in the U.S. dollar should markets begin to focus on increasing U.S. indebtedness and growing fiscal imbalances. Potentially, this elephant in the room is a lot bigger than the European debt situation. This speculation is partly driven by the very large purported U.S. gold reserves of 8133 metric tonnes or approximately 262 million troy ounces which comprises by far the largest gold holdings of any nation. Could this gold hoard rescue the U.S. from a potential financial catastrophe down the road? Maybe, but only if gold were revalued much, much higher. Some observers suggest that monetary aggregates such as M1, M2 or M3 should be used to determine the price to which gold would need to rise for markets to accept a gold-backed dollar if a crisis of confidence were to occur.  I decided to use figures for the U.S. National Debt instead. More importantly, I wanted to see how the debt of the U.S. compared to its gold reserves historically.

Between 1900 and 1940, U.S. indebtedness was typically two to ten times the gold price. Between 1940 and 1970 U.S. debt rose sharply and this ratio ballooned to almost 30. That's when the big catch-up in gold prices occurred and by 1980 the ratio was brought back down to 5 or so. After this the ratio zoomed again up to 65 or so by 2001-2002 at which point Gold entered another catch-up phase which continues to this day with the ratio at about 37 in early 2012. If we assume that the ratio will reach 5 again, gold would need to be $12,000 today.

But . . . U.S. debt continues to rise and some have speculated that not all the gold in Fort Knox and elsewhere is there anymore! H'm m m.

John Corzine can't find the money!

So John Corzine, former Chairman and CEO of MF Global, has no idea where the firm's missing money might be found. Interesting people, the likes of John Corzine. These are the people under whose direction all sorts of clever investment vehicles and trading algorithms have been created over the years. We've been assured by these same folks that countless derivatives and trading mechanisms are OK, in fact - good. When challenged, we sometimes get told that we don't have the necessary basics to understand these complex instruments. But of course he has an MBA and is a former Goldman Sachs Chairman and CEO and even former U.S. Senator and State Governor as well. His membership in the Bilderberg Group further establishes his luminary qualifications. Along the way, he and his cohorts have earned hundreds of millions of dollars for the services they have rendered humanity. Anyway, I digress.
My question is this: If a firm like MF Global with all its computer and investment resources and savvy can't find its investors' missing money, wouldn't you have to conclude that either they are crooks and are lying or that they really didn't understand their business so well, after all, and might not even understand basic accounting that well either? Well, there seem to be enough facts on the table already to support the "crooks" part, as the firm is known to have co-mingled its clients' funds with the firm's funds when they "needed" it. Further investigations will likely reveal a lot more illegalities, cover-ups, lying etc. But I suspect my other suspicion has played a role, too. Do these guys really know what they are doing? If they did, they wouldn't be in the pickle they are in right now, I would think.
As a matter of fact, I suspect that John Corzine would have plenty of company if some of his peers in the investment, brokerage, insurance and banking businesses were suddenly cut off from the bailout/stimulus/insider info train of the Federal Reserve. Most of their Ponzi schemes would collapse within a week. Look what happened to Lehman. But it doesn't help if for whatever reason you are no longer part of the club?

Can the U.S. ever really balance its budget?

Every once in a while, I visit the US Debt Clock Site to get a handle on the current U.S. fiscal and general financial situation. An interesting exercise is to see what kind of cuts would be necessary to achieve a balanced budget, that is, to reduce the deficit to zero and thereby to stop adding to the national debt every year. Well, we have to come up with more than $1,300 Billion in cuts. Gee, lots of ways to go about this but one combination is to eliminate defense altogether (scuttle the ships, close all the bases, send the soldiers home without pay or pensions, abrogate all military supply contracts, etc., and pray for peace - this saves $700B), then eliminate all federal pensions (too bad, folks - just sink or swim- this saves another $214B), then also eliminate all income security programs - too bad for all you unemployed folks! - this saves another $407B). That was easy, eh? Well, of course, politically, this is not doable! Furthermore, such cuts would devastate the economy, and with it, tax revenues, so you would need to cut much more than this to compensate. You see where I'm going.
Ok, let's try another angle - we'll just raise income taxes and do some minor expenditure cutting. So, if we doubled everyone's income taxes and eliminated all federal pensions, that might almost also do it, but whoops, since nobody has any money to spend, the economy would tank and therefore incomes and tax revenues would be affected, so we would need to raise taxes far more and/or cut more programs. H'mmm, nothing seems to work here, right?
Did you see the Congressional Super-Committee at work? Boy, did they ever agree on cuts, huh? Well, now you know why. It isn't doable, not politically, anyway. Not likely possible socially, either. Americans would be torching Capitol Hill, the White House, etc. So what do you think the U.S. will do/are doing? There is only one answer, and it is not a real solution but it kicks the can down the road, albeit at an even higher price down that road. The U.S., as well as most other western nations will simply continue to print ever vaster sums of money to make up for fiscal shortfalls. The likes of the Federal Reserve, the European Central Bank (ECB) and the Bank of Japan will just keep buying up more of their governments' IOU's (bonds and bills and other clever securities). This will happen under various guises such as QE1, 2,3,4, . . n, Operation Twist, "liquidity injections", whatever. The middle class will will get poorer and poorer and most will not understand why. The printing will continue until folks recognize that their currencies are being destroyed and enough folks lose their confidence in it, that a wholesale dumping of currency gets underway. Too bad the fiscal redress was not seriously attempted 20 to 30 years ago, when some of the measures needed might, while painful, still have been politically and socially doable given a committed President and Congress. But are the politicians wholly to blame for what has happened? No, I don't think so. After all, did voters elect politicians with "responsible" platforms or those that promised combinations of government programs and tax structures that were way too good to be true? As the old saying goes - It's hard to cheat an honest man".

Why do Nations Borrow ?

As the world gets increasingly mired in debt, Every day I listen to economists, talking heads as well as regular folks using terms such as "excessive debt", "manageable debt", "excellent (or poor) debt to GDP ratio", "low deficit", manageable deficit", etc. Debt and deficits may or may not be manageable but it is a slippery slope at best. Shakespeare had it right in Hamlet: "Neither a borrower nor a lender be; For loan oft loses both itself and friend, And borrowing dulls the edge of husbandry." When individuals enter into significant debt, it is usually to borrow money for a major purchase, such as a home with the idea of repaying this debt over one's working life. Many people, maybe most, especially in the past, have done exactly that. In addition, they have usually saved some money along the way and managed to leave something for their children. Individuals normally don't have chronic deficits because this would mean that such an individual was adding to his outstanding debt every year, rather than paying off the debt. This wouldn't make sense and would lead to bankruptcy. So, do individuals need to borrow in the first place? Well, maybe not, but if the idea is to acquire something like a home early on in one's career, or to start a business, this can make sense, provided that the repayment terms are not too onerous relative to one's earnings and spending habits and of course, that the loan is repaid.

But why would nations ever need to borrow, especially chronically (i.e. run deficits)? Since a nation is a very large collection of individuals, it would seem that whatever expenditures governments contemplate should be paid for by passing the hat around, usually in the form of taxes and duties. If you need to spend more, tax more. Why would any nation ever want to borrow money so future taxpayers would be on the hook? And why would you borrow chronically? Will it be easier to pay those taxes tomorrow than today? Do nations around the world expect some big infusion of money down the road from the equivalent of rich old aunt Millie passing away? Let's face it. Short of possibly having to repel an invading force where the very existence of a nation is at stake, sovereign borrowing just does not make any sense. What's worse, future interest payments will only serve to reduce the outlays available to provide citizens with government services. No, in fact, nations should purposefully run small surpluses for that rainy day to defray the unusually high costs of repelling aggressors or to deal with natural or man-made disasters.

Well, in fact, I think most of us know why nations borrow. It is human nature combined with politics. Politicians love to bribe the citizenry with their own or future taxpayers' money. And citizens? For the most part, they love to bribed. They vote for a better today, for their pet projects, etc. Tomorrow's pain is something that can be set aside for . . . tomorrow.  Unfortunately, history demonstrates that with time, borrowing costs mount and lenders become scarce, leading to debt crises. Then central banks are urged to print some of the shortfalls. This process is often disguised to reduce the rate at which confidence is eroding. We engage in stimulus, quantitative easing, blah, blah, blah. Eventually, as confidence erodes even more, increasingly massive printing becomes the only short-term measure available to avoid banking and institutional failures and finally city, state and sovereign failures. Unfortunately, history also shows that such a remedy eventually destroys that nation's currency in addition to that nation ultimately succumbing economically. If a minor currency is destroyed in this way, that country's transactions and trade can be substituted in some other currency, such as the $US. However, should that currency be the world's principal reserve currency . . .