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There were a few great discussions going on in the
last thread and so I thought I'd rejuvenate it with a fresh count!
Early on in the thread Hawks5999 quoted me and OG from Yo Warren B, you
are so OG! and then asked a question:
FOFOA: "Gold would not be valuable if one person owned
all of it. It is most valuable in its widest distribution possible, the
wealth reserve, which requires a much higher valuation than it has right
now."
Buffet: "This type of investment requires an expanding pool of
buyers, who, in turn, are enticed because they believe the buying pool will
expand still further."
Hawks5999: "Can you break down the nuance between these two
statements? Because they sound like they are both saying the same thing to
me. Sorry for being dense if it's really obvious."
Here was my reply:
Hello Hawks,
Great replies from Max, JR and
others, by the way!
It's not really obvious, but I'll try to break it down even further for you.
As JR pointed out, price and value are different things. Price is determined
at the margin. Think stock to flow ratios with the ratio acting as a governor
on the price in both directions.
Warren's stocks have relatively objective valuations through common metrics
like earnings, operating cash flow and the sum value of their component
parts. This is kind of like the NAV for GLD and PHYS. If the price falls too
far below that valuation (it is undervalued), the stock to flow ratio will
rise constricting the amount of flow (supply) at the margin where price is
discovered. If the price is higher than the valuation (it is overvalued), the
ratio will collapse flooding the market with shares.
Now compare that with gold which has no similar objective valuation. Of all
the possible "unproductive assets" out there, gold has the highest
stock to flow ratio because of its unique, singular properties. To think
about it simply, price is determined at the margin—the flow—while
value resides primarily with the stock(holders).
Does this make any sense? If gold is as undervalued as I say it
is, then we should expect the s/f ratio to explode, constricting the flow
(supply) at the margin.
Can you see how viewing price and value from this angle puts the onus on the
stock holders at least as much as on the pool of new buyers?
"Correlation does
not imply causation"
In light of this new perspective, we can see that price can converge with
value through the actions of either the current stock holders or
the pool of new buyers. And when valuation is of the relatively objective
variety, as it is with OG's stocks, it is usually a combination of both.
But in the case of gold, where value is entirely subjective, this is not
necessarily the case. In fact, I would even propose to you that,
subjectively, those who already possess the physical gold value it higher
than those who don't yet hold it. Ergo, the explosion of price to the level
of value is more likely to be brought about by the existing stock holders
exploding the stock to flow ratio toward infinity for a period of time than
by a stampede of panicked savers driving the price higher and higher.
Cont…
2/4
ANOTHER: "People wondered how the physical gold market could be
"cornered" when its currency price wasn't rising and no shortages
were showing up? The CBs were becoming the primary suppliers by replacing
openly held gold with CB certificates. This action has helped keep gold **flowing**
during a time that trading would have locked up.
(Gold has always been funny in that way. So many people worldwide think of it
as money, it tends to dry up [to cease flowing] as the price rises.)
Westerners should not be too upset with the CBs actions, they are buying you
time!"
Me: "Gold would not be valuable if one person owned all of it. It is
most valuable in its widest distribution possible, the wealth reserve, which
requires a much higher valuation than it has right now."
"Gold the wealth reserve" means A) only physical gold, and B) in
its widest distribution… "which
requires a much higher valuation than it has right now."
"Correlation does not imply causation." Gold in its most valuable
role correlates with it being in wide distribution, but it is not necessarily
caused by that. Are you starting to see yet? Perhaps gold's functional
change will cause its widest distribution, not the other way around.
Today's "gold" encompasses many other things. Ask any investor what
percentage they have in gold and whatever they tell you will likely include
mining shares, GLD, silver, maybe some platinum, and possibly not even ANY
discrete, unambiguous pieces of physical gold. This is an important concept
to grasp, that "gold" today is a bastardized term and the $PoG does not have anything to do with "gold the
wealth reserve—which means physical gold only."
People see the "paper gold market" working today and so they think
that it can work all the way up. Like we'll go from $2,000 to $3,000 to
$4,000 and so on all the way up to $55K. They think that as the pool of new
buyers flood into today's "gold" the shorts (or the bullion banks)
will simply have to cover their exposure and bid for any physical they need
until the price gets high enough for them to get it.
In many ways today's "gold" does need an expanding pool of
buyers. But here's the main difference between OG's stocks and physical
gold. From my 2010 backwardation
post:
Dollars bidding on MSFT stock set the value of that stock. If dollars are
frantically bidding on MSFT (high velocity), the stock skyrockets. If dollars
stop bidding for MSFT all at once (low velocity), the price falls to zero.
This is true for everything in the world **except gold**.
Gold bids for dollars. If gold stops bidding for dollars (low gold velocity),
the price (in gold) of a dollar falls to zero.
And from yet another angle we can put the onus on the existing stock holders
rather than a pool of new buyers.
Cont…
3/4
In the post above you just heard OG talk about three major categories of
investments which are, basically, stocks, bonds and "unproductive
assets". Through the singular properties of gold (durability, fungibility, divisibility, lack of industrial uses, CBs
have it, etc…) along with the focal point principle, we can go along
with Warren and focus on only gold as the third major "competitor".
Now in just three weeks I've written posts about both the King of Bonds and
the King of Stocks dissing bonds. That should tell you something about bonds,
no? So let's say it's mainly between stocks and gold at this point. As I have
pointed out, stocks are for investors and gold is for savers. Savers
outnumber investors by a longshot, and previously it was bonds that did it
for the savers.
So now we've got all these homeless savers that will need to choose between
stocks and gold (or else sit tight in bonds waiting to be sheared like either
the Greek debt holders or Zimbabwe pensioners). This bunch is NEVER going to
choose today's "gold" (the $PoG) en
masse. They will likely end up splitting the difference and going 50/50 in
stocks and bonds (or cash) while a few put 5% in GLD.
So what I don't foresee is a stampede by those homeless savers into
today's "gold". There may well be another mini-stampede like we had
in August, but it will display many characteristics of a bubble, including
the volatility and the downside, which savers don't like. Savers aren't
looking for the next XX-bagger and they don't like beta, so they are a hard
sell for both OG and the $PoG. Savers simply want a
nonfluctuating asset… preferably in real
terms.
So Freegold, newly stabilized at a plateau stasis
of ~$55K in constant dollars, will be very appealing to them. Funny to think
that they'll buy gold en mass at $55K but not while it's only $1700, but hey,
c'est la vie. As KindofBlue
wrote: "Early adopters [of the next reference point for purchasing
power] are being handsomely rewarded."
But once you realize that gold's highest value and widest distribution are
correlated but not necessarily causally related in the obvious direction, the
question then becomes how we get from here to there.
As I said (because ANOTHER taught me), "Gold bids for dollars. If
gold stops bidding for dollars (low gold velocity), the price (in gold) of a
dollar falls to zero." So you see, there
doesn't need to be a stampede into today's "gold" for real,
physical gold to become "priceless". ANOTHER wrote, "Gold!
It is the only medium that currencies do not "move thru". It is the
only Money that cannot be valued by currencies. It is gold that denominates
currency. It is to say "gold moves thru paper currencies"."
So now I'm looking only at physical gold **IN SIZE**, the kind of size that
represents entities that know WHY they are holding gold (i.e., not for paper
profits). And I'm wondering when physical gold will stop moving through paper
currencies, at least at parity with today's "gold", the $PoG. And I think that will probably happen when the $PoG goes too low. OBA has a neat theory about that.
Look at Buffet's piece above. He's shunning bonds but keeping his cash in
bills. That's what the savers are doing while they decide where to deploy
that cash. All the financial advisors across the land are advising savers to
hold some cash, because they just know there will be some deals soon.
And for the really big money, that means T-bills, just like the $20B
Berkshire is holding. And when a trade gets that crowded it chases the yield
right away, which is why the T-bills are heading to sub-zero yields.
Cont…
4/4
This is the rush out of future-dated debt into Here&Now
cash (T-bills for the really big $$$). It's the bank run shoebox
under-mattress effect en masse. This makes the dollar look (temporarily)
strong and today's "gold" (the $PoG) look
weak by comparison, gold bug protestations notwithstanding. So just imagine
another quick run-up like July/Aug. to, say, $2,333 correlating with a big
spike in the USDX/$IRX (price) and then a crash in the $PoG
down to ~$1,000 or lower. How hated would today's "gold" be by the
homeless savers then? That's some serious beta!
So that's why I said in the post, "ALL TRADERS dump ALL gold,
paper, physical, whatever, in my scenario. It has nothing to do with
insiders. It has to do with traders and weak hands." And at the same
time… because the return is surprisingly shitty all of a sudden… "physical
gold **IN SIZE**, the kind of size that represents entities that know WHY
they are holding gold" … "stops bidding for dollars (low gold
velocity), the price (in gold) of a dollar falls to zero."
This is when the stock to flow ratio explodes to infinity and physical gold
goes into hiding, when the price (the $PoG aka
today's "gold") gets too low to support parity between it and
"gold the wealth reserve, which means physical gold only."
FOA predicted something like this as well:
FOA (06/12/00; 19:48:25MT - usagold.com msg#26)
Put your cards on the table!
The current paper gold world will die (burn) as its value to users erodes,
not increases!
…Again, most everyone in the Western Gold bug game is running with the
ball in the wrong direction.
…So who is in danger of being hurt as this unfolds?
That's right, the Western paper gold long! I'm not talking about just the US
market! This is about the entire world gold market as we know it today. The
real play will be for the ones that get out in front of the move by owning
physical…
It seems every Gold bug sees only half the trade and has great faith that contract
law will favor a short squeeze. Yet, none of them see where it is the long
that will be dumping and forcing the discount!
The point is, there is no price discovery market for
"gold the wealth reserve" that could even require an
expanding pool of buyers. There's only the stock to flow ratio of physical
gold (gold the wealth reserve) as a tiny component part of the wide $PoG basket, today's (bastardized) "gold", a
ratio which is already very high and struggling to keep from going infinite
(parabolic). [Any stock with "zero" flow has an
"infinite" s/f ratio because in the function r=s/f, as f approaches
zero, r approaches infinity.] A rising $PoG
"stretches" the existing flow making it "larger" in
currency terms and keeping it from falling to zero. But what if the $PoG suddenly dips below even the cost of mining gold?
What is that cost today?
Once the flow of "gold the wealth reserve" (physical gold only) is
credibly reestablished at the revalued Freegold
price, the savers will eat it up like hotcakes! Ergo, "its widest
distribution possible."
"Correlation does not imply causation."
Hope this helps!
Sincerely,
FOFOA
Then victorthecleaner wrote:
FOFOA, fantastic! Why don't you make this an official posting?
No problem, Vic, here you go.
We also had a newcomer
show up with a repost from the Gold Standard Institute website which kicked
off a nice discussion about various hard money proposals and prescriptions
versus emergent Freegold.
The next day, Victor wrote another outstanding piece on his own blog called Currency Wars:
Why The United States Cannot Return To A Gold Standard. In
it he addresses one of the main proposals in Jim Rickards'
book, Currency Wars. Victor starts
off by asking if Rickards' proposal is even
possible, and then answers his own question with this: "The answer is
No. But why not? ...The answer is that the existence of the Euro prevents the
United States from returning to a gold standard."
Here are a few highlights, but please go read Victor's post in
its entirety:
Rickards advertises the return to the gold standard
in particular with the claim that the first country that makes this step,
would gain a considerable international advantage through the gain in
confidence in its currency.
The problem with this statement is that the advantage of the first adopter is
no longer available. The first step was made as early as 1999, and it was
done by somebody else: by the Euro (€). It was accomplished in a
fashion slightly more sophisticated than just a plain old-fashioned backing
of the currency with gold at a fixed exchange rate: The Eurosystem
of Central Banks, i.e. the European Central Bank (ECB) together with the
National Central Banks of the member countries of the Euro zone, account for
their gold reserve at the current market price of gold in €.
[…]
From these balance sheets, we can see that there is no advantage of early
adoption that could be captured by the United States. The Euro zone has
already anticipated this step, and the Euro enjoys an even more robust gold
backing. In fact, all else being equal, the comparative advantage of the
€ over the US$ increases with an increasing price of gold.
[…]
■ In
the United States, according to Rickards’ proposal, the government or the
Federal Reserve guarantees that one US$ can always be redeemed for 1/7000 of
an ounce of gold. The key to this guarantee is that the government pays out
the gold even if there is no private participant in the market who is willing
to sell her or his gold for this price. Even if the free market values gold
higher than US$ 7000 per ounce at some point in the future, the United States
Government is still required to redeem one US$ for 1/7000 ounces of gold
(this is the point of having a gold standard after all). How clever is that?
[…]
■
Since the ECB has never claimed that the Euro were as good as gold, they need
not redeem any Euros for gold. If somebody purchases gold with their Euros,
these Euros continue to circulate. The Euro is explicitly advertised as a
transactional currency, but not as a store of value. Gold is the store of
value. This is Free Gold, the separation of the store of value from the
medium of exchange, i.e. from the credit money that forms the transactional
currency (also see Section 7 of The Many Values
of Gold and FOFOA’s The Long Road to Freegold).
Let us finally remark that the price of US$ 7000 per ounce as proposed by Rickards merely serves as an example and that none of our
arguments depends on this precise figure.
The material presented in this section was inspired by Rickards’
book and by contrasting it with FOFOA’s point of view. See, for
example, Euro Gold, Party Like
It’s MTM Time, Reference Point
Gold Update 1 and Reference Point
Revolution.
[…]
In order to illustrate this effect, let us assume that the official US gold
price and the free market price in Euros diverge considerably. We estimate
that the US$ and the € presently have purchasing power parity at
an exchange rate of US$ 1.20 per € 1.00. As a very rough
simplification, let us say that one hour of labour
costs € 30.00 in the Euro zone and, at parity, it costs the same amount
in the United States: US$ 36.00. Also at parity, the official US gold price
of US$ 7000 per ounce corresponds to € 5833 per ounce. Let us further
assume the free market price of gold in the Euro zone differs substantially:
€ 8750 per ounce.
Firstly, there is the obvious arbitrage: The smart money in the Euro zone can
simply take € 5833, exchange them for US$ 7000 in the foreign exchange
market, go straight to the Federal Reserve and redeem this sum for one ounce
of gold which is immediately shipped back to Europe. There is therefore a
continuous flow of gold from the United States to Europe unless the currency exchange
rate adjusts to $US 0.80 per € 1.00. This is the exchange rate at which
the official US price of gold of US$ 7000 per ounce agrees with the European
free market price of € 8750 per ounce.
Although this adjustment of the exchange rate indeed eliminates the arbitrage
opportunity, it does not stop the outflow of gold from the United States to
Europe. The problem is that the currency exchange rate now deviates from the
purchasing power parity of US$ 1.20 per € 1.00. At the
no-gold-arbitrage exchange rate of US$ 0.80 per € 1.00, one hour of
European labour can be offered in the United States
for US$ 24.00 whereas American labour still costs
US$ 36.00 per hour. The United States therefore run an increasing trade
deficit compared with the Euro zone. Under the proposed gold standard, the
Europeans who initially receive US$ for their exports, can immediately cash
in and redeem their US$ for gold.
The flow of gold from the United States to Europe therefore persists
regardless of the currency exchange rate. If it is not a consequence of
direct price arbitrage, then it follows from an imbalance of the trade
accounts. In either case, physical gold reserves are drained from the United
States...
[…]
We see that the arrangement that is now proposed by Rickards,
basically used to exist during the Bretton Woods
period. In the late 1950s, the credit volume in US dollars was already
growing so quickly that the official US gold price and the free market price
of gold outside the United States started to diverge. Although the Western
European allies helped to stabilize the gold standard, it inevitably failed
because of the arbitrage and the trade imbalances sketched above. If a gold
standard of this type is established again while a major trade block openly
advertises a free market price of gold, it would probably collapse even
sooner than it did in the 1960s.
In 1971, the United States chose to terminate the gold convertibility of the
US dollar rather than to revalue gold in US dollars. We refer to
FOFOA’s It’s the
Flow, Stupid for the reasoning that lead to this decision. Finally,
please see his Once Upon A Time for
more details on the London Gold Pool. Side Note:
In fairness to Jim, Rickards/FOFOA reader Aquilus
asked Jim at a book signing event about a fixed versus floating gold price.
Because Aquilus knows that I, too, appreciate Jim's
work, he emailed me the following report:
"The more interesting part is that I had been trying to get him to
give me a straight answer on the notion (from his book) that once gold is
revalued to "the right price" the Fed would then step in and defend
that price (in a narrow range). He had been avoiding a straight answer for
months, but I finally got one yesterday while he was signing the book - in a
short one on one conversation.
When I asked him how he could seriously believe that a fixed price could be
defended when dollars continue to be issued and credit created, and how that
would be different from the old London Gold Pool, he smiled and said,
"no, no, you see, the defended price would indeed have to change every
year or else it would not work."
So, basically, he's still somewhere in the "we can semi-control"
the price with this Fed-defense of an adjustable price, as far as I can
tell."
UPDATE: Also see Blondie's comments
right under the post. Thanks for sharing, Blondie. …The ECB, however,
which does not guarantee a redemption of the Euro
for a fixed weight of gold, can engage in various types of Gold Open Market Operations.
Firstly, in absence of a liquid market for physical gold in Euros, the ECB
can act as a market maker and, say, bid for a fixed weight of gold at €
8745 per ounce and offer to sell a fixed weight at € 8755. If they bid
for and offer more than 10 tonnes each at any time,
they are able to make a liquid market for physical gold in Euros, a market in
which other central banks can trade the quantities that typically arise in
the settlement of international trade balances. As soon as it turns out that
there is more weight of gold sold than it is bought (or vice versa), the ECB
adjusts the bid and offer prices accordingly. This amounts to assisting the
price discovery for large quantities of physical gold while the reserve of
the Eurosystem remains essentially unchanged.
Let us stress that as of February 2012, there exists no liquid private market
for physical gold in € in which bid and offer would be quoted for
tranches of 10 tonnes or more at any time. In fact,
this is apparently not even possible in the London market in which gold is
traded in US$:
James G. Rickards,
Currency Wars, page 26:
In ordinary gold trading, a large bloc trade of as
little as ten tons would have to be arranged in utmost secrecy in order not
to send the market price through the roof [...]
Secondly, the ECB can manage a dirty float of
the gold price in order to smooth fluctuations in the currency exchange
rates, in order to influence the domestic price level, or even in order to
affect the competitiveness of goods and services from the Euro zone in the
international market. If they expand the monetary base and purchase gold in
the private market, they lower the exchange rate of the Euro relative to
gold, creating domestic consumer price inflation and rendering exports more
competitive and imports more expensive. Conversely, if they sell a part of
their gold reserve and cancel the base money they receive, they raise the
exchange rate of the Euro relative to gold, reducing consumer price inflation
and rendering exports less competitive and imports cheaper.
In particular, if things ever turned hostile, for example because not only a
book author but also some government officials started talking about
‘confiscating’ the gold owned by foreign countries, the dirty
float could be used in order to terminate Rickards’
experiment with the new gold standard in the United States at any time,
simply by expanding the monetary base in € and purchasing physical gold
in the open market. This operation is always possible because it relies only
on the ability to expand the € money supply, but does not require any
existing official gold reserve. In fact, any major currency area or trade
block who exports enough goods and services for which there exists a global demand,
can make this move. So far, none of them has.
[…]
It should be clear from Sections 2 and 3 above that it is the high price of
gold in terms of US$ or € that inspires confidence in these currencies
rather than the question of whether the currency unit is redeemable for a
fixed weight of gold. (There is one caveat though: as long as the US gold
reserve is owned by the highly indebted government rather than by the Federal
Reserve, it will never inspire the full possible confidence.)
[…]
Let us summarize what is the key point of Rickards’
proposal to return to a gold standard at a substantially higher price of gold
in US dollars. It is not the idea of the gold standard that the currency unit
would be backed by a fixed weight of gold. This would not be sustainable in
the long run, and it would eventually fail for the same reasons for which the
London Gold Pool failed. It is rather the revaluation of gold in US dollar
terms that inspires confidence and that addresses many of the present issues
such as recapitalizing the banking system.
We finally refer to FOFOA’s How is that
Different From Freegold for
another response to a very similar question.
Nice work once again, Victor! As Ari would say, it's good to have help carrying this water. B^D
Sincerely,
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