Thursday, May 13, 2010

"Gold - The 'Canary in the Coal Mine' for Paper Currencies"

Sydney M. Williams

Thought of the Day
“Gold – The ‘Canary in the Coal Mine’ for Paper Currencies”
May 13, 2010

The most impressive thing about the New York Stock Exchange (at least in my opinion) is that millions of dollars of securities change hands without the presence of lawyers and without the signing of documents. Over the phone, or through e-mail, or IM, or via the internet, one can place an order to buy 50,000 shares of Microsoft and the order gets executed at a price in line with the client’s wishes and a report, within seconds or minutes, is sent via the same medium in which the order was received – a $1,500,000 transaction, without a lawyer! It is always been so, and has become so commonplace that we take these transactions for granted. But a $200,000 house or a $25,000 car cannot be purchased without papers being signed and, in the case of a house, a lawyer present. What permits such trust and ease of transaction is confidence in the financial system and trust in the exchanges and counter parties.

Today, as debt-financed government spending is increasingly critical to western economies, such transactions reflect an inherent trust in currencies. Recently, there has been a growing confusion (either intentional or not) on the part of many policy leaders implying solvency crises are nothing more than liquidity crises. A liquidity crisis can be resolved with injections of capital. The cash will serve to tide the company, or country, over until the natural forces of an improving economy allows the debt to be re-paid. A solvency crisis also demands a cash infusion, but also suggests the company, or country, is bankrupt and is in need of restructuring – a reduction of costs and elimination, in whole or in part, of their debt obligations. In the United States, the most obvious current examples are Freddie Mac and Fannie Mae. California may be another. A number of the Mediterranean European nations would also qualify.

The problem with the state throwing money at bankrupt entities is that ultimately the currency is debased; so that a difficult, but manageable, problem becomes far more severe.

Watching the price of gold on Monday was instructional. On Sunday evening the European Union finance ministers announced €750 billion in loans and guarantees, as a measure of their will to defend the Euro. Markets on Monday, as expected, responded positively. The DJIA was up 404 points, or 3.9%, the biggest point rally since March 23, 2009. In sympathy, the yield on the Ten-Year Treasury rose by 11 basis points. Yet gold, which early in the day had been down $22.00, rallied in the afternoon and closed down only $10.00, at $1200, suggesting the markets fear of paper currencies.

There is little doubt that Washington had to inject funds into the system a year and a half ago. The risk was real that the financial system could have melted down. It also appears that something similar may have been happening in Europe, though credit markets had not seized up to the extent they had in the fall of 2008. However, LIBOR, over last week has risen by 40% to 42 basis points, a substantial increase, but far below the 465 basis point level it traded at in September-October 2008. Even so, it is now at the highest level it has been since last August. So liquidity was necessary and was provided, but the problems are structural – Greece, for all intents, is bankrupt. Without serious cutbacks in entitlement expenses, it is hard to conceive that normal economic growth will be adequate to pay back what they owe. In the United States, one could make the same argument regarding Fannie Mae, Freddie Mac and, in fact, California. These entities are not having liquidity problems; they are insolvent. Both FNM and FRE are necessary to the housing industry, as they now account for about 90% of the mortgage origination market. But they are requiring enormous continued infusions of money, and their operations demand increasing oversight and regulation. The existing system has manifested the worst consequences of cronyism, which explains Senator Dodd’s decision to exclude them from his pending financial reform bill. In their current form, they continue to ask for only minimal down payments making them a sequestered entitlement. Their balance sheets should either be incorporated fully into the Federal Government’s budget, or they should be spun off as private, regulated businesses – a doubtful possibility in today’s market.

The risk policy makers run, as they pump billions of Dollars/Euros into failing enterprises – treating the symptom, not the cause – will be a debasement of the currency, which will cause investors and consumers to lose confidence, thereby threatening capital markets. An honest acknowledgement of insolvent institutions is the first step toward redemption.

While capital markets have been exposed as having cracks and no one doubts the need to repair those problems, on balance they have served us well – Main Street as well as Wall Street. What does work, though, should be left alone. We, in the West, have been the fortunate beneficiaries of a capital markets system that, at its heart, is based upon confidence and trust. Anything that engenders that confidence must be viewed skeptically, and that includes the risk of expanding paper currencies (sanitized, or not) at unmanageable rates. The penalty is exorbitant inflation. The price of gold is “the canary in the coal mine”; its rise needs to be taken seriously.

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