Monday, January 9, 2017

Some back and forth with Koos Jansen on Gold Market

Dual pricing of Gold

Date:22nd Dec 2016.

Freegold theory says that existence of paper gold brings the price of gold down. This happens because some physical gold demand goes into paper demand. How much of it is true, is up for debate.

There are other parts of the theory which show that Gold's value should be much higher, but has been held down due to the paper gold system. Basically Gold was never completely free from the shackles of paper gold. First the gold standard, resulted in the currency acting as the paper gold. Then after it's demise the paper gold system was created. I guess because people feel safer holding paper promises to gold than real gold. Basically, the price of gold has remained suppressed forever.

Now the theory predicts that everything is in place for freegold to arise from the ashes of the current system. It just needs the paper gold system to die out. It will die out naturally when the gold is not available for sale at the market price. The market price is set by the sellers and buyers of paper gold, ie the price is set in the west. And the east buys at that price. As the price goes down due to selling of paper/physical in the west, the buying of physical increases in the west.

Note that the east does not buy the paper much.

So if anytime it happens that the west sells a lot of paper/physical gold, and the demand from the east increases so much that the sellers in the west cannot meet that demand. The problem will happen due to the difference between the paper demand in the east. So if west sells too much, the physical sold will be less than the amount of physical that the east wants to buy at that price. This will cause the price of physical to rise, but similar demand for paper will not materialize. This will break the price of gold.

When the price of gold breaks, the gold will go in hiding. It will only be available in the black market at a much higher price. The market price will become only of paper gold, causing it to crash. I don't expect the price of gold to reach its freegold value immediately. It will take some time as more and more people will start buying gold. Yes that time has not come so don't expect this to be true at the moment.

Now the theory says that the "Giants" know the real value of gold. This is supported by the fact that price of every other rare stuff is rising in the world. Price of paintings by masters, extremely rare gems, etc are rising in price. Gold should be there, but it cannot be there, as the price of gold is too low. The gold available on the market cannot bear the "Giants". If they tried to buy on the open market the price of gold would rise too fast. Now "Giants" are patient, they don't need to buy gold. They can just buy other things, which they are doing.

But what if a huge stack of gold became available off the market. Will they want to pay a premium for it? I think they will, because they already have too much disposable income. Another had given an example where somebody had put up a stack of 9 million ounces, to be sold unbroken. It was bought at a premium by somebody, ie off the market. Maybe somebody can check that story out. It's a huge amount of money, buying around 280 tonnes of gold at once. It was more than the lots that UK sold. At the time gold was around 300$/oz, so the amount was 2.7 Billion at the time, and if it was sold on the market, it would have caused the price to go down, like the UK selling did. But somebody bought the whole thing at a premium. Makes sense through the freegold lens, otherwise doesn't.

Koos Jansen responded with the following

Dated: 22nd Dec 2016

I think what you miss is whether owners of "gold" are aware they own physical gold or a derivative of gold (unallocated, futures, etc). I think everybody is perfectly aware what he/she owns, and there is not a single instance where a physical gold payment is settled with paper gold (ie try to sell unallocated on the streets of India).

You write:

"First the gold standard, resulted in the currency acting as the paper gold."
I can see your point but the credit created from gold during the gold standard was "thought by the owners of the credit to be physical gold". Just like now, people that have money in the bank "think they own (ie) 10,000 dollars", they have no idea only (roughly) 5 % "exists". That's a difference.

Credit creation by banks does not equal paper gold creation.

You write:

"I guess because people feel safer holding paper promises to gold than real gold."

Please name me one example of someone that feels like this. If they hold a paper promise apparently they're not interested in gold, only in making dollars.

You write:

"It will die out naturally when the gold is not available for sale at the market price."

Again, this is a myth. There will always be gold available in the (wholesale) market. Hefty premiums and delays can arise, but there will always be sellers if the price is right (no sellers, price will go up).

You write:

"The market price is set by the sellers and buyers of paper gold."

How do you know? The price is not set by the large trading volumes (IMO). The thing is this, paper gold (paper hereafter) and physical gold (phyz hereafter) are two different products that are connected in price through the mechanism of 'delivery' for futures and 'allocation' for unallocated accounts. And, I just stated all owners of the two products are perfectly aware which type they own.

Of course the essence is phyz - as physical gold is phyz, and the underlying asset of futures and unallocated is also phyz. So how can paper determine the the price of phyz in the long run (short term different story, different post)? Suppose, 'they' smack the price of paper to $500 an ounce. Is there anybody on this planet then required to buy or sell gold at $500 an ounce? No (except miners, different post). That's why my theory is that in the long run 'physical supply and demand' is leading (for both paper and phyz). see

You write:

"So if anytime it happens that the west sells a lot of paper/physical gold, and the demand from the east increases so much that the sellers in the west cannot meet that demand."

What is the West selling? Paper or phyz? If the East is buying phyz 'someone' must be selling phyz.

The West cannot meet demand? Is there any proof? Did the price explode? COMEX default? LBMA implosion? Supply is there, what else are the Chinese importing?

You write:

"the physical sold will be less than the amount of physical that the east wants to buy at that price. This will cause the price of physical to rise, but similar demand for paper will not materialize. This will break the price of gold."

You mean the price of gold (paper and phyz) can, simply, go up? Without something breaking. What can exactly break?

You write:

"When the price of gold breaks, the gold will go in hiding. It will only be available in the black market at a much higher price. The market price will become only of paper gold, causing it to crash. I don't expect the price of gold to reach its freegold value immediately. It will take some time as more and more people will start buying gold. Yes that time has not come so don't expect this to be true at the moment."

This makes no sense to me. Why would it hide? Gold is immortal, there is 180,000 tonnes above ground. why would it stop moving?
This all sound like some wet dream of phyz holders. Not real to me.

You write:

"...At the time gold was around 300$/oz, so the amount was 2.7Billion at the time, and if it was sold on the market, it would have caused the price to go down,"

Why would a sell cause the price to go down? The size/volume of phyz sold and bought does not mean the price should go up or down. The forces between supply and demand set the price. Volume has nothing to do with it.
If APPL shares are traded a lot, should the price rise or all?
Volume doesn't mean anything.


My thesis remains: if the price of gold is suppressed long term phyz needs to be supplied by CBs in the open market. Paper can only influence short term moves (with consequences).

I replied with the following

Dated: 23rd Dec 2016

"I think what you miss is whether owners of "gold" are aware they own physical gold or a derivative of gold (unallocated, futures, etc)."

Why do you think I believe that Paper buyers are not aware that they are not buying physical. Actually that is the difference between the west and the east. The west is comfortable with buying paper. They have been living with paper gold for much longer than a century.

"The thing is this, paper gold (paper hereafter) and physical gold (phyz hereafter) are two different products"

Exactly. And this is the reason why the price can only match when there are sellers providing phyz at the price that is required to keep the demand and supply dynamics of paper. It is the phyz that cannot be printed, so the availability of phyz is of utmost importance for the price match. If the phyz isn't there, the price match will break.

"that are connected in price through the mechanism of 'delivery' for futures and 'allocation' for unallocated accounts"

I don't care about the future price of gold, that is what is predicted by the futures. The current price depends only on the current delivery (or allocation) of physical. No physical, no price. The gold goes in hiding.

You do agree with the demand and supply setting the price of gold. But you think that the paper buyers and sellers follow the price set by the phyz. I have the opposite opinion. Can you tell me exactly how the price is defined by the market? Does it happen that first physical guys put show their demand and availability, and then set the price, and then the rest of the paper guys use that price for their trading. Or is it dynamic. The paper guys do their thing and the physical guys do their thing.

I think what happens is every body is buying and selling and the critical thing for the price is that the price is being set in the west. The east is using that price to buy or sell gold. The east mostly buys the phyz, they don't sell much, at least the selling is consumed locally. They don't deal much with paper. So the phyz buy and supply is not really setting the price. The buyers (east) are just using the price set by the sellers (west). The buyers only buy when the price is low. That means there is some entity that acts as a soak to keep the slack in demand and supply when there is more demand than availability. That is where FOFOA's coat check theory comes in and GLD fits in.

If the price is set in the west and the main phyz buyers are missing from the equation what is setting the price, the obvious answer is paper. Yes there is some buying and selling of physical going on too. But that is not very material to the price mechanism, as the major buyers are missing from the equation.

"The West cannot meet demand? Is there any proof? Did the price explode? COMEX default? LBMA implosion? Supply is there, what else are the Chinese importing?"

Great. Looking for the proof of future in the present. Its like looking for the proof of a market crash in the period of boom :-).

"You mean the price of gold (paper and phyz) can, simply, go up? Without something breaking. What can exactly break? "

If the west cannot supply the gold that the east demands at the price quoted by the west, will there be a disconnect? The GLD has been draining. That is why look at it, to see when will it be closed down. That will be the moment. Of-course you cannot prepare when that happens, it is already too late.

"This makes no sense to me. Why would it hide? Gold is immortal, there is 180,000 tonnes above ground. why would it stop moving?"

So continuing from the previous argument that west sets the price and east buys at that price. What happens if the price is set too low. It can happen if people are selling too much paper, and GLD has run out (yes that is a requirement, that is why we watch it :-)). The demand from the east will outstrip the supply by the west. The East will be willing to pay a lot more, when they find that gold is not available at the given price, because they will know that something has broken.

"Why would a sell cause the price to go down? The size/volume of phyz sold and bought does not mean the price should go up or down. The forces between supply and demand set the price. Volume has nothing to do with it.
If APPL shares are traded a lot, should the price rise or all?
Volume doesn't mean anything. "

You mean to say selling is equal to trading??? If a lot of gold is sold in the open market, there will be a lot more gold available for the buyers. That gold must be absorbed by somebody. It will depend on how slowly the gold is sold. Remember that very few people in the west buy phyz. The phyz would then need to be absorbed by some investors who are willing to allocate that much of money to buying the phyz. The price will drop. Of course it will get absorbed by the GLD nowadays, but at that time it did not exist.

You don't remember the selling of gold by UK, and how it pushed the price of gold down? Or do you think there was another mechanism for that.

Koos sent the following Image in support of Price follows Flow Theory

I dissected it here

Dated: 4th Jan 2016

Lets look at the data here.
I am looking at the net flow/ETF Flow and gold price. Not import/export.
I think the bars above 0 means net buying and below 0 means net selling.
I do not think that ETF flow is more important for price, although it is more important than phyz. XAUUSD is most important but that probably cannot be monitored.

Interesting thing about the ETF flow chart is that it is much more positive than negative till Dec12. Then selling dominates till Dec15. Still buying is positive flow is overwhelming compared to negative flow. This I think is due to ETF creation. I think that a lot of it has been created than has been destroyed. Like gold gets mined but not consumed. So overall flow for gold is also positive.

Lets look at different periods.
Jan 05 - Jul05 - price is stable, net flow negative, ETF stable.
Jul05 - Oct 05 - price rising, net flow negative.
Oct05 - May06 - price rising, net flow positive. ETF positive, peak buying Dec05
Above shows net flow is lagging price. Not clear for ETF flow.

May06 - Jul07 - price more or less stable, net flow positive, except Oct 06. ETF positive.
Aug07 - Mar08 - price rising, net flow positive. Note that net flow was negative during Aug07. ETF mostly positive.
Shows mildly that flow is lagging price.

Mar08 - May08 - price down, net flow positive. ETF negative in Apr08, in sync with price drop. Or maybe huge sale XAUUSD, causing sale in ETF.

Jun08 - Jul08 - price up, net flow positive. ETF positive.
Jul08 - Oct08 - Price down, net flow negative. ETF peak on Sept08.
Possible correlation with flow.

Nov08 - Sept11 - Price up, net flow positive, except Jan11, Feb11, Sept11, Oct11. ETF flow is much more mixed.
Flow gets negative after the price starts dropping. Shows flow is lagging price.
Sept11 - Oct12 - Price fluctuates wildly, Flow remains mostly positive.
Oct12 - Dec13 - Price drops, Flow turns negative from Jan 13.
A 3 months delay in flow reaction of price drop.
This is the most delay that can be seen from the data.

The rest of the data is also similar, where flow is following the price drop. But later the variation is too much. But it is always the flow following the price change, not the other way.

Reasons why Gold market will break

Dated: 7th Jan 2017

There are a few things that you have to understand first

1) Price is set by west
2) Most physical is bought in the east, at prices set by west. ie physical buying depends largely on the east.

The following flows logically from the first two truths.
3) So Physical flow depends on the Price, rather than Price depending on Physical Flow.

If you have trouble understanding the above logic, it is going to be tough understanding the rest. Because it depends on 3).

There is another rule, that we must agree on.
A) Paper flow is separate from Physical flow. ie paper can and is normally bought and sold separately from Physical. ie Paper flow has nothing to do with Physical flow.

Now there are several consequences

To keep the paper market relevant, the bullion banks must manage the flow of gold, so that if the demand from East is too low at the set price they must hold it, and if the demand is too high they must provide it. This means there is a need to buffer the gold during the slack in flow. This is where GLD comes in.

I don't mean to say that GLD is the complete buffer, but that it is the visible part of the buffer. If GLD closes down, the paper market will become vulnerable to breaking.

Anytime the demand from east goes so high, that the bullion banks cannot supply the required gold, the price of gold must rise to meet that demand. But we already know that the paper gold sells in a different plane A). So it will put a strain in the paper market, as the paper will be required to sell at a higher price than what the paper market is able to bear. This will force the ETFs and other sponsors to buy the paper at the higher price, to keep their paper relevant. If this situation continues for too long, the ETFs will close down and/or go bankrupt.

Once that situation happens the paper gold market will be broken.

Now we have to think of why the demand from East will get too high. There can be several reasons.

1) The mine production goes too low. This is happening, as prices are too low for spending to find new mines. Eventually the current mines will get exhausted.
2) The price goes too low. The east buys based on the price. The lower it is the more volume they will buy.
3) Trust in paper evaporates. This could be triggered by trust in other paper instruments. This could be a global phenomenon in the coming crisis.

This is why freegolders watch GLD 1) and become happy when the price of gold drops 2). But that might be mute, as the coming crisis could trigger a loss in trust in paper instruments 3).

Wednesday, December 28, 2016

Some thoughts on current monetary crisis

This is an old article (23 Feb 2012), but was posted in the wrong place.

Money basically means a transactional unit that can be used for buying stuff. What this transaction unit can be is pretty open.

Most commonly money is the national currency. This currency has a force of law behind it, and everybody is expected to accept it for a monetary transaction. The force of law accords the currency with very high liquidity. These days all currencies in the world are paper currencies. Such currencies do not really have any value apart from its government controlled value. I say controlled, because ultimately the market place decides what value it has. The government can just guide the market to arrive at a given value. The government can increase/decrease the pool of currency, which will in effect reduce/increase the value of the currency. Or it can change the Reserve Requirement for the banks to change the value of the currency.

Reserve Requirement creates a multiplier effect. Say a bank gets 100$ from a customer and CRR is 10%. So the bank is free to loan out 90$. This is obviously paid to another person, who will save it in the bank. So bank will get it back. Again the bank will loan out 81$, which is 90% of 90$. If you take this to conclusion bank will finally have all the 100$ as reserve and it would have given 900$ as loan to other people. So in effect the base currency has expanded 10 times.

One thing to remember with currencies, they are based on faith, and tend to lose value when people lose trust in the government. So any monetary crisis will trigger political changes.

Money can be other items as well, for example gold and silver. Gold is supposed to be a commodity, but it does not behave like a commodity. It's price does not depend on the production and consumption (where recovery would be prohibitively expensive), as both are way too small. World Wide annual Production is around 1.5% of the total stock, so the price does not depend on the production. Consumption of gold is just around 10% of the production, ie .15%. So we can see that it is not a normal commodity.

Silver shares some characteristics, but the consumption of silver has increased a lot, it is now nearly 80% of the production. So although the stocks are still increasing, the price does have a small dependency on production and consumption.

These commodities which are used like currencies have some associated transactional costs, eg taxes and profit margins of dealers. The higher the transactional cost the lower the liquidity. Gold generally has a higher liquidity compared to silver. In India the taxes for silver are higher and generally dealers will charge a bigger margin for silver than gold.

So what does gold behave like? Lets look at a different concept now.

What is Saving? When you produce something, you use it to buy things that you consume. If you produce more than you consume, the difference is called credit. If you consume more than you produce the difference is called debit. If you have credit you can save it so that you can consume the credit later, or invest it in the hope that you can get more credit than you invested at some future time. If you have debit you have to take on a debt to pay for your consumption, and pay for excess consumption later along with some extra interest.

We might think that putting the money (or credit) in bank is saving. But its not. It is investment. You are giving your money to the bank to lend it out and hopefully make a profit and then give you interest on your credit.

So if putting your money in bank is not saving, then what saving is? Lets say you consume 1 Kg of rice every week. And with your monthly income you save enough to buy 4 Kgs of Rice more than what you would need this month. If you do buy the 4Kg Rice you are saving your excess production, for consuming it next month. So buying any commodity in excess of your consumption can be construed as saving. Saving is basically deferred consumption.

Rice is fine for saving your credit for maybe a year or two, but then you have to also think about storage costs, and the possibility of loss because of the damage. If you wanted to save your credit for a longer time, with minimal storage costs, you could buy a commodity that survives longer. Gold is exactly suited for this task. Infact this is the only significant use of gold, even when it is used as jewelry, it is just a store of value. Gold also tends to have a more stable value over time when compared to other commodities, because it is not like a commodity.

Gold does not act like a commodity so its value also cannot be evaluated in the same way as a commodity. We will look at the factors that affect its value now. Remember we are not considering the price in terms of a currency, but the value in terms of other commodities. This value can be potentially different for different individuals, depending on what they generally consume, or what they want their savings for. But in general the value tends to be similar.

First the factors that affect a commodity.
1) Amount of Production - Over Production of the commodity will tend to reduce its price.
2) Cost of production - This fixes the minimum price.
3) Consumption - More consumption will increase price.

The above three factors apply to a commodity, but Gold is not like a commodity, so lets see what factors affects its value. Its value depends on value of other things rather than its own production and consumption.

1) Technology - Automation allows production to become cheaper. This depresses the value of the products in real terms, and consequently in terms of Gold. This happens because Technology has so far not affected the value of gold much.

2) Prosperity - Technology increases productivity which increases earning of people. While simultaneously making the basic necessities cheaper. The two together creates a lot of saving potential. The higher saving potential should lead to more storage in gold, but since gold quantity stays nearly same, the value of gold should increase, in comparison of other stuff.

3) Population - As number of people increase, there are more people that would want to store their excess production as gold for rainy day scenarios. Increasing the value of gold. This is traded off with increase of value of other commodities, because more people means more value of the commodities. So Population would probably not have any special effect on the value of gold.

4) Perception - When people see gold as an investment, it does not match up. It does not produce anything. It forever stays what it was. This can cause the price of gold to reduce substantially, as people don't think of gold as a good "Investment".

5) Paper Gold - When there are instruments that are not gold but are considered as good an "investment" as gold, the price can be substantially reduced. Currently there is nearly as much "paper gold" as there is physical gold. This might not look much, until you realize that most of the physical gold is with people that hoard it away, while most of the paper gold is used only for trading. The transaction ratio is more than 20 times physical. A large part of this transaction might be just plain investment in nature, and not really a proxy for physical gold. So the depression may not be exactly 20 times.

If we look at the value of gold with respect to other things and not in respect of currency, we see that the gold has not risen in value since 1970. Before that it may have even dropped in value, since 1930s. So for the last 80 years gold has been relatively stable, while technology has improved phenomenally. Productivity and prosperity have gone up phenomenally. Why is it that gold has not gone up anywhere near where it should. The reason is paper gold and perception in much of the western world has changed a lot. Actually the increase in the value of gold during the last decade could be attributed to the rise in eastern economies, which perceive gold to be valuable.

Now we have some basic facts that will help us look at the current monetary crisis. Some more terms will be added as we go. I will split the remaining into several components of the crisis. Any one of them could trigger loss of faith.

A) American Ballooning Deficit and USD's Reserve Status
B) OTC derivatives bubble and the Banking system.
C) European Sovereign Debt Crisis.

A) American Ballooning Deficit and USD's Reserve Status

America is suffering from exponentially exploding Deficit for at least 10 years. For the last 3 years the Deficit has crossed the point of no return. Some facts about the Deficit crisis.

1) Budget Deficit has reached more than a Trillion Dollars per year, which is around 10% of the total GDP now. Compare this with the growth rate of <3% and the nominal inflation at 3%.

2) American Total external Debt has crossed the GDP, and growing at 10% every year.

3) American Total Debt has crossed 2 times the GDP. Total Debt is in excess of 50Trillions.

4) US doubled their monetary base between 2008 and 2009. This will cause a devaluation of USD to half, when the money hits the market via the multiplier effect. Further Money Printing has not stopped and in fact will increase a lot, if the money does not enter the market.

Such dire straits mean that US will not be ever able to pay back the trillions of Treasury Debt that it has issued to other nations for transaction purposes.

Much of US's problem is related to USD's Reserve Status. Reserve Status means that other countries need USDs for their transactions. This has forced other countries to collect more and more USDs. China being the major holder of T-Bills. This has been propping up the American Economy for the last 20 years. They have been slowly moving away from producing anything tangible, and are mostly using the Reserve Status for their livelihood. Their prosperity is linked with the Reserve Status of USD.

Other countries need the USD for any transactions. If a country (like China) produces
surplus stuff it will get more USDs. The USDs being a Paper Currency does not automatically increase the value of Chinese currency, and provides no braking. Similarly USD's can be printed without restriction so it does not stop America from consuming so much by depressing their currency.

Now most countries (including China) understand that the money they have in T-Bills is not going to ever be worth anything. This is the reason why Countries in Asia are doing Currency Swap agreements. Currency Swap agreements allow a country to trade without using USDs. There are now several such Swap agreements. China and Russia are at the forefront of these agreements. Even India has got into some of these. All big economies of Asia, China, Japan, Russia, India are into it.

These currency swap agreements are a big problem for the Reserve Status of USD.

The main reason why USD is the reserve currency, is because all major oil producing countries trade only in USD. Iraq had tried to get out of USD, and had started trading in Euro. This is what had forced USA to attack Iraq. It was not the oil. It was the loss of Reserve Status. If America had not done anything, other countries would also have followed suit. We have the same situation now with Iran selling its oil in other currencies, including Yuan (Remnibi). If US does not do anything about it the OPEC countries will also follow suit. OPEC countries also know that USD is worthless in the long run. They are just very afraid of American retaliation. I would think that this hatred encourages these countries to sponsor Terrorism.

Some people think that Iraq attack was for the oil or for creating expenses for their defense industries. This may be partially true. But the fact is that the war had cost america a lot of money, and the budget deficit it caused is irreparable. The govt would not have made the war if it was not a matter of life and death for America.

In any case there is a very high possibility of America attacking Iran. After that we can expect Oil prices to increase a lot. It is still a matter of life and death for them.

Now we have seen that USDs Reserve Status is under attack. And it is going to lose the status in the very near future. Now the question arises what will take its place. There are several options.
1) Yuan
2) Euro
3) SDR
4) Gold Standard
5) Gold (RPG)

1) Yuan is currently a tightly controlled currency. The Chinese govt will have to loosen its control over the currency before any other country will consider it as the reserve currency. Although several small countries are considering it, but more important are the bigger economies. They will not accept it. One of the reason is also the communist govt there. Even if they do accept it, we will get into the same situation, but with China at the helm instead of USA. Who will feel safe in this situation? China will do worse things with its agencies compared to what USA did with CIA.

2) Euro is a very good currency. But the European Union Members are currently under fire because of their past spending habits. Using the Euro will again cause similar issues as the current USD. But in this case the whole of the Euro will be the beneficiary. It will kind of force everybody to join the EU, and start using Euro internally. Bad for weaker economies that cannot devalue against it. Current crisis is causing the ECB to print money just like US, and driving it to make it cheaper. The same is happening for all currencies of developed countries.

3) SDR is a paper currency based on a basket of currencies. The SDR will float against all other currencies. This would be a good idea except that its not a natural solution. It's biases will depend a lot on who defines it. China does not want SDR because it knows that the western economics will load the dice against them. It is the strongest economy now, but won't get the treatment it should under the regime.

4) Gold Standard is often recommended by people as a future replacement for currency for internal use. If (and its a big if) all countries started using gold as a standard, then we will have this situation. Infact most countries before the 20th century were on either silver or gold standard.

It worked well earlier because Technology growth was slow, so the rate at which the value of gold increased was quite slow. This changed in the beginning of 20th century.

When a country goes on a gold standard it fixes the price of the currency on a fixed amount of gold. The fix is such that the currency is higher valued than the gold amount. This makes people use the currency in preference of gold. With time due to technological innovations, commodities become cheaper compared to gold. But the prices quoted for commodities does not reduce, as retailers would prefer to keep the balance. Slowly the Currency becomes devalued compared to gold. Now people prefer to keep gold instead of the currency. This results in a crisis, and the fix needs to be fixed again. Actually gold does not appreciate as much as it should and the currency does not depreciate as much as it should due to the existence of the fix. Since 20th century the fix has become unworkable due to speed of technological growth.

The World Reserve Currency USD was on a Gold standard till 1971, it had kept the price of gold low artificially. When that fix was broken, the gold appreciated immediately to several times. It reached its peak in 1980. After this gold price was somehow controlled to prevent loss of faith in USDs. The manipulation was very successful till 2001, when it was brought to near production costs, and it reached near the price of gold in 1975. Since then it has been steadily growing, possibly due to the introduction of Euros which uses gold as a prominent reserve. Part of the reason for the gold price depreciation was the monumental increase in paper gold instruments.

Basically Gold Standard cannot be implemented in this century within any country.

5) Gold RPG is a natural Reserve mechanism. Reference Point Gold means that all currencies are indexed based on their gold prices. The higher the price of gold in a currency the lesser its value. This allows every country to trade in their individual currencies and its perceived stability. If some country produces much more, they will start collecting a lot of currency, then they will buy goods particularly gold with these. When more gold enters the country, the price of gold will drop in their currency, causing their currency to become stronger. Buying will become cheaper but selling will become more difficult for the country applying a sort of brake to the excess production. The reverse will happen for import surplus countries.

This scheme is workable and doesn't suffer the defects of Gold Standard, as it does not fix the value of currencies, but it floats against currencies, and provides only a reference point.

Regardless of which route the world goes, all the paper instruments that are marked in USD will go down with it. Including gold instruments. This will force a revaluation of Gold.

B) OTC derivatives bubble and the Banking system.
In good times plenty of credit is created. This credit is deposited in banks. Banks due to the multiplier effect are able to lend out the money to people. In most countries the Reserve Requirement is too low. Since the banks want to make more money, and don't want money sitting in their banks, they have every incentive to lend it out. This easy money results in loans that are not good. Eventually some of the loans go bad, and the bank loses money on it.

When Debt goes beyond a threshold, there is no chance that money will be returned to the banks. The threshold depends on the percentage of money people save, the interest rate, and the ratio of existing credit to debt. The system does not crash at this point. The system crashes when the bad debt extinguishes the reserve with the bank.

One might think that the crash of 2008 was due to housing bubble, and they would be right. But the housing loans were involved in what is called OTC Derivatives.

The OTC bubble was less than 700Trillion dollars at the time of the last collapse, with a lot more value. Now it has crossed 700Trillions with a lot less value.

The OTC Derivatives bubble has not yet abated, even after the crash because the US government shoved the problem under the rug by printing money and feeding it to the banks. This bubble is due for another collapse, which will get another large infusion. Eventually the people will realize that things are not going to improve and the system will collapse. Lots of large western banks will go down. Much of the paper instruments will become trash. Banks in eastern economies will also suffer if they have much exposure to such instruments.

The problem cannot be delayed for very long. I would think 3 years is the tops, with very high chance that the collapse happens much sooner.

C) European Sovereign Debt Crisis.
European Sovereign Debt Crisis is not really a very big problem, but it might act as a trigger which could result in the collapse of banks. The problem is not really that PIIGS nations can default, this happens and is actually better for the countries involved. eg Ireland, Iceland. There are several other countries. The problem really is trying to paper over the problem with printed money. That will cause hyperinflation ala Zimbabwe. ECB has not been trying to print the money, but is being forced to print, to show that it is concerned about the fate of individual European countries.

Greece is going to default, and so are some of the other PIIGS countries. When Greece defaults the ECB will make sure to pay the banks enough money so they don't collapse due to their exposure. This might be done for Portugal also. But eventually this scheme will fail.

Conclusions and Actions
We have established the following major points above.
1) USD is in real danger of losing its reserve status value.
2) Western banks are on the verge of collapse, and actually depend on continued USD strength for their survival.
3) Gold value is probably quite a bit lower than what it should be.

Lets see what each of these points mean for us.

1) USD is in real danger of losing its reserve status value.
When USD loses its reserve status, there is a lot of USD in several countries, that will be forced into US. Consequently there will be lot more USDs than required. Also the USG has been printing a lot of it. These problems together will likely cause USDs to drastically lose purchasing power, and there will be hyperinflation in USD terms. This will be very problematic for US Citizens or people living inside US. Most will lose their livelihoods. US also does not have much production of real goods and mostly it imports things. This will make it very difficult for people their to survive. It is possible that there will be large scale rioting and arson.

It is imperative for American people to invest their worth in physical goods and properties. Lack of real production means that food will be very difficult to get. People should store food for at least a year or have means to get out of the country. People should also think about personal protection because if they have the means to survive they will be good targets for arson.

2) Western banks are on the verge of collapse
This is very much tied to the USD strength, as the major banks of the world and their OTC bubble has been held together by huge printing of USDs. This means that people should get their money out of bank instruments and into physical objects or stocks of companies that produce physical things. Depending on the health of their countries financial condition and production status they may have to take other precautions. eg India is mildly in deficit but it can feed its population. So food will not be a problem. Money in any bank that is either western or private bank that may have a lot of exposure may be dangerous places to store money. Public banks maybe safer as govt is likely to save them.

3) Gold value is probably quite a bit lower than what it should be.
Lets try to evaluate what the factor of depression is.
First thing to understand is that the value of gold (or indeed any object) depends on the flow, and not on the actual physical amounts. This means that the gold trading is a very good estimation of how much the value should be.
At present times physical to paper gold is 1:20. This would mean that gold should be 20 times the present value.
But this is not real because much of the trading would not be actually a proxy for actual gold. Lets say that factor is 4. So the real markup is now 5 times.
Another factor is perception. At present perception in much of the world is not very positive for gold this is another cause for gold value being less. Of course this factor will not turn over night, and will take some time maybe years to achieve full potential. This maybe a factor of 2-3.

So if we take it into consideration, the price of gold will jump around 5 times around the time when all gold paper becomes worthless. Of course there will be jump in silver too, but the magnitude maybe smaller.

Due to massive jump in value, perception will also increase. So the value is likely to go 7-8 times and then will possibly still go further up over the next months/years.

The above does not take into consideration the possibility that RPG may become the future international trade mechanism. If RPG gets incorporated into international dealings, then gold will become a preferred form of reserve, and all central banks will try to obtain some of it. This will increase the flow and might add another factor of two for the duration when banks are striving to obtain it. This might take some time maybe a few years.

It would be a good idea to convert as much as possible into gold, because in the near future its not only going to be a great store of value, but it will probably beat most investments.

It will probably beat real estate hands down.

Further reading: This is a blog dedicated to the concept of FreeGold RPG. It clarified the concept of money and gold in my mind. Do note that the Factor of 4, that I speculated about, is my own. The blog people do not believe that any such factor exists, and they do know a lot more about gold trading than me. That is my fudge factor to make the numbers look realistic :-). This is a repository of articles on present financial situation. Articles vary a lot in quality, but you do get a lot of information, if you pick properly.

Saturday, June 6, 2015

Freegold: How will we get there

In this article I am trying to see how the present will move towards Freegold. This will be modified as I get comments from other more knowledgeable people.

Currently we see that the Bond bubble is breaking down. But the problem at present is that there is a liquidity crunch as US is not printing. Also the panic is not widespread so there is no urgent need to get out of Bonds. It is very slowly deleveraging. The slow deleveraging is causing the Dollar to rise.

I think that the following steps would happen before and during the coming crisis. Note these will not be clean phases. A lot of overlap will be happening. As different people will be doing different things.

1) Eventually the panic should spread causing the bond market to implode. At that point a lot of money from Bonds will move into Dollars. Due to this movement dollar will rise very fast. People will probably sell other currencies to make money by moving into Dollar. The reduction of other currencies will only be with respect to the Dollar. It could happen that paper gold crashes during this phase, but I am not so sure.

2) Eventually people will start moving out of the Dollar. This will happen differently in the US and other currency zones. In US people will be buying stuff, causing inflation to rise in the US. While non-americans will be selling Dollars to buy other currencies. Non currencies like XAU, Bitcoins will also be bought, causing these to rise pretty fast. This will be the phase that will trigger hyperinflation in USD. I am not sure how it will play out with Pound and Yen. I don't think they will crash during this phase. Gold will definitely go into hiding in this phase.

3) Once USD is crashing towards hyperinflation, people will get worried about their currencies and they will want to get into something real at this point most currencies will start to fall and prices will rise. This is the phase when XAU will crash, as gold will not be available and the two will get out of sync.

4) Gold revaluation happens on the Shanghai Gold Exchange. Several Central Banks will sell gold to reduce the liquidity in the market caused due to people getting out of their own currencies. Britain and Japan will not have enough gold to reduce enough liquidity, and also they have already printed a lot of their currencies which will cause a massive devaluation. This is the phase that is firmly in the Freegold Economic Order.

Thursday, March 19, 2015

Some basics of currency, inflation, and deflation

We use currency a lot. It is different in every jurisdiction. In India we use Rupees. This article focuses on several questions regarding currency. What it is, how it is created, how it affects economy etc.

What is Currency?

The 1000 note says that the RBI Governer "promises to pay the bearer the sum of one thousand rupees". What would the RBI pay you if you were to take the 1000. Actually you will get another 1000. They would laugh at you if your note is not mutilated :-).

The Currency Notes are a form of receipt that the govt gives you for services rendered. Say you are a govt employee. They can be used to pay to the govt for the services that the govt renders to you. The govt collects tax as a payment for the services it provides you.

How is Currency created

The govt creates (or prints) the currency when it spends it on (or rather issues the debt to) its employees or buys stuff for the govt use, or uses services of other private entities. It destroys the currency (or the debt) when people pay taxes. In reality that same currency may be reused for payment. But it is easier and more accurate to think of the two as creation and destruction of govt debt. If the two balance, then no new currency is put into the market, and we can say that no (new) printing has occurred. This means that all the currency we see in the market is a debt issued by the govt. So for the people to use Currency as Medium of Exchange it must first be created by the govt, by over spending. So the budgets cannot really balance perfectly in a growing economy. There will be too little currency and there will be deflation. The concept of origination of inflation and deflation we will deal next.

Inflation and Deflation

In essence Currency Notes are a Debt Note that Govt issues, not unlike debt bonds. If you have 1000 ₹ then the govt owes you 1000 worth of services. The value of those Debt notes is decided by the common man. They decide how much milk or rice they would provide for the note. Of course this depends on the availability of currency notes in circulation. If people looking for rice have more notes than yesterday, then the value of notes will fall, and correspondingly the price of rice will rise. This is basically the Quantity theory of money.

Now the Quantity theory of Money includes a term Velocity. This is where the simple notes in circulation point becomes complex. Velocity is a measure of how many times a note changes hands in a year. The lower the velocity, the less the impact of the quantity of money.

Lets see how inflation affects the velocity. Lets say the rice you buy today will keep for a year. Also storage costs and hassle for storing the rice for the year are small. And the inflation rate is high enough that it makes sense to store the rice for the year. It depends on the storage and hassle costs. Lets say you have deflation that is inflation rate is negative. In this case rice will be cheaper tomorrow, so it makes no sense to store the rice. Nobody will buy it. If the inflation rate is low, then some people for whom the storage and hassle cost is low, will buy it. If the inflation rate is very high lots of people will want to store the rice and get rid of the currency. If more people start to buy the rice (and other things) the more the velocity of the currency.

A high inflation rate causes the velocity to increase which can quickly cause a vicious cycle if a lot of currency is already printed. Eventually this should stop, provided no more currency is printed and/or the Central Bank steps in to absorb the liquidity.

If lots of currency is printed but the inflation rate remains low, people will store the excess currency, and it will not get into the market and cause inflation, ie velocity will drop correspondingly. So as more currency is printed, the more it is absorbed, keeping the inflation rate unchanged. This means that just because currency is printed doesn't mean it will cause inflation. This also means that as soon as inflation increases above a threshold, it will cause the inflation to become runaway, upto a point. That point is decided by the amount of money that has been printed. If more printing is done by the Govt, inflation will keep on increasing.

The reason why printing is done by the govt is because it needs to pay its employees. It needs to buy stuff that are required by the govt. The only way to stop printing would be to downsize to the point where spending equals tax collection. Normally govts get into this condition because they are spending too much in the first place. Getting to the point where they do not need to spend, requires a huge downsizing.

Now we have seen that printing the currency does not increase inflation. Then what causes inflation. The inflation is caused at the ground level. It is caused if there is less of something and the demand for that cannot be offset by something else. This causes people to pay more for the object. This would happen if the lower class people have money. So inflation rises only if poor people get more money than they had been having.

There is another mechanism by which inflation can happen. Lets say a country does not produce enough oil to be used by the govt. The govt needs more, in this case it will use its foreign currency reserve to buy the oil in the international market. Lets say the govt does not have enough foreign reserves, then it must sell its own currency to buy foreign currency to buy the oil. The selling of its own currency will cause the value of the currency to go down. Since the oil is required by the country and affects the prices on the ground there will be inflation. If the country is self sufficient this will not cause any inflation at the ground level. The drop in the value of Currency relative to foreign currencies will only affect the prices of imported items. As long as the imported items are not necessary (like oil), it will not cause inflation. This is why even though Ruble is losing value in the foreign markets, there is no inflation on the ground except imported items. This is why it does not affect the poor and lower middle class people there. Actually the Russian case is interesting as the country is a surplus country, so its not like it needs something. The currency is dropping because the speculators are selling Rubles and buying foreign currencies. The Ruble also needs to drop, so that the input costs to oil production can drop inline with the Oil. If Ruble had not dropped with the oil price drop, it would be in trouble, which would have anyway caused the Ruble devaluation.

We see that the world is afraid of Deflation. Deflation is caused when there is not enough demand for the stuff that is produced. This happens when a country produces a lot of goods for foreign consumption, and does not consume enough. It can also happen in certain industries if they are superseded by new technology. If you think of Electronics Industry it seems to be in a perpetual deflation, per item, but the industry as a whole is growing. When we talk about deflation, we are concerned about the whole country's economic output reducing, because of lack of demand. So that the earning gap due to the lack of demand causes layoffs etc. Normally printing is seen to be the answer to the problem of deflation. It is only helpful sometimes for a short time. The problem with current economy is that the deflation effects have been for a long term. And printing has not helped tide it over.

Sunday, May 5, 2013

Bitcoin: What Why and How.

What is Bitcoin
Bitcoin is a virtual currency. It's management is completely decentralized and done by open source software running on millions of nodes on the bitcoin network. The production of bitcoins depends on finding a block of data which has a certain property. When such a block is found the bitcoin network awards the finder with a number of bitcoins. At first the award was 50 bitcoins, but at present it is 25 bitcoins. Every 4 years the award reduces to half. In the first 4 years 10.5 million bitcoins were created. There exists about 11 million bitcoins at the present time. By the year 2140 all the bitcoins (around 21Million) will have been generated.

The creation of bitcoins is controlled through a parameter called difficulty. The difficulty is adjusted in such a way that only one block can be found every 10 minutes. The whole things depends on an algorithm called SHA-256 (Secure Hashing Algorithm version 2 with 256 bit output). This algorithm is as yet unbreakable. Its not clear whether quantum computers would break it. But in any case they are too far off in the future.

The task is to find a block which results in a hash value that has a predetermined number of zeros at the beginning of the 256bit hash output. Since there is no way to determine what block will have this property, so all sorts of blocks must be tried till one such block is found. The difficulty is directly proportional to the number of zeros in the hash. The difficulty is recalculated after every 2016 blocks are generated. This event would be after 14 days if the networks computational capability did not change.

The network's computational capability is calculated in Hashes per second. Currently the network capability is around 75TerraHashes/sec or 75 Trillion hash computations per second. As more computers are added to the network, its capability increases, and the corresponding difficulty must increase so as to keep the block generation capability constant. Currently the difficulty is nearly 9million.

To find the blocks we use a software called miner. It is a software that searches for a block that has the required difficulty. The block is basically a piece of data plus a nonce. This nonce is a 32 bit integer which is incremented every time to get a new block. As such 2^32 blocks can be generated. Hashing functions have the property that even a single bit change will cause the hash output to change completely. So big changes are not really necessary.

Initially people were using their PCs to compute the hashes, and that was enough. Then some people ported the miners to GPUs. These provided a big jump in hashing capability. Next the miners were ported to FPGAs. These resulted in an even bigger jump. The latest machines in town are the ASICs. The CPUs on the PCs are long past their usefulness. You will spend more money on power bills than you will make money from the bitcoins they generate. GPUs are also on the way out. They are profitable at the moment, but in a few short months they will not be anymore.

More info in this link.

Why the interest in Bitcoin
Bitcoin is an internet currency, which has same property as any other Store of Value item. Its supply is more or less fixed. It cannot be generated at will. This makes bitcoin similar to gold, but with a new property of being trade-able in the digital world. Currently it is under the radar for most of the people. As more and more people realize its benefits, its value will increase.

Its value has been related to recent crises. During the Greece crisis its value had risen 35 times, from less than a dollar to 30$, after that it came back down to about 10$, with an effective jump of nearly 15times. Then during Cyprus crisis it jumped from around 12 dollars to 240$, a jump of 20 times, and then settled down at around 130$ presently, an effective jump of 10times. I believe that the jumps have been due to the requirement of moving money offshore during these crisis.

I am expecting that during the coming financial meltdown lots of money will be looking to move. This will attempt to go into bitcoins, as gold will not be available. This will cause bitcoins to jump a whole lot. I would think on an unprecedented scale.

A unique thing about Bitcoins is that they can be traded by speculators, and still retain its store of value property. For gold to be traded, we need to have paper contracts. Since in the future paper contracts for gold will be frowned upon. The traders are likely to move to Bitcoins, and gold will serve as the international reserve. If this is true then bitcoins are poised to become an international currency competing with other currencies of the world.

Currently there are about 11million bitcoins, with the market price of around 140$/bitcoin, the market capitalization is around 1.5Billion$. This is way too less. The market capitalization must grow many many times to achieve the required capitalization. I would expect atleast a 1000times increase in the long term. And around a 100 times during the crisis.

If the price of a single Bitcoin goes to 10,000$, one would think how the trading for smaller items will be done. Actually there is no problem. A single bitcoin is made up of 100 million Satoshi's the smallest unit of bitcoins. At 10,000$s a microBTC will be equivalent to 1 cent. Even at that level Bitcoin can accept a 100times further increase, without it being a problem.

There are two potential problems. One is that the same theory that brings about Bitcoin can be used to create other virtual currencies. Actually there are several now, but none of them are anywhere near Bitcoin. And are not expected to grow up to challenge Bitcoin. As time goes on, it will become more and more difficult for an incumbent to overthrow Bitcoin. The second issue is quantum computing. Quantum computing is still in its infancy. It will be probably at least 20 years before it is able to cause big problems for the current Public Key Cryptography, which is the most vulnerable. By that time we will probably move to QC resistant algorithms. Ultimately Quantum Computers may allow a much faster generation of Bitcoins. This is not a problem in itself.

Both of these do not look very problematic at this time.

Probably the most serious problem is that govts can try to clamp on bitcoin exchanges. These are the entities that allow exchange of bitcoins with local currency. This has been tried by the govt of Canada, and others are thinking about it. But their main motive would be to prevent black marketing in the bitcoin world. These bitcoin exchanges actually allow the govt to make sure people do pay their taxes, and they can track the transactions. People looking to avoid taxes will be trading on other P2P networks. Only time will tell, but I expect that the govt will not try to stop legal exchanges as they result in people using legal methods of transactions. Preventing exchanges will make people move to illegal methods.

Bitcoin is not anonymous. Bitcoin uses the Wallet Address for transactions. This wallet address can be changed for every transaction, but the wallet address can be linked to the IP Address. To avoid using your own IP Address you can use tor to anonymize the transaction completely.

Bitcoin is an open source currency, so stopping it is near impossible. Remember MP3. The Media companies managed to shut down several companies that allowed sharing of MP3, but eventually they had to give up. Same thing will apply to govts, if they try to go against people's will. This does assume that Bitcoin is as useful as MP3s. It is not going to be beneficial for them in the long run. Better would be go along and keep the maximum people in the taxnet.

As compared to gold, gold is expected to not have any taxes once it becomes the international reserve. But bitcoin will continue to attract capital gains tax. This will make Gold a better store of value, but bitcoin should not be a bad store of value.

The last problem with bitcoins is that a certain technical understanding is required at the present time. The situation will improve slowly. There is a bitcoin card introduced recently. Paypal is also thinking of getting into Bitcoins.

Now that I have put some wildly optimistic spin on Bitcoins, lets have a look on how to use them.

How to use Bitcoins
You have to first create a wallet. There are two ways to create them. You can go to any number of internet websites that allow you to create the wallet, or you can download the bitcoin software and create a wallet on your own computer. A wallet is defined by a large number called an address. Bitcoin transactions happen between two wallets. So when you buy some bitcoins, you give a person some money via credit cards, or some other means and your wallet address, and the person transfers bitcoins from his own wallet to your wallet. The amount of bitcoins your wallet contains is known to the network. Because of this nobody can forge your wallet. But if you lose your wallet address you will lose your bitcoins, so it is a good idea to keep it safe somewhere, not easily hackable. Encrypt it preferably.

To obtain bitcoins you can buy them on an exchange or you can also create them. For that you will need to buy a mining hardware. The most advanced machines are ASICs, and are in very high demand these days. The technology is very new so there are delays in making them as well. But hopefully the situation will improve in a few months. Of course the difficulty will rise very fast. But I don't expect it will rise as fast as the value of BTC. It will still be wildly profitable.

There is a tradeoff, if you buy the mining rig, and the crisis comes too fast, you won't be able to collect enough BTCs, so it might be beneficial to directly invest in Bitcoins. If the crisis is far away, it is probably better to go with a mining rig.

Ofcourse the mining rig option is only open for technical people. There are some companies that are providing mining rigs on rental, so they manage and you can earn the BTCs produced by the mining rig and pay the managers some rent.

Friday, January 11, 2013

What happens if Gold Price goes too low?

Many people fear if the gold price will become too low and they will lose their investment. I, on the other hand, am waiting for the Gold price to get too low :-).

People who fear gold prices getting too low are thinking in terms of currency. This is the wrong way to look at gold. Gold is the currency that measures other currencies. Measuring it in terms of other currencies is a mistake.

If you look at the amount of gold held by Central Banks you will notice that they have increased their holdings since 2008. If the value of gold could drop, why would Central Banks increase their holding?
Bron Suchecki of Perth Mint has written a nice summary of the CBs activity over the past decade. You can also look at the data per country, almost every country has increased.

Now lets look at how the price can drop without crisis and why it will be a good thing for physical gold holders.

The first thing to understand is that gold price at the present time does not depend on physical gold demand, it depends on paper gold demand. There is a huge amount of paper gold trading that goes on in the world and it dwarfs the physical gold trading 1,500,000:4,500. My number in previous articles was way too low. Wikipedia also corroborates those numbers.

Currently the price of gold is down, and has been down since Sept 2011. This does not mean that there is no demand for physical gold, it just means that there is little demand for paper gold. If the demand for paper gold keeps on reducing the price of gold will drop. Lets see what will be the consequences of such a drop.

There is 4500mt of gold traded in the world. Of this 2500mt comes from mining and 2000mt is from scrap. Scrap means the gold sold by people. Of the 4500mt, over 2000mt is used in Jewelry. The jewelry use is typically by Asian people. This demand is very inflexible, as in it cannot be replaced by paper gold. Another 1000mt is used by bullion investors. This demand is somewhat flexible, as it can be replaced by paper gold. But note that people who buy physical gold are paying extra costs for it. If they really wanted it for short term trading they would not be buying physical gold and instead would buy paper gold. So the majority of this demand is also inflexible. About 300mt is industrial demand which is very rigid.

It is very likely that if the price of gold goes down demand of physical will go further up. The Indian govt is trying to convince people to buy paper gold, but unfortunately you can't make jewelry from paper gold :-).

Now lets see what other effects happen when the price of gold goes down.

Mines are affected with a low price of gold. There are two kinds of costs that we read about in the mining industry. Cash Costs, that are actual running costs. These costs are minimum, and are required for running the mines. Below these costs the mines will not be able to run. But this is not the actual costs at which the mines will close down. There are other costs involved, exploration, and profits. No business will operate at no profit. Even share holders want profits. The total of these is the Running Cost of a mining company.
Running costs are probably crossing 1500$/oz at the present times. Cash costs were nearly 700$ in 2011, and are now upto 900$-950$/oz. Barrick Gold had a cash cost of only 460$/oz in 2011. The present price of gold is around 1650$/oz. It is expected that the mines will be in deep trouble at 1350$/oz.

What happens if the price of gold is 1350$/oz? Or if the costs of mines increase further owing to inflation, reduction in yield, and reduced exploration.

The mines will start closing down, reducing the mining output. If the Output goes much below the current level, the demand for physical gold will outstrip the production. This can only be managed with a higher price, but the problem is due to a lower price. The demand for physical cannot be reduced by unavailability of physical from mines, because there is a huge above ground stock in common people's hands.

What will happen is that some people will be willing to sell gold at a higher price than what the paper gold market suggests, and Asians (particularly Indians) will be willing to pay the higher price. If this is done commonly and openly, the price of paper gold and the price of physical gold will diverge. It is highly likely that this problem happens in India, because the Indian Physical market is much more active than the rest of the world. At that time true value of paper gold will be revealed which is zero.

Once the paper gold's value is revealed, immediately the value of physical gold will rise. There will be a discontinuity as the physical gold will more or less disappear from the market as lots of money will be after gold, and slowly the real price will be arrived at in the actual market.

Remember the above treatment is done in the case of no crisis situation.

The above case is highly improbable. It is highly likely that if this situation happens, the 1.5million tonnes of paper gold which is equivalent to 70T$, more than the global GDP, will be gone. This will cause a major disturbance in the Economic health of the world. It is highly likely that we will plunge into a crisis situation.

Because of this consequence to the world economy, the price of gold will never be allowed to drop so low that mines start closing down, or people wanting physical are not able to get their physical easily. The price will drop when the crisis happens, in that case lots of paper investments will become worthless, including paper gold. Note: Stocks are not paper investments, but you do need to have the papers in your possession. The crisis will happen overnight as it is a consequence of loss of confidence, which happens overnight.

Another issue is China. China is at present the largest producer and consumer of gold. It is actually turning into a black hole for gold. It has been buying a whole lot of gold via Hong Kong. It is also buying up large mines in South Africa and elsewhere. Rest assured it is not buying these mines to sell the gold in open market. China seems to be intent to have 10,000tons of gold as reserve. Once the effective production of gold (not including gold in Chinese control), gets too low, the economy is in trouble. The Chinese have already shown that they are now, not too much concerned about the economy going south. China was the country that bought US Treasuries in the last decade to allow the system to survive for so long. Since Sept 2011, it has stopped providing that support. Since then China's UST hoard has been reducing.

The countries worst affected by the economic downturn are US, UK and Japan, so these countries can help keep the price of gold up. Of these really US is the only one which can actually do something about it. It seems Europe has also given up. There was no surge in the price of gold before the 4th Jan ECB's quarterly update.

My estimate for the crisis is between 2 to 5 years. Possibly earlier than later. It seems to me that UK will be the first to plunge into crisis, and then trigger the rest.

Monday, October 29, 2012

Understanding Budget Deficits, and how it causes Hyper Inflations

Govt is always a net consumer. The govt taxes the production of its citizens to obtain money for its expenditure. If the taxes collected and the expenditure balance out then the budget is balanced. But we have a problem, people do not want to pay more taxes, the people want some freebies ie subsidies and other free stuff, and the govt is inefficient and govt servants maybe siphoning out the money. This means that its difficult for the govt to balance its budget, and most likely it results in budget deficits.

The Central Banks (except the special case of ECB) are under the directive of the Government. They must provide money to the Government as much as they require. The govt will give some collateral to the bank, in the form of a Debt Note. The Central Bank will then try to sell if off, to whoever may buy it. Normally banks buy them, because they are safe investments. The govt will be able to pay off the loan, because they can issue another debt note to the Central Bank, and the Central Bank will provide the govt money to pay off the loan.

Money is created when the Central Bank gives it to the govt, and it is destroyed when the govt returns money to the Central Bank. Most of the time the Govt is just receiving money from the CB. The money provided by the CB is called base money. Money can also be created by a normal bank, when it loans more money to the people than it has. This money is called credit money. Base money most of the time grows. Base money is critical to understanding HyperInflations. Credit Money have little impact on it, as during HI, the normal banks do not make loans.

The govt pays money whenever it buys something or pays salaries to its employees. If this money is in excess of what it received from the citizens as taxes, there is more money in the market. The govt gets this money from the CB by issuing the debt note. This debt note is sold by the CB. The people deposit the money they received from the govt into banks. The banks use this money to buy the debt note. It is no risk investment for the banks. As long as this process works, there is no extra money in the market, and there is no added effect of inflation.

The debt selling is basically kicking the can down the road, as the debt must be payed back in the future when it matures. The govt may again create more debt to pay off the maturing debt. There by kicking the can further down the road. Another option would be to reduce the deficit and actually pay off the debt from the money from collected taxes.

It never makes sense for the govt to increase taxes and fire their employees and tighten their budgets. The people do not like it. So the only option for the govt is to kick the can down the road. The ability to receive free money, allows the govt to grow, to unsustainable levels. The people also love it as there is more spending for the masses. The actual producers have higher taxes, but not high enough that they care too much. Eventually the debt becomes so big that the govt cannot service the interest payed in the debt, within the tax collected. When this happens the govt must reduce the interest rates so low that it can service the interest.

When the interest rates reduce, the banks reduce the loan rates to match and start paying low interest on their deposits. Due to low interests people start taking more loans and stop depositing money in the banks. Now the banks do not have enough money in the banks to buy debt. They need to sell it, so the govt can no longer sell more debt to banks. The Central Bank at this point must buy back the debt, providing money to the banks. Once this starts to happen, the money stays in the economy. Due to the easy access to money the govt has increased its expenditure to enormous levels. The govt cannot easily reduce the deficit. There is also no point in tightening budgets at this point, as the production is not enough to pay off the debt. At this point Hyper Inflation becomes inevitable.

Peter Bernholz studied a number of hyperinflations and came to the conclusion that the point of no return is when Debt grows more than 80% of GNP, and deficit grows beyond 40% of Budget. If the deficit is reduced again, then the problem can be contained, but unless it was due to a war, it is not possible to reduce the deficit.

The hyperinflation does not start as soon as govt starts to buy debt from the banks or it goes beyond the limits given by Bernholz. Even though the money is entering the market, it must be chasing ever lesser number of articles, for hyperinflation to start. If the money stays in banks, then there is no problem. The banks are also not paying much interest and they are fearful of lending it to people, as they are risk averse at this point. The economy is not doing well during these times. That is part of the reason for the increasing deficits. So the money can stay in the banks for a long time. Actually due to this risk averseness, the economy may face a deflation, causing the govt to pump out more money, in an effort to prevent deflation.

If the banks are allowed to trade in the markets, they start to buy stocks and other assets. This causes the market value of those assets to rise. Due to the rise in these assets companies start to get more money. They are able to hire more people and give larger salaries. The market enters an upbeat mode. People get more money, and they start to buy stuff. This allows spending to increase. The excess money starts chasing real day to day objects. The inflation may pickup at this time, depending on whether there is enough objects in the market. As long as everybody can get what they need there is no problem and the prices will not rise. The country starts to buy stuff in the international market with the created money. As long as the international market perceives the currency to be trustworthy, the country can import stuff, and the inflation is not a problem.

Basically at this point, inflation will happen in whatever stuff is not easy to get at. If that stuff is not important, people will move to other stuff. As availability gets lower for more and more stuff, the public starts seeing high inflation. Eventually the inflation rate gets high enough that people do not want to hold the currency. At this point they will buy anything that they can get their hands on. This is the point of runaway inflation, or hyperinflation. The govt must support itself, so it must print ever higher amounts of currency to pay salaries to its employees. Credit money disappears, as the banks no longer give out loans, and they basically become a part of the govt. The govt starts to take over many failing businesses that it needs for its employees to use.

Eventually the govt employees do not earn enough money from the govt, and they start doing other stuff. The govt starts downsizing. This is the end phase of the hyperinflation. When enough people have left govt jobs, the deficit can be controlled. The govt can start a new currency, and restart the economy.

Lets see how this relates to the US.

The 70s saw US Government get into perpetual deficits. They have been in deficit for 40 years. Initially Europe and Japan where absorbing the deficits in the form of Treasuries and bonds. After 2001 when Euro was formed, Europe backed out from buying Treasuries. Then China started buying the treasuries. The debt became too big to be processed in 2005, and that year saw the interest rates dropped down to near zero. The banks started to fail in 2008, which required the govt to start buying debt.

China stopped buying debt/treasuries in Sept 2011. The govt started Operation Twist to buy long term bonds and convert them to short term debt. As we can see in the following graph it was increasing base money.

Now the only way some of this deficit is being absorbed is through Currency War. Some countries notably Japan, Brazil, Australia are devaluing their currencies by buying USD, so that the USD does not depreciate in their currency. Then they have to buy treasuries from the USG against those USDs. In QE3/4 FED has announced that it will buy 85 Billion USD worth of Mortgage bonds every month. In the graph above we can see that it has already printed 300B in the last 3 months.

The HI in US economy has been inevitable for at least the last 5 years. But now the vicious cycle has started as the govt has started buying 85 billion USD worth of debt every month. The US population has been a non-saver for a very long time now. So the deficit has been bought by foreigners rather than US people, for a very long time now. Notice that during this month the stock market has finally started to go up. This is due to the massive printing by govt. The next stages are clear. US should start to get some sort of inflation in daily use items. But this may take some time as the USD is the reserve currency and the US is able to buy things from the Rest of the World using those USDs. So it will be able to buy stuff, to prevent the prices to rise in the market. So before inflation sets in, the Rest of the World has to stop selling stuff to US. This can only happen if they remove their dependency on USD, which is actually dependent on the Middle East which sells them oil for USD.

The Middle East actually wants gold, so they will only sell their oil for USD till they can buy gold in USDs. This is the basis of petrodollar. So the trigger can be one of two things. 1) Panic in the trading world, due to collapse in UK or Japan. 2) Collapse in the price of gold, and gold goes into hiding.

1) Remember UK and Japan are considered safe havens, but their economies are in nearly as much bad condition as US. They will also undergo hyperinflation. They are not protected like US, as their currencies are not the reserve currencies. The condition of UK is a bit worse, and they have also started US style printing. Japan is a bit behind, and they are undergoing deflation, because they haven't been printing enough. That is about to be rectified. If one of these country's economy collapses, it could trigger the rest of trio to collapse as well.

2) Paper gold market is dropping a lot now. This is seen in the gold prices. At lower gold prices Asians buy a lot more physical gold. This means that physical gold supply becomes tight. If the price of gold goes even lower, the mines can shut down, resulting in even lesser availability. Also the western people that are dishoarding lose interest in selling their gold, because they think that they are making a loss by selling at such cheap rates. If the gold supply disappears, middle east oil nations will not get gold for dollars, and they will be less inclined to support US dollars.

We are basically in the last stage of the collapse. And gold will not be available for much longer.

There is a way in which normal people can break this cycle. The way is to not store money in banks. The money stored in banks WILL be used to buy govt instruments, which allow govt to do deficit spending. The only way out, is putting your money in stocks, land and gold. Never in bank instruments, Fixed Deposits, Mutual Funds etc. Also invest only in companies that create something, not in stock of banks.