Gold and Social Control


Are the gold stocks a buy? Probably. But stocks world wide are crashing, and you must wait until they stop falling. The gold stocks acted beautifully up until Friday when Switzerland announced that it would put a referendum to its people proposing a sale of half its gold reserves and the gift of the proceeds to Holocaust victims.

In a basing formation you often get panicky sell-offs that last one or two days. The referendum may not be that popular in Switzerland. In any event, the Goldman Sachs Commodity Index ("GSCI") is still in a nice uptrend, the CRB is in an uptrend, and the Dollar is falling. Platinum and silver are in uptrends (the charts have been making higher lows since July, in the case of Silver, and February in the case of Platinum.) M-3 is still on a tear. The XAU, an index of the larger gold stocks, has broken below its September low of 92 and may test the July low of 87. But the price of gold is diverging from the price trends in oil, silver and platinum, which it normally follows.

The headlines in the commodities pages blast about central bank gold sales. What they fail to mention is that through all the central bank selling over the past 4 years, there has been an 800 pound gorilla in the closet quietly buying all that gold. This gorilla doesn't care to prop up the price of what he is buying (like the typical mutual fund manager). He is perfectly content to see the price of what he has already bought fall further, so that he can buy more.

One thing we know for sure about the 800 pound gorilla is that he has protected cash flow. Unlike a hedge fund, which must generate profits at all times or sell out its positions, this gorilla makes his living on something other than appreciation of what he is now buying.

But let me emphasize that this gorilla has cohones - real big ones!

Not only has he bought up the gold the central banks have sold, but he has also bought up the next three years of production of all the senior mining companies. And, ladies and gentlemen, he has bought these thousands of tons of gold at 12 year record low prices.

Now let me ask you who you think is smarter, the 800 pound gorilla who is buying up all this gold at 12 year lows, or the genius central bankers who have watched gold fall from its highs of $800 in 1980 and are selling now at multi-decade lows?

Well, what happens to gold and the gold stocks depends on what (if anything) the gorilla does on Monday.

If the stock market panic spreads from Asia to the U.S. market, then the gorilla will probably wait for lower prices (and so will the little monkeys like me who are watching him). If so, the gold stocks will sell off as badly or worse than the general market. The time to buy will be when the stock market stops going down.

But the currency crisis in Asia gives me an excuse to talk about broader trends in international economics that you will seldom see discussed in public because they involve money, wealth and social control.

The Asian nations have extraordinarily high national savings rates. The Japanese have a gross national savings rate of 30% of income and the Chinese 40%. As you might expect, a large supply of savings means a low price or low interest rates. In Japan, short term interest rates (including rates at the local bank) are a mere half of a percent, while long rates are 1.8%.

Real interest rates (the nominal rate less inflation) in Asian countries are sometimes zero or negative.

High savings and low interest rates give Asian manufacturers a source of cheap capital for expansion. This gives them a significant price advantage in international markets.

From the perspective of the manufacturing elites that run Japan (or China) this savings rate is both a source of wealth and a potential threat. Let's talk about the threat first. Elites everywhere must keep the peasants working. After all, someone must produce the goods in Japan and China. If the average Japanese saves 30% of his income each year, how long will it take for interest on his savings to replace 80% of his income, at which point he quits work?

If real interest rates are 8%, then the answer is 17 years. On the other hand, if real rates are 1.8%, then the answer is 73 years. In high-savings rate societies like Japan and China, a high interest rate policy would be a disaster, because the workforce would contract and wages would rise dramatically. Even worse, the peasants would no longer be dependent and subject to the social control of a "job."

Thus, for the Japanese and Chinese elites, high interest rates are a potential disaster.

But more important, low interest rates not only guarantee social control of the domestic population, but provide profit opportunities for the financial elites and the financial institutions they control. How? Simple!

A Japanese (or Chinese) bank can borrow from its customers at anywhere from .5% to 1.8% and then lend to the United States Government at 6%. Japanese corporations and wealthy individuals may lend their profits or savings in America, Europe, or Latin America at much higher interest rates than they can by making Japanese or Chinese savings deposits.

Asian countries such as Taiwan, Thailand, Hong Kong, Indonesia and Singapore, all have huge domestic savings rates and follow the same policy as Japan. The only thing needed to make sure their financial institutions and elites make money lending to U.S. borrowers at high interest rates is currency stability relative to the value of the dollar. So naturally, each of these countries pegged the value of its currency (more or less) to the value of the dollar.

Now pegging your currency to the value of the dollar is fine, as long as the banks and lending elites do not allow excessive lending to interest rate arbitragers (which puts downward pressure on the local currency), and as long as the products of the manufacturing elites are selling well in foreign markets. American buyers of stereos and computer parts pay in dollars, which must then be converted into Ringit, Bhat or Yuan to pay wages and purchase supplies. More dollars being exchanged for the local currency puts upward pressure on the local currency, while fewer dollars creates downward pressure.

And a slowdown in exports has precipitated the Asian currency crisis. The hedge funds began to detect the excesses, and they started selling the local Asian currencies. The local currencies fell in value.

Notice that the manufacturing elites benefit from the devaluation, because their borrowings are denominated in the low interest rate currency, and the lower currency value makes their products far more competitive in international markets. The financial elites who sold Baht, Ringit or Yuan earlier and invested in U.S. debt aren't hurt by this devaluation either. If these financial elites arbitraged by borrowing locally and lending internationally, they will profit twice, once on the high U.S. rates, and a second time because it is now cheaper to pay off the local lenders after the currency devaluation.

As you can see, it is the poor local savers, the peasants, who get clobbered. Their savings are now worth from 20% to 50% less depending on the country they live in. And because they buy bread in their own local currency, they will not notice the loss until their local prices begin to rise after the devaluation.

Thus the high savings rates of the peasants dictate a low interest rate strategy for the governing elites in Asia. These high savings rates are assets to be carefully managed.

The U.S. elites are faced with a mirror image of Asian societies. We have a 15% gross national savings rate. If we plug that rate into the retirement equation, we see that at an 8% real rate it will take the average American peasant 24 years to save enough to replace 80% of his income and quit work. At a 4% real rate, it takes 38 years.

So the U.S. elites can allow much higher interest rates without disrupting the labor force.

The U.S. elites have created a consumerist debt-driven culture that craves imported goods. This profitable resource that U.S. elites control (ability to sell TVS and stereos into this debt dependent market) can be shared with foreigners. But the cost of capital is high for the U.S. manufacturing elites, and the cost of labor is relatively high.

Thus, there are three simple questions on the table in all these international trade disputes: 1) Who gets to sell into the American Market, and how much? 2) To what degree will the U.S. manufacturing elites be allowed to tap into the cheap capital and cheap labor of the Asian countries by borrowing in the local currency to build manufacturing plants there? and 3) to what degree will U.S. financial elites be allowed to participate in the rape of Asian peasants (alongside Asian banks) by borrowing Asian currencies at Asian interest rates and then investing the proceeds in high interest yielding dollar denominated debt?

That is what the complex technical disputes about tariffs, market access, and currency controls are really all about.

While the Fed Funds rate set by the Federal Reserve was 3% back in 1991 through 1993, U.S. investors with access to bank credit could borrow (with only 5% down) at 4% and invest the proceeds in the two year note at 6%. Now, they must borrow yen and take the currency risk. However, as long as the borrowed currency goes down, you make more than you anticipated on the arbitrage in rates. If Asian rates are low enough, you may be able to buy a derivative for a couple hundred basis points to hedge the currency risk. It cuts your profit in half, but then you don't have to spend nights watching your screen. Ahh - life's tradeoffs! Half of New York and Boston makes its living that way. It beats working for a living - and as Clark Gable said to Marilyn Monroe in that Classic movie "The Misfits" - "anything's better than wages!"

Now you should be asking at this point, "what does this have to do with gold?"

The answer is "plenty."

Without a government guarantee, or without gold reserves, a deposit at a bank is a very risky junk bond. The bank borrows from Peter at 3% and lends to Paul at 6%, making its living on the rate spread and having no money of its own. If Paul cannot repay his loan, Peter loses his deposit at the bank.

In the 19th century, no governments or central banks guaranteed deposits. So savers would not put their money in a bank unless the bank had reserves of gold to guarantee its deposits.

Thus, having gold meant that the bank could borrow at a lower interest rate than if it did not. In other words, the bank's profit opportunity depended on its having gold. The more gold in reserve relative to deposits, the lower the interest rate the bank could pay its savers. The bank's owners would place 25 ounces of gold in the bank in exchange for its stock, and the bank would then borrow 100 oz from Peter at 3% and lend 100 oz to Paul at 6%. Thus, the yield on gold could be calculated quite easily, and depended on the amount of gold required to inspire confidence in the deposit. If 10 oz would do the trick, then the yield was a phenomenal 30%. If it took 50 oz then the yield on gold was only 6%. And that is why a banks "reputation" was so important.

As in our example above, while deposits and loans were issued in local currencies, these currencies were all exchangeable for gold. It was the spreading of default risk over multiple loans, and the holding of gold reserves behind deposits that made the gathering of deposits at low interest rates possible. Thus, the role of gold in 19th century Europe was similar (in a way) to the role of high Asian savings rates today. It created an opportunity for financial arbitrage and made capital cheaper for local businesses.

Now in the first half of the 20th Century, advisors to governments discovered that economic growth, and thus national power, were constrained by how quickly mining companies could locate and extract more gold from the ground. If the mines could only add 2% to the gold stock each year, then deposits and loans could only grow at a 2% rate without threatening confidence in the banking system.

Governments needed faster growth so they could collect more taxes, buy more votes and fight more wars. The economists thought up the idea of Government insuring or guaranteeing bank deposits. Then, banks could get by with much smaller reserves set by government regulation. Gold would only be needed by governments to inspire confidence in the currency and maintain exchange rates.

And as long as governments agreed to expand deposits and loans at roughly the same rate, then there would be no embarrassing inter-governmental gold transfers.

For governments, the value of gold could be calculated the same old way - by determining the reduction in interest rates gold holdings inspired. But unlike the 19th century, the psychic link between gold and low interest rates began to fray.

Gradually, countries began to hold things called "dollars" as reserves behind their currencies rather than gold. The advantage of these "dollars" was that they could be invested in U.S. treasury notes and bore interest that parliaments and legislatures could measure and understand. The interest earnings made the central banks (which guaranteed the deposits of the peasants) look like profit centers to the politicians.

Gradually, central banks became convinced that gold was not needed to inspire confidence in the their currencies. It was better to have "dollars" which gradually replaced gold as the reserve currency. Besides, if you had enough "dollars," you could threaten to sell them all at once just before an election, driving up U.S. interest rates and producing a nasty recession. If you have enough dollars, you can get as much access to the credit-card enslaved American peasants as you wish, without fighting a nasty and expensive war.

Double bonus. No need for gold and no need for expensive armies.

So why would anyone (let alone some quiet 800 pound gorilla) want to buy gold?

To find the answer we must ask what is a "dollar."

A "dollar" is a computer cipher - a few electrons in someone's memory bank. So is the Yen, the Yuan, the Mark and the Frank. So are all the rest. Nothing but computer ciphers. Nothing but raw, unalloyed confidence. Nothing, in effect, but nothing!

The "dollar" is a belief system. A dollar is faith that it, and all of the other species and subspecies of computer ciphers which we value now and exchange for real things will continue to be valued in relation to those real things in a stable and predictable way - forever - Amen!

So what is the Gorilla betting on when he buys gold?

He is betting that the belief system we know as "a dollar" will crumble at some point.

The discipline of gold is lost, and the policy device for aligning confidence in modern currencies is the central bank's ability to increase interest rates. Instead of buying more gold, the central banks will raise the interest rate enough to attract funds into their currency. But the policy device for increasing confidence will deprive the elites of their profit opportunities and "unjustly" benefit the peasants.

Interest rate increases are tolerated now because the belief system holds that the interest rate increase need only be temporary until confidence is restored. What if high rates must be extended for long periods? What if nations give up on high interest rates and begin competitive currency devaluations to spur exports in the face of shrinking demand from aging populations all over the world?

What if the U.S. keeps importing millions of low I.Q immigrants and turns into (more of) a third world country which can no longer produce enough software to fund all the plastic debt we incur for imported cars, televisions and VCRs?

What if, in 20 years, foreign holders of dollars begin to perceive a default risk on the dollar denominated debt they hold?

What if the dollar suddenly no longer is the reserve currency, and hundreds of billions of them flood back from foreign banks to America at a tiny fraction of the value they had before the flood started?

What if, as the Euro-American population ages, American consumption contracts, throwing Asian countries into nasty recessions and forcing them to sell those reserves denominated in U.S. dollars.

What if Iran sinks the Nimitz?

What if merchants refuse to exchange a loaf of bread for $2, and demand instead $2000?

The 800 pound gorilla is in no hurry. Nor should he be.

The belief system we know as "the dollar" will not collapse tomorrow.

However, it is clear that the 800 pound gorilla understands the uncertainty principle.

If confidence must once again be restored with gold reserves, then given the quantity of Dollars, Marks, Yen, Yuan, Ringit, etc. etc. those reserves will cost $5000 per ounce, and not $308. And that presupposes no increase in the units of these various "belief systems" outstanding between now and the day that the uncertainty principle raises its ugly head.

And that ladies and gentlemen, is all you need to know about economics, gorillas, gold and social control!


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