15 September 2008

The Window is Open

The money creation window of the Federal Reserve is wide open, but it doesn't seem to be doing much good. The share price of countless financial institutions continues to crater, as the market senses that these overleveraged behemoths have assets on their balance sheet that do not reflect today's reality. The boom has passed, and we are now in the bust, just like night follows day. Wealth destruction is today's prevailing force as assets of all sorts are marked down in value.

What the Federal Reserve wants to make us believe is that the liquidity it is providing through its various lending schemes is sufficient to make solvent those financial institutions that have become insolvent. Unfortunately, economics doesn't work that way. Capital - and not newly printed dollars - is needed to make insolvent banks solvent, and given decades of over-consumption and under-saving, capital is in short supply.

Last year the Treasury and the Federal Reserve told us the sub-prime crisis was "contained". Then they told us that bailing out Bear Stearns would end the financial meltdown. They told us that Fannie Mae and Freddie Mac had sufficient capital and liquidity and would not need a bailout. What else are they going to tell us trying to make us believe that today's over-indebted financial structure will not collapse?

The point is that financial assets are based on promises, and promises are being broken right and left. It is no surprise therefore that bank balance sheets no longer reflect reality, and that many financial institutions are trading below their book value. The market understands the nature of today's wealth destruction and is therefore taking a prudent 'hair-cut' to bank balance sheets. The result is that a firm's market cap is probably a better reflection of a financial institution's real value than its quarterly reports. In short, the assets of many financial institutions are overstated.

In the 1930s wealth destruction resulted in deflation because the dollar's fixed link to gold led to a contraction in the money supply. As promises increasingly came to be doubted, wealth moved out of financial assets into tangible assets. As the most liquid tangible asset, gold benefited the most, and its purchasing power soared as a consequence, even against the dollar, which was devalued 69% against gold from $20.67 to $35 per ounce. In a deflation, the value of money increases, and in the 1930s, the value of gold increased the most of any money.

There is wealth destruction now, but the value of dollars and all national currencies is decreasing because of inflation. The cost of living is rising today even by the government's own measure, which many people including me believe understates the true loss of dollar purchasing power. Of course, gasoline prices have fallen over the last couple of months, but compare today's gasoline prices to where they were a year or two ago. In fact, to get a true measure of the loss of purchasing power in all national currencies, compare the price of nearly everything to a year or two ago. With the notable exception of real estate, the price of most everything is going up.

Real estate is a special case. Its price is going down because it had become way overvalued a year or two ago, and prices at that level were unsustainable. Consequently, we are today seeing wealth destruction, but to get the true picture, we need to keep in mind that we are measuring the decline in house prices and other real estate assets with a currency that keeps inflating. And the prospects are that the dollar will keep inflating because the Federal Reserve's 'window' remains wide open, as is the 'window' at every central bank around the world.

In short, the wealth destruction of the 1930s resulted in deflation because national currencies had a fixed link to gold, and the quantity of dollars shrunk as insolvent financial institutions went bankrupt. This time around wealth destruction is leading to inflation because central banks are creating 'money' out of thin air to try plugging the black holes on the balance sheets of insolvent financial institutions in an attempt to keep them out of bankruptcy. It won't work. They will still go bankrupt because central bank liquidity does not help bank insolvency.

All central banks can do is postpone for a while the final reckoning. As more and more promises are broken, increasing amounts of wealth will exit financial assets to avoid counterparty risk. This wealth will go into tangible assets, and gold in particular because it does not have counterparty risk.

So why did the price of gold drop last week?

It's a good question, particularly given the fact that the Dollar Index was unchanged from the week before. I could and will point to the usual culprits, including governments and over-leveraged hedge funds. But the price of most things dropped last week, including crude oil and other commodities too. So here's the important point.

Have the reasons for owning gold and silver changed in the last week or last month? I don't think so. We are witnessing significant wealth destruction today that is undermining the solvency of financial institutions. Yet the cost of living today is rising because the dollar and other national currencies are being inflated as central banks around the world try to make insolvent institutions solvent by pumping money out their lending 'window'. But there is something even more worrying than inflation.

National currencies come with counterparty risk. They are based on promises, and promises are becoming increasingly unreliable. One does not have to rely on promises and accept counterparty risk when owning tangible assets like gold and silver, which in my view have become exceptionally undervalued.

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