Inflation Versus Deflation: Part Two

December 17, 2008

In my previous blog entry, I explained that:

  • The current economic crisis could result in either deflation or inflation;
  • Deflation and inflation have very different effects on savings and investment vehicles, so understanding the probability of one or the other can help you make better decisions with your money;
  • Whether we end up with deflation or inflation depends on whether or not the Federal Reserve can succeed at getting money to move through the economy again.

Our task now is to assess the likelihood of the Federal Reserve achieving its goal.

The Zero-Bound Problem

Ordinarily, the Federal Reserve controls the rate at which money flows through the economy (its “velocity”) by changing the interest rate that it charges member banks for overnight loans (the “Fed funds rate”). Through the mechanics of the commercial banking system, lower short term rates cause a reduction in the rates that banks charge for long term lending, such as car loans and mortgages. Lower long term rates, in turn, stimulate economic activity.

Despite the Fed’s aggressive program of lowering the funds rate in the past year, commercial banks have remained reluctant to lend, and long term interest rates have not declined. Just yesterday, with falling consumer prices raising further fears of deflation, the Fed lowered its funds rate to a record low of 0.25%.

The Fed has arrived at the “zero-bound” problem: it cannot lower interest rates below zero. The Fed has reached the end of the rate reduction paradigm for controlling the velocity of money.

The zero-bound problem explains why, in addition to announcing the rate cut, the Fed announced its readiness to “move to a new phase of monetary policy in which it prints vast amounts of money.” To prevent a deflationary spiral, the Fed must employ other means to get money to move through the system to return the economy to an inflationary track.

Unconventional Measures

In 2002, before he became Chairman Of the Federal Reserve, Ben Bernanke addressed precisely this issue in a speech that earned him the epithet “helicopter Ben.” In his talk, Bernanke reminded his audience of Milton Friedman’s description of a central banker dropping money onto the populace from a helicopter. Also known as the “printing press speech,” Bernanke’s address included the following formulation:

Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.

In my last blog entry I explained that inflation is a monetary phenomenon: very simply, an increase in the supply of money relative to the goods and services produced by the economy causes prices to rise. A steady increase in the nominal prices of goods and services discourages savings because, unless interest rates keep pace, unspent money rapidly loses its value. Thus, the plan to “reduce the value of a dollar” serves as a mechanism to fight deflation. Dollar devaluation, we shall see, lies at the core of the Fed’s deflation fighting strategy.

The Fed has done a lot of creative thinking about the uses to which it can put the printing press in order to revive spending. In 2005, Robert Blumen published an article in which he analyzes a number of papers and speeches on this topic by Bernanke and other Fed officials.   Few people have the interest or patience to wade through this kind of material. But understanding the Fed’s thinking about deflation fighting gives a good deal of insight into current events, such as yesterday’s announcement. Blumen has done a great public service with his analysis. With his help, I shall now enumerate some of the Fed’s tactics.

  • Long-Term Interest Rate Intervention: The Fed can influence long-term interest rates by buying long-term bonds on the open-market.  The Fed has already implemented this strategy in order to lower mortgage rates by purchasing mortgage backed securities. Yesterday’s statement makes it clear that the Fed will continue purchasing mortgage securities as well as long-term US Treasury bonds.
  • Lending: A 1999 paper, Monetary Policy and Price Stability, explains that “A central bank can also attempt to spur private aggregate demand by extending loans to depositories, other financial intermediaries, or firms and households.” The Fed has already engaged in a record level of lending through its discount window and has been buying commercial paper. Yesterday’s announcement says the Fed now intends to implement a “Term Asset-Backed Securities Loan Facility to facilitate the extension of credit to households and small businesses.”
  • Currency Devaluation: In a paper entitled Monetary Policy When the Nominal Short-Term Interest Rate is Zero, Fed officials describe the concept of a “money rain” whereby it would “give money away either through directly disbursing currency to the public or by disbursing it through the banking system.” As I observed above, devaluation forces people to spend their dollars to avoid losing their savings. Devaluation, by the way, can also be achieved through what these papers refer to as “exchange rate intervention.” The central banks of other countries might, for example, agree to sell enough of their dollar reserves into the open market so as to effect a deliberate fall in the dollar.
  • Imposition of Negative Interest Rate: In the paper Monetary Policy in a Zero-Interest-Rate Economy, a Fed official observes that the Fed could induce people to spend by a mechanism to “make money pay a negative nominal interest rate, by imposing some type of ‘carry tax’ on currency and deposits.” In other words, people saving money in dollars would have to pay for the privilege of doing so.
  • Direct Purchase of Goods and Services: By exchanging federal government debt for freshly printed money, the Fed could indirectly “conduct an open market purchase of real goods and services.”  This idea, also presented in Monetary Policy in a Zero-Interest-Rate Economy, may sound far-fetched. But it might be what yesterday’s Fed statement hints at by saying it will “continue to consider ways of using its balance sheet to further support credit markets and economic activity.”

This inventory of ideas gives a pretty good idea of just how far the Fed will go to reflate the economy. As a  student of the Great Depresion, Ben Bernanke believes it necesary to fight deflation with these types of tools to avoid long-term economic suffering. As one can see from the developments of the past several months and from yesterday’s Fed statement, we must take these ideas at face value. We must understand them not as theoretical possibilities, but as an armamentarium of tactics that it fully intends to deploy now that it has reached the zero-bound. Very simply, the Fed will stop at nothing to prevent deflation.

With this understanding of the Fed’s strategies as background, I am confident that the deflationary trend of the past months will not last long. It could continue for a number of months into 2009, or perhaps even into 2010. But I have little doubt that, by dint of its creative application of monetary authority, the Federal Reserve will prevail.

What Will Happen To All That Money?

Mainstream economists view inflation of around 3% or so as benign. A bank CD paying interest of 5%, or a long-term bond paying 8%, would compensate for inflation and leave the investor with a reasonable return. The mainstream investment and economic community assumes that, one way or another, the Fed will target a reasonable level of inflation once the crisis has subsided.

And, indeed, the Fed has mechanisms for “mopping up” the excess money it creates in order to prevent excessive inflation. The Treasury can deposit the proceeds of bond sales with the Fed, taking those dollars out of circulation and reducing their inflationary effect. The Fed can also increase the reserve requirements for banks. For example, by increasing the deposit to loan ratio from 10% to 15%, less money would circulate through the economy. And of course the Fed can raise interest rates.

But one has to wonder whether the Fed, or the government, would have the discipline to throw cold water on an economy recovering from a severe recession. A monetarily responsible Fed under Alan Greenspan should have raised interest rates when the economy showed signs of recovery from the dot.com bust. Its failure to do so led to the housing bubble that caused the current recession. Our economy’s  addiction to credit as a vehicle of economic “growth” will make the Fed reluctant to slow down credit expansion as the economy recovers.

More importantly, in the coming decades our government will be forced to adopt a deliberate policy of inflation to cope with the national debt. Our national debt has reached over $10 trillion. Adding future entitlements such as Social Security and Medicare to the mix brings the total in coming years to a mind-boggling $70 trillion. And, of course, all of the bad corporate debt that the Fed continues to buy in order to rescue the banks adds to this burden.

Inflation can serve as a release valve for any government facing this level of debt obligation. You’ll recall from my discussion of the mortgage as a hedge against inflation that inflation transfers wealth from creditors to debtors because the nominal value of the loan decreases as the nominal value of the underlying asset inflates. In a similar way, the government’s obligation to entitlement beneficiaries (most notably retirees) becomes a smaller burden when inflation persistently and steadily devalues the nominal value of the fixed payment. It has the same effect on the government’s debt to international creditors, such as China, who hold large dollar reserves in treasury debt.

Bear in mind, too, that since the government controls inflation statistics, it can control whether and to what extent entitlement payments keep pace with true inflation. Please review John Williams’ work on inflation for more about the true rate of inflation.

Ultimately, an economy that depends on an indefinite expansion of credit to sustain its growth cannot go on forever. Eventually, debts must be paid. In the current crisis the Fed is introducing the world to the printing-press approach that will later serve to cope with the country’s debt.

But eventually this strategy must fail. Relentless devaluation of currency renders it worthless.  The dollar must die eventually.

How To Save And Invest

I do not believe that a currency collapse is imminent. The more likely scenario is a slow burn lasting for decades in which a series of booms and busts will obfuscate the underlying trend towards hyperinflation.

In the short term (for the next year or so), the prices of stocks and consumer goods may continue to fall due to the the effects of defaulting credit and gloomy economic reports. In any economic climate, a prudent savings and investment strategy would keep enough emergency funds in cash (short-term bonds and bank CDs) in case of protracted unemployment or other exigencies. Just bear in mind that the cash you would need in the short term for emergencies will lose its value over the long term as the Federal Reserve pursues its policy of relentless and deliberate devaluation of the dollar.

A long-term portfolio should include some percentage of investments that hold their value independently of the monetary system, such as commodities, precious metals, and businesses that produce food and energy.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser

Inflation Versus Deflation: Part One

December 14, 2008

Benjamin Roth’s Depression Diary chronicles the impressions of an Ohio lawyer during the Great Depression. He paints a poignant picture of things that happened to investors in that era. “For over a year now,” he writes in 1931, “people have been buying stocks at what they think are bargain prices.” But, he adds later in 1936, “these early buyers were badly mistaken and many of them were wiped out.”

The process that took stock values down by 90% from 1929 to 1932, and depressed the prices of virtually everything else, is known as “deflation.” The story makes plain the danger of investing in any financial asset during a deflationary spiral: if that asset’s market has not truly bottomed, you risk great losses. Today one frequently hears in the financial news what a bargain good companies are selling for on the stock market. Roth’s journal entries provide a scary backdrop to this advice.

Last week I alluded to a debate that his been raging for several years within the contrarian financial community between the inflationaistas and the deflationistas. Both sides have always agreed that excess consumer and government debt would lead to an economic crisis.  They continue to disagree about the outcome, even as the outcome unfolds before our eyes.

Roth’s diary should clue us in to the fact that either outcome, deflation or inflation,  bears more than academic curiosity. Either one can change the results of any particular savings and investment strategy. It matters even — or rather, especially — if all you ever do is save money in a passbook savings account or Certificate of Deposit. Deflation would magnify the purchasing power of your savings , whereas inflation would diminish it. Generally, the strategies for dealing with inflation and deflation have little overlap. In making up your mind about how to proceed, you’ll want to have some idea about the probability of one outcome over the other.

My discussion will be lengthy and will occupy this week’s and next week’s blog entries. It will challenge your attention span and your willingness to follow technical detail.  So please bear with me. I promise to reward your attention with a greater understanding of current economic events.

Credit: Bubbles And Contraction

To understand how a deflationary spiral works, you have to understand the inflationary bubble that precedes it. The bubble begins with the availability of cheap credit. First the central bank lowers the interest rate on short term loans.  Then, through the mechanics of fractional reserve lending, the member commercial banks offer lower interest rates on long term loans to their customers. As more money enters the system, nominal asset prices rise. But eventually prices get so high that buyers stop buying and the bubble reverses itself. The weakness in such bubbles lies in the understatement of risk by lenders.

Let’s look closer at this phenomenon through the lens of the subprime mortgage meltdown.  Subprime mortgage lenders (and apparently rating agencies) assumed that the economy would remain strong enough for borrowers to sustain their mortgage payments. They also assumed that the values of homes would remain high enough to cover the mortgages in the case of default.

Of course, the inevitable happened.  Home prices got so high that, even at low interest rates, buyers stopped buying, and prices began to fall. And when initially low “teaser rates” on mortgages re-adjusted to their higher long-term rates, borrowers became unable to make their mortgage payments. An increase in defaults put more homes on the market in distressed circumstances, reducing the value of homes to below the amount of the mortgages that financed them.

Such loan defaults end up as losses on the balance sheets of the banks, causing some of them to go out of business. If those banks owe money, their creditors also suffer losses. As loan defaults cascade through the banking system, banks hoard their cash to maintain the integrity of their balance sheets and become reluctant to lend.  When they lend, they do so at prohibitively high interest rates.

The contraction of credit wreaks havoc on other financial assets.  In our day, hedge funds had attempted to magnify their earnings by borrowing heavily against their assets. As credit tightened due to subprime mortgage losses, the hedge funds’ creditors  raised borrowing rates and demanded additional collateral even for relatively safe investments. To raise cash, the hedge funds had to sell off holdings in stocks and commodities, resulting in price declines.

Credit contraction also slows down economic activity. For example, the banks’ unwillingness to extend letters of credit has seriously affected international trade. Many businesses depend on short-term loans known as commercial paper in order to function on a day-to-day basis. Commercial paper, too, has suffered from the credit contraction.

As businesses fail or contract from the paucity of credit, they lay people off. Fewer people have money to spend or are afraid to spend it for fear of losing their jobs, slowing the economy even further.

If it continues unchecked, credit contraction leads to the general price decline known as deflation.

Inflation And Deflation Are Monetary Phenomena

Almost everyone has heard of the law of supply and demand. Very simply, the more scarce a product or service, the higher its price. The requirement that plastic surgeons go through many years and hundreds of thousands of dollars in medical training makes them relatively scarce. But almost anyone can, with enough motivation, clean a house. Thus you pay a plastic surgeon thousands of dollars for the few hours of time it takes her to fix your nose,  whereas the house cleaner earns $10 per hour.

The price effects of inflation and deflation differ quite a bit from supply-demand dynamics. For many economists,  and for the purpose of our discussion, changes in the money supply cause inflation and deflation. The great economist Milton Friedman is famous for saying that “Inflation is always and everywhere a monetary phenom­enon.”  That is, inflation results from an increase in the supply of money relative to the goods and services in the economy; deflation results from a decrease of money supply.

With this point in mind, remember that, in our system, all money is debt. All money flowing through the system began as the transfer of money from a creditor to a debtor. If everyone in the world paid off their loans at once, all money would disappear from the economy. Availability of credit increases the money supply and thus creates “economic growth,” while the unavailability of credit results in economic contraction. Please watch Paul Grigon’s documentary, Money As Debt, for a really good explanation of this concept.

So, credit contraction plays the lead role in the drama of a deflationary spiral.

For the moment, although the price of oil and other commodities has dropped, true deflation has not yet taken hold of the economy. The prices of food, housing, and health care remain relatively stable. But if the contraction of credit continues, the supply of money to the economy will eventually decrease and all prices will fall.

How To Save Or Invest For Deflation

In investing and saving, inflation and deflation have different consequences. In deflation, the dollar-denominated value of everything drops. Relative to goods and services, then, the purchasing power of cash increases. But since less of it flows through the economy, cash is hard to come by.

Although I do not believe that true deflation has taken hold at this point, the desire for cash in a credit contraction might explain the behavior of investors in US bonds. The demand for short-term US bonds has pushed their yield almost to zero. When transaction fees are figured in, investors are paying a premium over par value for these securities because of their perceived safety.

In inflation, on the other hand, cash becomes less valuable because prices expressed in the currency become higher. In such an environment, it becomes advantageous to buy stocks, commodities, and real estate because their prices will rise in nominal value, thus preserving the original value of the investment.

I should add that deflationista extraordinaire Mish Shedlock believes gold to be a good investment for both deflation and inflation because of its true role as money.  Robert Prechter, on the other hand, insists that even precious metals will decline in nominal value under deflation.

What Can Be Done?

Though complicated by the many intracacies of modern economics and finance, the argument between the deflationistas and the inflationistas boils down to one fundamental question: will the monetary authorities succeed in reflating the economy?

Once deflation sets in, stopping it becomes very difficult. The deflationistas assume that the monetary authorities are ultimately powerless against the economic forces driving deflation. They foresee a sustained period of monetary contraction resulting in a global depression with chronic and high unemployment. The inflationistas argue that the monetary authorities will succeed in getting money to move through the economy again and thus put the economy back on the inflationary track to “growth.”

To make up your own mind about this question, you will need to understand  how the Federal Reserve seeks to accomplish this goal. I shall examine the Fed’s strategy in my next blog entry.

© 2008 Philip Glaser

Debt As An Inflation Hedge

December 4, 2008

I highly recommend Axel Merk’s latest discussion of the Fed’s fight against deflation. He addresses many of the currency and debt dynamics I have touched upon here in the past weeks, but with greater technical depth and detail. One element of Merk’s discussion deserves particular focus:

Banks are in the business of borrowing short and lending long: typically, banks would have deposits (short-term loans from depositors, callable at any time) and lend to finance long-term projects. This may well be the greatest carry trade of all times, except that it has neither credit, nor currency risk; it does have interest risk, i.e. if long-term interest rates go up because the market prices in the risk of inflation, then banks could lose money.

A bank pays a lower rate of interest to its depositors than it charges for the long-term loans it lends. If it gives its depositors 2%, but charges its debtors 6% for a mortgage, it profits from the 4% spread.

The risk to the bank from rising interest rates deserves our attention because, as Merk explains in his article, it now drives a number of the Fed’s current actions. I have already alluded to the possibility that China may grow increasingly reluctant to purchase US debt obligations. The drop in oil prices now makes it less likely that oil producing countries will want to purchase US debt, as well. By the simple law of supply and demand, a decrease in demand for US Treasury Bonds would force interest rates to go up.

Now imagine a scenario in which rising interest rates force the banks to pay its depositors 4%. The higher payment to the depositors squeezes its spread on the mortgage loan down to 2%. Many banks mitigate this kind of risk by selling mortgages to third parties. But of course that just transfers the problem to bigger banks.

As the bank of all banks, the Fed must do everything to protect the interests of the banking industry. Thus, as Merk observes, on November 25 the Fed announced that it would purchase $600 billion of mortgage-backed securities. This announcement signaled to the market an increase in demand for these securities and consequently sent their yields lower. The Fed publically justifies these actions as a means of unfreezing the credit markets. But they also have the effect of protecting the banks’ profits. The Fed has many other tricks up its sleeves to accomplish these goals, all euphemistically defined as Quantitative Easing.

The debate rages between the deflationistas, such as Mish Shedlock and Robert Precther, and inflationistas such as James Turk and Peter Schiff. The question boils down to one’s belief in the the Fed’s ability to accomplish its goal of getting money to move through the economy to prevent a deflationary spiral (a state of high unemployment and consequent decrease in prices as the country suffered in the Great Depression). If it succeeds, but fails to remove the excess money it created from the system, inlation will result.

As a believer in both the Fed’s ingenuity and the inevitability of inflation, I have suggested investing a limited but steady stream of savings in precious metals, for reasons that I have outlined in this blog. But, in the interest of diversification, I am now scrutinizing another tool for coping with inflation: a fixed rate mortgage.

If you have the nerve to tolerate the gory details of how badly our government manipulates inflation statistics, I recommend having a look at John Williams’ Shaddow Stats. Using the same inflation calculation methodology that the government used in the 1970s (when it counted food and energy in its inflation formula), Willams estimates current inflation to be at around 11%. But because the government’s official inflation numbers understate inflation by about 7%, salaries have not kept pace. The 1970′s differed insofar as the government did not lie about inflation so that salaries did increase with inflation.

Daniel Amerman makes an important observation about all this: people who held fixed rate mortgages from the 1960s paid those mortgages off in inflated dollars throughout the 1970s and got their homes virtually for free. The fixed interest rate guaranteed that the payment in nominal dollar terms stayed the same, while salaries, again in nominal dollar terms, increased. This dynamic made the mortgage payments an increasingly smaller expense of household budgets. In effect, inflation transferred wealth from creditors to debtors.

Now it should be even more clear why, as I discussed above, the Fed will do anything in its power to prevent interest rates from rising.

No one can know for sure whether or not the Fed will succeed in preventing a deflationary spiral, or whether inflation will become undeniable enough that salaries have to rise. But Amerman would argue that even people who can afford to own their homes outright can benefit from mortgaging some percentage of their home as a hedge against inflation.

In order for this strategy to work, a number of conditions must be met:

  • The homeowner must have emergency cash available for making the mortgage payments for any foreseeable period of unemployment;
  • The homeowner must also have diversified their portfolio into assets that would do well if inflation does not turn out as predicted;
  • The mortgage’s interest rate must be fixed; an adjustable rate mortgage in a period of inflation is disadvantageous to the mortgage consumer.

To be honest, I am not sure whether I believe this strategy to be practical or ethical. But it intrigues me. If nothing else, this discussion will have given you a better understanding of how the banking system works and how it could even work to your advantage.

DISCLAIMER: I am not a professional financial planner and have no credentials in this area. You should always review your financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil.

© 2008 Philip Glaser

Precious Metals Prices: The Tale of Two Markets

November 30, 2008

In my discussion of  alternatives to physical possession of  precious metals a few weeks ago, I alluded to price distortions in the precious metals markets. A multi-million dollar purchase of gold in Toronto, at a price well above that of the official exchange, illustrated the point in a striking way. Price discrepancies of this magnitude have become so commonplace that I feel compelled to say more about them now.

Official commodities markets like the COMEX set the “spot” price for precious metals quoted at places like The Bullion Desk. Ordinarily, when you purchase bullion coins from a dealer, the price you pay includes both the spot price and a “premium.” Under normal circumstances, the premium makes up the dealer’s cut in the transaction.

About eighteen months ago, for example, the per-ounce premium on five, one-ounce Krugerand gold coins from a reasonable dealer came to around 4.5%. With the spot price at around $670 per ounce,  the premium amounted to $30 per ounce. The same premiums held for silver.

Ideally, then, the spot price should reflect the supply-demand dynamics of the marketplace, and the dealer’s transaction costs make up the premium. Today, the premium has taken on a new role: it now compensates for spot prices that are too low given the true demand for gold and silver bullion.

In the Toronto transaction I mentioned above, the buyer paid around $300 per ounce more than spot. In a November 22nd interview with Jim Puplava, veteran precious metals specialist John Dudy (The Goldstock Analyst) told of a client who received a premium of $600 over spot for gold coins.

The divergence between the spot price and the true cost of bullion has led one website to track completed transactions for gold and silver coins on ebay.  Here one finds premiums ranging from 14% to 155% depending on the coin, with the typical prices being in the 40%-60% range.  Analysts now routinely distinguish between the “paper price” of gold determined by the COMEX (that is, the spot price) and the true “phsyical price.”

Demand for gold and silver bullion has reached the point where dealers predict it will take months to fulfill orders. The Perth Mint recently stopped taking orders. The demand for precious metals results from the growing mistrust of national currencies, and in particular the dollar.

According to Bloomberg, the Fed and the Treasury have so far pledged $7.7 Trillion for their interventions to save the banks. “Fed officials have made it clear,” said the New York Times earlier this week, “they are prepared to print as much money as needed to jump-start lending, consumer spending, home buying and investment.” As further business failures cause a cascade of credit defaults through the banking system, more and more phony money will circulate through the economy. $7.7 Trillion is just the beginning. None of this bodes well for the dollar as a reliable store of value.

But why do the spot prices on the COMEX fail to measure the true demand for precious metals? The answer to this question lies in the technical workings of the COMEX. A contract to sell on the COMEX, a so called “short” position, does not obligate the seller to make physical delivery of the item he sells. In fact, most COMEX contracts settle in cash before their delivery date. The COMEX serves as much the purpose of commodities speculators as it does the consumers of commodities. The COMEX even places a limit on physical settlement of a buy or “long” contract. It limits delivery of silver, for example, to 7.5 million ounces, or 1500 contracts, per month.  But it places no limit on the number of short positions.

An analysis by Ted Butler shows that two or three large players are holding extraordinarily large short positions on the COMEX. As of July 1, 2008, two U.S. banks held 6,199 short contracts of COMEX silver (about 31 million ounces). As of August 5, 2008, two U.S. banks held 33,805 short contracts of COMEX silver (about 169 million ounces), a five-fold increase . These short positions cannot possibly be backed by actual production or inventory of the metals. But they have the effect of an increase physical supply: from July 14 to August 15, silver prices dropped from a peak of $19.55 to a low of $12.22 , a decline of 38% . The numbers for gold tell the same story.

Rising precious metals prices reinforce their role as true money, as a store of value more reliable than fiat currencies. By suppressing the price of precious metals through these fraudulent futures contracts, the banking industry maintains the apparent viability of fiat currencies as a store of value. A major shift in storage of wealth to precious metals would accelerate the devaluation and demise of the dollar. Indeed, The Gold Anti-Trust Action Committee has for years made the claim of precious metals price manipulation.

Many observers predict that some large buyers might call the COMEX’s bluff by demanding physical delivery on futures that come due for settlement in December, putting the COMEX in default on these contracts. It’s hard to say how likely this scenario could be. But the wide divergence between the COMEX prices and the physical market has to lead to a reconciliation of some kind: a conspiracy of this magnitude, I hope, cannot go on indefinitely.

© 2008 Philip Glaser

How Do We Pay For The Bailouts?

November 21, 2008

The Federal Reserve and Treasury are making a desperate attempt to prevent the kind of deflationary spiral that led to the Great Depression.  In such a spiral, creditors, coping with defaults on existing credit, refuse to lend or lend only at prohibitive interest rates . As less money flows through the system, people lose jobs and cannot spend. Others fear losing their jobs and become conservative in their spending. This reduction in spending further reduces the flow of money, resulting in further job losses.  It’s an ugly scenario.

A major focus of the prevention effort lies in purchasing the bad mortgage and credit card debt held by major banks. By exchanging bad debt for cash, the Treasury enables the banks to remain viable because their balance sheets will demonstrate cash in place of bad debt. When they are viable, the banks will resume lending. Lending will increase the flow of money through the economy, which in turn will cause a resumption of what mainstream economists refer to as “economic growth.”

It would be a good thing if these actions in fact prevent a prolonged recession or depression. But I want to briefly explain some rather disturbing consequences of what the government is doing. I’m afraid the discussion will be rather technical, but I believe that it is important for folks to understand some of the mechanics of money creation, debt, and currency valuations. So please bear with me.

Revenues from taxes do not provide the funds with which to purchase the bad debt from the banks. So the government has to borrow the money. To do so, the Treasury issues bonds. In 2009 the US government will have to find buyers for upwards of two trillion dollars in new debt.

China has been a major buyer of US Treasury securities. It had a surplus of American dollars because of its exports to the US. By exchanging the dollars it received from its exports for Treasury debt, China helped finance the US debt and, in a self-reinforcing cycle, enabled the US to continue importing China’s products.

But the reduced spending and imports by US consumers has diminished the amount of cash with which China can purchase securities. (This may explain recent slowdown in the growth of dollar- denominated debt instruments held by foreign countries.)  And now, China plans to spend over $500 billion on its own domestic  stimulus package. To finance this package, it may sell some of its dollar reserves. China may be poised to shift from being a net buyer to a net seller of US securities.

The supply-demand dynamics of the credit markets could counteract the Federal Reserve’s effort to increase money flow by lowering interest rates. When the level of debt to be sold exceeds the number of willing buyers, the buyers must be rewarded with higher interest rates. Very simply, the “investment” must be made to appear more attractive. But the Fed must avoid raising interest rates: high interest rates constrict the flow of money and impede economic growth.

The Treasury and The Fed can take a couple of different routes to financing the debt without increasing interest rates. the Federal Reserve can create money out of thin air. When no other buyer can be found, the Fed can “monetize” the treasury debt by exchanging it for money that comes into existence at the flick of a switch. When China purchased US Treasuries, it exchanged cash already in the system for those debts. The effect was to exchange existing money for the promise of future money. It did not increase the amount of money in the system. But monetization increases the amount of money in circulation. Thus the Fed’s inevitable purchase of billions of dollars in treasury debt will increase inflation significantly. Some observers believe that monetization has already begun. Indeed, by its own numbers, the aggregate base of money has increased in recent months by almost 800%.

A deliberate and coordinated devaluation of the dollar could also help with the debt problem. A dollar devaluation would enable foreigners to buy US debt at a discount due to the relative strength of their currencies, without raising interest rates. It’s not clear to me exactly how such a devaluation could be controlled, though unleashing the Plunge Protection Team on the currency markets might do the trick.

Both monetization and devaluation would hurt anyone who saves their money in the traditional “safe haven” assets: certificates of deposit and US Treasury securities. I have already said a good deal about how to protect one’s assets against this type of scenario in this blog. You might to review past articles to get a feel for these options.

© 2008 Philip Glaser

How Our Monetary System Harms The Environment

November 6, 2008

I can’t imagine a more exciting time to be an American. After eight years of deterioration in our foreign relations, civil rights, and economic policy, Barak Obama will bring meaningful change to our country. My parents had the privilege to witness the rise of Martin Luther King as our country’s greatest civil rights leader. I am priviledged to witness the election of America’s first Afro-American president.

Facing the worst economic crisis since the Great Depression, Obama is wasting no time in putting together an economic security team. His consideration of Paul Volker for the post of Treasury Secretary has great significance. For several years now Volker has been observing with increasing alarm the economic imbalances that lead to the current crisis. As Fed Chairman under Jimmy Carter in the 1970s, Volker restored confidence in the dollar by raising interest rates. Doing so took a great deal of vision and courage because high interest rates impede economic growth. But he succeeded in putting the economy on solid footing for the longer term. Considering Volker for the post of Treasury Secretary demonstrates that Obama understands the type of economic leadership our country needs.

But the current crisis is merely a symptom of the deep structural problems in our world’s financial system, problems that also lie at the root of our environmental crisis.

Catherine Austin Fitts’ audio seminars on The Falling Dollar introduced me to fiat currency and the likelihood of a monetary collapse sometime in the next decade or so.  In her interview with James Turk she pointed out that some environmentalists do not like precious metals. However, though improper mining practices do have a negative environmental impact, she argued that the long term effects of fiat currency and the fractional reserve banking system have done far worse. James Turk added that in the 1960′s Paul Einzig predicted the detrimental environmental outcome of our world’s monetary practices.

I have been planning to research Enzig’s writings to develop my understanding of this problem. Then, today, Providence dropped this wonderful video presentation, Money As Debt, into my lap.

Aside from explaining with great clarity why our monetary system must eventually crumble under its own weight,  Paul Grignon’s fourty-seven minute presentation demonstrates the incompatibility of our fractional reserve banking system with ecological sustainabilty.

In our economic system, the consumption of natural resources must keep pace with the growth of money-debt supply to avoid hyperinflation (hyperinflation can only be avoided when the material output of the eoncomy keeps pace with the growth in money supply). The system makes plundering the earth’s resources not only profitable, but continuously necessary.

Anyone interested in sustainable living must understand and embrace this understanding of our monetary practices. To save the planet, we must develop an alternative system, one that does not require exponential growth in both the money supply and the consumption of natural resources.

And if you choose to protect your personal assets by purchasing precious metals, know that doing so constitutes an act of economic and political protest. By withdrawing value from the monetary system and storing it in a way that does not require interest payments from any counter party, you undermine the money-debt mechanism that our banking system feeds on.

Please watch Grignon’s presentation and think about these ideas. He gets to the sustainability problem at the end of the video, but please watch all of it: very few people have presented the history and practices of fractional reserve banking with this level of clarity and insight. And then bring your questions and comments back here for discussion. I’m really excited about the level of clarity that Grignon brings to these issues.

Note: I recommend that you mute the sound on the video and let it run all the way to the end without watching it, and then rewind it to the beginning and unmute. This way you will buffer the entire video and avoid the annoying interruptions that occur when streaming video content over the web.

Have a great day!

© 2008 Philip Glaser

Physical Versus “Paper” Silver And Gold

October 29, 2008

A few days ago I began writing a very different piece. With the concept of Limits to Growth as background, I introduced Financial Permaculture and The Great Turning. These ideas can inspire us to envision and work towards a future in which communities, at the local level, manage their resources to foster reasonable and sustainable prosperity for themselves. Such a vision can be a comfort in times like these when the world’s anonymous mega-economy heads into a terrifying collapse, dragging many innocent bystanders down with it.

But the cosmos did not want me to write such an article this week: Despite having carefully saved the draft of the piece in my blogging service Monday evening, the content had just disappeared when I went to work on it on Tuesday morning. And of course I did not have a backup on my own hard drive. The cosmos is probably right. The chaotic busyness of October burnt me out and I needed a little bit of a break. I’ll do the Deep Thinking next week. Or whenever.

So now I shall, instead, write rather briefly about what to do if the idea of holding physical silver or gold makes you uncomfortable. I also need to give you an update on the latest precious metals market gossip.

A relative of mine, nervous about owning and storing silver bullion coins, recently began purchasing shares in SLV, an Exchange Traded Fund  that you buy through a broker like a regular stock. I do not trust SLV and similar instruments (e.g., the gold ETF, GLD) because I don’t know for sure that they really own the metals that they say they do. Funds like these also purchase futures and other paper proxies that follow the official market price of gold.

Without ounce-for-ounce backing in real silver and gold, these funds have some characteristics in common with fiat currency. In particular, at some point the market may figure out that they do not actually own the metals and downgrade their price.

However, having done some research into this question, I can confidently recommend two alternatives to physically holding silver and gold.

  • Central Fund of Canada: This fund has only one purpose: to own physical gold and silver (roughly half of each). You buy shares of this fund (ticker symbol CEF) on the stock market just like any other stock. Unlike the ETFs, it employs rigorous and redundant third-party accounting mechanisms to ensure that the shares traded on the exchange do represent real ounces of silver and gold.
  • Goldmoney.com: This company’s propieter, James Turk, contributes frequently to the Financial Sense Newshour and is endorsed by Catherine Austin Fitts. The operation runs very differently from CEF. You open a personal account with goldmoney.com and purchase a specific amount of gold or silver. Goldmoney.com holds the physical metal, also under redundant third-party accounting mechanisms, in vaults in London and Zurich. It is an easy and cost-effective way to secure precious metals.

I personally use both of these mechanisms — I trust no one else to hold precious metals on my behalf.

I have already discussed the price volatility of precious metals. Let me reiterate: I do not advocate that you put all of your savings into precious metals. I advocate putting some percentage of your savings into precious metals as a hedge against inflation, counterparty default, and currency collapse. Their price volatility makes them a poor choice for money that you need to use in the short to near term.

I believe that silver and gold are real money. The fiat currency system enables the banking system to manipulate the economy in ways that, over the long term, penalize people who live within their means and spend only what they can afford rather than what they can get credit for. So the sharply dropping price of precious metals in the official commodities markets lately leaves me disheartened.

But actual transactions of physical gold and silver tell a price story rather different from the official spot price on the COMEX (the official commodity exchange). Bullion dealers and mints cannot keep up with demand for physical gold and silver. Consequently, buyers are paying a premium of 100% for some types of silver bullion coins on ebay. In essence, buyers are willing to pay double the spot price for some coins. In a recent article, Jim Willie describes a gold transaction of conspiratorial proportions. Last week in Toronto a multi-million dollar purchase of gold took place at $1075 per ounce, while the COMEX price of gold last week was around $300 per ounce less.

In other words, good old fashioned supply-demand dynamics are pushing up the price price for physically held precious metals. The disconnect between the official market price and the physical price can only mean that the paper representations of the metals (futures, certificates, etc.) do not really represent the metals themselves. But the official market price is bound to catch up with that the physical market.

Jim Willie’s article also observes, by the way, that the foreign entity purchasing gold at $1075 per ounce settled the transaction in Euros. He also draws our attention to similar transactions over the past several months where foreign entities settle transactions for large amounts of gold in foreign currencies. For example, a few months ago a sovreign entity moved four hundred metric tons of gold into storage with the Royal Canadian Mint. Might some central bank in Europe or elsewhere be taking steps to back its currency with gold? Willie thinks so. If he’s right, the official metals markets would have quite a reaction!

Please review my usual disclaimer: I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner. I recommend finding one who understands monetary inflation and peak oil. Also, I have no affiliation with or other reason to promote the Central Fund of Canada or goldmoney.com.

© 2008 Philip Glaser

The Trashcan Root Cellar

October 20, 2008

The comments on last week’s entry brought to mind a disturbing moment in my evolution as a bloger. A really nifty feature of my blog publishing service shows other sites linking to this blog. Imagine my delight, after only a few posts, to discover such an “incoming link.”

The Neo-Patriarch And Me

My delusions of grandeur faded as I read the title of the link: Wealthy Investors Hoard Bullion. I find myself resonating with many of the topics on the Neo-Patriarch’s home page: homesteading, gardening, cryptography, conspiracies — this is all right up my alley!  (I’m not so sure about his interest in Christian Polygamy, although I have to confess some fascination with another piece to which his site led me, this one about Orthodox Jewish Polygamy). My affinities with the Neo-Patriarch make it all the more painful that he believes my blog’s financial views to be directed towards “the wealthy.”

The mis-impression stems, no doubt, from my exclusive focus on money for the past several weeks. But of course, as Valorie and Crystal rightly observe, and as I’m sure the Neo-Patriarch would say, saving money does not tell the whole survival story. Material survival depends very simply on food, clothing, and shelter. Whether you view it as a medium of exchange or as a store of value, money does nothing more than enable you to procure these things. So why not just secure shelter and the means to produce food and clothing? Once you have those, your need for money diminishes significantly (especially if you have goods you can barter for the goods you can’t produce yourself).

Setting The Record Straight

But I just have to say a couple of things about money and “the wealthy.” The government’s fix for the credit crisis lets the wealthy who beneifted from and created the credit bubble get away with their misdeeds and places the enormous cost on the rest of us. Through inflation, it will penalize those of us who spend modestly and save diligently for the arrogance and greed of those who lend and borrow profligately. One of my intentions is to rectify this situation by offering information about sound money.

I also made it clear that Franklin Sanders’ Monthly Acquisition Program makes it possible for people of just about any means to invest regularly in silver bullion coins as a means of protecting some portion of their savings from the ravages of hyperinflation. The purchase of silver bullion coins through this program can help anyone, especially folks  with little money to save, protect their savings. This advice is not for The Wealthy — it is for you, Joe The Plumber!

Putting My Money Where My Trashcan Is

The great problems that face us today — peak oil, deflationary depression, monetary collapse, and climate change — point towards the same solution: self-sufficiency. The low-cost petroleum that has made it so cheap to buy food in grocery stores cannot last forever. But getting off the food production grid takes quite a bit of effort. You have to develop a number of long-forgotten skills to grow and store your own food.

Meaningful change of any sort must proceed in small, manageable, and measurable steps. That’s why I suggest moving some portion of your savings into precious metals in small increments. Baby steps towards self-sufficiency ought to follow the same pattern.

As a simple example, I offer the trashcan root cellar. Before the invention of the refrigerator just about everyone had a root cellar. A root cellar preserves food in the constant, below-ground temperature of 50 to 55 degrees Fahrenheit. Many foods can survive all winter long in this temperature range. A cursory google on the topic of root cellars will reveal a wealth of designs.. However, the drainage and ventilation mechanisms for a traditional root cellar made from a framed structure require quite a bit of forethought and knowledge about such matters. And the affair can become rather expensive.

The Joe-The-Plumber, trashcan root cellar, provides an inexpensive and simple alternative. The instructions go something like this:

  • Procure a 25- or 30-gallon galvanized steel trashcan;
  • Dig a hole;
  • Put four inches of gravel in the bottom of the hole for drainage;
  • Bury the trashcan, leaving about four inches of trashcan above the surface;
  • Cover the trashcan with straw or hay and a plastic cover;

Digging Our Root Cellar

Remember to place the trashcans somewhere that you can get to easily when there’s a lot of snow and ice on the ground. You’ll also need to understand which foods are compatible for root cellar storage (see Root Cellaring by Mike and Nancy Bubel for further details). You can make additional trashcan root cellars for different food varieties, such as apples and vegetables.

Positioning The Trashcans

In our case, the greatest expense turned out to be digging equipment — $50 after we split the rental six ways with neighbors who dug root cellars the same day. If that exceeds your budget, you could form a root cellar digging party with some neighbors and take turns on a series of weekends or weekday evenings digging each others’ holes. It can be a great opportunity to get to know your neighbors — a grand social affair. Or dig it yourself at your convenience.

The Root Cellars

The Root Cellars

The trashcan root cellar will take you far in your journey to self-sufficiency. Increasing your capacity to store food makes you less dependent on the grocery store and thus less dependent upon the petroleum-based transportation grid. Even if you don’t grow your own food, you can buy from local growers and store it for use throughout the winter. You will be in a better position to weather the economic storms that lie ahead. And it’s good for your carbon footprint, too!

© 2008 Philip Glaser

It’s Time To Hoard Some Cash

October 12, 2008

In constructing an intelligible picture of the unfolding global banking crisis, I came across a useful piece by Axel Merk, whose voice I have come to appreciate hearing on the Financial Sense Newshour. Aside from his typically clear (if rather technical) explanation of events, Axel suggests hoarding some cash along with precious metals. Notwithstanding the U.S. Dollar’s future as toilet paper, current events make me inclined to agree with this suggestion.

We need to understand the gravity of what might happen to our banking system.

In my discussion of counterparty risk last week, I touched upon the technical workings of the fractional reserve banking system. You tend to think of a bank as an institution that keeps your money safe and rewards you with interest.  A more useful description takes into account that the interest constitutes your share in the bank’s profit from lending your money. Really, the bank functions as a broker that lets you lend your money out to counterparties.

All of this works just fine as long as:

  1. You and the other depositors in the bank agree not to demand all your money all at once (remember, the bank’s borrower’s hold 90% of the bank’s assets); and
  2. The counterparties to whom the bank lent your money make payments on the money you lent them reliably until they pay the bank back.

In other words, the financial health of a bank depends upon the reliability of the creditors whose loans make up the lion’s share of the bank’s balance sheet. For this scheme to have integrity, the bank must be able to count the money owed to it as a viable asset. The credit crisis now in progress stems from point 2 above: The counterparties to a massive amount of debt cannot make their loan payments.  As creditors fail, the banks’ balance sheets look more and more precarious. Sub-prime mortgage holders make up the bulk of today’s failed counterparties. But the amount of this debt pales in comparison to the mountain of credit default swap “assets” that will fail as the recession deepens.

To avoid putting themselves deeper in the hole, banks have stopped lending. In our credit-driven economy, Axel Merk points out, many otherwise sound businesses depend heavily on short-term loans known as commercial paper in order to run their businesses. Unless the credit starts flowing through the system again, many companies risk going out of business. A wave of such failures could cause a downward spiral into a depression.

This past week, the central banks of the US and Europe lowered interest rates to make it easier for their member banks to get access to cash. The central banks want their member banks to use the inexpensive cash to compensate for the failing debt in their balance sheets. But the banks, rationally, have not taken up the central banks on their offer: Taking on more debt just makes their position more precarious.

In the solutions now being undertaken, the treasury departments of the United States and Europe would recapitalize the banks directly: rather than lend money to the banks, they would give them the money in return for an ownership stake.

This nationalization of US and European banks has a nauseating and unavoidable ring of socialism. Having grown up with the world’s two superpowers threatening to anihilate each other over a disagreement about distribution of wealth, I find this development hard to swallow. But preventing a cataclysmic failure of the banking system has to take precedence over ideology, for the moment. The global financial system has been breaking for a long time, but you don’t rearrange the deck chairs when the ship is sinking.

No one can predict the outcome of this crisis. But the risk of systemic bank failure should not be ignored. In the long term, the hyperinflation resulting from the governments’ attempt to save the system or to revivie it after it crashes will make precious metals the most reliable safe haven. But hyperinflation has not yet arrived, and an immediate and systemic bank failure would make it difficult to get your hands on plain old cash to buy basic necessities.

So, as Axel suggests, it’s a good idea to go to your local bank and get some dead presidents. Bury them under the proverbial matress or, preferably, in a more original hiding place. It would also be wise to stockpile some canned food and bottled water.

I apologize for sounding apocalyptic. But this is serious business. I’d rather act a little panicky now than end up unable to feed my family. I hope that in a few weeks you can justifiably accuse me of being a drama queen today. I’d prefer that embarassment to the outcomes that seem a bit too plausible at the moment.

© 2008 Philip Glaser

Price Volatility of Precious Metals

October 6, 2008

Something rather strange happened to me just after publishing last week’s article. You’ll recall that that article dealt with purchasing precious metals. After the dramatic 700 point drop in the Dow, a neighbor stopped me outside my house and said: “You were sure right about the market!” Something similar happened a few years ago: the stock market dropped sharply, shortly after I had sent out an email to my circle of friends and neighbors about monetary inflation. A different neighbor at that time said the same thing: Oh, you were right about the markets!

I have the sinking feeling that my recent advice gave the impression that precious metals mitigate the risk of stock market investments. Yikes!  I’d  be happier if my neighbor had complained to me about the drop of silver prices from their high of over $20 per ounce in March to under $11.00 on September 11th of this year. A Maalox-moment if ever there was one!

The decline of silver and gold prices in the past several months illuminates some important points about the volatility risk of investing in precious metals. To begin with, let’s reiterate the risks that precious metals do mitigate: loss of principal value due to inflation, monetary collapse, and counterparty default.

Inflation

Inflation results from an increase in the “velocity” of money. That is, when the supply of money in the economy increases, spending also goes up. The increased demand then drives prices up. Money supply grows primarily through expansion of credit. For example, the housing bubble now in the process of collapsing came about because the Federal Reserve dramatically lowered interest rates in 2000 and 2001 to deal with the recession of those years. Low interest rates make credit less expensive and thereby increase the velocity of money. The dramatic rise in the price of energy and food in the past few years result from the increased money supply. (The supply-demand problem of petroleum and natural gas is a whole other problem that I shall take up at some point in the  future.)

Precious metals protect purchasing power against inflation because its price rises with everything else. Thus the rise of silver from around $5.30 per ounce in January 2000 to its highs of this past spring. Gold prices tell the same story. Holding silver and gold since the year 2000 would have compensated for the 40% drop in the value of the dollar during the same period.

Monetary Collapse

The dollars in which we transact business have no backing by precious metals or any other real commodity. Our legal tender laws force us to accept dollars as payment for business transactions. History shows that  “fiat” currencies like ours follow a particular pattern of decline in which the government overproduces money in order to cover its debts: the examples include Wemar Germany following World War I and Argentina in the late 1990s. The increased money supply causes hyperinfaltion, a situation in which the highest face-value bill has more value as toilet paper than as a medium of exchange. At that point, the populace turns to other media of exchange. Precious metals provide a reliable store of value when the currency reaches the hyperinflationary state.

Counterparty Risk


I mentioned last week that, in our fractional reserve banking system, a savings bank can lend out 90% of its deposits. By definition, a bank cannot satisfy a demand for all of its deposits at one time. It relies on most people leaving most their deposits in the bank most of the time. The borrowers to whom the bank has lent the depositors’  money indirectly owe that money to the depositors. The bank’s borrowers, not the bank itself, holds most of the despitors’ assets. If these counterparties default on their loans in great numbers, the depositors’ money disappears. When large numbers of people and businesses default on their loans, as in a severe economic downturn, depositors loose confidence in the balance sheet of the bank. In a “run on the bank” a large number of depositors demand their deposits at the same time and the bank has to close its doors. FDIC insurance protects depositors against this kind of scenario. But a massive banking meltdown could easily overwhelm and bankrupt FDIC itself.

When you physically hold precious metals, you avoid counterparty risk entirely.

So What’s The Catch?

Like any asset class, precious metals do not perform well in all economic situations, the worst situation being deflation. In the typical deflation scenario, a credit bubble reverses itself into a credit contraction. Interest rates rise and banks become reluctant to lend money even to each other. The decrease in money supply reduces the velocity of money, causing the reverse effect of inflation: the price of everything drops. The drop in the prices of stocks, energy, agricultural commodities, and precious metals in the past few weeks exemplies the kind of deflationary pressure that occurs when credit tightens. Deflation may be the only situation in which cash and short-term bonds have an advantage over other asset classes: as the price of everything drops, the relative purchasing power of cash increases. The deflationary crisis of the Great Depression presented great buying opportunities to anyone who had cash to spend: real estate, for example, could be purchased at bargain basement prices.

Other factors affect the price of precious metals. Many hedge funds hold precious metals in the form of paper-based obligations. That is, they do not hold physical precious metals, but hold various kinds of financial instruments that represent precious metals. As shareholders in these funds demand redemption of their shares, the hedge funds dump their precious metal holdings (along with other commodities) to raise cash.

Intervention in the markets by central banks to undermine gold as the primary competitor to fiat currency also plays a role. The Gold Anti-Trust Action Committee has for years chronicled interventions of this sort.

If any of this seems counter-intuitive, take note of the the fact that precious metals dealers today have difficulty fulfilling orders — gold and silver bullion are flying off the shelves faster than the refineries can produce it, and it can take several months for the backorders to be filled. Based on physical demand the price of precious metals should be much higher right now. The disparity between the market price and physical demand suggests either deliberate market manipulation or the short-term effect of hedge funds dumping their paper proxy holdings of precious metals.

My belief in the long-term outlook for inflation remains firm. The recent spate of bailouts have increased the Federal Reserve’s balance sheet dramatically. And as the default credit swap crisis enlarges the circle of credit problems from the mortgage sector to the economy as a whole, more bailouts will come.

But that’s not all. In the next few years, the retirement of the baby-boomer generation will put tremendous pressure on government entitlement programs such as medicare and social security. The government will have no way to meet these obligations other than borrowing more money. Through the machinations of the Treasury department and the Federal Reserve, the government debt will further increase the money supply and inflation will run rampant.

Precious metals will do well in the long term as our monetary system unravels. But, as we see today, the volatility of precious metal prices make them a poor choice for money that you need to access in the short-term.  Holdings for more immediate use are better held in the short-term bonds of foreign countries that follow more conservative monetary policies. One mutal fund to consider, the Prudent Bear Global Income Fund (ticker symbol PSAFX), holds a diversified portfolio of short-term bonds in a number of such countries. You will need to figure out the right mix of physically held precious metals and something like PSAFX for your own personal asset protection plan.

A Slightly More Useful Disclaimer

This is the point in my post where I have been saying “I am not a professional financial planner and have no credentials in this area. You should always review your long-term financial plan with a qualified financial planner.” That of course is true. But this time I would like to offer you the view of Chris Ciovacco, who is a professional financial planner and does have excellent credentials in this area. In his recent article Investing Now: The Big Picture, Chris observes:

While there is no question gold still has very positive long-term prospects for a variety of reasons, risks remain in an environment where there is open trader talk of possible U.S. dollar intervention by global central bankers. . . . Gold’s lower lows and failure to make a new high during a very serious financial crisis, tells me the following:

  • For the moment, the markets are more concerned about economic weakness rather than inflation (the focus will change in the months and years ahead).
  • Dollar strength is curbing the demand for all commodities, including gold.
  • Central bankers and policy makers do not want to see high gold prices. High gold prices put a spotlight on excessive money creation and government intervention into the free markets (all related to debt and currency debasement). Central bankers and policy makers still carry a heavy hand in the financial markets. They can crush the little guy in the short run. They can alter markets in the short-run. Gold’s 28% drop between July 15, 2008 and September 11, 2008 is a painful illustration of this concern.

In the interest of brevity I have left out the parts of this section of the article in which Chris advocates for reducing one’s exposure to gold (and by extension we would say silver as well) during this period of uncertainty in asset values. That would not be my personal approach because I have more of a buy-and-hold orientation. But please take a look at his article for further and more technically detailed insight into another view of how one might proceed in this market environment.

© 2008 Philip Glaser


Follow

Get every new post delivered to your Inbox.