Fair Value Gold?

I was asked by email today what would be my counter-argument to this new piece by Paul van Eeden. I thought I would share it with you. But first, here is a snip from Paul's article, "Gold is over $1000 an ounce - Now what?"

Given that the gold price is trading at a 25% premium to its fair value and that we can imagine several scenarios whereby the US dollar could rally and the gold price could fall, it seems to me that betting on a higher gold price right now is merely a bet on the Greater Fool Theory. That is not to say that the gold price could not continue to rally - markets can remain irrational far longer than rational people ever imagine they would. Personally, though, I have no interest in buying an over-priced asset in the hope that it will become even more over priced - not even gold.

Here was my reply...

The dollar is so much more than just its quantitative body, its size. If it was not, it would have surely collapsed back in the 1970's after being set free from gold. But something else developed, an insatiable demand for dollars that allowed for the supply of money to be increased time and time again with little inflation showing up in prices and almost a negative affect on gold over a 20 year period. How was this possible in a world that was supposed to actually perform under Austrian principles of monetary inflation?

Obviously the printing of money and the expansion of credit had little to do with gold price inflation, at least from 1980 through 2001. 1971 to 1980 and 2001 to 2009 were different, but what was happening? Was it a shift back and forth between a quantitative monetary effect or something else entirely?

What changed in our first and only 38-year experiment with a completely symbolic, unbacked fiat currency was that, from an Austrian perspective, we were shocked and surprised to find such a tremendous demand for such a singularly worthless currency.

This demand came from its ease of use and from the ease of credit creation and international transactions. We got little plastic cards and key fobs that could pay for anything from gas to groceries. The banks got the equivalent of the Midas touch when it came to credit expansion. And the globalization movement got the most liquid capital movements ever imagined.

Perhaps it took 9 years for all this new demand to mature, but once it did, we got the 1980's!

But did you notice something about all the demand developments I listed? The were all based on the dollar's ease as a transactional unit. None of them were based on its intrinsic value. None were based on its store of value function. None were because of its superior use as a denominator of debt. Only for its ease in issuing debt.

But for hundreds if not thousands of years these two separate functions of money have been ingrained into our human psyche as one and the same. Money, as we know it, is both a transactional medium and a store of value.

So in the 1970's, we watched as acceptance of this new symbolic transactional unit grew. In the 80's and 90's we watched as the dollar exploded in quantity and global use, with relatively little inflationary impact. And then in the new millennium, we are seeing another shift: the recognition that the dollar is really only good for its transactional use. But quite poor as a store of value.

So gold's price rise is not a function of inflation, as van Eeden says, but is instead a function of a global sea change away from using the dollar as a store of value. When viewed from this perspective, gold's rise has only just begun.

What do you think allowed for 20 years of dollar expansion with no gold price inflation? It was the soaking-up of newly created dollars as people all over the world held them as a store of value. Wall Street exploded as the enabler of this misguided demand, while the real demand was for the dollar's transactional ease. China followed, as did much of the developed world. But now this trend has reversed.

This is why van Eeden's money supply analysis is meaningless. I fully expect transactional dollar demand to swell from time to time as large holders of debt liquidate into a new form of savings. This is because that fading value must pass through dollars to get where it is going. But you must understand that whatever the USDX does, it does not represent new savings flowing in.

The transactional money supply is tiny compared to the supply of dollar-denominated savings. It is a bottleneck that must be traversed to get into gold. So the USDX is a misleading metric for those of us watching gold rise in value. Jim Sinclair will be right in the end, but the path there may still hold some confusing hiccups along the way.

The quantity theory of money DOES apply, but in a much more complex way than van Eeden shows. Too complex, in fact, for anyone to fully understand. The QUALITY of money also applies, alongside the quantity.

For this reason, my personal focus on the quality and quantity of money revolves around hyperinflation, a currency event that is separate from the rise in gold which is driven by the first ever separation of monetary functions. The various qualities of modern money can be simply viewed as M0, and then M1, M2, and then M3 and broader. My argument is that only M0 matters once hyperinflation takes hold. And that all of the money creation over the last year has been M0. I argue that large swaths of wider money have been converted to M0 by the Fed, like turning a living creature into stone. I also argue that guarantees foreshadow future M0 conversion, and that guarantees are being handed out like candy on Halloween. For all these reasons I see the tinderbox of hyperinflation being rained down upon by hot embers from the forest fire of burning dollar-denominated derivatives and other Ponzi paper.

It is the principles above that must be understood because any quantitative analysis in today's rigged financial environment will deliver dubious results.

I notice that van Eeden focuses on the collapse of credit money but discount's the Fed's current monetization as being "only" $900 billion of base money (M0). Then he says,

And while the increase in the US money supply as a result of the Fed's priming is material, and has maintained US monetary inflation at historically high levels, it is nowhere near hyper-inflationary rates, nor is there any reason to believe that hyperinflation is remotely likely in the US.

Here is where Richard Maybury's description of "velocity" (as opposed to money supply) comes into play. Velocity, as Maybury says, can turn on a dime, and has the same effect as increasing the supply!

Hyperinflation begins as the dollar is first repudiated as a store of value (a reversal of velocity), and second as an international transactional unit. Hyperinflation does not begin with the printing of million-dollar-notes. That comes later as the government responds to the failing dollar value in the way we all know it will. Iceland's government did not have this option last year. But the US does. It will print to "slow the pain". But in reality it will be causing long term pain that will be felt by the whole world, especially us in its legal tender zone.

To make the kinds of quantitative conclusions that van Eeden makes is to assume that free market adjustments to the real value of the dollar are fully up to date. This is the wrong assumption, as the dollar's (non) value has been masked for 38 years by both willful acts of the Fed, and also an irrationally exuberant market for Ponzi paper.

In 1971 the dollar became intrinsically worthless. But the advent of computers made this symbolic currency explode in value as a transactional unit. Only now, 38 years later, are we starting to realize that transactional value and time-store-of-value are not the same thing.

So to assume, as van Eeden does, that gold's value should simply counter-lever the supply of worthless dollars completely ignores the global separation of monetary roles that is happening today. This is NOT simply a figment of Another's imagination. You can see it on all scales from individuals on up to the CBs if you bother to look outside of the United States.

From a quantitative perspective, like van Eeden takes, we could be looking at something on the order of a $60 Trillion flow that will move from symbolic-idea-denominated savings into hard gold savings, when all is said and done. And as this happens, the very denominator of the former will explode numerically so that the final outcome will appear much different than any quantitative analysis could even deliver at this point in time.

On the issue of interest rates, the dollar is only as valuable as what it can purchase either inside the US or outside. The outside is now working on other forms of pricing, so the dollar's only future value must be juxtaposed against what it can purchase inside the US, even for those holding dollars on the outside. And any increase in interest rates, whether market-driven or Fed-driven, will have a decidedly negative affect on an already failing economy. In other words, 'not much to purchase here'. This is why, and how, an increase in interest rates this time around (unlike 1980) would only exasperate hyperinflation and send the price of gold into the outer solar system.

The dollar is in a serious Catch-22 this time around, which is why I say my conclusions are unavoidable.

Van Eeden assumes that gold is always going to be the inverse of the dollar. But even Another and FOA said that, in the end, the dollar and gold will rise together. I have been saying this for a while too. It will be the final exit from paper into gold that must pass through the bottleneck of a few trillion transactional dollars. But this belief that van Eeden and so many others have will cause them to miss out on the greatest transfer of wealth ever.

In this same vein, technical analysts and Elliot-wave deflationists will also sell gold as it hits $1,300, the worst trade in the history of planet Earth!

Regarding China: China is in a badly manipulated and rigged position right now as well. Only its position is the inverse of ours. In my last post I said that (Savings) = (Production) minus (Consumption). The Chinese people are in a position of forced savings by their communist collective. They are being forced to produce, but not to consume the fruits of their own labor while it is being shipped to the USA. And the communist collective is stockpiling this windfall profit by printing local currency like it's going out of style, stealing purchasing power from its own people as it forces them to save.

But as trends reverse, which they are now, these same people who have been forced to delay consumption will suddenly find themselves supporting their own economy as they use their savings to purchase a higher standard of living. On top of this, they are now starting to save gold! Which will only AMPLIFY this effect as we transition to Freegold!

Another concept that van Eeden ignores is that at the same time as the dumping of the dollar in international transactions is being discussed, China is signing new international deals for the renminbi. I don't believe that China wants to print the new global reserve currency. But this new usage demand for the renminbi will have the de facto result of soaking up some of this Chinese inflation. And as this slow, global process moves forward, I think a lot of people (including the Chinese themselves) will be surprised at the result.

I do not believe that Chinese communism has created a great economy. I only believe that the mistakes they have made simply happen to be the inverse of ours. Dumb luck! And that everyone will be surprised how things actually play out.

I believe that we are witnessing a market-driven global shift to meritocracy; economic power based on merit and credibility. I believe Martin Armstrong nailed it when he said this will be the end of socialism. And honestly, I wouldn't be surprised if the transition to Freegold signals the beginning of the end for Chinese communism. I'm not predicting this (it would take 20 years or more), I'm just saying I would not be too surprised!

Given that the gold price is trading at a 25% premium to its fair value

Fair value against what? A piece of paper? Or fair value against the REAL wealth of the world?

In my opinion, time will reveal who was "the Greater Fool".

Sincerely,
FOFOA