The Shoeshine Boy

To set up this post I will share with you two brief predictions I recently received by email. These were both in email blind copied to large groups of recipients that included me. The two senders do not know each other. In fact, their only connection is that they are both supporters of my blog on the highest order, I know what they each do for a living (very respectable), and I therefore hold them both in high regard:

Email 1:
This is a very orderly secular bull market. The bubble, that WILL come, is still about 2 or 3 inches to the right of the margin on the right side of this chart...

Email 2:
Perhaps we are talking about the first general realization among the investing public that the Fed cannot/will not rescue us with their magic wands and QEs… This may be it, the beginning of Stage 2 of gold's rally, where the smart money starts moving in. Stage 3 is next when the shoeshine boy tells you: Buy gold!

For those of you that don't know the meaning of the shoeshine boy reference, JFK's father, Joe Kennedy claimed that he knew it was time to get out of stocks in 1929 when he received investing tips from a shoeshine boy. Ever since, the shoeshine boy has been the metaphor for "time to get out"; for the end of the mania phase in which everyone, even the shoeshine boy, wants in.

Joe Kennedy

Joe Kennedy's credibility on this "bubble top calling" issue is bolstered by the fact that from 1929 to 1935 his fortune went from $50 million to $2.85 Billion in today's purchasing power. And the take-home lesson in this story is that it is time to sell ANYTHING once the shoeshine boy is recommending it. Because the next phase is the blow off phase where the item in question comes crashing back down.

Bubble Phases

And the fact that two of my favorite readers are now calling for an eventual bubble in gold reminded me that it has been 9 ½ months since I wrote Gold: The Ultimate Un-Bubble. Perhaps it is time for an update.

Now I'll grant that the point in both of the quotes above was that we are nowhere near the bubble top. And they were addressed to people that are very jumpy when it comes to bubbles because they have been burned by a couple bubbles in recent history. But even so, I think they expose a fundamental misunderstanding of what is actually happening today.

How Gold will handle even the Shoeshine Boy

Before I get into what is actually happening with gold today, I want to show you WHY it is happening to gold. And WHY gold is different. There's a unique thing that happens with gold. ANOTHER said it pretty clearly (even if still a bit cryptic) in his very first post:

"Gold has always been funny in that way. So many people worldwide think of it as money, it tends to dry up as the price rises."

In a future post I'll explain the context in which ANOTHER made this statement because it portends vast changes in the international monetary system directly in front of us. (Remind me of this. I was going to include it here but the post grew too long even without it. :) But for now, we need to look at why this statement is true. For this I turn to John Law. Well, not the real John Law, but another pseudonymous blogger like me using his name back in 2006:

An illustration

Let's start by comparing two hypothetical cases.

In case A, a million Americans decide right now to move all their savings into Dell stock, buying at the current market price no matter how high.

In case B, a million Americans decide right now to move all their savings into gold, buying at the current market price no matter how high.

In both cases, let's say each of these test investors has an average of $10,000 in savings. So we are moving $10 billion.

Neither gold nor Dell can instantly absorb $10 billion without considerable short-term increases in price. Because it would require us to predict precisely how other investors would react, we have no way to precisely compute the effects. But we can describe them in general terms.

In case A, the conventional wisdom is right. Our test investors should expect to lose a lot of money.

This is because Dell has a stable equilibrium price which is set by the market's estimate of the future earning power (price-to-earnings ratio) of this fine corporation. Because it is not the result of any new information about Dell's business, the short-term surge should not affect this long-term equilibrium.

Since there will almost certainly be a short-term price spike, many of the test investors will be buying at prices well above the stable equilibrium. In fact, the more investors we add to the test, the more each one should expect to lose. Doh!

But there is no way to apply this analysis to case B.

Precious metals have no price-to-earnings ratio. With gold formally demonetized (that is, with no formal link between gold prices and currencies such as the dollar, as there was until 1971), there is no stable way to price it. There is no obvious equilibrium to which the gold price must converge.

It is true that gold has industrial uses. It can be priced on the basis of industrial supply and demand. The conventional wisdom is that it is.

Thus we can say that gold, for example, is overvalued if gold miners are selling more gold than jewelry makers and other industrial users want to buy. At present (with gold near $700), they probably are. So if you follow this reasoning, the right investing decision is not to buy gold, but to sell it short.

But this just assumes that there is no investment demand for gold. On the basis of this assumption, it shows that gold is a bad investment. Therefore there should be no demand for it.

Therefore, when our case B investors put $10 billion into gold, that money has to be used to bid gold away from its current owners, many of whom already believe that the price of gold in dollars should be much higher than it is now.

So the result of case B is that the gold price will, as in case A, rise immediately. But it has no reason to fall back.

In fact, quite the opposite. Because the gold price is largely determined by investment demand, any increase in price is evidence of increasing investment demand. Mining production, noninvestment jewelry demand, and industrial use are relatively stable. Investment demand is a consequence of investors' opinion about the future price of gold - which is, as we've just noted, largely determined by investment demand.

This is not a circularity. It is a feedback loop. Austrian economists might call it a Misesian regression spiral.

Suppose you believe this. It's all well and good. But what does it really prove? Couldn't gold still be just another bubble?

And why should gold be a better investment because it has no earnings to price it by? This makes zero sense.

To answer these sensible objections, we need a few more tools.

Nash equilibrium analysis

The Nash equilibrium is one of the simplest and oldest concepts in game theory. (Nash is John Nash of A Beautiful Mind fame.)

In game theory jargon, a "game" is any activity in which players can win or lose - such as, of course, financial markets. And a "strategy" is just the player's process for making decisions.

A strategy for any game is a "Nash equilibrium" if, when every player in the game follows the same strategy, no player can get better results by switching to a different strategy.

If you think about it for a moment, it should be fairly obvious that any market will tend to stabilize at a Nash equilibrium.

For example, pricing stocks and bonds by their expected future return (the standard Wall Street strategy of value investing) is a Nash equilibrium. No market is infallible, and it's possible that one can make money by intentionally mispricing securities. But this is only possible because other players make mistakes.

(Nash equilibrium analysis of financial markets is not some great new idea. It is standard economics. The only reason you are reading a Nash equilibrium analysis of the interaction between precious metals and official currency now on the Web, not 30 years ago in the New York Times, is that the Times gets its economics from real economists, not random bloggers, and the profession of economics today is deeply tied to the institutions that manage the global economy. Real economists do not, as a rule, spend time thinking up clever new reasons why the global financial system will inevitably collapse. They're too busy trying to prevent it from doing so.)

What Nash equilibrium analysis tells us is that the "case B" approach is interesting, but inadequate. To look for Nash equilibria in the precious metals markets, we need to look at strategies which everyone in the economy can follow.

Let's focus for a moment on everyone's favorite, gold. One obvious strategy - let's call it strategy G - is to treat only gold as savings, and to value any other good either in terms of its direct personal value to you, or how much gold it is worth.

For example, if you followed strategy G, you would not think of the dollar as worthless. You would think of it as worth 45 milligrams, because that's how much gold you can trade one for.

What would happen if everyone in the world woke up tomorrow morning, got a cup of coffee, and decided to follow strategy G?

They would probably notice that at 45mg per dollar, the broad US money supply M3, at about $10 trillion, is worth about 450,000 metric tons of gold; that all the gold mined in human history is about 150,000 tons; and that official US gold reserves are 8136 tons.

They would therefore conclude that, if everyone else is following strategy G, it will be difficult for everyone to obtain 45mg of gold in exchange for each dollar they own.

Fortunately, there is no need to follow the experiment further. Of course it's not realistic that everyone in the world would switch to strategy G on the same day.

The important question is just whether strategy G is stable. In other words, is it a realistic possibility that everyone in the world could price all their savings in gold? Is strategy G in fact a Nash equilibrium?

There are no market forces that would tend to destabilize it. Or are there? Actually, it turns out that we've skipped a step in our little analysis.

Levitating collectibles

The problem is that the exact same analysis works just as well for any standardized and widely available asset.

For example, let's try it with condoms. Our benchmark of all value will be the standard white latex condom. We can have a "strategy C" in which everyone measures the worth of all their assets in terms of the number of condoms they exchange for. Cash payments will be made in secure electronic claims to allocated boxes of condoms, held in high-security condom vaults in the condom district of Zurich. And so on.

This is obviously ridiculous. But why? Why does the same analysis seem to make sense for gold, but no sense for condoms?

It's because we've ignored one factor: new production.

Let's step back for a moment and look at why people "invest" in gold in the first place. Obviously they expect its price to go up - in other words, they are speculating. But as we've seen, in the absence of investment the gold price would be determined only by industrial supply and demand, a fairly stable market. So why does the investment get started in the first place? Does it just somehow generate itself?

What's happening is that the word "investment" is concealing two separate motivations for buying gold.

One is speculation - a word that has negative associations in English, but is really just the normal entrepreneurial process that stabilizes any market by pushing it toward equilibrium.

The other is saving. We can define saving as the intertemporal transfer of wealth. A person saves when she owns valuable goods now, but wishes to enjoy their value later.

The saver has to decide what good to hold for whatever time she is saving across. Of course, the duration of saving may be, and generally is, unknown.

And of course, every saver has no choice but to be a speculator. The saver always wants to maximize her savings' value, as defined by the goods she actually intends to consume when she uses the savings. For example, if our saver is an American retiree living in Argentina, and intends to spend her savings on local products, her strategy will be to maximize the number of Argentine pesos she can trade her savings for.

Here are five points to understand about saving.

One is that since people will always want to shift value across time, there will always be saving. The level of pure entrepreneurial speculation in the world can vary arbitrarily. But saving is a human absolute.

Two is that savers need not be concerned at all with the direct personal utility of a medium of saving. Our example saver has little use for a big hunk of gold. Her plan is to exchange it for tango lessons and huge, delicious steaks.

Three is that from the saver's perspective, there is no artificial line between "money" and "non-money." Anything she can buy now and sell later can be used as a medium of saving. She may have to make two trades to spend her savings - for example, if our saver's medium of saving is a house, she has to trade the house for pesos, then the pesos for goods. If she saves directly in pesos, she only has to make one trade. And clearly trading costs, as in the case of a house, may be nontrivial. But she just factors this into her model of investment performance. There is no categorical distinction.

Four is that if any asset happens to work well as a medium of saving, it may attract a flow of savings that will distort the "natural" market valuation of that asset.

Five is that since there will always be saving, there will always be at least one asset whose price it distorts.

Let's see what happens when that asset is condoms. Suppose everyone in the world does adopt strategy C, just as in our earlier example they adopted strategy G. What will happen?

Just as we predicted with gold, there will be massive condom buying. Since condom manufacturers were not expecting their product to be used as a store of wealth, demand will vastly exceed supply. The price of condoms will skyrocket.

Strategy C looks like a self-fulfilling prophecy. Condoms will indeed become a costly and prized asset. And the first savers whose condom trades executed will see the purchasing power of their condom portfolios soar. This is a true condom boom.

Let's call this effect - the increase in price of a good because of its use as a medium of saving - "levitation."

Sadly, condom levitation is unsustainable. The price surge will stimulate manufacturers to action. Since there is no condom cartel - anyone can open a factory and start making condoms - the manufacturers have no hope of maintaining the levitated condom price. They will produce as many condoms as they can, as fast as possible, to cash in on the levitation premium.

Levitation, in other words, triggers inventory growth. Let's call the inventory growth of a levitated good "debasement." In a free condom market, debasement will counteract levitation completely. It will return the price of a condom to its cost of production (including risk-adjusted capital cost, aka profit). In the long run, there is no reason why anyone who wants condoms cannot have as many as he or she wants at production cost.

Of course, condom holders will realize quickly that their condoms are being debased. They will pull their savings out, probably well before debasement returns the price of a condom to the cost of producing one.

We can call the decrease in price of an asset due to the flow of savings out of it "delevitation." In our example, debasement causes delevitation, but it is not the only possible cause - savings can move between assets for any number of reasons. If savers sell their condoms to buy Google stock, the effect on the condom price is exactly the same.

Because condom debasement is inevitable, and will inevitably trigger delevitation, savers have a strong incentive to abandon strategy C. This means it is not a Nash equilibrium.

The whole sad story will end in a condom glut and a condom bust. The episode will be remembered as a condom bubble. In fact, if we replace condoms with tulips, this exact sequence of events happened in Holland in 1637.

So why won't it happen with gold?

The obvious difference is that gold is an element. Absent significant transmutation or extraterrestrial trade, the number of gold atoms on Earth is fixed. All humans can do is move them around for our own convenience - in other words, collect them. So we can call gold a "collectible."

Because it cannot be produced, the price of a collectible is arbitrary. It is just a consequence of the prices that people who want to own it assign to it. Obviously, the collectible will end up in the hands of those who value it highest.

Since the global bullion inventory is 150,000 tons, and 2500 tons are mined every year, it is easy to do a little division and calculate a current "debasement rate" of 1.66% for gold.

But this is wrong. Gold mining is not debasement in the same sense as condom production, which does not deplete any fixed supply of potential condoms. In fact, it only takes a mild idealization of reality to eliminate gold mining entirely.

Gold is mined from specific deposits, whose extent and extraction cost geologists can estimate in advance. In financial terms, gold "in the ground" can be modeled as a call option. Ownership of X ounces of unmined gold which will cost $Y per ounce to extract is equivalent to a right to buy X ounces of bullion at $Y per ounce.

Since this ownership right can be bought and sold, just as the ownership of bullion can, why bother to actually dig the gold up? In theory, it is just as valuable sitting where it is.

In the form of stock in mining companies which own the extraction rights, unmined gold competes with bullion for savings. Because a rising gold price makes previously uneconomic deposits profitable to mine - like options becoming "in the money" - the total value of all gold on earth does increase at a faster rate than the gold price. But the effect is not extreme. 2006 USGS figures show 30,000 tons of global gold reserves. This number would certainly increase with a much higher gold price - USGS reports 90,000 tons of currently uneconomic "reserve base" - but the gold inventory increase would be nowhere near proportional to the increase in price.

In practice, modeling unmined gold as options is too simple. Gold discovery and mining is a complex and political business. The important point is that rises in the gold price, even dramatic rises, propagate freely into the price of unmined gold and do not generate substantial surges of new gold. For example, the price of gold has more than doubled since 2001, but world gold production peaked in that year.

The result is that gold can still levitate stably. Even if new savings flow into gold stops entirely, debasement will be mild. The cyclic response typical of noncollectible commodities such as sugar (or condoms), or theoretical collectibles whose sources are not in practice scarce (such as aluminum) is unlikely.

Of course, if savings flow out of gold for their own reasons, it can trigger a self-reinforcing panic. Delevitation is not to be confused with debasement. Again, it is important to remember that debasement is not the only cause of delevitation.

What we have still not explained is why gold, which is clearly already levitated, should spontaneously tend to levitate more, rather than either staying in the same place or delevitating. Just because gold can levitate doesn't mean it will.

Money in the real world

In case it's not obvious, what we've just done is to put together a logical explanation of money, using gold as an example, and using only made-up terms like "collectible" and "levitation" to avoid the trap of defining money in terms of itself.

Now let's apply this theory to the money we use today - dollars, euros, and so on.

Today's official money is an "artificial collectible." Money production is limited by legal violence, not natural rarity. If in our condom example, the condom market was patrolled by a global condom mafia which got medieval with any unauthorized condom producers, it would resemble the market for official currency. No one can print Icelandic kronor in the Ukraine, Australian dollars in Pakistan, or Mexican pesos in Algeria.

It may be distasteful to hardcore libertarians, but this method of controlling the money supply is effective. There is minimal unlicensed production of new money - also known as counterfeiting.

It should also be clear from our discussion of gold that there is nothing, in principle, wrong with artificial paper money. The whole point of money is that its "real value" is irrelevant. In principle, an artificial money supply can be much more stable than a naturally restricted resource such as gold.

In practice, unfortunately, it has not worked out that way.

Artificial money is a political product. Its problems are political problems. It does no one any good to separate economic theory from political reality.

Governments have always had a bad habit of debasing their own monetary systems. Historically, every monetary system in which money creation was a state prerogative has seen debasement. Of course, no one in government is unaware that debasement causes problems, or that it does not create any real value. But it often trades off short-term solutions for long-term problems. The result is an addictive cycle that's hard to escape.

Most governments have figured out that it's a bad idea to just print new money and spend it. Adding new money directly to the government budget spreads it widely across the economy and drives rapid increases in consumer prices. Since government always rests on popular consent, all governments (democratic or not) are concerned with their own popularity. High consumer prices are rarely popular.

There is an English word that used to mean "debasement," whose meaning somehow changed, during a generally unpleasant period in history, to mean "increase in consumer prices," and has since come to mean "increase in consumer prices as measured, through a process whose opacity makes chocolate look transparent, by a nonpartisan agency whose objectivity is above any conceivable question, so of course we won't waste our time questioning it." The word begins with "i" and ends with "n." Because of its interesting political history, I prefer to avoid it.

It should be clear that what determines the value of money, for a completely artificial collectible with no industrial utility, is the levitation rate: the ratio of savings demand to monetary inventory. Increasing the monetary inventory has a predictable effect on this calculation. Consumer price increases are a symptom; debasement is the problem.

Debasement is always objectively equivalent to taxation. There is no objective difference between confiscating 10% of existing dollar inventory and giving it to X, and printing 11% of existing dollar inventory and giving it to X. The only subjective difference is the inertial psychological attachment to today's dollar prices, and this can easily be reset by renaming and redenominating the currency. Redenomination is generally used to remove embarrassing zeroes - for example, Turkey recently replaced each million old lira with one new lira - but there is no obstacle in principle to a 10% redenomination.

The advantage of debasement over confiscation is entirely in the public relations department. Debasement is the closest thing to the philosopher's stone of government, an invisible tax. In the 20th century, governments made impressive progress toward this old dream. It is no accident that their size and power grew so dramatically as well. If we imagine John F. Kennedy having to raise taxes to fund the space program, or George W. Bush doing the same to occupy Iraq, we imagine a different world.

The immediate political problem with debasement is that it shows up in rising consumer prices, as whoever has received the new money spends it. If we think of all markets as auction markets, like EBay, it should be clear how this happens.

Debasement and investment

We haven't even seen the most pernicious effect of debasement.

Debasement violates the whole point of money: storage of value. As such, it gives savers an incentive to find other assets to store their savings in.

In other words, debasement drives real investment. In a debasing monetary system, savers recognize that holding money is a loser. They look for other assets to buy.

The consensus among Americans today is that monetary savings instruments like passbook accounts, money market funds, or CDs are lame. The real returns are in stocks and housing. [Written in 2006]

When we debasement-adjust for M3, we see the reasons for this. Real non-monetary assets like stocks and housing are the only investments that have a chance of preserving wealth. Purely monetary savings are just losing value.

The financial and real estate industries, of course, love this. But that doesn't mean it's good for the rest of us.

The problem is that stocks and housing are more like condoms than they are like gold. When official currency is not a good store of store value, savings look for another outlet. Stocks and housing become slightly monetized. But the free market, though it cannot create new official currency or new gold, can create new stocks and new housing.

The result is a wave of bubbles with an unfortunate resemblance to our condom example. When stocks are extremely overvalued, as they were in 2000, one sign is a wave of dubious IPOs. When housing is overvalued, we see a rash of new condos. All this is just our old friend, debasement.

This debasement pressure answers one question we asked earlier: why should gold tend to levitate, rather than delevitate? Why is the feedback loop biased in the upward direction?

The answer is just that the same force is acting on gold as on stocks and housing. The market is searching for a new money. It will tend to increase the price of any asset that can store savings.

The difference between precious metals and stocks or housing is just our original thesis. Stocks and housing do not succeed as money. Holding all savings as stocks or housing is not a Nash equilibrium strategy. Holding savings as precious metals, as we've seen, is.

Presumably the market will eventually discover this. In fact, it brings us to our most interesting question: why hasn't it already? Why are precious metals still considered an unusual, fringe investment?

The politics of money

What I'm essentially claiming is that there's no such thing as a gold bubble.

This assertion may surprise people who remember 1980. But markets do not, in general, think. Most investors, even pros who control large pools of money, have a very weak understanding of economics. The version of economics taught in universities has been heavily influenced by political developments over the last century. And your average financial journalist understands finance about the way a cat understands astrophysics.

The result is that historically, the market has had no particular way to distinguish a managed delevitation from an inevitable bubble. Because of Volcker's victory, and the defeat of millions of investors who bet on a dollar collapse, the financial world spent the next twenty years assuming that there was some kind of fundamental cap on the gold price, despite the lack of any logical chain of reasoning that would predict any such thing.

Even now, there is no shortage of pro-gold writers who predict gold at $1000, $2000 or $3000 an ounce, as though they had some formula, like the P/E ratio for stocks, that computed a stable equilibrium at this level. Of course, they do not. They are only expressing their intuitive feeling that gold is very, very cheap right now, and tempering it with the desire to be taken seriously.

Gold's main weapon is one we alluded to already: a sudden, self-reinforcing, and complete collapse of the dollar. In a nutshell, the problem with the dollar is that it's brittle. When Volcker did his thing, the US was a net creditor nation with a balance-of-payments surplus. Its financial system was relatively small and stable. And it had much more control over the economic policies of its trading partners - the political relationship between the US and China is very different from the old US/Japanese tension.

For the Fed, what is really frightening is not a high gold price, but a rapid increase in the gold price. Momentum in gold is the logical precursor to a self-sustaining gold panic. If the US federal government was a perfectly executed and utterly malevolent conspiracy to dominate the world, let's face it. The world wouldn't stand a chance. In reality, it's neither. So a lot of things happen in the world that Washington doesn't want to see happen, and that it could easily prevent. Anticipating surprises is not its strength. [1]


Holy Cannoli, Batman! I think this is the longest "snip" I've ever used in a post. Nine pages in Word, just for that quote. And I even edited several pages out of it, "to tighten it up!" I hope you enjoyed it.

To recap, a rising gold price is evidence of increasing investment demand, which confirms the belief of those that already invested in gold that it was a good investment. And because investment demand is over and above the relatively stable industrial supply and demand dynamic, any new investment dollars must bid gold away from its current owners. And because saving in gold is a Nash Equilibrium, the price will rise very high. And because gold is THE monetary metal with the highest monetary to industrial use ratio, it will have no reason to fall back when it reaches its top.

And, as ANOTHER said, "So many people worldwide think of it as money, it tends to dry up as the price rises."

Stock, Flow, Supply and Demand

Let's try a little thought experiment and see where it leads us. This might be a bit of a mind bender and a challenge for me to articulate, but what the heck, we're already 11 pages into this thing. Why stop now?

Let's think of all the physical gold in the world in the same terms as our price discovery markets classify the gold they hold secure for private parties. (You do know that the gold for sale does not belong to the exchanges, don't you?) There is that gold which is "eligible" for delivery. And in our experiment this would be all the physical gold in the world. It is ALL "eligible" to be handed to someone else in exchange for something else. (The only requirement for eligibility in our thought experiment being that it is a physical object made of gold.) And then there is the gold that is actually "registered" for delivery. In our case this would be the gold that is up for sale or expected to go up soon.

So "eligible" is the "stock" and "registered" (for delivery) is the "flow," sort of. (Yes, I know that flow would mean the gold coming out of the ground and then being used up in jewelry and electronics if gold was like other commodities, but it's not, so get over it.)

Now what I just wrote is not entirely correct. You cannot simply compare stock to flow like that because they have different measuring units. Flow is measured in units/time and stock is just units. They do not and cannot compare. The only meaningful relationship they have is a ratio. Stock:Flow, or units/(units/time), which = time. This yields us a time value in which the flow will deplete the stock. So "our flow" is the amount of "registered" gold that actually gets delivered in exchange for something over a given time unit.

In the world as a whole, gold has the largest stock to flow ratio of any commodity, which is why it is unique. This means a very high time value for the depletion of gold stocks. In fact, it is an infinite time value since gold is not consumed, it is merely shuffled around until it ends up with those who value it most. So in our case we'll think of flow as delivery demands actually being met with "registered" stock over a period of time. And in this view, "stock to flow" is a dynamic system that is complicated by many factors.

One complication is that, today, physical and paper gold exist as "stock" at par with each other inside the system. And the flow of paper happens prior to the flow of physical stock (on the price discovery exchanges). In other words, price is discovered in paper and then delivery comes later. Price is not discovered at the physical delivery window. In fact, whether there is any physical at that window when you finally show up with your paper depends on dynamic changes that happened earlier.

As the paper flow precedes the physical flow, the supply and demand dynamics can change very fast, perhaps even so fast as to give the impression that they traveled faster than the speed of light like a tachyon, went back in time, and originated in the past! (Making them impossible to get out in front of!) As demand increases while registered gold is depleted and/or deregistered one of two things must happen. Either the price must skyrocket or the supply of paper must explode to take up the slack.

And as either of these things happen – or they both happen together – we end up with John Law's self-sustaining Misesian regression spiral. Where today's demand is determined by yesterday's performance. (We can call it "the tachyon effect" if you'd like.) This applies to both physical gold and paper gold, and the feedback loop will have separate effects on these separate elements of the market. It will be the cause of the separation and the result will be a flood of paper and no registered gold to service the delivery demand portion of it.

Ultimately the stock to flow ratio of physical gold will go inverse to that of paper gold. Infinite flow demand against zero registered stock. Zero time until physical depletion, concurrent with infinite time until paper depletion. At this point the price will have to go infinite and paper supply will separate because parity will no longer exist.

And in case you haven't noticed, we are now, apparently, at a novel stage in the game. The stage when it is becoming obvious to almost everyone that the Fed can do nothing but print more money (QE), and that it plans to do just that. I draw your attention to gold trading at $1,301 today as evidence! And regarding the Fed, what does a monkey with a hammer do? That's right. It hurts itself.

Being at this stage in the game right now, when clarity is spreading like wildfire, we can expect a further run up in the price of paper gold. Of course the price discovery market buys and sells paper gold so a move in either direction is possible in the short run, but the general trend in gold should now be obvious, even to monkeys. And don't forget that delivery of physical in this market is secondary, and only comes after price discovery occurs in paper.

So with this dynamic situation we find ourselves in, we should expect conflicting signals and responses in the gold market. The flow of gold should increase as demand from dollars pulls on the market. And the supply of gold bullion should be withdrawn or "deregistered" as the people holding it realize their investment belief has been confirmed.

From a demand perspective, flow should increase per the economic law of demand. And from a supply perspective, it should decrease. But how is this possible? Well, this is where price factors into the dynamics of the situation. In most commodities (and all other markets for that matter) flow would be measured in the weight of the good. "How many ounces are flowing?" But gold is a little different.

Because gold is behaving in this case primarily as a savings instrument, flow can be measured in the amount of savings being exchanged. Just like exchanging dollars for euros. In other words, to properly judge the flow we should look at the aggregate amount of wealth flowing "into" gold rather than the weight of gold changing hands. And in this view, the flow can increase with demand even as the stock is withdrawn. Price takes up the slack. It can even accommodate the shoeshine boy without threatening a top.

But there's another element in this dynamic situation that must be considered. And that is paper gold. As I said, price discovery occurs in paper only, and delivery comes after the fact. So paper supply creation can easily absorb the pressure of increasing demand while relieving price of its "taking up the slack" burden.

However, unless the ratio of physical stock "registered" to become flow rises along with the creation of new paper gold, well, "Houston, we've got a problem." And I'm talking about registered physical stock measured in weight, not value! Which is QUITE a problem!

Fortunately, to quote John Law (not the real one), there is no need to follow this challenging scenario further. Instead, we can just repeat ANOTHER's line once again:

"Gold has always been funny in that way. So many people worldwide think of it as money, it tends to dry up as the price rises."

In economic terms, ANOTHER was referring to gold's price inelasticity of supply here. In other words, gold seems to violate the economic law of supply. As the price rises, the supply dries up.

But another funny thing also happens when gold "tends to dry up as the price rises." Even more people join the "many people worldwide that think of it as money." And this means that gold violates the economic law of demand as well, delivering a positive price elasticity of demand. In other words, gold is a Veblen good. But unlike a Rolls or the Mona Lisa, gold is divisible and fungible making it the Veblen good that puts the common man on equal footing with the Giants!

This is what FOA meant:

In this world we all need much; blessings from above,,,,, family,,,, home,,, friends and good health. But after all that, one must have currency and an enduring, tradable wealth asset that places our footing in life on equal ground with the giants around us,,,,,, gold!

And this is how and why gold WILL accommodate even the shoeshine boy without collapsing!

There is no such thing as a physical gold bubble.

So, to wrap this beleaguered post up, let's just say that we have the distinct makings of a parity break between paper and physical gold in the works. The supply of paper gold must rise while the supply of physical is withdrawing (deregistering). The flow must also rise, at least in nominal terms, so the price will skyrocket to take up the slack. And as expanding paper competes with a rising price for the "slack taking-up" role, who do you think will win?

Could they each have their way? Could the price rise to take up the extra demand while supply contracts at the same time as easy paper dilution wins itself a lower price? Confused yet?

Well, this situation leaves us with an uncomfortable question. If the only price of gold we know today is the price of paper gold, what is going to happen to "the price of gold?" Will it skyrocket? Or will it plummet?

And if we apply the principles learned in John Law's amazingly long piece in a logical way to this uncomfortable predicament, we'll find ourselves at the conclusion that the true Nash Equilibrium is to take possession of physical gold. And, if you already have some, not to sell it while the price is rising OR falling (this time).

And with the supply of paper gold rising to meet demand while physical is being withdrawn, the only conclusion we can come to is that the gold buyers **IN SIZE** will have to stop buying from the price discovery marketplace because, if they do their due diligence, they'll clearly see that subsequent physical delivery has become impossible at the present price.

So, in conclusion, the price of gold will plummet!

That's right. At some point in the future, after the price of gold rockets upward, it will fall like a box of rocks! And right about that time you'll see more of Robert Prechter on CNBC than you ever thought was possible.

But here's the challenge. When the price of gold falls to $200 per ounce, try and get some physical. I'm sure that Kitco will sell you some from their pooled account. And GLD will be standing ready to sell you a share at $20. But just try to take delivery. I think you'll find it will be impossible at that point.

And that's why you've got to take delivery NOW, at the current "high" price of $1,300. Don't wait for the dip. Oh, yeah, the big dip is definitely coming. A **BIG** "correction." But will there be any physical available? Perhaps at $1,200 if you're really lucky. At $200? No way.

When I look into MY crystal ball, here is how I see a future gold price chart developing (roughly, of course):


And with that, I'll leave you with my replies to the email at the top:

My reply to email 1:
Is this an orderly bull market in paper gold or physical gold?

The bubble that "WILL come"... will it be in paper gold or physical gold?

Is there a difference between paper gold and physical gold?

Is your chart showing paper gold or physical gold?

My reply to email 2:
You may be right on stage 2. But my gut says that stage 3 is when it's obvious everyone's flooding into gold and the real physical **IN SIZE** decides its best move is to withdraw from delivery registration. At that point the paper market won't be able to handle the flood.

My bet, when the shoeshine boy tells you to buy gold he'll be talking about small gold coins only. GLD probably won't even exist anymore. And in this unique historical case, the shoeshine boy will not be the bad omen of a bubble top mania phase, but he will instead be the amazing bell-ringer of a new era. One in which even shoeshine boys can save their surplus wealth in gold. One I like to call Freegold. Because a physical-only gold market can actually handle everyone PLUS the shoeshine boy, unlike any other market.


Sincerely,
FOFOA

[1] From Why the Global Financial System is About to Collapse
by John Law
Edited by me for length and content.

Open Forum

I think a few people didn't notice that at 200, the comment thread starts a new page. Jenn, yes, your comment posted two times and was answered. But here is a fresh thread to start anew.

Just Another Hyperinflation Post - Part 3

Let's try this one more time. Let's look at it from a purely conceptual angle. Most of the following discussion will not be a proof of the inevitability of hyperinflation, but merely the proper way to view the flow of capital in a panic while analyzing the probability that it will be called "hyperinflation" in hindsight, after the fact. This is what seems to be most lacking in the descriptions I read from those who cannot accept that fiat currencies always end the same way, and that the dollar has reached the end of its timeline.

To get there, I will walk you through several visualized metaphors in an attempt to build a workable mental image of hyperinflation. Hopefully you will be able to use this mental imagery when analyzing the deflationists' claims that it simply cannot happen to the US dollar.

So first, I would like you to imagine two flat, parallel planes. Those that know M theory can envision two membranes, very close to each other but only touching at a single point:


The top plane we'll call "the monetary plane" and the bottom one will be "the physical plane." And just so that we don't get confused with "the flat Earth society," those of you with advanced visualization skills can picture this same scheme as a globe with a membrane (or a Matrix of sorts) wrapped around it but not actually touching:


Now, for the purpose of this visualization exercise, I am going to challenge your definition of the word "money." In all likelihood you think of money as that which is substituted in the middle of a barter exchange. Something like this:


There is no right or wrong definition of the word "money," there are only poorly defined uses and clearly defined uses of the word. In the context of any single discussion, it is better to use a clear definition than to simply rely on everyone's common understanding.

In this discussion I will be talking about "the monetary plane," and in this context the word "money" refers to BOTH the medium of exchange and all forms of wealth reserves that exist in this "monetary plane." That is, "money" in this discussion is the medium of exchange PLUS any store of value that is not found in "the physical plane" of existence. Hopefully this is clear enough so that I don't have to add another three pages of descriptions.

In antiquity, the monetary plane didn't even exist. All wealth was held in the physical plane. In fact, even the medium of exchange was in the physical plane back then. So in that way, it was actually a barter exchange of one physical item for another, even if the other physical item was a chunk of gold. That chunk of gold existed in the physical plane. And for the purpose of this particular discussion, I hope this distinction is clear.

In today's monetary plane, enormous amounts of wealth are held as "someone else's thoughts of value" not value itself. And as ANOTHER once said, "time moves the minds of people to change, and with this, the thoughts of value also change. In this day, as not in the past, the loss of paper value as a concept will destroy the very foundation of wealth that this economic system is built on. This drama has started and is well underway!"

Credibility Inflation

Referring to my post, during times of credibility inflation the monetary plane swells large along with its credibility. One way to picture this is an hourglass, as I did in Gold is Wealth:


The top of the hourglass is the monetary plane and the bottom is the physical plane. And during times of credibility inflation, sand accumulates in great quantities in the top. Here are my pyramids representing the two planes from that same post, stacked on top of each other in a visual similar to the hourglass:


As I said in my Credibility Inflation post, the latest period of credibility inflation ran from 1980 until 2007. Since then, the credibility of the monetary plane has been deflating against the protestations of the Fed and CNBC. That doesn't necessarily mean the sand has gone down the hourglass yet, but its desire to cross the "bottleneck" is growing as the credibility of the top part deflates.

The stage for this was already set when the top swelled too large for the bottom to handle over the past 30 years:


Gravity alone would have brought it down gradually but for the managed perception of credibility that was holding it up, even as pressure built. But with credibility now deflating (that's the REAL deflation) it's anybody's guess when the pressure of over-inflation will bring it exploding downward with a force much greater than gravity alone. It's overdue at this point, kinda like The Big One in LA.

Some of you may have already figured out that hyperinflation, in my visualization, will be the great flood under pressure from the monetary plane back down to the physical plane of existence. And you may have noticed that this great flood must pass through a "bottleneck" of sorts to get where it's going. And perhaps you surmised that, if under enough pressure, this hyper-flow could actually BREAK the fragile neck in the middle of the hourglass.

In my pyramid above, taken from my Gold is Wealth post, I have that "neck" represented by gold. That's because that particular post was more about my #1 topic, Freegold, while this post is about my #2 (of 2) topic, hyperinflation. So for the purpose of this post, I will change that "bridge" between the monetary plane and the physical plane to dollars. For the bottom I'll use physical dollars, since they do actually exist in the physical plane. And I'll change the second layer on the top to "broad money," representing "balance sheet money," M1, M2, M3, MZM, TMS etc…


Now when I say we have already hyperinflated the $IMFS (the Dollar International Monetary and Financial System) over the last 30 years, I am referring to this whole top pyramid:


When deflationists see monetary deflation, they are looking at this part, and they see the value of the dollar in this circle rising:


When they see price deflation, they are looking primarily at this part, and they see the value of real estate and other things in there falling:


But they are missing the significance of the bigger picture; that the credibility of the entire top of the pyramid is deflating. And it was this credibility that was holding all that sand up there in the first place. With the value of the top red circle falling and the value of the bottom red circle rising, the deflationists see "deflation."


But what I see is the beginning of a capital flow, in one particular (and significant) direction:


Legal tender laws mandate the medium of exchange, but they do not and cannot name the store of value. For that they rely on credibility management by institutions like the Fed and CNBC. Jim Sinclair calls this MOPE. And it is the monetary store of value that is on the move, not the medium of exchange. But thanks to legal tender laws the monetary store of value must pass through (and be priced in) the medium of exchange, dollars, whenever it is on the move.

Thanks to our legal tender laws, in order for all that "wealth" at the top of the upper pyramid to escape to the bottom pyramid it must pass through the dollar. But as this occurs, the dollar swells in value. It becomes "more expensive." It'll cost you more derivatives to buy a dollar in order to pass through the neck of the hourglass. The dollar becomes a little bit harder to get, and this starts to look like deflation to the deflationists.

Now I'm really not trying to gross you out in this next little bit. But in order to pass through my next explanation I am going to have to carefully and delicately shift metaphors... without visual aids this time. ;)

As escape pressure builds in the upper regions of the upper pyramid, the legal tender dollar constricts its escape route like a clinching sphincter muscle as its (the dollar's) price rises. And then all that value that escaped the upper region starts collecting and compacting in the large intestine of Treasury Bonds, held in place only by the swollen sphincter that is the swelling dollar.

Not that I hope you can relate to this metaphor – I'm sure some of you can – but what do you think happens when that "flow restrictor" lets go, just a tad? Do you think "just a tad" escapes? Perhaps… at first. But with the Fed shoveling Ex-Lax (QE) into the system like there's no tomorrow, what do you think the end result will be? Will it be a journey back up into the stomach?

I know I haven't proven anything in this post. But I warned you at the beginning that was not the goal. The goal here, as I stated at the top of this post, was to give you the proper way to view the flow of capital during a panic when analyzing the probability that it will be called "hyperinflation" after the fact.

Notice that there is nothing in this view about the addition of new dollars. There is nothing about printing wheelbarrows full of money. All that stuff is secondary to the initial blast that explosively exits through a very small opening.

The lesson I hope you'll take from this story is simple. The next time a deflationist tells you there is no possible mechanism for hyperinflation in the dollar, just show him your sphincter and say, "oh yeah?" ;)

This metaphor even holds for the Weimar hyperinflation. If we think about our 30 years of credibility inflation as "packing the musket" for hyperinflation, then we can view the first year and a half of the Weimar three-year experience in the same light: "packing the musket." From Wikipedia:

It is sometimes argued that Germany had to inflate its currency to pay the war reparations required under the Treaty of Versailles, but this is misleading, because the treaty did not allow payment in German currency. The German currency was relatively stable at about 60 Marks per US Dollar during the first half of 1921.[1]

But the "London ultimatum" in May 1921 demanded reparations in gold or foreign currency to be paid in annual installments of 2,000,000,000 (2 billion) goldmarks plus 26 percent of the value of Germany's exports. The first payment was paid when due in August 1921.[2] That was the beginning of an increasingly rapid devaluation of the Mark which fell to less than one third of a cent by November 1921 (approx. 330 Marks per US Dollar).

The total reparations demanded was 132,000,000,000 (132 billion) goldmarks which was far more than the total German gold or foreign exchange. An attempt was made by Germany to buy foreign exchange with Marks backed by treasury bills and commercial debts, but that only increased the speed of devaluation. The monetary policy at this time was highly influenced by the Chartalism, and was notably criticized at the time from economists ranging from John Maynard Keynes to Ludwig von Mises.[3]

Yes, this is the same quote Mish used. Sounds pretty bad when you read that from August to November, in 1921, the Mark fell to less than one third of a cent! But it sounds less bad when you realize that it fell from only one and two thirds of a cent. That's like saying he fell to the bottom of the Grand Canyon without mentioning he was standing on an applebox at the bottom of the Grand Canyon. To restate: during this period the German Mark fell from 1.67 cents to .33 cents. Only an 80% fall. This was Germany's "packing the musket" phase, similar to our 30 years of credibility inflation.

At this point the Mark looked the same, and it actually stabilized for the next 6 months! But the musket was already packed, just waiting for the collapse of confidence. And the collapse of confidence is what brought hyperinflation to Germany. It came halfway through 1922 after a conference with U.S. investment banker J. P. Morgan Jr. produced no workable solution to Germany's problems. Here's the next part of the Wikipedia article that Mish didn't include:

During the first half of 1922 the Mark stabilized at about 320 Marks per Dollar accompanied by international reparations conferences including one in June 1922 organized by U.S. investment banker J. P. Morgan, Jr.[4] When these meetings produced no workable solution, the inflation changed to hyperinflation and the Mark fell to 8000 Marks per Dollar by December 1922.

This came later, as a reflex to the collapse of confidence

Hyperinflation was the result of the collapse of confidence after the conferences failed. The wheelbarrows that soon followed were the effect of this collapse of confidence, not the cause. The initial printing in 1921 "packed the musket." The loss of confidence in mid-1922 fired the musket. And then the real printing began out of necessity! By November of 1923 wheelbarrows were no longer big enough. The banks were counting their money by the ton.


An Afterthought

I realize that some of you are going to complain about "physical commodities" being on the top pyramid of my visuals. They are there as a class of speculative investments with its value anchored in the industrial use of those commodities which fluctuates along with the health of the economy. This industrial use value will disappear, at least temporarily, during a hyperinflation. And the actual commodities will retain an appropriate value through the hyperinflation out to the other side. But if they are bid up by speculation prior to the hyperinflationary event, their final value on the other side may actually be lower in real terms, even if it is much higher in nominal terms.

A monetary commodity, on the other hand, like gold, will rise because its value is anchored in the MONETARY use of the metal, as seen on the ECB balance sheet. So as you are deciding on a metal in which to ride this thing out, ask yourself in which function, monetary or industrial, is its value anchored. And you might just want to follow in the footsteps of the Giants, because they are clear and large, and easy to follow.

Sincerely,
FOFOA

For more on the gold angle in the above discussion, please read:

All Paper is STILL a short position on gold 3/23/09
Gold is Wealth 11/21/09
and Gold: The Ultimate Wealth Reserve 12/29/09

Just Another Hyperinflation Post - Part 2

The question was asked: Is this inevitable with any debt-based system?

Short answer for now. ;) Systemic collapse is inevitable as long as the item used for lending is the same item used for saving.

In a gold money system with gold lending (which is always demanded by the collective will) fractional reserve banking is the inevitable result. And from there, bank failures are the inevitable result at the first sign of panic (loss of confidence). And from there, some of the savers lose their money.

In a fiat system, the fiat is lent and the savers hold the notes, one way or another. This lending and note holding always increases the money supply just like gold lending and gold-denominated notes expand the gold money supply. You lend something and then you can claim it in the form of a note while the borrower claims it in the form of the currency. Even the notes circulate as they become marketable.

So lending always expands the money supply, whether it is gold or fiat. And when the savers save in the same thing being lent, collapse ultimately comes (or at least threatens), whether gold money or paper. And then the system must undergo a fundamental change one way or another.

The problem is that the expanding money supply due to lending always lowers the value of a unit of currency. Even if it is gold. If I loan you a $1 gold money, you now have $1 gold and I have a $1 gold note. The money supply has just doubled, and the value of $1 gold just dropped in half.

This is a fact of money systems. We can try to get rid of it by outlawing lending, but that is like outlawing swimming in the summertime, or beer drinking.

The solution is quite simple. And I didn't come up with it. The problem is that at the point of collapse, some of the savers are wiped out, whether gold money or fiat. Think about those at the back of the line during the bank runs of the 1930's. They didn't get their gold. They lost their money.

Today we don't have this problem anymore. The guy at the back of the line gets all his money, it's just worthless in the end. We solved the problem of bank runs (bank failures) but not the problem of value.

The solution is that the monetary store of value floats against the currency. It is not the same thing that is lent! It is not expanded through lending and thereby diminished in value. Instead, as $1 is lent, and now becomes $2 ($1 to the borrower + $1 note to you the lender) and the dollar drops to half its value, the saver, the gold holder will see the value of his gold savings rise from $1 to $2.

It's a concept so simple, yet so foreign (or alien) that almost no one can grasp it. Yet it has been around for quite a while.

The bottom line is that ALL money systems are debt based as long as you have lending and borrowing. And the process of lending and borrowing always dilutes the money supply and hurts the value of the money. So why should savers save that same money?

Why should national treasuries be at risk of a currency crisis? A nation's treasury is arguably one of the more vital forms of savings in civil society. Should a nation's treasure be capable of vanishing in a flash crash?

Hard Money versus ____ Money

When we talk about gold money we often use the term "hard money." And one misconception that pops into most people's mind is that "hard" money means hard like a rock, or hard like a piece of metal versus "soft" like a piece of paper that folds nicely into my wallet. Or the ultimate soft, a digital electron that moves at the speed of light.

This may not seem like a big deal, but I think it is. What is actually meant by "hard" money is that it is difficult, or hard to get. The opposite of hard being easy, not soft. Hard money cannot be expanded easily (without risk) because it has an anchor in the physical world.

We generally think of the people that want a "hard" money being the stodgy old rich Republican conservative white men that already have money. They want a "hard" money so the paupers will have to work "hard" in their big industry factories to get some of it. And so the money they already have will retain its value.

On the other hand, the debtors like easy money, especially the kind that loses value over the short term making repayment of their debt easier. The farmers love easy money. They take out a loan when they plant and by the time they harvest they are getting more money for their crops than they did last year. And the seed loan is easier to pay than when it was originated. More cash, easier terms, less pain.

So here's the question. Why can't we have hard money for the savers and easy money for the debtors? Is this possible? Could it work?

Now imagine that some people living under the "exorbitant privilege" of the United States for half a century spent a few decades designing the principles of a new currency that would help get them out from under that burden; the burden of supporting the perpetual trade deficit of someone else. They would have had a long time to evolve their thoughts and ideas and create a currency architecture unlike the world had ever seen before. Imagine that they were working on this for at least 37 years.

Now, let's take a look at the architecture of the euro. In January of 1999 the euro was born. And if we go to this page on the ECB website, page 51, we see that plans for the euro began in 1962:

1962 - The European Commission makes its first proposal (Marjolin-Memorandum) for economic and monetary union.

Obviously, now, the euro has its "easy" money for lending to the debtors and lubricating trade. Just look at the European banks or Greece getting in trouble. They just print up a bunch of euros and loan them to the banks or Greece at better-than-market terms. Voila – EASY MONEY.

But then the euro also has its savings, its "official reserves," which are specified to be at least part in gold. At the beginning, in January 1999, they were 30% in gold bars. And they also legislated that this gold should FLOAT against the new currency. So, now, for 46 consecutive quarters they have religiously revalued their reserves – their savings – against the euro.

Now the "official reserves" consist of mostly dollars on the one hand (euros are not a reserve to the euro, only foreign currency and gold) and gold on the other. So by FLOATING these reserves (the "savings"), gold has risen to 60% and the (mostly) dollar portion has sunk from 70% down to 40%. And notice that they are "floating" their "hard money" against THEIR "easy money." You can see it right here on their latest quarterly report:

Gold: EUR 1010.920 per fine oz.

Gold, floating in euros. Hard money floating in its own easy money. Not dollars, euros! Savings floating in debt, not being dragged down by it. The store of value floating – PUBLICLY – in a swamp of medium of exchange.

What else? Oh yeah! They now sell gold to the citizens right from the tellers at the bank (in some places?), with 0% VAT. Everything else has a VAT, including silver. If I recall, silver has a 17% VAT (perhaps someone in Europe can confirm). That's "Value Added Tax." Crazy, huh? Gold - 0%!

What else? Oh yeah! They convinced the EMU members to stop selling off their gold. This was a big problem. Politicians love to sell off the gold reserves to fund their pet projects. But the European CB's put a stop to that with the WAG in 1999. They limited the CB sales of gold to 400 m/t per year total, among all the CB's. So they had to cooperate not to go over that amount. Then they renewed the agreement in 2004 and again in 2009. And all the while the sales diminished until, in 2009, they reversed! In 2009 they actually took in some gold!

What do you think will happen to their "savings" (I mean "official reserves") when the claims on foreign currency (dollars mostly) default through currency collapse? Of course gold will rise! Will it rise more than 66%? In dollars that would be about $2,100. You think gold will exceed that when the dollar collapses? Will it exceed that value in euros? If it does, the euro's "savings" will rise, even without selling a single dollar! Dollar value will just disappear and reappear in the gold! A transfer of wealth, so to speak!

That's the beauty of savings that FLOAT!!!

Hmm… let's see. Did they actually pull it off? Did they create the perfect currency? With hard money for the savers and easy money for the debtors? Well, Greece and the banks are getting plenty of easy money right now, and the hard money is rising in value along with the process. I wonder how it will all work once the dollar system's conjoined twin, the paper gold market, fails along with the dollar.

How well will their hard money savings float against the easy money transactional currency once there is no fractionally-reserved paper structure weighing it down? Should be pretty amazing, huh? And I wonder what the price of gold coins will be then. They may have to mint tiny amounts with more alloys. Do you think? I bet a pure ounce of Maple Leaf will become a family heirloom at that point. Wonder if it will be soon? Hey, how much are those Maples right now?

Back to Hyperinflation

Another common misconception about the hyperinflation we face today was posed:

Many people look to the Weimar Republic in Germany and Zimbabwe as examples of hyperinflation, which were the results of government intervention and bad policy, and make parallels to our current predicament. In both cases wheel barrels and armfuls of cash are used to purchase everyday items, such as sundries. The merchants in the Weimar Republic would charge customers by the pound of currency rather than its face value. What you are seeing in these pictures is physical currency, not digital currency.

In the US economy there is only a small percentage of the money supply that is actually in physical currency form, with a good deal of that physical currency held outside the US.

Just think to what percentage of your wealth is held in physical form? Very little in fact, maybe less than 1%. Think of what percentage a population distrusting in the government and with no trust in the banking system would hold in physical form? Much more, possibly higher than 80%. Due to this fact I believe that you cannot accurately make a comparison between the US and Zimbabwe or Weimar

My point is that there simply isn’t enough physical currency to create a hyperinflation scenario similar to Weimar or Zimbabwe. While it is true that the Fed is creating copious amounts of money at the moment, it is only being created in the digital form and not the physical form. The term ‘running the printing presses’ is misleading you to believe that the Fed is printing currency when in reality it is creating a series of 1’s and 0’s that are being deposited into virtual banking accounts. All digital.

The digital money being ‘printed’ by the Fed is the type of money that most people would normally assume to be hyperinflationary; it’s the most potent type of money, it’s high-powered money and it forms the monetary base money. High-powered money is the foundation of the fractional reserve banking system. In the perfect economic climate this high-powered money would be loaned against to create 10x the amount of credit-money. But we currently don’t live in that perfect economic climate and that high-powered money is getting almost no traction at all. You have to have an economy that is functioning properly to ignite those digital dollars.

Here was my reply:


I put this image here again so I can refer back to it from time to time.

Throughout our journey up a graph similar to this one, there will be several monetary events which are difficult to contemplate right now. But I hope to ease this difficulty. And I also hope that previsualization will make it a little easier on my readers when this monster seemingly rears its ugly head "right out of the blue."

In my last post I mentioned the "excess reserves" that will ultimately have to be printed into physical cash. This is one of the monetary events that will happen near the beginning of the graph above. It won't require wheelbarrows at that point, but as we move up the graph you will need bigger and bigger ones. An SUV would actually be quite handy. Not a pickup truck, though (wind will blow your cash away). So be sure you have some gold so you can afford the impossible price of scarce gasoline for your SUV!

In Gonzalo Lira's second hyperinflation article, he asked the question, "Where will the bundles of cash come from?" Great question! And he answered it with "palliative printing." This is another of the events on the journey up the graph. Only "palliative printing" is near the top end of the graph.

Gonzalo correctly points to "palliative printing" as a wheelbarrow-enlarging event, which comes at the very end stage of a hyperinflation. And he presents it as palliative to the people. But this printing is usually most palliative to the government and its expanding rank of stooges. Sure, there will be "welfare" along the way, but for the most part the freshly printed cash will buy the most goods and services for the first hands it touches. And then less for the second. And even less for the third and so on. And this prime purchasing power will be mostly reserved for the government that prints it.

So these are two easily identifiable monetary events. I haven't gone into them in much detail yet because there is a deeper issue that we need to fully understand first. And that is the fundamental difference between digital money and physical currency. 99% of everyone has no real understanding of the difference.

The few deflationists that think they understand what will happen will tell you to hoard a boatload of cash. This advice will help you for maybe a week to a month. If you stored your emergency supplies like you should have, it won't help you much at all. And if you hoard only cash in lieu of real stockpiles of necessities and gold, then you will have ______ yourself in the end.

I tend to think that the ideal amount of cash you want to be hoarding when the fire starts is about a month's worth of expenses. Maybe a little more. But much more and you may have to juggle your cash back into your bank account as you "wait" for the inevitable, and you will probably end up holding a large stockpile of cash after it becomes worthless. Any less and you may miss out on some bargains during the week to a month that cash values exceed digital money. In any case, it's good to have a little cash under the mattress.

The week I'm referring to is the much-ballyhooed "bank holiday," while the Fed scrambles to get fresh cash out to the banks. It will last anywhere from a few days to two weeks in my estimation. And during that time, cash will have more value than plastic.

But to get where we are heading with this discussion, we must understand the fundamental difference between digital money and cash as I said. Most simply stated, in our modern system – cash is to digital money – as gold was to cash – during the gold standard years. Let this sink in.

Cash will become worthless, unlike gold after the 1971 parity split. So what will happen to digital money (today's "1970's dollar")? And what will become of gold?

Digital money is the same as what I call "credit money" or "balance sheet money." It is "thin air money." But… there is a fundamental difference between "thin air money" from a private bank and "thin air money" from the Fed. A HUGE difference. More on this in a moment.

When a bank creates money "from thin air" it is creating a liability upon itself. It owes a dollar. Yes, it owes a physical dollar once it creates new "balance sheet money" "from thin air." And unless it can legally print that physical dollar (which only the Fed can), then it must earn that physical dollar it now owes.

So if you borrow a dollar from a bank which it conjures on its balance sheet "from thin air," and then you walk out with a physical dollar, that bank is now short one dollar. But on the asset side of its balance sheet it has a note that says you owe the bank $1.10, which is why the bank let you walk out with that dollar.

But if you borrow a dollar from the bank and leave it in your account, then the bank still owes you a physical dollar while you owe the bank a physical $1.10. And when you pay the butcher with a $1 check and the butcher deposits that check into another bank, all that does is transfers your 'physical $1 claim against your bank' to the other bank. Your bank now owes the butcher's bank a physical dollar. And that other bank owes the butcher a physical dollar.

Now if the butcher pays the baker a dollar for a loaf of bread, with a check, and the baker deposits that check in your bank (you and the baker have the same bank), then that cancels out the physical dollar your bank owes the butcher's bank. And the butcher's bank no longer owes the butcher a physical dollar either.

So as you can see, "thin air money" is really just the 'physical dollar debt' of the banks that gets shifted around from bank to bank. So imagine if the bank were to write itself a big profit. All it would essentially be doing is saying, "I owe myself a dollar." You should try this. Make a balance sheet and oblige yourself to pay yourself a million dollars. Then go see if you can spend it!

I tried this once. Trust me that it doesn't work!

So all this digital money that everyone thinks has replaced physical cash is actually fundamentally inferior to physical cash in a **SIMILAR** way to how physical dollars were fundamentally inferior to physical gold in 1970.

But the big difference between then and now is that physical dollars CAN be created at will. BY THE FED! Gold, obviously, cannot.

Now let's get back to those excess reserves held at the Fed for a moment. They are FED liabilities, which are different from private bank liabilities. Fed liabilities are fundamentally different because the Fed can print gold, or at least gold's equivalent in today's banking system. The Fed can print physical dollars. So Fed liabilities are contractual obligations to PRINT gold, I mean physical dollars, while private bank liabilities (M1, M2 etc…) are all contractual obligations to EARN or find (or collect) physical dollars.

So what happens when the banks can't earn the dollars that everyone thinks they have on deposit?

Someone commented:

…at some point the people lose the faith and begin turning over the money stock trying to grab real wealth. The timeframe of this switch in behavior is still up for debate with me.

As I say, I've kinda given up on the timing angle. Not only because this is impossible to time, but because I've finally realized that it doesn't matter. These goofballs that keep saying they know the timing and it's years away couldn't be more wrong. Yet they look like geniuses every time it doesn't come. Timing is a fool's game because hyperinflation is like an earthquake. It could hit at any moment once it is overdue.

Another comment:

…but the printing of physical currency is one of the last stages in the game.

No it's not. The printing of physical currency will be the central theme all the way up that curved graph. Hopefully above you got the point that digital currency is simply a promise by private institutions to find you a physical dollar that they don't yet have. Digital currency only circulates as a tethered unit, tethered to the institutional circuit of banks. Imagine a dog run, where you put your dog's leash on a taut steel cable and your dog thinks it is running free, but it is really tethered the whole way down the run. This is how digital currency circulates. When you transfer a digital payment to someone, your bank and their bank are the ones that actually agree to a new debt between each other.

This is important because it happens billions of times a day. But let's envision a large international wire transfer to make the point clear. Let's say you want to wire a million bucks to your buddy in Hong Kong. The wire may go through in a day, but what has actually happened? What happened was that your bank promised the bank in HK that it would ship over a million physical dollars! And the HK bank accepted that promise at full value before it handed your friend a million bucks.

No specially designed or officially approved electrons crossed the ocean through the wires. There was not physical "transfer." Only an agreement between two banks. An agreement to ship a million physical dollars! Now as I said, this happens billions of times a day and most of the agreements are cancelled out by promises in the opposite direction. But whatever is left unsettled ultimately gets settled in physical dollars.

If the two banks are in the Federal Reserve system then the unsettled portion is settled by transferring cash held at the Fed. Some of those reserves at the Fed get moved over from Bank A's account to Bank B's. But remember, reserves held at the Fed are the same as cash, because the Fed prints cash. I can't stress this enough. This is what BACKS the whole entire system… that the Fed prints cash. Cash backs the system. Physical cash. It is the reserve, just like gold used to be the reserve. There is NO SUCH THING as digital money that has replaced physical cash. It is an illusion!

And just because we have all bought into the modern banking system illusion of "digital currency" does not make it any more real. How real it is or isn't will be revealed when the system starts getting stressed! When institutions will no longer take the promise of another institution on the other side of the planet at full value!

Right now the Fed is barely maintaining institutional confidence by throwing around guarantees like they are nothing. But what do you think all these guarantees actually mean at their very core? They are all, every one of them, guarantees to print physical cash at the end of the day. This is what lubricates the whole international free market. The confidence that HK bank has that the US bank will ship physical cash if need be.

I realize that this is practically INVISIBLE to most of you, in a way similar to the allegory about the Peruvian Indians that could not see the Spanish ships when they first arrived because they had no prior knowledge of any such things existing. Because today you value that "digital currency" just the same as cash. Maybe you even value it more! So how can the HK bank possibly value physical cash more than promises from an American private bank?

Well, once your wire goes through, your buddy in HK will have the option to walk in with a suitcase and get that cash. That is a physical asset the bank is holding. And it will release that physical asset to your buddy on the promise that it can get more from your bank at a later time. If someone else sends a wire for another million and the HK bank doesn't have enough cash on hand left over, it could create a credibility problem for that bank, right?

Another comment:

…does the printing of physical currency require a banking panic leading to a bank run leading to a bank holiday?

I think your question is, Is a bank holiday inevitable, unavoidable? I believe it is. And here's why.

As I have said, hyperinflation starts before the first new dollar is even printed. It is a nasty little collapse of confidence in the currency (and its banking system) that begins in the hidden little corners you never even considered.

Remember above I said that the HK bank accepted the promise from the US bank at face value? Well let's say that something has just happened in the markets somewhere that shook them up. Let's say that everyone is a little uneasy about something that just occurred. Maybe it was something strange at a Treasury auction, or… who knows? Anyway, at some point there is going to be a risk premium for accepting institutional promises of delivery of something physical in the future.

That HK bank knows it will have to cough up the cash today if it accepts the wire, but it may not see the replacement cash for a week. Will that cash in a week be worth the same as the cash going out the door today? Probably. But if there's a chance that it won't, then there is a risk premium to be charged. This is one hidden little corner where that nasty hyperinflation bug may first appear.

Once the time factor begins to present a perceived risk to the institutional banking system, it's all over. The system will need a large infusion of physical cash. Each and every "digital currency unit" is a debt of a physical dollar, backed by a debt, backed by a debt, backed by a debt and so on. It is a very long chain. And like all chains, it is only as strong as its weakest link! And there are a lot of weak links out there. The FDIC says about 800 of them right now if you believe the FDIC.

When one of these weak links breaks, it will not be enough to simply feed the cash to that broken link. The time factor will come into play. The Fed will have to ship physical dollars to ALL the links in the broken chain at once to avoid a panic. This will require a large infusion of physical cash.

Luckily this is possible today! Cash is the reserve, and cash can be created at will!!

Back in the 30's, gold was the reserve, but gold could not be created at will. If it could have been, then they would have just closed the banks long enough to truck enough gold out to the banks. And it's not just the customers lining up outside the banks that forces this action. It’s the interbank settlement process and the interbank confidence that lubricates this process. And eventually it will also include the larger retailers, who operate with a huge degree of confidence in the bank clearing system.

Think about the amount of promises a large grocery chain takes in every day with the confidence that settlement will happen before it needs to pay its obligations. The whole economy is like this. Whether one realizes it or not, the whole economy is operating on the confidence of the ultimate delivery of physical cash in the clearing process.

How about a gas giant like Shell? Think of all the "digital money" promises it takes in with faith in the clearing system to clear all imbalances each night.

There will come a point very quickly after confidence is shaken by some event, that physical cash will start to carry a small premium over digital money. This will be the time factor rearing its ugly head. I know of one cigarette shop that advertises a "cash price" in the window! This store charges less if you pay cash! That's not because of the time factor, of course… yet! But at some point those signs will start showing up at more places.

Today most vendors will eat the 2% it costs them to accept digital money. But what about when that cost rises due to the time factor risk premium? If someone pays you in cash today, you can go to the grocery tonight and buy food with it. If someone pays you with plastic, it will take a couple days before Visa deposits 98% of that amount in your bank account. Will your bank have any physical dollars then? So that you can recoup the lost 2%+ by getting the better cash price at the grocery?

Once this time factor settles in it will spread very quickly. The cigarette seller will prefer cash and will give you a discount for it so that he can go quickly and get the cash discount from the grocer. The banks will need loads of physical cash at this point. And they already have some of what they will need, sitting in excess reserves at the Fed.

The First Mechanism for Extra Zeros

How much will the Fed have to print up, and how fast? Unfortunately, $1 trillion in $100 bills is still 10 billion physical notes. If the Fed tried to print that, all in hundreds, in one week, that would require a printing rate of 1 million notes per minute, or 17,000 per second, 24 hours a day for a week. In other words, it is impossible.

But there is a simple solution! It's been used many times before and thus has many precedents. The euro already has €200 and €500 notes, presently trading for $254 and $636 respectively against the dollar. So it wouldn't be a huge leap for the Fed to print $500 and $1,000 notes instead of $50's and $100's in an attempt to hold the banking system together. It's actually a no-brainer. It reduces the printing time by a factor of 10!

Now instead of 1 million per minute, it's only 100,000 per minute. Well, that might be tough too. So it'll probably take a couple weeks and even then be an insufficient amount.

There's another option as well. They've got all those new $100 bills already printed. They could release the new bills at 100:1 on the old bills. Most people don't see this as hyperinflationary. They think of it as "issuing a new currency." So what's the difference between the two? There is NO DIFFERENCE!

Issuing the new $100's at 100:1 would be the same as issuing a $10,000 note. Same exact thing. But you must realize, it's not the notes that are driving the collapse (hyperinflation), it's THE OTHER WAY AROUND.

The hyperinflation is driving the need for the notes! So simply issuing the new $100 at 100:1 would not be an instantaneous devaluation of the dollar against all goods and services. No, they are rising at their own rate, REQUIRING a $10,000 note! Whatever you could previously get for $100, like a banana, would still be $100 in old dollars (for a few minutes anyway) after the new currency is issued. Most people don't think about it this way.

They think of the issue of new currency as "solving the problem" or "stopping the collapse." They think it would cause an immediate 100:1 revaluation of all goods and services allowing the monetary authority "to get ahead of the hyperinflation" and stop it dead in its tracks. No, it doesn't work this way. Issuing a new currency is only a very temporary fix and worst of all, it feeds fuel to the fire.

Hyperinflation is very hard to stop once it starts. The only way you can stop it is by switching to a harder currency. But unfortunately for the dollar, this will not be a realistic option.

If the dollar tries to peg itself to a new parity with gold (a new "emergency" gold standard) in the middle of the hyperinflation process, it will experience a run on any gold it puts up as backing. Imagine if Zimbabwe had tried to stop hyperinflation by opening a "gold window," selling gold at a fixed price in Zim dollars. (See image at the top!)

In Zimbabwe, they only stopped the hyperinflation by officially switching to a harder currency, the US dollar. But what currency could the dollar switch to? The euro? This is a possibility, but more likely the hyperinflation will simply run its course over a few months and by that point we'll ALL understand Freegold.

Sincerely,
FOFOA