My Candid View – Part 8

Hi FOFOA,

I just got off the phone with Bob. He's quite keen to discuss the dynamics of hyper-inflation as it relates to freegold, and wants to know, for example, what will happen to commercial banks? Will they survive? Will they be nationalized, etc. etc.? He's very interested in as much detail as possible about the nature of the transition. I know you and I have talked about the way that the paper gold market is likely to be concluded in the manner of a corporate board meeting where things are essentially wound down in a closed meeting that happens quite quickly.

Bob has a grasp, up to a point, about the HI scenario, but he doesn't seem to have factored in the role of gold in recapping, for example, central banks. He seems to be under the impression that your view was simply that HI would just wipe out the debt and that would be that. Maybe I misunderstood him, but that was my takeaway.

I pointed out that since the balance sheet of, for example, The Fed is full of debt which will be rendered worthless, they will need something to compensate for that loss of value. Obviously The Fed doesn't have actual gold. They have paper certificates from The Treasury who possess physical gold, despite the vaults underneath The New York Fed, but if they are not to be shut down, that gold will not to be mobilized on their behalf. Bob was aware that The Fed has no gold.

He's also interested in the history of the petrodollar which seems reasonable.

And he wanted to know how average citizens would acquire gold after the transition. I said they would acquire it pretty much the same way they do now. Government monetary agencies will not be in the business of dispensing gold to those who want to exchange their currency for physical.

We'll probably speak once more on Friday, and it looks like the interview will be taped next week. I think it will be about a fifteen minute interview that will be edited down to eight to ten minutes

Cheers,
Edwardo

Hello Edwardo,

I'll just knock out a few answers quickly...

Commercial banks should be mostly fine through hyperinflation. They are essentially flat the dollar. That means that it doesn't matter where the value of the dollar goes, their liabilities move right along with their assets. Banks may or may not close their doors during the worst of it. There won't be much use for credit because interest rates would be prohibitive, so there won't be much for banks to do during the crisis.

There's no reason for banks to be nationalized. They will automatically become more like utilities because they will lose the pool of savers' saving which they are used to churning and skimming. Give up on the notion that justice means banks, as businesses, will be destroyed or nationalized. Banks are a necessary part of the system and they are basically immune to hyperinflation because their balance sheets only require nominal performance from the currency.

It is impossible to know exactly how the transition will look. Things could unfold in a variety of orders that all lead to the same set of inevitable events. The gold market will fail to deliver at the highest level causing physical gold to go into hiding until a new order emerges that gets it flowing once again. That new order will be a different kind of market consisting of only allocated or physical sales. There will be no unallocated, swaps, options, futures, forwards or leases because the price will be set at the highest level where the largest volume physical transactions take place.

The commodity-like structural framework necessary for paper proxies will no longer exist. The price gold is trading at the highest level will be many times the actual cost of mining, therefore mining will be tightly controlled and the flow of traded gold will, for the most part, not be new gold like it is today. Gold in the ground will essentially become a supplemental extension of official above-ground monetary reserves.

Meanwhile, the dollar's overvaluation will come to an end. Understand that the dollar is overvalued today because people outside of the US accumulate dollars. This is what causes the overvaluation. They don't even have to sell the dollars they already have, they simply have to stop accumulating more dollars and the overvaluation will end in a heartbeat.

Having oil priced in dollars obviously helps maintain the overvaluation of the dollar, but it does not in and of itself cause it. Oil states may take dollars for their oil, but then they spend those dollars. The oil states do accumulate some dollar reserves, but to the extent that they accumulate dollars rather than spending them is really the only extent to which the oil states directly support the dollar's overvaluation. It also gives other states more reason to accumulate dollars because they can be spent on oil. The point being, it is the accumulation or hoarding of dollars that causes the overvaluation.

So when that ends, a devaluation of the dollar will ensue. Where we will see it first I can only guess (i.e., on the USDX, in currency pairs, at the grocery store, in the bond market, etc...). Where we will ultimately see it in very short order will be in the cost of US foreign imports, especially those most needed by the USG. This will cause an internal budget crisis in certain agencies of the USG and the National Defense Resources Preparedness Executive Order will quickly kick in allowing each department of the government to independently issue guarantees and payments in any amount necessary to keep the shit flowing in, with the Fed assisting each agency in serving as its fiscal agent (yes, that's in the EO).

Hyperinflation begins with a devaluation and then the feedback loop that keeps it going occurs at the market bottleneck where printer himself spends without limit. No one other than the printer can afford the higher prices because, for everyone else, there is an immediate "shortage of money". Hyperinflations are ironically characterized by a shortage of money for everyone but the printer. This is why, for everyone but the printer, transactions usually turn to barter or credit indexed to a stable foreign currency during the worst of it.

This event will destroy the dollar. And by that I don't mean that the dollar will disappear, but simply that all dollar-denominated debt will be destroyed, and remember that one person's debt is another person's savings or reserves. So dollar-denominated savings and reserves will be wiped out all over the world as the USG tries to maintain its own status quo in real terms.

Now imagine if this were simply a hyperinflationary event with no Freegold revaluation. Imagine that Rickards and all the others are correct in that gold will simply rise along with everything else that is real. Let's look at a simple CB balance sheet with 85% of its reserves in dollars and 15% in gold.

Right now this CB has:

$85B in dollars and $15B in gold at today's price. That equates to about 360 tonnes of gold.

So let's look at the real purchasing power held in reserve by this CB. Let's use barrels of oil as a proxy for "real purchasing power" since everyone needs oil.

$85B in dollars = 810 million barrels of oil
360 tonnes of gold = 142 million barrels of oil
Total PP = 952M bbls

The GOR (gold:oil ratio) is about 12.3 right now. If it's simply a hyperinflationary event without the Freegold revaluation, then that GOR will remain roughly the same, just as it has for the last 70 years.

So as the dollar hyperinflates into oblivion, that portion of the purchasing power will go poof. Meanwhile, no matter how high the price of gold goes in dollars, if everything else (oil, silver, milk, eggs) is rising at a similar rate, the real purchasing power of the gold reserves will remain the same. Here's what it would look like:

$85B in dollars = Zero barrels of oil
360 tonnes of gold = 142 million barrels of oil
Total PP = 142M bbls

The monetary reserves will have lost 85% in real purchasing power. Think about that in terms of the entire planet's-worth of physical reserves. When the lights go out on the dollar matrix, the reality underneath will be revealed. And unless something else is revalued in isolation from everything else, then the aggregate amount of reserves will simply decrease by the amount of dollars in existence today. Does that make any sense?

No, of course it doesn't. There are always winners and losers. It's not that the dollar will lose and "everything else" wins. Something else will win, and I think it's not only obvious what that thing is, but also, thanks to the Freegold lens, it is also obvious how and why it will occur.

The Fed is really just a proxy for the USG. The USG can take the monetary power away from the Fed on a moment's notice. The UST can issue its own money. Therefore the USG has control over the Fed in extremis. If we are to believe FOA (which I do), the UST will ultimately deploy at least some of its gold to slow the dollar's decline. In my view, it is pretty obvious how this will come into play. I think that during hyperinflation, as the real inflow of free stuff is contracting regardless of how many zeros they add, the USG will make some payments in gold for the most vital (in its own opinion) imports. But these payments won't necessarily be in the open. They will be behind closed doors while in the open the payments will be made in dollars in order to give the impression to others that these vital imports are not rising in price as fast as everything else.

I'm not sure exactly what you mean by "the history of the petrodollar." But the connection between dollars and oil traces back to 1932 when a US oil company first struck oil in Bahrain leading to a relationship between Saudi Arabia and the US that exists to this day.

http://en.wikipedia.org/wiki/Saudi_Aramco#History

Sincerely,
FOFOA

What minimum price do you imagine is required to put the paper gold market out of business?

What kind of question is that? ;D It's the "gap up" and not the specific price that will end the paper gold market.

"What kind of a question is that?"

A fair one I'd say since your expressed view was that gold had to go above some of the more modest targets that have been tossed out, which for the sake of discussion might be $5,000 an ounce, to put the paper gold market out of commission. It's not a view that's ever made much sense to me.

I think the specific revaluation price and the inability of the paper markets to cope with any sudden revaluation are separate issues. Ignoring for the moment the reasons why $55K makes more sense than a $5K revaluation (and the reasons have nothing to do with breaking the paper market), I think that an overnight reval to $5K would certainly kill the paper markets.

First of all, think about how much of the paper market must be hedged in correlated assets. All those "correlated" hedges fail upon a revaluation (price change in isolation). So the shorts are no longer flat, they are exposed.

Next, think about COMEX just as an easy example. Sometimes during the night the POG changes wildly. So from a floor trader's perspective this is like an instantaneous gap up or down. Now think about the fact that COMEX is really a cash-settled market. So imagine a COMEX short holding a $1M position. Upon revaluation he would suddenly owe $3,875,000 rather than $1M. That's across the board. So even in paper settlement terms, a reval to $5K would break the banks and no one would get paid, even in currency terms.

Imagine the massive de facto short position held by the bullion banks that is only offset with derivatives in correlated assets. Upon revaluation, even to $5K, those theoretical short positions become real short positions, and the largest banks in the world are suddenly facing a brand new liability, even if it is only dollar-denominated.

Say the BBs conservatively have a $100B theoretical short position in terms of their outstanding gold-ounce-denominated liabilities that is offset by $100B in derivatives. As gold revalues 3.875X (which would be to $5K from today's price), they would now have $387.5B in liabilities offset by only $100B in assets (excluding reserves), leaving them owing $287B (in dollars) overnight. That's like sudden-death bankruptcy. So basically any significant revaluation would crush the paper gold markets. I think the reason for higher numbers lies elsewhere.

Bear in mind that a reval to $5K is quite different from a rally, a bull run, or an inflationary spike to $5K which would take all of the correlated commodities and currencies along for the nominal ride as well. Hell, even an overnight reval to $2K from here would probably kill the shorts and leave the paper longs with no counterparty to make good on their sudden "windfall".

But that's not going to happen, because when it happens, the reval will go high enough to get gold flowing in any size that anyone, including the Giants and oil states, want and can afford. And I assume that those at the top whom Another knew have a price in mind that will kick start this monster once it seizes up.

I wonder what that price is, but, equally, I have in mind that the revaluation has to compensate for all the lost wealth that has accrued in debt instruments over decades and will be destroyed as a result of what we see transpiring. Being made whole is going to necessitate a very high price, and, as we know, gold can go to pretty much any price theoretically because its reval is walled off from economic activity.

"That's like sudden-death bankruptcy."

This brings us back to the state of commercial banks post reval. Am I missing something here or are we not talking about some real decimation in some of the biggest names in banking?

My point was to show how the paper market is destroyed. The paper market is destroyed because if it's not, then the banks are destroyed. The banks won't be destroyed because they'll settle those claims at the paper price, which could be quite low at settlement time. This process argues for at least a short period of "gold in hiding" rather than the immediate emergence of the new physical-only market which would make it more difficult for the banks to get out of that short position. It also argues for a transition following a collapse in the POG rather than a rally or a spike. The higher the POG at the time of reval, the less the reval in real terms or else the higher it must go, plus the shorts will benefit less if it happens during a spike in the POG.

They have an easy and well-established way of dealing with this. They simply halt trading and declare forced liquidation of all positions at the last price. If you refuse to take the cash during the forced liquidation, good luck trying to get your physical in court later. Hope you read all the small print they ever put out. ;D

Okay. It's the old, cashed out at the last quoted price before the screens go black condition. I wonder what the minimum amount of time is required to achieve what you describe. Not very long I'd say. And I am wondering how long HI will go on for given that the effects of HI in America will be felt planet wide. I just don't see it going on for very long. If Volcker got an earful of "do something" back in '79 I can't imagine that the feedback from the four corners of the globe isn't going to be deafening, not that he or she will need to hear it in order to pull the plug on the dollar.

Volcker got an earful because they didn't want the collapse to continue. Today they are more prepared, so I don't think that Bernanke or whomever will get an earful from Europe. If they do, Congress and the President will give them the finger and keep printing. It will go on as long as the USG refuses to give in to the inevitable (unavoidable) austerity diet that's heading its way.

During hyperinflation, the trade deficit collapses to zero in real terms even as it reaches near-infinity in nominal terms. It is the collapse in real terms that they will fight. I'm sure there will be some tipping point at which the diminishing returns of printing become indisputably obvious. But even then, the USG is a big, hungry monster. I can imagine it going past the point of reason and, besides, there will be hidden benefits that will become equally obvious, like the cleansing of all of the debt. Perhaps reason enough to keep printing a little while longer even after there's no other return in real terms.

So, in summary, my mid-range guess is 6 months, but it could be as short as 3 months or as long as a year IMO. Then again, I suppose it could roll out more slowly than I expect, more like Zimbabwe, where the USG finds that printing the shit out of the dollar brings real returns longer than I expect. In that case, maybe two years, but I think that's less likely.

"I wonder what the minimum amount of time is required to achieve what you describe. Not very long I'd say."

Not long at all. Technically it happens the moment they declare it. And then the accounts can get credited within 48 hours. It's not unlike issuing a brand new currency and giving everyone 48 hours to get to the bank and exchange their old currency for the new one. The old currency is already worthless as soon as they announce it except for the limited window of time they allow you to exchange it for the new one. If you hang on to that old currency, it'll just die on the vine once the window closes.

I don't expect Europe to be the leader in making unpleasant noise because they have their system in place to mitigate the ill effects of dollar HI. I agree that extinguishing the debt or at least vastly reducing it will amount to a goal of sorts, but the political class is going to be hearing from the locals the way Volcker was hearing it from the Europeans. How long will they hold out in the face of the kind of ugly displays they are apt to experience. If there's ever a betting pool for this I'll take the under on a year.

Under on a year is a good bet. 3 months may even be more likely than 6 months. I don't know. The complaints will come from the disruptions to the just-in-time supply lines, and people may turn to their government for help, demanding even more printing (free stuff please). Perhaps the savers and conservatives are screaming to stop the insanity while the majority points to the conservatives as heartless rich and demands that the USG print the shit out of the currency to get as much free stuff as possible. It's hard to predict who will be rational and who won't. Well, I guess it's not that hard. ;D

Regarding HI, we know The Euro is set up to weather the storm; do you have any thoughts on some of the other more important nation states and how they will be affected?

As I said, HI begins with a devaluation which translates into a jump in prices, especially foreign imports. What follows is the government's reaction to the devaluation and the jump in prices.

I think that, as Another explained, all currencies are more or less tied together today, not just because they hold dollars as foreign exchange reserves backing the currency, but also because they trade more or less freely and float against each other from minute to minute. So when the dollar devalues, it may initially be against all other currencies, but I think that they too will follow in (extremely?) short order. In other words, all currencies should see a general devaluation around the same time. Of course they can't all devalue against each other at the same time, so that mutual devaluation should play out as a jump in commodity prices, a devaluation against the physical plane.

So as you see, even though other currencies may quickly follow the dollar down a short waterfall, that won't relieve the ball-of-twine budget crisis the USG will be facing with a jump in prices.

The point being that in each currency's case, where it goes from there depends on the local government's response to the sudden crisis. Some will just devalue like Iceland, others will go hyper as the government panics and prints. What sets the Eurosystem apart is that no single government has control over the ECB, so, even if they panic, they can't print. So look at currencies where the government can say "print" and then try to judge if the government will. That should give you a good idea of which ones have a higher probability of going hyper along with the USD. The usual suspects like Japan and the UK are kind of obvious. Less obvious are commodity-based dollar system supporters like Australia, NZ and Canada, the ones that FOREX Trader calls the "comdolls" (ie. commodity dolls). I don't know about Russia and China. They should be interesting to watch. They are both big countries with lots of local resources and pseudo-communist governments, so their governments' survival impulse may be more heavy-handed locally than joining the international print fest.

Today I did a Skype check with Bob's producer. It looks like early next week for the interview.

Was she hot?

Listen to you. She said she couldn't display a vid from her end, which sounded like utter rubbish, but there you go.

Inflation or Hyperinflation?

"…The dollar is so vastly overvalued today because the rest of the world has kept it on life support for 30 years past its expiration date. It is the stability of dollar prices at that small marginal flow that sustains the illusion of wealth in the entire, massive monetary plane. And yet the modern "hard money thinkers" think that we can somehow retain this level in real terms by simply devaluing the dollar against gold and then managing that new "gold value". I wish all the modern hard money thinkers – you know who they are so I don't need to mention any names – would just take a few minutes and listen to FOA and maybe, just maybe, see how wrong they are…"



FOA on Currency Styling, Currency Management, Dollar Hyperinflation and End Game Scenarios

From FOA on Currency Styling, Currency Management, Dollar Hyperinflation and End Game Scenarios last November, here's 'Boulevard of Broken Dreams' by Green Day. The reason I chose this song was partly for the chorus line "I walk alone" as it relates to FOA's parting words. But I also liked this song because I could relate to the lyrics myself as the Freegold foundations explored here are not very popular in the precious metals community for various reasons:

"I walk a lonely road
The only one that I have ever known
Don't know where it goes
But it's home to me and I walk alone…"