EmptyWells: Financial & energy views by Simon Woodhead

Why I love gold and silver

Thu, 11 Dec 2008 14:32:27 +0000

I can't profess to being a long-term gold bull but I am certainly born again. Having been invested in Gold for the last 3 years, my confidence has grown as the reasons for owning it have compounded. I'll set those reasons out here.

The only investment I prefer to gold is silver, and to understand silver, you need to understand gold. I view it as mini-gold with leverage, subject to the same factors but also unique influences of its own.

First and foremost, gold is money. It has been used for thousands of years in trade either a direct unit of exchange or as backing for paper money. The 'history of money' explores this further. Silver is no different except its use as direct coinage, by virtue of its lower value per unit of weight, is more recent.

My initial interest in gold stemmed from its place as a Dollar hedge. In 'the abuse of the dollar' I have set out how the US has run a perpetual trade deficit and suggested it is not sustainable. There are few alternatives to the Dollar as the world's reserve currency but the need for an alternative is difficult to argue against. A return to 100% gold-backing is unlikely but I do fully expect an increase in the weightings of gold amongst surplus countries and some have already made noises in that direction. More directly, gold is priced in US Dollars and typically trades conversely.

Gold is a hedge against inflation. Pick a commodity and trace its price back in various currencies to observe the currency's loss of purchasing power. Compare it to gold over long or short time periods and you will find that gold has kept pace to a shocking degree, i.e. an ounce of gold still has the same purchasing power it did historically. The chart below shows the price of crude oil from 1945 in USD and gold. I say relative as this is a logarithmic chart as these more accurately depict % changes, i.e. an increase from 2 to 4 will be the same distance vertically as an increase from 4 to 8, unlike a conventional scale. You'll note that despite the massive fluctuation in the Dollar price, the price in terms of gold, i.e. gold's purchasing power in terms of oil, has not materially changed.

Gold is a hedge against deflation. Yes, you read that right and in fact the whole inflation or deflation debate is actually insignificant if we simply agree that things are going to get bad. In times of uncertainty and instability, gold is regarded as a safe harbour.

In short, gold is a preserver of value. You will not 'get rich' buying gold but it does enable you to stand still while inflation, deflation, currency fluctuations, and other crises affect asset values and purchasing power. Gold is not consumed and the entire amount mined in human history is tiny. It has been regarded as precious throughout human history and is one of few asset classes in the known universe that has actual real and lasting value.

Silver is like gold but with a few differences. Geologists estimate there was 10 times as much silver in the ground as gold, and one might therefore expect it to trade at 1 tenth of the value of gold. The exact ratio varies due to the fact that silver has other factors affecting it. Unlike gold, it is 'consumed' and much of what has been produced in history now sits in landfill. On the one hand that makes it scarcer but on the other hand exposes its price more to sentiment and perceived industrial demand. Investment demand is becoming more significant for silver and I view it as a volatile form of gold which in the long run will outperform gold.

Not everyone agrees of course, and many refer to gold (and implicitly silver) as barbarous relics. I simply say that just about every central bank across the world holds stocks of both gold and silver in their vaults. One exception is our own Bank of England where in his first act of self-proclaimed economic wisdom, Gordon Brown sold the lot at $275 - a third of the current price. Others have a little more competence and newer powers such as China are moving towards increasing their gold holdings. They understand that gold is money.

If you are reading this, you’re hopefully ahead of the curve but for all the above reasons, I think gold and silver are going to get a lot more attention over coming months and years. Dare I suggest they could even be the next bubble.

Inflation or deflation?

Thu, 11 Dec 2008 10:05:46 +0000

There used to be an expression: ‘lies, damn lies and statistics’ suggesting that you could present any picture with suitable interpretation of factors. That is no longer appropriate but not for the reasons you may think. Unfavourable interpretation of statistics is no longer possible as those that paint the ‘wrong’ picture are no longer available (e.g. money supply) or their composition is continually tweaked so backwards comparison is no longer possible (e.g. inflation measures). To make matters worse, the very questions that we seek to answer contain terms on which there is no clear definition, it having been changed over the years. So let us take a step back, define what we’re talking about and let common sense do the rest.

First, some definitions. These aren’t official economist or government definitions as there are no agreed or consistent ones. These are my definitions taking the common ground and common sense from everything I have read. If you disagree with them on non-intellectual grounds, I’d welcome your views.

Inflation: The most common contemporary view is that this refers to rising prices. However, find a dictionary from 20 years ago and you will see the definition then was ‘an expansion of the money supply’. Co-incidentally, rising prices are defined as a consequence of inflation, not a characteristic. Seems sensible.

Deflation: The opposite of the above - a contraction of the money supply with falling prices as one of its consequences.

Recession: The official definition is two quarters of negative growth in GDP. Seems too much scope for intellectual masturbation there for my liking! Recession is a period of contraction following growth which has typically lead to a build up of inventories/stocks in the economy. It is essentially a correction during which the excess inventories/stocks unwind.

Depression: Headlined on the news as a very bad recession, and outside the living memory of most economists. Whilst many would agree with ‘very bad recession’, there are those that think the use of a new word might imply something different and the consensus seems to be that a depression is a period of generally falling asset prices and is nothing to do with excess inventories or the other characteristics of recession. That said, rising unemployment, economic slowdown and starvation (a.k.a a bad recession) are consequences.

Now we’ve agreed all that (!), let us look at the current situation. Prior to mid-2007 we were in a period of inflation with strong economic growth having pushed asset prices up, the US property bubble having started to burst, others beginning to follow and the excess credit beginning to unwind.

Fast forward to today and we have Central Banks and Governments both separately injecting liquidity into the financial markets, injecting capital into banks, mailing cheques directly to consumers, reducing interests rates rapidly towards zero. Their goal is to avoid deflation at all costs and free up the credit markets.

In the inflation camp, many whose opinion I respect argue that we were in a period of inflation immediately prior to this and, in fact, there were concerns of it getting out of control. They argue that pumping money into the economy can only lead to inflation later on, although do concede that a period of dis-inflation will precede it.

The deflationists, whose opinion I also respect in some cases, claim that ‘money supply’ also includes credit and that newly printed money is simply replacing contracted credit. Therefore there is no increase in money supply, ergo there will be no inflation and in fact we are in such a very bad recession that there will be deflation.

Now, I’ve listened to a lot of these guys, I’ve played with on-line economic models, I’ve read everything I can and frankly I risk turning into an academic. I shouldn’t knock them so much and wouldn’t read their work if I thought it was worthless but I do feel when you get so deep into a subject it becomes very easy to not see the wood for the trees and to concentrate so much on the theoretical attributes that common sense, history and human nature get ignored. I have to view things simply so my tiny brain can comprehend them but tend to lean heavily on history, common sense and human nature.

The US Treasury stopped publishing M3 (a measure of money supply) some years ago as they argued it was no longer relevant. Thankfully, due to its widely perceived significance, others (shadowstats.com and nowandfutures.com) have continued calculating it from what information is available. They have also taken account of the changes to inflation measures to give us a figure without lies going back historically. Let’s look at these two together, courtesy of nowandfutres.com.

My interpretation is that the link between money supply and inflation is undeniable but you draw your own.

So, what has the money supply done...

Ok, so it shot up to unprecedented levels in 2007 but since then they appear to have slackened off on the money creation.

Or have they? Do you remember Enron? They built a ‘highly profitable’, ‘solvent’ company by mastering the art of hiding the problems where nobody could see. Hold that thought as you consider the following chart which attempts to show the total money supply adding in all Fed and Treasury operations.

This one is the same data over a short period showing the composition. Note all the new wedges.

Suffice to say: ‘ouch!’.

In my mind, this looks like the makings of inflation but what about history and human nature? In the past, monetary policy has been loosened to head off a slowdown and has caused inflation downstream, but this time it might be different. Oh, that phrase takes me back and I wish I’d saved a Pound for every time I heard it when I was managing money! Needless to say, it rarely was different except at the minute levels of academic analysis, the outcome was always pretty much the same!

So what about human nature? Well, Ben Bernanke is the world expert on the Great Depression and he has long argued that it could have been averted by the creation of liquidity, masses of it, much sooner than it was. Of course, if he undershoots we won’t avert the crisis, and instead will enter a ‘bad recession’ with ‘deflation’. He could also reign it back in at just the right moment. Given the passion of his argument and what you know of human nature will he a) get it just right and all will be rosy, b) undershoot, c) overshoot? Answers on a postcard please.

Where does that leave us then? I think we can safely assume a massive increase in the money supply which we can expect to ultimately feed through to rising prices. By our definition that puts us in a period of inflation, leading to inflation by the more commonly agreed definition. However, there is a lag, and we’re currently in it. I’d come down on the side of dis-inflation to describe that.

So, recession or depression? Well either way it is going to be pretty rubbish! I would argue however that we have been in recession for some time and for the last several months have been in a depression. Banks and hedge funds the world over have been unwinding excess credit (de-leveraging to use the buzzword) by selling assets causing asset prices to fall irrespective of the state of inventories or economic growth.

The last wander into academia has given me a headache now and I’ve tied myself in a knot. How can we be in a depression and have inflation? Well if we apply the common sense definitions above, quite easily. If we apply the accepted definitions we’ll need to fight amongst ourselves a bit more or invent a new word altogether. How about ‘stagflation’. Heard that one before?

The bubble maker

Wed, 10 Dec 2008 15:42:55 +0000

In 'the abuse of the Dollar', I outlined how the US has consistently consumed beyond its means, funded by producing nations. But what has caused that?

In the late 1990s, the US economy was reeling from the failure of a major hedge fund - Long Term Capital Management - and underwent what in many ways could be seen now as a mini-rehearsal for today's events.

Against this background, and concerned about Y2K, the Federal Reserve released liquidity into the markets to spur consumption. Y2K fears turned out to be overblown and with some positive talk from the powers that be, the technology sector became the home for what was by that stage surplus liquidity. Slowdown averted, the dot com bubble was born.

By 2001 that bubble was unwinding and the US entered recession. Interest rates were slashed to 1% and the miracle of derivatives was embraced. Another slow down averted, more cash in the system and the housing bubble was born. Over and above increasing house prices, and house purchases by those who couldn't truly afford them, this was accompanied by a massive expansion of credit a good part of which was released equity, i.e. a drawdown of the increase in a property's price by way of a loan. This released equity was then re-circulated in a massive increase in consumer spending until the brakes needed to be applied to avoid runaway inflation.

Fast forward to today and we're in what is widely termed a recession (I disagree but that is another article). This could rightly be called the recession of 1999, or the recession of 2001, both having been postponed by increased liquidity. Doubtless, that act of postponement has built the pressure which now has to unwind, in addition to the unwinding of the latest and largest bubble itself.

The Federal Reserve, now chaired by Helicopter Ben (a nickname earned by his statement that to avoid a slowdown we should drop helicopter loads of cash on the economy) is releasing liquidity into the market at an unprecedented and astonishing rate. I will explore that and the potential consequences in another article!

The abuse of the Dollar

Tue, 9 Dec 2008 20:38:09 +0000

In ‘the history of money’ I described how the US Dollar had risen to reserve currency status and how in 1971 the ability to redeem it for gold was quietly withdrawn. Here I describe what has happened since.

Every country exports goods and services, and imports other goods and services. Some economies export and import more, others less. The difference between the two results in either a trade surplus or a trade deficit.

A deficit puts the country into debt with its trading partners and ultimately makes its currency worth less. A surplus results in foreign currency reserves, ultimately viewed relative to the US Dollar.

Frequently, the US Dollar is also used for trade between countries and not involving the USA, e.g. China purchasing oil from Venezuala. On the one hand this puts the surpluses to work but ultimately producing nations are left with more Dollars than they need.

I’ve prepared the chart below from the latest IMF data. It shows the surplus and deficit in US$ terms from 1980 to 2013 using estimates from 2006/7 onwards. I have only shown the top and bottom 4 countries for clarity. Click on the image to download a full size PDF.
What this shows, hopefully very clearly, is that certain countries run persistent deficits whereas others run growing surpluses - the US and China being the key examples.

Deficit countries must borrow US$ to square their position. Surplus countries have US$ to invest, either loaning them to deficit countries or more often investing them in the US.

A common home for these Dollars is US Treasury bills, i.e. newly issued Government Debt, on which they derive interest paid, you guessed it, in Dollars.

No, you haven’t misunderstood although it does make no sense. Producing nations sell goods for Dollars which, by virtue of the US consuming more than it produces, end up accumulating as surpluses. They then loan these to the US Government by buying Treasury bills which are essentially new Dollars issued to finance the budget deficit. Think of it like a store card where every Dollar you spend gets lent back to you!

As the chart shows, this situation has persisted for a long time and shows no sign of abating. The US’ excessive consumption has financed its excessive public spending. The only reason it has continued and remains is because the producers of the world have continued to accept it.

To make the situation even more unpalatable, every new Dollar created essentially devalues the Dollar - there are more in issue represented by an unchanged productive capacity. This manifests itself as inflation within the country, the stealth tax to end all stealth taxes, but has a curious effect internationally. If you borrow Dollars, inflation erodes your debt. If you loan Dollars, your loan similarly gets eaten away by inflation. Sure, you have interest on it but in the current environment the net result is actually negative, i.e. those Dollars are falling in purchasing power faster than the interest on them can offset.

As things stand the US owes almost $11 trillion which is $35,000 for every man woman and child living in the country. That is increasing at a shocking and in recent times accelerating rate.

Meanwhile, China’s foreign currency reserves (mostly US$) are nudging $2 trillion and accelerating. And lets be clear, that is $2 trillion that has a negative rate of real interest.

Of course, such is the supportive result of the acceptance of Dollars that there is something of a positive feedback loop. Were China and others to stop accepting Dollars, or begin to reduce their reserves of them, the result would be a devastating fall in the Dollars purchasing power. They are in a catch 22 situation but it cannot be sustainable.

Independent nations such as Iran have already made the move away from Dollar dependency, preferring to sell their key export (Oil) in Euros. Strange how all of a sudden they are such a threat to the Western World. OPEC is also very carefully making rumblings towards selling oil in a basket of currencies rather than Dollars alone.

That can only be the sign of things to come and, as history has taught us, the Dollar will go the way of every failed fiat currency before it and a new reserve currency will emerge. That will be a painful process.

The history of money

Tue, 9 Dec 2008 10:01:17 +0000

Before we get into what is happening today, and might happen tomorrow, it is vital we revisit the fundamentals. This isn’t an academic paper and is intentionally light on detail in order that the key points are not lost. If you want academia there is a mass of information on the Internet by people far brighter than I.

So, let’s go back, way back, back to the time of cavemen when there was no such thing as debt, income, or wealth. Families lived on the food they hunted or produced, in the homes that they created.

As time went on, trades evolved, and one person may have been better at hunting than another, whilst the other was a better at gathering firewood for example. This lead to barter where food may be swapped for wood in whatever ratio was agreeable to both parties. Barter is not just something from prehistoric times and can be seen in any situation where humans are deprived of what we now know as ‘money’ - e.g. the school playground or prison.

The problem with barter is that it requires a straight swap at that point in time between two parties. If, in our example, the one caveman didn’t need firewood but instead wanted a spear, three people were involved and the transaction became complicated. Equally, what if he wanted firewood later in the year, no means to store it but only had meat today? These factors greatly complicated and limited things.

So, the human mind in all its ingenuity developed the earliest forms of money. A third party unit of measure, that was sufficiently scarce so as to be trusted and didn’t perish, was required. It didn’t matter what this was as long as it was generally acceptable and had intrinsic value. So, our caveman could now sell his meat whenever he had it, store whatever ‘money’ they had agreed upon (wine, salt or metals being early examples) until later in the year when he could purchase both a spear and firewood as he needed.

As society progressed, the units of money became more sophisticated or cumbersome. Gold has been an example for much of history but equally in Ancient Egypt, bags of food grain were used. It quickly became apparent that lugging bags of grain around wasn’t exactly practical and instead they began depositing the grain in Royal or private stores, getting a receipt in exchange. They could then carry that receipt around, exchange it for goods and services, with the ultimate recipient having the trust and confidence that he could take it to the store and redeem it for his grain. In more modern times the goldsmiths in 17th Century England did exactly the same with gold and these promissory notes are the earliest example of money as we know it today - a trusted promise with no intrinsic value. We’ll come back to this.

Now, as mankind travelled further afield and became more developed, all of these problems manifested themselves on an international scale. Individual regions had their own system of money but how could a merchant pay for goods at the other side of the world? The same evolution took place with him initially bartering goods and ultimately trading goods for gold which they then had to lug around. With the rise of the British Empire, merchants eventually began to trust their gold to London’s goldsmiths in return for a receipt. Those receipts could then be exchanged for goods and services across the Empire, safe in the knowledge that behind each one was physical gold which it could be redeemed for.

Goldsmiths were the forerunners to banks and ultimately bank issued notes were replaced by Government issued notes, still retaining their qualities as a promise to pay the bearer an amount of gold. The Bank of England was formed in 1694 and the British Pound became the strongest, most stable currency of the 19th Century and the closest equivalent to pure gold. This is what we (erroneously) think of as the ‘gold standard’ where every bank note was backed by an amount of gold and redeemable on demand. What a perfect system!

At an international level, countries outside of the British Empire had developed their own currency systems and Central Banks but as a result of trade would be left with surplus Pounds. They knew these could be exchanged for gold and trusted them in the same way that their own people trusted their currency. More often than not, their Pounds were stored, in the same way that the gold they represented would be, but in a far more liquid and readily available form. The first global ‘reserve currency’ was born.

I said we’d come back to the grain stores and the goldsmiths, so here we go. Whilst thousands of years apart they both quickly realised that nobody knew how much was in their store except them and experience taught them that they always had something in the store even with seasonal shifts and the ebbs and flows of redemptions. In fact, the more trusted the system became, the fewer redemptions they had at all, with notes being traded freely and taking on a perceived value of their own. Others also knew that these entities were the store of wealth and the people to speak to if one needed financial assistance. They quickly learnt that they could make loans to these people, simply by issuing new notes. These notes were backed by whatever was in the store but there became far more notes in issue than could be redeemed at face value.

In that simple step, they had created what we now know as ‘fractional reserve banking’, and ‘inflation’ whose definition in those days was an increase in money supply (it has since been rewritten to describe its consequence - increasing prices).

Just as the pharaohs and the goldsmiths before them, the Central Bankers learned that they too could print more money than they had backing for with seemingly little consequence. The issuer of the ‘reserve currency’ could print further beyond its means as its currency was not only used for trade with itself, but stored and used amongst its trading partners themselves.

At the time we now look back on as the ‘gold standard’, national currencies were backed to a tiny extent by gold. The agreement to exchange for gold therefore was really only an agreement between the Central Banks themselves and not an agreement to redeem all currency for gold.

Britain abolished the gold standard with the outbreak of WW1, and other nations followed quickly with the Great Depression. Why? They needed to inflate the economy with more money than they had backing for and wanted to simply be able to print it.

In the US, by 1880, only 16% of currency and deposits were backed and by 1970 that had fallen to 0.5%. Throughout this time though, the Dollar had emerged as the new global reserve currency and was still redeemable for gold for international transactions.

That all changed in 1971 when the promise for redemption was quietly withdrawn and the US Dollar, whilst remaining the global reserve currency, ceased to be backed by anything. A Dollar is redeemable for a Dollar, nothing more. The same is true of all major currencies in the world today. Fiat currency was born - paper money backed by nothing.

Fiat currencies trade in the world relative to the productive capacity of the issuing countries. The greater a country’s output, the greater the trust and confidence in its currency and the higher its relative value.

The one exception remains the US Dollar which enjoys the privileged position of being the reserve currency, taking the place of gold as a store of value and a medium of exchange between the Central Banks. That is the subject of another post altogether though....