It has occurred to me that there have been so many technical and fundamental pieces written, some very good yet complicated pieces written, far out (in reality not so far out) conspiratorial pieces written and even mathematically and logically correct yet difficult to understand pieces written regarding the precious metals. Without being complicated or technical, I’ll try to write a most basic “primer”…with just one preexisting assumption. This one “assumption” is that the U.S. government is broke. Even the average person today knows that this true, if you do not believe or agree with this assumption then there is no point to you reading any further. I could show you this from multiple angles financial, mathematical and plain old common sense but I won’t because I will assume that this point you already understand.
OK, so what does a financially broke government mean? Normally it means that a big change in the standard of living is on its way because the United States issues the world’s reserve currency there are other more “global” ramifications. I will touch on these ramifications but I want to focus “internally” and write from a U.S. centric point of view first.
What does a bankrupt Treasury and central bank really mean? First, it means that since the Treasury does not have the ability to “pay,” the central bank must issue more currency and thus diluting the exiting currency’s value. Without a long winded explanation, this is your basic and garden variety monetization that results in “hyperinflation.” You see in the old days when money was backed by gold we might have seen an actual deflation where the currency value went up today, since currency can and is issued at will with no backing, the end result will be hyperinflation.
Let me just briefly touch on our “money.” Dollars (Federal Reserve notes) are backed by the “full faith and credit” of the U.S. government. Let’s examine this for a moment “full faith and credit,” what does this really mean if the issuer is broke? Exactly how much “faith” would you have lending money to someone who is in the process of bankruptcy and cannot pay their bills? And “credit,” how much credit is available to a bankrupt entity? In case you were not aware of this yet, the Federal Reserve has been purchasing 70% of U.S. Treasury issuance for going on 2 full years now. Why is this you ask? Because the rest of the world has and is losing “faith” and no longer extending us “credit.” In simple terms, the rest of the world has stopped buying U.S. Treasuries. By default (yes, a pun intended) the Federal Reserve has been forced to purchase the bonds that the rest of the world is refusing to buy.
This is a problem, a very big problem because the Treasury absolutely MUST sell new bonds to rollover previous bonds that are coming due for maturity and also to pay the interest on the total outstanding. Without the Federal Reserve purchases, the U.S. Treasury would have already been forced into a “technical” yet very real default several years ago.
OK, so the above spoke about our “money,” dollars which are issued and backed by a bankrupt entity. Simply put, a broke government means a broke and broken currency. What else does a broke government mean? Let’s look at the banking system. If the government is broke then what does this say about the banks? First, you must understand that the banks are “built” upon a foundation of U.S. Treasury bonds. If these bonds are impaired in value or worth “less” then what does it say about the banks themselves? “Don’t worry the FDIC is there to save the day” you say? Really? The FDIC does not have enough funds to save just one single major bank should they fail, where will they get more capital from? From Congress authorizing more funds from an empty Treasury? Do you see? Everything works because of one assumption…that government is NOT broke. What if this basic assumption is wrong?
I would be remiss if I didn’t mention that gold is currently trading at the price of production meaning that very few companies can make a profit at these prices. Silver’s price is at least $5 an ounce under the cost of production so the more silver that is produced the greater the losses to the mines. This cannot continue for very long, not to mention that “ore” is being chewed up that does not get replaced because it doesn’t “grow on trees” like money apparently does from central banks. Please understand that as more “money” is created, inflation will continue to increase which will only increase the cost of production further. I mention this because of the laws of supply and demand. Higher production costs without higher bullion prices will only restrict supply from current levels. While on the topic of “supply and demand,” global supply has been 2,700 tons per year and demand has been well over 4,000 tons for over 15 years now. This supply “deficit” had to have come from somewhere. This “somewhere” can ONLY have been the central banks themselves as they are the only ones with a “spare” 1,500 tons or so per year to supply.
I want to connect the dots in this piece with the obvious. If you know that the government is broke then you know that the currency that they issue is also broke or worth “less.” You can also divine that if the government is broke then their bonds are also, these bonds are core foundational capital to the banking system. Knowing this, you can then make the leap that there is not only a problem with the currency itself but also a problem with where it is you are keeping this “money.”
With the above paragraph in mind, it follows that you should do two things A. get a “better” money and B. keep it in a safer place. I would also like to address “timing.” Everyone knows that you want to buy low and sell high but I am going to tell you that this will not work with the precious metals, the “selling” part at least. If you know that the issuer of a currency is broke, why would you ever “sell” your precious metals at a “profit” to receive more of the broke currency that you dumped in the first place? If you know what the end game boils down to, meaning that the currency of the broke entity will eventually go to zero or be converted to another currency at a lower value, why would you ever want to play that game? If you sell your precious metals for dollars (more of them at a “profit” so to speak), are you not reentering “the game” that you already know will end badly? The idea of purchasing precious metals in the first place is to leave the game, selling an ounce of gold for $1 million very well may be ridiculously cheap and far less than a week’s worth of labor after a hyperinflation. This is not grandstanding as we have no idea how much more “money” will be printed and we certainly do not know how much (if any) gold is left in Ft. Knox or the other depositories since there has been no audit of our gold since the 1950’s.
To wrap this up, assuming that you understand that the U.S. government is broke then why stay in a game where you know how it ends? Every government since the beginning of time that overspent “paid” for this overspending by first selling their gold and then overprinting their money. This combination has always and without exception led to their currency loosing value “slowly at first and then all of a sudden” to the point of having no value at all. This is the current situation of the U.S. dollar with one nasty caveat; the dollar is the foundation for much of what the world calls “wealth.” Ask yourself what this “wealth” is really worth if it all derives value from a currency that is issued by a bankrupt entity?
I know that this realism is not pleasant to read…but it is real and it is true. History has shown us that the absolute best investment to own when a country goes broke is gold, only this time it will not just be one country it is system wide. The entire global financial system relies on the dollar for “value” as central banks use dollars as the primary reserve. Is this “sound finance?”
Bill, I have a question. Is deflation a really bad thing for the country, or is it just a really bad thing for Ponzi Schemes? It is painted as being about the blackest thing on earth but I am wondering if a reset is not only inevitable but also a good thing to wring the gambling derivatives, twisted price relationships, collateral collapse, etc. out of the market and get back to basics. Should we prepare for deflation and welcome its arrival?
not a bad thing for the country but yes a bad thing for the banks. It will be a massive deflation versus gold while the currency itself hyperinflates to oblivion. Long term it is a must for a society with a true rule of law. I say this because when you “trade”, both parties must give “something”…something for nothing cannot last forever.
I have thought about selling some gold/silver to pay off my fixed rate mortgage debt after a substantial rise but also before a reset causes the loan value to be restructured as well. This is one exception I can see as being of value in transferring back into fiat, IF indeed PM prices rise quite a bit before any such loan restructuring.
I have a question that goes to derivatives, Bill. I can understand why CDS can be 100% loss of notional value, but what about interest rate derivatives, where only the difference between fixed and floating times a notional value is lost, rather than the total notional value itself? For instance, if you and I entered into a $100 million interest rate derivatives contract where I traded you floating for fixed, and the difference after one year is 1% to your good, I owe you $1 million. The entire $100 million notional is not at stake to be lost. So is that notional amount of $100 million included in total derivatives? If so, it seems misleading in the context of money at risk of loss to the financial system, because only a fraction of it is at risk of loss.
I agree with you on the first part. The second part not as much. Most “CDS” are to insure the bonds (principal) themselves. Yes you are correct about the $100 million example but how much “capital” is behind this to carry it? $1 million? $10 million …or only $100,000? You also forget about the drop in price of the $100 million “fixed” bonds, where is this loss accounted for and who absorbs it? So, yes there is an argument for “netting” but not very strong because “notional” will become real in a collapse as there are underlying positions to account for. Also, you must understand that in a collapse, EVERYTHING will go and NOTHING will be solvent in the financial sector because the losers will not have the ability to pay the winners who hedged “losing positions”. EVERYONE will lose. It is much more technical than this but these are the nuts and bolts.
Bill, great articles and once again I thank you for personally giving feedback and discussing issues associated with them.
The part about CDS I do fully understand. The other part I am having more difficulty with. I thought the notional amount of $100 million is not any real amount of bond that would be at risk, but instead a fictional, notional amount for purposes of our derivatives bet. The carry amount would be whatever we have to post on our losing positions, again only a small amount compared with the notional. But clearly, if we are hedging a another exposure/risk (hence the reason for the derivatives bet to begin with), we could be on the hook for considerably more losses on our initial exposure if for no other reason than counterparty risk.
Even with my understanding of the issue as being less than notional derivatives at total risk, cascading defaults are a huge risk that, as Jim Rickards puts it, are not factored into modern portfolio management models. Two low event possibilities can be much higher risk than thought if one causes the other (eg. Fukishima earthquake causes tsunami causes tital wave, causes nuclear disaster, or Deadliest Catch leak in tanks causes power outage when separately each is a very low risk event).
Good logic as always, Bill.
This is from the BIS.
OTC derivatives markets continued to expand in the second half of 2013. The notional amount of outstanding contracts totalled $710 trillion at end-2013, up from $693 trillion at end-June 2013 and $633 trillion at end-2012.
My math tells me that even if 90% of the derivatives cancel each other out, somebody is still going to have to come up with $71 trillion dollars! I wonder who that will be?
when all is said and done, they will not cancel or “net out”.
your logic is meticulous. Too bad city treasury offices and lawyers won’t accept payment in pm coins. We think we should stack up on these to get ready for either a rise or a way we can use them. we cant eat them. While we get ready to use them by accumulating them they smash their usable value. and then what happens when we want to sell them cause u can never really use them and everybody is selling them and there is a surplus of sellers—- say at $50/oz for silver? So they dont want them then and also you get devalued worthless cash back? odd…. where does this all lead…. within an immoral evil government and mostly cowards for americans hiding in these systems this mess is pathetic…. and leaves a moral man with a song, a prayer and Bill Holters words…. because we are very confused out here. Especially when a guy like Eric Sprott gets it in the red like down like 65% in the last 2 years. But then he probably has it all hedged and didnt tell us really what he does…. he just told us to buy buy buy PM’s…..keep buying…..buying ..buy silver at $40/0z,.,,,,buy at $50….buy buy…buy…dont worry..its all so odd because the logic is meticulous but like the medical system. If Surgeons and pharmacists own the hospital and you enter and they are your doctors and your sick…. guess what you get. You don’t get herbal medicine…. so the criminals have the PONZI SCRIPT and run the SCAM and BRIBE everyone… so those of us that love the truth hang on the words of ranting Andy and the cowboy Bill….this was my rant…this mornings manipulation was so blatant even a first grader could see it. These criminals should be sued, jailed and anyone invested in precious metals reimbursed….. with Gold!! this country is a joke because of the DEMONS(Obama,Bush,CFTC and all the rest) running and benefiting from its present corrupt structure.there are too many good Americans left to have to put up with this. This is how we feel out here in middle class land. Mr. Frank
I feel your frustration Mr. Frank and I assure you that Eric Sprott does too. He is the real deal, I know him personally and his skin is 100% in the game and is feeling the same emotions as you are. Hang in there and try to relax because the storm that’s coming for America will be far worse than PM investors are feeing now.
Just found out my recently passed on grandfather at 99 yrs of German decent, fleeing Germany before the war and worked his entire life at the ny daily news believed usa government are just taking their orders from the oligarchs. Presidents are just puppets in the big scheme of things. Here I am thinking I have been awaken recently with the help of the internet but evidently this thought is nothing new. I thought I was the first in my family to have these beliefs. I wish I knew this before he died, I’d like to ask him why he believed this. My guess is Pearl Harbor attack or JFK . So when will the fed or shall I dare say the old British oligarchs “pull it” on the economy? Or will another war start up first for cover. I’m worried about their next move since the system is broken
that’s a shame, you missed an opportunity for one heck of a conversation,
Great post! Been reading a lot about precious metals. Thanks for the info here!
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