Sunday, May 3, 2009

Gold - The apex of the pyramid

John Exter's liquidity pyramid that is. Exter was a central banker who worked at the federal reserve in the 1940s and 1950s and somehow emerged with his intellect intact. He was on the inside, knew how the system worked and yet didn't like Keynesian or Friedmanite economics. His concern about a global fiat money system, once it emerged, was that it would eventually blow out in a deflationary implosion rather than an inflationary one. This is the opposite of what most Gold bugs believe and yet results in a similar conclusion: Gold Gone Wild (i.e. strong bull market in Gold).

How can Gold have its cake and eat it, too? It's actually quite simple. In a hyperinflation, almost every asset goes up in price. Bread, guns, real estate, silver, Gold, commodities, stocks. Almost anything besides cash and bond prices does well. So, really, Gold is not super special in a hyperinflationary blow-out, though as a currency that has high intrinsic value per unit of size, it can be transported across the border easily if chaos erupts (which it usually does during a hyperinflation) and used to make bribes along the way if needed.

In a hyperdeflation, Gold also does well, but in contrast to a hyperinflation, it is one of the only things besides cash that does well. This is why I keep pounding the table about Gold. I think we're headed for a deflationary economic depression and in this setting, cash and Gold will perform similarly (at least for a while). However, if I am wrong and a geopolitical event somehow dethrones the U.S. Dollar, cash will be rapidly devalued whereas Gold will increase in value.

People who don't understand that Gold is a non-debasable currency can't understand the dichotomy. In other words, how can Gold bulls have it both ways? If you think of Gold as the strongest currency in the world that requires no faith in government, it is easy to see why this dichotomy works. In Zimbabwe, U.S. Dollars are "as good as Gold" (implying the strength of Gold, obviously) because they were recently in a hyperinflation. Zimbabwe dollars, however, were very close to completely worthless. In other words, think of Gold as a foreign currency that remains strong in the face of a domestic currency crisis (i.e. it's not Gold that's rising, it's the local currency that's sinking).

Now, in the reverse setting of deflation, people scramble down Exter's liquidity pyramid:

Exter hypothesized that as deflation intensifies, people "scramble" down the pyramid towards its apex to get "more liquid" during a deflation, since cash is king and other assets are all declining in price together in tandem. Those who are most liquid are most able to survive the asset price deflation and benefit from the massive asset price declines once the dust settles.

If the deflation we are in continues to grind onward, and I believe it will for a time, Treasury Bill (i.e. the 90 day U.S. government bond) yields will go negative as they did in the 1930s - yes, that's a yield of less than zero percent. The 10 and 30 year bonds will fall out of favor as the longer term outcome becomes murky (i.e. their yields will rise) but the shorter the date of maturity for U.S. government debt, the higher the price (i.e. lower the yield) will go.

Once we get to negative yields on the T-Bill, people will just want to hold physical pieces of cash and stuff them under the mattress as the saying goes, because banks will become too suspect as the cascade of bank failures grinds on and the FDIC is unable to keep up with the demand for paper dollars. Electronic digital money can be created with a keystroke, but actually figuring out a way to print enough paper money will be problematic, as the government and federal reserve are currently unprepared.

This may force the government to declare that only digital money needs to be used, but paper U.S. Dollars will have a premium attached to them. Yes, it seems paradoxical. And yes, I would advise everyone to set up a "rainy day, outside the bank" paper money fund to cover emergency expenses despite my concerns regarding the long-term health of the dollar.

At the apex of the pyramid sits Gold, the true and real money that the human race has decided upon, the current 40 year shenanigans aside. Gold is the real king during a deflationary depression and Gold miners will benefit tremendously from a glorious new bull market once the dust settles. Real estate and general stocks, on the other hand, will remain mired in a multi-year devastating bear market (with a few upward swings along the way as false "green shoots" of hope spring up and then wither away).

There are now $1.4 quadrillion worth of global derivatives (that's 1,400 trillion for those not familiar with fantasy-level numbers like this) on a planet with an annual GDP of well under $100 billion. These derivatives are actually increasing in number during the current economic downturn, which to me suggests that we have a long way to go before the most brutal point of deflation hits the United States, which will be when this nuclear pile of toxic paper implodes.

This is why I hold physical Gold (and a little fiat U.S. paper cash for emergencies) and why I think all prudent investors should, too.

[Note: This commentary has also been published in its entirety on and on]

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