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Tuesday, June 16, 2009

Everyone to the Lifeboats!

It's nearly impossible to watch television without seeing ads for firms setting up card tables at local hotels wanting to "turn your old, broken, unwanted gold jewelry into cash." Better yet, call an 800 number to have a padded envelope mailed to your home, stuff it with all your unwanted gold jewelry, mail it back, and someone will melt it down, tell you exactly how much actual gold there was, and send you a check for that amount of gold.

Okay, quick question. How many people would trust a firm they've only heard of via television to honestly report the amount of real gold in the junk sent in and cut a check at the current exchange rate? Assuming you get a check at all? Of course, sophisticated investors are too smart to mail in their money to someone else who will tell them after the fact how much they'll really get for their investment.

Right?

The interesting thing about economics, money and human psychology is that when everything seems to operating within a range of predictability, everyone involved begins thinking they understand more than they really do about the mechanics of the system. Indeed, participants begin thinking they understand more than can be known about the system. The longer things operate within that predictable range, the greater the tendency to extrapolate that current behavior (as they (mis)understand it) beyond the range supported by the underlying fundamentals.

Treasuries provide one recent example of this phenomena. In December of 2008, demand for three month Treasuries skyrocketed so much that yields actually went negative for a brief period of time before cooler heads prevailed and realized paying $1.01 today for $1.00 three months from now made no sense. Buyers caught up in the frenzy lost track of the fact that the Treasury market does not exist to provide a zero-risk piggy bank for investors to stash an unlimited amount of money. It exists to produce cash for the government when it needs to borrow funds. When it has what it needs, supply goes to zero. When the number of investors needing an extremely low risk place to keep cash for short intervals is relatively small, the Treasury market satisfies that need as a side-effect of the government meeting its fiscal needs. When the demand for short term safety drastically outweighs the government's need for short term cash, the mechanism breaks down from the perspective of the investor seeking a safe haven.

Treasuries aren't the only example. Between summer 2007 and summer 2008, investors looking for both safety and quick profits piled into crude oil and drove the price to $145 dollars before reality kicked in and the price dropped like a stone -- 75 percent in five months. Demand didn't drop 75% but the distortion created by an influx of cash from speculators trying to avoid liquidity issues in other segments (MBSs / CDOs) evaporated once the mismatch between supply and demand became too large to ignore.

When markets are volatile and people feel economically insecure, the psychological urge to look for a "lifeboat" is not only unavoidable, it's a rational reaction. However, a quick look at another common "lifeboat" investment -- gold -- points out that every lifeboat has its limits. For those first entering the lifeboat who are able to time a graceful exit, lifeboats can be extremely profitable. However, making money off a lifeboat is vastly different than PRESERVING money in a lifeboat. Understanding the difference requires understanding three key factors:

1) how big is the lifeboat?
2) what is it good for?
3) when does a lifeboat make sense?


How Big Is the Lifeboat?

Here are some basic facts about gold:

* there are roughly 145,000 metric tonnes of gold in existence as of 2001 (#1)
* precious metals like gold, silver and platinum are measured in troy ounces (12 troy ounces per pound)
* there are 32,150 troy ounces per metric ton
* the price of gold as of June 14, 2009 is $937.05 per troy ounce or $30,126,157.50 per tonne

Thus, the total value of all known gold reserves in the world is $4,368,292,837,500 or $4.4 trillion dollars. A staggering amount of money.

Or is it?

The gross domestic product of the United States for 2008 was $14.29 trillion (#2). For the European Union, $18.39 trillion (#3). For the world, $60.69 trillion (also #3). Hmmm. That means all gold reserves are only worth about 7.25 percent of yearly economic activity.



What Is It Good For?

The answer isn't "absolutely nothing" but the correct answer is much less obvious than it would appear to casual investors. Gold obviously has decorative value as it has for centuries in jewelry and it has some utilitarian value in dentistry and as a conductor in computer circuit boards, etc. For most people, gold's true value is perhaps its most intangible -- as the ultimate, perfect medium of exchange -- MONEY. Gold is worth something because it's gold and it's always been worth something.

Skipping that ultimate metaphysical argument, let's just accept that at face value. After advancing beyond gold coins as a medium of exchange to fiat coins and currencies, gold has always been viewed as the financial medium of last resort any time faith in fiat money waned or outright collapsed. Psychologically, people feel a desire to pile into gold as a life raft when they fear an economy based on fiat money is about to capsize.

The "lifeboat" analogy of gold really doesn't make sense though. To see why, one has to understand three key inequalities in economics:

money does not equal GDP does not equal wealth

In the American economy of $14.29 trillion for 2008, there wasn't $14.29 trillion in cash in existence all at once in the wallets of consumers and cash registers of businesses. A much smaller amount of actual cash cycles through the economy multiple times throughout the year. Each time it changes hands as part of a transaction that produces net value, it gets counted and increments GDP.

More importantly, GDP does not equate to wealth because GDP is an immediate measure of simple economic activity and does NOT reflect the source of funds that paid for the activity. Wealth on the other had DOES reflect the source of funds of economic activity and it reflects the cumulative result over time. If you spend $50,000 per year, you're creating $50,000 of economic activity but if you're borrowing $50,000 per year to do it, your wealth is certainly not increasing $50,000 per year.

Gold's current role in the worldwide economy is that of ballast -- a psychological / economic backstop for fiat currencies to ensure any fluctuations in percieved value of any one currency can be acted upon without a free-fall drop. Current worldwide stores of gold cannot act as a final last resort store of value without producing massive, crippling fluctuations in values and halting virtually all worldwide trade. In other words, gold's role is to stabilize a very small part of worldwide MONEY to ensure money continues to flow to produce GDP which over time produces long term wealth. It does not and cannot scale to protect wealth itself.

Imagine for a moment that every single American household attempted to shift all of their non-home net worth into gold. According to the Federal Reserve's Flow of Funds report for 1Q2009 (see #4), home equity accounted for 41.4 percent of household net worth so the balance not tied up in homes amounts to $29.51 trillion. What would happen?

When $29.51 trillion dollars go searching for $4.4 trillion in gold, two disastrous things happen -- simultaneously.

Since the supply of gold is relatively unchanged over any short period of time and demand has skyrocketed, the price of gold skyrockets. More importantly, the price of all other assets being sold falls as people unload stocks, bonds and other commodities. Anyone pursuing this trade sells at an artificial low to buy at an artificial high. They are also climbing into a very crowded lifeboat. The more rapidly the price goes up as more people climb in, the more danger they face from a few people deciding to suddenly cash out and make it evident how little liquidity there is in holding gold at 2x to 7x normal prices. Now imagine how volatile the climate would be if everyone in the world was trying to get into the boat, not just American investors.

When Does a Lifeboat Make Sense?

The above thought experiment is sheer hyperbole. Clearly, gold has played a valuable role for decades in calming nerves and allowing investors to hedge concerns about exchange rates between individual currencies. But what if currencies around the globe are in decline? What if the combination of collapsing banks (and contracting credit) and mushrooming fiscal deficits (and possible inflation) are paralyzing investors who aren't sure what do? In particular, what if doubts about the American economy in particular are sowing doubts about the use of the US dollar as a world currency? Are investments in commodities -- gold in particular -- a useful hedge against drops in dollar-denominated wealth?

The pro arguments are relatively straightforward. What about the con arguments? Are the fears driving people to the boat well founded?

Here are a few things to consider:

1) How practical is an "un-wind" of a US dollar-denominated investment? -- For example, if China decides to reduce purchases of new Treasuries due to concerns over mushrooming US deficits, a precipitous drop in demand for new Treasuries will also tank values of existing Treasuries, crippling China's existing holdings. China understands this very well. This doesn't mean they'll continue pouring more into Treasuries but it puts a lower bound on how quickly they can diversify their holdings, for their own selfish bottom line. Given the amount we owe, they clearly have the upper hand, but in a very real sense, they are trapped and cannot literally exit their position without damaging their own export-dependent economy as well.

2) What are the alternatives for a world currency? -- Does anyone think the Russian ruble can provide a more trusted medium of exchange for international contracts for goods / services? Do you want Vladmir Putin as the world's central banker? How about the Chinese yuan, the currency of a country trying to walk the tightrope of leveraging high tech in its economy while hiding "tank man" from Google search results twenty years after the Tiananmen Square massacre?

3) Who plans on financing the international cop on the beat? -- If the rest of the world has grown tired of America serving as the world's policeman around oil shipping lanes and keeping bitter enemies with nuclear weapons (Pakistan / North Korea) in opposite corners from high growth economies (India / South Korea), what's going to happen when we pull our troops home? Will North Korea suddenly open the border, stop starving its citizens and turn on the lights at Bally's Casino in Pyonyang? Which economies will suffer most when those uneasy stalemates return to full conflicts?

4) How much do you really know about accounting standards, corporate law and property rights in emerging countries? -- Would you really be comfortable directly investing most of your wealth in a Russian or Chinese firm? Or how about a European Union country? Despite the attempt at a single currency adopted by most members, those members all still pursue a hodge-podge of fiscal policies. Any confidence their politicians will be able to resist deficit spending for local constituents without tanking the shared currency?

4) Where are alternatives for high-growth investment and what currency do you want to use for profits? -- See questions #2 and #3.


Takeaways

With all of the monumentally stupid things the United States has done to our own banking system and economy, it's important to keep in mind several key things. First, when we did this to ourselves, many other countries copied us and wound up damaging their economies as well -- in some cases, inflicting more damage than we did.

Second, in economics, everything is relative. Capital won't flee a market that drops 40% if a 40% loss is the best return available.

Third, nothing in economics scales to infinity. Finding an investment capable of growing $1 million or even $1 billion at 10 percent per year is vastly more feasible than finding an investment that can absorb $100 billion or $1 trillion and grow that 10 percent per year. Any attempt to swing large amounts of capital from one asset class to another or from one economy to another overnight will inevitably produces bubbles and subsequent crashes.

Finally, in economics and society, everything is linked. If things tank badly enough in the United States for you to be worried about converting a large portion of your net worth into gold, MANY aspects of society throughout the world will be vastly different than they are now. Even if the pyramid of industrial economies collapse, will your position be any more desirable if your assets are invested in a firm operating in one of the economies at the bottom of the pile?

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#1) http://en.wikipedia.org/wiki/Official_gold_reserves

#2) https://www.cia.gov/library/publications/the-world-factbook/geos/US.htm

#3) http://en.wikipedia.org/wiki/List_of_countries_by_GDP_(nominal)

#4) http://www.federalreserve.gov/releases/z1/Current/z1r-5.pdf