Gold's Challenge

The gold standard failed because a gold standard and central bank cannot coexist. It is as simple as that. That is particularly true when the gold standard is not sound in the first place, which many argue it wasn't. At any rate, when the dollar was backed by gold prior to 1933, the fiat monetary boom (1914-1929) engendered by the Federal Reserve System resulted in a bust sequence that in turn resulted in a series of bank panics a few years after the stock market crash of 1929.

Oh my, bank runs are bad for the economy, aren't they? They sure are if that means disciplining the engine of "growth." After all, depositors lost confidence in their banks. The system of inflation can't work without the confidence of its participants.

Precisely. So they proceeded to withdraw their "money," or gold. Roosevelt's bank holiday fixed them (us) though. After the holiday was up, US citizens were fined if they held gold assets. Hoarding was out, and spending was in. Within a year the first "Federal Reserve" note, not backed by any amount of gold, was issued.

Think about it. The free banking system uses a lender of last resort to sustain a monetary boom and, in the end, de facto defaults on its own deposit liabilities. The citizen gets it both ways: directly in his wallet now, and over time through consistent debasement. Without a lender of last resort sponsoring the 1920's inflation, it could be argued that the boom wouldn't have become so misguided in the first place. Indeed, the gold standard in the end was the discipline, which prevented the free banking system from continuing the inflation. Depositors voted against banks and for their gold.

The lender of last resort is the political connection between the banking industry and government. It is used by the banks and paid for by the government, or its citizens in the long run.

Anyhow, here's my point. There's a slight wrinkle in history we need to iron out. In "Gold and Economic Freedom," a 1967 essay (in Ayn Rand's book Capitalism, the Unknown Ideal), Mr. Greenspan said that a free banking system was the natural evolution of a gold standard. He argued it much like Menger argued how money first came into being, that a free banking system backed by a lender of last resort simoly became superior to the gold standard. Aside from the arguable fact that sound money had already ended with the National Bank Act of 1863, the truth could probably be more accurately found in Gresham's law.

In the end, it was a political objection to sound money that buried the so-called gold standard, and it arose out of a checkmate. Depositors that wanted to protect their savings from the "free banking system" had to choose between private property and government help. In the end, again, they voted for government help.

As long as banks can lend out more than they have, bank runs are inevitable, unless there is a lender of last resort to sustain the (monetary) inflation.

The inevitability of the bank run lies in theories explaining how monetary inflation affects the business cycle, and even with some common sense. Credit expansions just cannot go on forever. But today's society believes that they can. And they can for what seems like forever with enough financial engineering, political wrangling, and enormously growing derivative markets arising out of the need to shift the growing systemic risk around to different counterparties, like a hot potato.

If the dollar were backed by gold today, none of this is possible. It is the reason that central banking and the gold standard are at odds, and why they cannot coexist. A central bank could not sustain these monetary booms to the extent it does, if gold were allowed to function freely as money.

The free banking system is not the natural evolution to a gold standard. It is, on the contrary, its enemy (Mises might say that it is also simply an interruption, or setback, in the process whereby the markets ultimately develop a sound money). And the central bank is a political vehicle used to undermine it as well as the system of private property / production (or capitalism), which gold-as-money is intended to protect.

But so long as the system of fractional reserve credit is not recognized as flawed, in the first place, the central bank will have a mandate. Yet, if it becomes realized as flawed, depositors will once again be forced to choose between economic justice and government help - which includes the burden of hidden taxation.

So long as our policymakers continue to perceive the cure for our economic problems (usually a manifestation of inflation anyway) to be more credit or monetary inflation, government and bureaucracy will grow and grow. It will have to, if only due to the errors made by inflationist policy.

In the end, investors must choose between exercising their Constitutional rights to private property, something legally unique to American citizens, or more, and more, government. The government's biggest influence today lies in its ability to persuade us that it can stimulate the economy, through inflation. This is its main weapon, and it stands in between the existence of the Federal Reserve System and the investor's decision to hoard what he or she thinks is money, in what may ultimately amount to a political objection of central banking.

For those of us bullish on gold today, this is the Gold market's ultimate challenge.

We're looking for a three to five year bull market in gold that should begin sometime this year, if it hasn't already. This bull market in gold, we contend, will be all about overcoming the State's global monopoly on money. For gold to win, in the end, will require the utmost moral conviction on the part of every single individual who holds the power to vote for the system of private property… to veto the government, if you will. Long-term global prosperity depends on it.

If you accept this argument then it isn't difficult to imagine the world's central banks all have a common goal. Everyone must by now know they are the ones engaged to replace gold, after all:

"In summary, then, although information technology by its very nature has lowered risk, it has also engendered a far more complex international financial system that will doubtless bedevil central bankers and other financial regulators for decades to come. I am sure that nostalgia for the relative automaticity of the gold standard will rise among those of us engaged to replace it." - Alan Greenspan, sometime in 1999.

So now that you know who "they" are, it's funny that the Bundesbank is talking about diversifying out of its bullion holdings and into equities, on the premise that over the long run stocks outperform. The fact that central bankers are natural opponents of gold-as-money is small in comparison to how grave the situation must be for them. After all, their money is only good so long as there is confidence in stock and bond markets. Unfortunately, today there is this valuation problem in those markets.

Effectively, what Bubba is saying is not different from what is said in any other market crisis by the main players supporting the market. It isn't much different than what promoters do or say to control their markets. The difference is they're allowed to do it. Unfortunately for them, that's the only difference. For both the promoter and central bank ultimately succumb to the laws, or discipline, of markets.

This week was a tough week for gold. Bubba came out on top as commodity prices blew off, by Monday, after a two-month gain of better than 11% in the main indexes.

Oil prices ended the week back to where they started, after meeting some technical objectives, probably influenced by the bearish sentiment on Wall Street, in the other commodities, and finally egged on by what seemed like Bush's final attempt at peace in the region. Early in the week, Iraq and Iran threatened oil embargos against any supporters of Israel's reportedly increasing aggression in the region. The Saudis and Kuwait rejected the notion of an embargo, probably since Bush was promoting their peace plan for the resolution of the conflict between Israel and Arafat, the Palestinian authority.

Palladium prices fell because analysts discovered that Ford Motor Company invented a technology that reduced the amount of palladium they needed. Ford disclosed that it would reduce its inventory of palladium by half. Palladium prices fell sharply.

Falling stock and commodity prices provided impetus to bullish bond trade, however. The long bond was up about 3% on the week by Friday, and Wall Street noticed. The Dow was able to bounce, a little. The other averages weren't. They ended at their lows for the week, as well as only slightly above support levels that could seriously extend the bearish argument if breached.

The dollar ended down marginally, on the week. We are of the opinion that it is going to suffer badly as a consequence of shifting priorities in global trade, and as a consequence of an eroding investment premium related to the dwindling of prospects for returns on dollar denominated financial assets.

But we are also going to suggest that global trade is breaking down because there is no valid common global medium of exchange. We would like to propose that trade has been deteriorating as a consequence of the erosion of confidence in the dollar as a sound common medium of exchange.

If that is true then Bush's shift in trade policy is reactionary, and the fall in the value of the dollar is just around the corner.

Whatever happens in Japan, it's bullish for gold. If the Yen and Nikkei fall apart, it is bullish for gold. If the Yen and Nikkei go up, it is bullish for gold, because the dollar will be going down. Only, investment demand for gold will grow in the US instead of Japan.

The Australian dollar is still trending up, but the RBA's decision to hold rates steady pressured it against the greenback this week, which kept the US dollar's decline in check, generally. Softness in the Aussie is bullish for gold demand. Still, the chart of the Aussie, as well as those of most currencies, continues to build bullish bias.

I think this week will be very bearish for US/European stock markets, bearish for the US dollar, bullish for gold (including equities), the yen, and maybe the Nikkei.

Anything can happen in the oil markets, but we expect most surprises to happen on the upside, and stay generally bullish on oil and other commodity markets. But this week, the focus should be on Wall Street, the dollar, and Gold.