Why Washington’s “Privatizing Profits–Socializing Losses” Policy Is So Bullish For Gold

Since when has American business worked with a net?

Since now, apparently.

Our entire free enterprise system, both sides of that coin, always represented the chance to succeed beyond our wildest dreams…as well as fail like never before. It’s a market dynamic that’s worked astonishingly well—success and failure remain extremely strong motivators.

In fact, when it comes right down to it, the fear of failure in this day of unsparing media attention may actually drive a person or company the most.

But that fear, at least for an elite few, has now gone the way of 8-track tapes, slide rules and great, big cell phones. Today, Washington has slapped the “too big to fail” label on certain large corporations…although nowhere does it say that American taxpayers also get to participate in their profitability, when those businesses finally get back on their feet.

Not that we’d actually accept a corporate handout. To most red-blooded Americans, that would come awfully close to socialism. But the inequity of “privatizing profits while socializing losses” should strike home to anyone with a family, a mortgage, gas to buy, food to put on the table and no assurance whatsoever that their success would always be underwritten by a rich uncle.

The perceptive expression, “privatizing profits while socializing losses” comes from someone who knows a great deal about the matter. Nouriel Roubini, a former senior advisor to the U.S. Treasury, observed that Washington’s rescue plan for Freddie Mac and Fannie Mae is “socialism for the rich, the well connected and Wall Street; it is the continuation of a corrupt system where profits are privatized and losses are socialized.”

Roubini isn’t alone in sounding the alarm. “When I picked up my newspaper yesterday, I thought I woke up in France,” declared Senator Jim Bunning of Kentucky. “But no, it turns out socialism is alive and well in America. The Treasury secretary is asking for a blank check to buy as much Fannie and Freddie debt or equity as he wants. The Fed's purchase of Bear Stearns' assets was amateur socialism compared to this.”

Even so, the prospect of a failing Fannie and Freddie does challenge the imagination. The two account for some $5 trillion in mortgages, which, put in some perspective, approximates Washington’s entire debt. Both companies may, in fact, have mutated into something that’s “too big to fail,” and could well deserve some special consideration. Still, the federal government didn’t hesitate at all in putting us taxpayers on the hook for at least $1 trillion of their troubles.

Let’s try to frame this picture more clearly. As private companies, Fannie and Freddie were both able to profit unconscionably on their way up by making easy mortgage money available to unqualified home buyers (thereby inflating the real estate bubble)…today, after the bailout, both corporations enjoy business almost as usual as if nothing ever happened…and, since you and I essentially just co-signed for them, these folks won’t have to lie awake at night worrying about their losses on their eventual way down.

That’s how a couple of private businesses are living the American dream.

“The size of the bailout of Fannie Mae and Freddie Mac could easily surpass $1 trillion. But Congress has no understanding, at all, of what's about to happen,” warned analyst Porter Stansfield.

The consequences of this and other devastations to the economy are not easy to figure. On one hand, as banks lose boatloads of money through customer defaults, foreclosures and bankruptcies, powerful deflationary forces get set in motion. On the other, Washington is infusing banks and the economy with at least that much money, which, obviously, will have an inflationary impact.

Regardless of how it all comes down, fear, mistrust, doubt, deflation, inflation and war all play into the strength of gold. “Watch gold prices continue to rise, even accelerate, as the US economy goes into recession, then depression, while inflationary and deflationary forces battle each other like two vultures fighting over which one gets to devour the juicier part of the carcass,” declared MarketOracle.com’s Alex Wallenwein.

As a counter-inflationary investment, gold plays an almost legendary role. Witness how it’s kept abreast and even ahead of soaring oil and food prices.

But gold can also shine in a deflationary environment.

During the Great Depression—the Great deflationary Depression—the precious metal was in tremendous demand by both banks (looking to cover explosive buying and trading by customers holding paper) and individuals wanting to secure a storehouse of value during that frightening economy.

Demand was so hot, in fact, that Washington decided to terminate the gold standard at $20.67 an ounce in 1934 (while confiscating privately-held gold and halting the issuance of gold coinage) then re-adopt a $35 an ounce fixed price for the precious metal that same year…all of which meant that the now illegal-to-own gold bullion had effectively risen 69% during the first five years of the depression. Other forms of gold prospered, too. Homestake Mining stock, for example, rose from $80 in October 1929 to $495 per share in December 1935 for a 518% return, another reflection of how depressionary-era folks yearned for the precious metal.

And stocks not related to precious metals? They headed the other way. Those holding equities watched the typical $10,000 portfolio sink to $3,600 by the 1935 depths of the depression.

Does that mean you should avoid gold because the government might just confiscate it again (thanks to more unruly demand)? Not if you owned collectible or rare gold coins. The actual language of Roosevelt’s executive order was that “gold coins having a recognized special value to collectors of rare and unusual coins” were to be exempt from confiscation. That would also be the case today.

So no matter what lies ahead—inflation, deflation or a hellish combination of both—you’d probably do well to make your portfolio’s root diversification gold. That’s especially true if we find ourselves in the unhappy position of co-signing for more troubled banks.

Kevin DeMeritt

President, Lear Financial

www.LearCapital.com

July 29, 2008