So last week a very savvy investor asked me my view (h/t Simon Popple) on – When and what will break the chains on gold by those seemingly omnipotent forces that so assuredly keep its price in check? In essence, the belief is (and I expect for most honest and impartial analysts this is true) that because there is potentially significant downside risk to a global monetary system built upon a currency to which gold represents the proverbial kryptonite (we’ll discuss why), there are checks in place within the system, to ensure that kryptonite doesn’t become too potent. The architects of the existing system would have been foolish not to implement checks on gold.
And due to traditional physical gold transactions being cumbersome in a world of click, point and trade, checks on gold come surprisingly simple (paper market). However, there now exists a broadening network of architects (think China’s Silk Road Fund, gold ATM’s in Dubai and electronic exchanges like Allocated Bullion Exchange) creating a modernized electronic infrastructure where physical gold transacts as efficiently as all other financial markets but while maintaining the inherent intrinsic and enduring value. Modern logistics for a monetary system with 5000 years of staying power will make it incredibly difficult to rebuild checks on gold subsequent to the death of the Fed.
Below I will provide the Hypothesis, Groundwork, Empirical Evidence and Conclusion that will speak to the title of this essay. With that, grab a coffee and enjoy!
The monetary system enacted in 1913 (and all fiat monetary systems), issuing currency backed by interest bearing indenture, was fatally flawed due to a requirement for its very survival to create an ever-increasing stock of money, without also providing the means for perfect investment, resulting in a system where debt ultimately consumes all profits and labour over time. A system only a banker could love. Because such a system is predicated on devaluation (by its requirement for perpetual growth in money stock) and because that sealed its fate, the system’s end was perfectly predictable upon its inception.
The system’s fatal flaw is inherent in that its very survival necessitates that each dollar supplied requires more than a dollar returned. With that the economy necessarily became a mechanism for ever increasing trade (cash) flow (a banking objective and function), conflicting with its natural mechanism as a means to a rising standard of living (a societal objective and function). The result being an unsustainable build up of debt by way of artificial money creation, which would force economic inefficiencies such that capital allocators would necessarily forsake labour for profits – an unnatural behaviour given labour (i.e. consumer) is the subsistence of profits in the same way profit (i.e. employer) is the subsistence of labour.
With that natural bond broken, the economy would become an impediment rather than a mechanism for growth. Ultimately the amassing inefficiencies overwhelm the monetary system’s ability to make adequate adjustments, transitioning it to the final stage of mass contraction (economic cannibalism – we have now entered this stage) and then death. This will result, as it always does upon the breakdown of intrinsically valueless currency systems, in gold’s chains being broken. Once again establishing gold as the basis for both transactional currency and storage of wealth (as we saw during the 1930’s banking crisis and then more recently with gold’s meteoric price rise post 2008 banking crisis).
This may sound like quite a grand hypothesis and I can see the monetarist disciples rolling their eyes already (as a Booth grad I know how you think!); and so to give the non believers a glimpse at the validity of the hypothesis, allow me to provide a quick observable microcosm lending significant credence to the subject hypothesis before we get started. Think about the 2008 credit crisis. The entire debacle began when policymakers decided to artificially create value out of nothing. That is, they wanted to create housing wealth to those that had not earned it as evidenced in the following excerpt from “The National Homeownership Strategy: Partners in the American Dream”, which was the Clinton Administration official proposal to the banking sector that kicked off the entire housing disaster.
“For many potential homebuyers, the lack of cash available to accumulate the required downpayment and closing costs is the major impediment to purchasing a home. Other households do not have sufficient available income to make the monthly payments on mortgages financed at market interest rates for standard loan terms. Financing strategies, fueled by the creativity and resources of the private and public sectors, should address both of these financial barriers to homeownership.”
And so false value was created but to each dollar of false value created was attached a very real obligation that required repayment of that dollar plus interest. And so despite an increase in trade flow (housing by way of mortgage, and consumer expenditures via inflated housing equity) the system predictably failed to achieve the only (impossible) premise for which the system relied on for its survival, namely perpetually increasing property values. And so the system collapsed as was entirely predictable.
As we know, the false value or the illusion of wealth creation ended with total wealth for 90% of the US falling by 40% (a staggering statistic that remains unimproved even 6 years on). The thing to understand is that this was entirely predicable and was predicted by Ron Paul in a 2001 speech to Congress (and Peter Schiff, and many others subsequently). The point being the system was fatally flawed from its very birth and so its death was, in fact, absolute and predictable. There was no uncertainty as to its fate, as the system design necessitated its own end. I will show that inherent within our monetary system exists a similar fatal flaw and predictable end.
The (Required) Groundwork
Now to truly grasp the when and what it is imperative to understand the how and why underlying the monetary system and it’s inherent fatal flaw. To do so requires laying some groundwork. And so let’s begin….
I believe a useful way to understand gold and its interrelatedness to the financial, economic and markets universe is as a physicist understands gravity in the physical universe. Relative to other forces it appears mostly passive and almost tepid. Something we pay little mind to despite being cognisant it is always there in the background. That said, gravity is ubiquitous and despite generally remaining on the “no danger” end of its continuum, given the right physical scenario (e.g. supernova), it becomes perhaps the only force in the universe that can literally tear a whole in the fabric of the space-time temporal, creating a point called the event horizon beyond which its attraction simply overwhelms all other forces.
Generally gold has a similar character in that it is the one monetary force that has stood the existence of human trade and there is no corner of the financial economic universe in which gold is rejected. Further, given the right financial economic scenario its attraction becomes stronger than all other assets and we’ve seen this proven time and time again, for literally thousands of years. The architects of the fiat banking system themselves are among the worlds largest hoarders of physical gold. That very fact alone should resonate to the non believers as one simply cannot explain it away. Bernanke once stated to a Congressional Finance Committee that he believed the only reason banks bought physical gold was tradition. And he should have either been prosecuted or fired, as he was either lying or grossly ignorant about his own organisation’s activity.
But so then the question becomes what is the right scenario to turn gold from a domestic cow to a raging bull? And the answer is naturally as complex as the system to which it poses a threat. Now I apologize for the (perhaps) excessive metaphors but they serve a point of understanding; so think of an airplane’s autopilot system. There are literally thousands of stimuli being checked every second (wind speed, fuel, air temp, etc) in order to keep on an appropriate course. And as these stimuli change the autopilot system makes continuous slight adjustments to maintain its course. However, when enough stimuli begin to deteriorate sufficiently the physical laws actually begin to overwhelm the software’s ability to adequately adjust and the plane goes down. Likewise in our current monetary system we have checks in place that make continuous adjustments as the stimuli change. We call this monetary policy.
Over the past 100 years of monetary policy we’ve seen our system make several major adjustments to foster the desired course. Early on, the first major failure (great depression) of monetary policy clarified that the new system could not be trusted to safeguard one’s wealth and gold again became the trusted currency. This required the new system make some material adjustments which were highly focused on offsetting the potential for gold to interfere with the new system taking off once again. In fact, the threat gold represented was so severe to the survival of the central banking monetary system that the implemented ‘adjustment’ was to literally confiscate all gold within the US and lure as much of it from foreigners as well. The idea being if you, in effect, criminalize its use you might be able to break its age old hold on the people’s trust.
(Interestingly, the US government enlisted a private entity – the Federal Reserve – as the middleman to confiscate the gold but allowed them to take a spread of 75% on the trade. That is, the Fed paid people $20/oz for the confiscated gold but just 10 months later sold that gold to the Treasury for $35/oz. Fortunately by the 1930’s Americans had mostly forgotten about the Revolutionary War and so the strategy was implemented and successfully transforming America back into a nation ‘by the bankers for the bankers’.)
Now pulling gold out of the new system was not just to make people forget about gold and hop on the dollar train. It was much more substantive than a simple promotional strategy. Gold is primarily a storage mechanism of purchasing power. And the new monetary system couldn’t survive if wealth was being stored. The system required the expenditure of wealth and income (we’ll prove why). And so getting gold out of the hands and homes meant the storage mechanism was gone.
And so cash began to flow again out of the hands and homes as there was no longer a way to protect one’s purchasing power beyond the short term. This concept was not so much a policy as it was the very lifeline of the central banking system. However, it meant that as money flowed out, money had to subsequently flow back into the hands of those who, by system design, couldn’t hold onto it, lest the system collapse. And so the culture of commercialism was born.
The reason is inherent in the system. As each dollar added to the system is backed by an indenture requiring some interest, that printed dollar must become materially more than a dollar to not only pay itself down plus interest (to the banking system) but to also provide enough return to allocate between profit (shareholders) and labour (consumers) such that the cycle can begin again.
Now on paper, one could suggest that efficient allocation of that dollar will provide enough return to pay down the principal dollar plus the interest plus some return left over to split between profit and labour. However, and I’m most comfortable suggesting, the boys of Jeckyll Island were acutely aware that economies don’t work that way. Economies are not steady state but dynamic and sufficient investment returns would not always be achievable.
And when sufficient returns are not achievable through productive economic investment, the system, requiring new dollars the same way humans require new air, has no option but to increase money supply to cover the cashflow deficit (think debt ceiling debate which is not at all a debate but good political theatre over an infinite debt envelope implicitly approved in 1913).
The system requires continuous monetary expansion which is not a naturally occurring economic phenomena and so relies on a safety net of artificial monetary expansion (debt monetization). But because the currency was exchangeable for gold, more money printing also required more gold available for exchange, which by no coincidence, confiscating America’s gold also provided. Quite a brilliant strategy, if one has the (perceived) authority to thieve an entire nation’s gold holdings.
However, that artificial process of monetary expansion hinders the natural process of output expansion by weighing the process down. In an economy with a fixed supply of money, output expansion occurs through deflation, which shows up in rising money velocity. In effect, the economy is the system and its objective is efficient output (i.e. improving standard of living). However, in a central banking system, the economy’s objective is cashflow not output. Output is simply one tool to increase cashflow. The difference is critical. The result is that output is inefficient and expansion results through inflation (i.e. declining standard of living), which ultimately shows up in declining money velocity (and elsewhere). We will put all of this to the test empirically below.
And so with the gold confiscation having provided a means for more money printing, the central banking monetary system once again took off. This was sufficient to keep the wheels greased for a couple decades, however, by the end of the 1960’s and with LBJ’s Great Society (a massive societal income subsidy) it became obvious that, despite the increased gold reserves backing monetary expansion there just wasn’t enough of the vexatious metal to support the kind of money stock required to feed the beast. Gold was still preventing the monetary system from reaching its ideal cruising altitude. This was because gold still had a defined and exchangeable value tied to the the currency underlying the monetary system. In effect, gold was acting like a leash on a dog, preventing it from full freedom to run and play at will and this just wasn’t going to work.
And so the next major monetary system adjustment (taking place under Nixon in 1971 – the end of Bretton/Woods) was to cut gold loose, creating a pure fiat currency constrained only by the fiscal discipline of the nation itself. And quite literally fiscal discipline was but a fanciful dream. Even today, it is being delivered to Americans as an ardent goal on which to base one’s political campaign. But the system, by design, doesn’t allow for fiscal discipline. And there exists a dark irony in the move to a pure fiat currency in that the central banking system had to necessarily move to a pure fiat currency for its mere survival. That was a literal certainty meaning it was wholly predictable in 1913. The irony lies in the fact that doing so also guaranteed the system’s death, which was also absolute upon its creation and thus entirely predictable.
But because Americans had been separated from gold for so many decades at this point, and because households were beginning to feel the fiscal drain of rising inflation the system architects felt there was little risk of the age old metal making its way back into the hands and homes of everyday consumers. And this was true, at least in the short run. Shortly thereafter, the monetary system reached full cruising altitude, seemingly having neutralized gold’s natural bonds with the economic world.
For decades gold remained dormant while the nation believed it was unfettered by debt ratios, monetary devaluation and exorbitant consumption. A belief Americans are to this day, force fed from Pampers to poppy fields. At the same time, corporations and their shareholders (capital allocators) believed a healthy economy no longer required capital be split between profits and labour but instead determined the goal should be to allocate as much capital as possible directly to profits.
Labour was no longer seen as a harmonic and intricate part of the ecosystem and the economy was no longer maintained as a construct for the American standard of living but a precision tool for profit and cashflow. And so introduce the Free (hardly) Trade Agreements (circa 1990’s – NAFTA, GATT, etc), which allow corporations to circumvent high labour/regulatory costs by moving capital to lower cost but higher risk regions. The trade agreements offset the higher risk by defining that international law will protect their capital and profits via the executed trade agreements, which limit the host nation’s autonomy to set policies that would impede on profits.
And so the party got bigger and bigger and things seemed great. Corporations were cutting labour costs by a ratio of 25:1 and unrestrained money supply was supporting the debt subsidized incomes. And because the money was flowing nobody felt compelled to pay any mind to the winds getting heavier, the sky getting darker and the engines losing power.
At this point I’d like to share an interview (h/t Mickey Shendrick for clueing me in on this) from 1994 with Sir James Goldsmith on the Charlie Rose show. I’ve embedded just Part 1 of 6 (from YouTube each about 10 mins) but I would recommend everyone take the time to watch the entire interview at some point (part 3 has a particularly good debate), as SJG proves himself as prophetic as Orwell and as enlightening as Jesus.
So certainly some were paying attention to the fact that the economic landscape was beginning to change sufficiently so as to create that right scenario whereby gold would no longer remain passive. In fact, 20th century Nobel nominee, Michal Kalecki had predicted that a monetary system that targeted full employment by way of stimulating private investment via interest rates (e.g. the Fed) would necessarily beget negative interest rates. And some 70 years later he was proven right. Furthermore, Kalecki predicted that the system would also require income subsidies which has also proven dead on.
And this really takes us to the promise land in terms of finding our answer. When and what breaks the chains on gold pricing? For it is the culmination of time and a fatally flawed great experiment, whose architects superciliously believed themselves capable of circumventing the laws of economics, that will bring about the main event.
I think we are ready to start applying the facts to our theoretical construct that the monetary system is fatally flawed and will result in gold breaking out of its cage as the warden succumbs to its forlorn fate.
The Empirical Evidence
So now we must generate an analytical and empirical diagnosis upon the primary elements of the central banking monetary system. Namely, we are going to study interest rates, debt levels, output, money supply, profits and labour in an attempt to both substantiate the patterns discussed above and to determine if there is a predictable point of system death. And if we can predict that point, we also predict the point at which gold will break free from its chains to once again take its place as the world’s only enduring currency.
Let’s start with interest rates, debt and output.
The first chart above depicts the perpetual deterioration of the 10 yr rate (blue line), using 10 yr as a proxy for average rates. By looking at the debt-service-to-GDP (green line) we can see that rates have declined such that debt-service-to-GDP remained in a range of 2% to 5%, with an average around 3% for at least the past 50 years. Had rates not declined perpetually, debt service would have become an unmanageable detractor of GDP. So perpetually declining interest rates is one of the adjustments the system made to maintain its course (as Kalecki predicted in 1943).
Next let’s look at output. Remember because the fiat system requires ever increasing trade (cash) flow it is essential that output never move to a state of extended contraction. And what we find is that while GDP (output) growth (purple line) averaged between 3% and 5%, regularly peaking above 6% from 1965 to 1990, the 25 years since is not only averaging less than 3% it has failed to produce even 1 peak above 6% while still producing several major troughs.
The takeaway being output growth has been deteriorating for the past 25 years and has been struggling to maintain 2% real growth for the past 6 years (the last time things were this bad for an extended period we started WWII; do you see a similar pattern emerging today??). We must note that to maintain even the dangerously thin 2% growth the system has implemented monetary policy adjustments so extreme that even the most adventuresome academics would not have considered them outside of theoretical discussion (refer to red line in the above chart- discussed below).
Be cognizant that when extended real GDP growth falls to or below 0% it will necessarily end the central banking system i.e. death of the Fed – as it exists today (a mathematical certainty). And so, we must comprehend the importance of and implications on official CPI and thus on ‘official’ real rates vs ‘real’ real rates. ‘Real’ real rates are beginning to impact G7 bond markets despite the Fed’s hesitation to raise rates.
The crux of the issue is what does a monetarist do about supply side (cost-push) inflation when discretionary demand is already on life support?
If you raise rates you further hurt nominal output but if you don’t raise rates the supply side inflation begins to swallow up the real in real output, pushing real GDP into negative territory. The supply side inflation is a natural consequence of corporations propping up earnings by contracting operations (i.e. forsaking labour for profits). For the past several years the Fed has remained steadfast on trying to stimulate nominal demand by maintaining ZIRP, however, with supply side inflation becoming a real problem they might be forced to raise rates to prevent a deterioration of real GDP. These are the impossible conflicts that arise as the system breaks down.
And now let’s move back to the above chart to see how we are achieving the dangerously thin real 2% growth in output over the past 6 years. The answer is simple, debt (via money printing). If we look at debt as percentage of GDP (red line) we find that since the early 1980’s growth in output has required proportionately and perpetually more debt, eventually exploding post 2008 with growth rates never imagined possible (or necessary) by economists, in such a sophisticated US system. In fact, over just the past 6 years we have been forced to increase debt to GDP by 70%, with debt now larger than GDP. That figure is as staggering as it appears in the above chart (red line post 2008) given we are now talking trillions not billion or millions (the equivalent of each working American taking on roughly $70K in additional debt over those 6 years).
The following chart shows that we have built up so much debt that we are no longer generating sufficient return to cover even the principal $1 let alone interest, profits and income. The red circles depict periods where returns were less than the principal dollar.
But the above two charts are a reaction to an underlying set of economic inefficiencies below the outer surface of the macrocosm. And to dig into those we need to look below the surface to see the underlying elements of our economy, which the system relies on to provide efficient growth.
The underlying elements we need to review are profits and labour.
What we find is that while the macrocosm has been in decline for the last 25 years, the underlying elements appear to have been running strong until the end of the 1990’s. And then around 2000 we have a massive dislocation between labour and profits. Specifically, since 2000 labour participation rate has dropped by 7% and real median incomes have dropped 10%. But the real story is the nominal story. While corporate profits have seen an incredible 360% increase since 2000, nominal incomes have managed only a 25% increase. This begs the question, how do corporate profits increase 1500% faster than incomes?
Well remember the system predicted that due to the economy being maintained as a means to trade (cash) flow (serving a bankers objective) rather than a means to rising standard of living (serving a societal objective) capital allocators would eventually forsake labour for profits due to inherent inefficiencies leading to strategic operational contraction (think reallocation of capex and wages to div payouts and share buybacks).
But to really understand the dislocation between profits and incomes we need to look further down the rabbit hole.
And so let’s breakdown GDP, employee compensation (wages and salaries) and personal consumption (PCE).
We see in the above chart nominal GDP (green line), PCE (purple line), compensation (red line) and a forth line (blue line). What we find is that nominal GDP and PCE appear to maintain a fairly decent growth trajectory relative to compensation. But so we need to explain how consumption is growing faster than compensation. And the answer is in the mystery (blue) line. What we find is that in order to get from employee compensation to the growth in personal consumption we must add in both consumer debt and welfare and when we do so we get the blue line which tracks PCE growth almost perfectly.
But let’s really dial in on these relationships in the next chart to fully understand the dynamics and to get to the bottom of these dislocations.
This chart shows us that while personal consumption is increasing as a percentage of GDP (green line) it is not increasing by way of compensation. We can see that compensation as a percentage of GDP (orange line) has been steadily declining since the late 1960’s. This really solidifies the concept that GDP is not a representation of standard of living but of trade (cash) flow. Perhaps more telling is the fact that employee compensation to personal consumption (light blue line) has declined by some 25% and since the late 1960’s.
This chart perfectly confirms the fallacy of continuously available sufficient efficient returns resulting in the need to subsidize incomes; necessitating the ‘grow at all costs’ policies that provide for perpetual welfare and consumer debt expansion. All of which is required for the system’s very survival, given the system dies without monetary expansion (each dollar must grow larger than a dollar). It is these relationship dynamics that underlie the long-term deterioration of the macrocosm we saw in chart 1 above (interest rates, GDP and public debt).
It must be understood that the existing central banking system, by its very design with each dollar supplied obligating more than a dollar in return, naturally requires (but doesn’t naturally deliver) perpetual increases in cashflow with output acting as part mechanism and part red herring. And this really pinpoints the fatal flaw. As consumer debt and welfare are forced into the system the system gets ever less efficient, ultimately burying itself.
And this is not ring fenced in the US. The central banking system is a terminal disease that has metastasized globally as depicted in the following chart (source: Bloomberg), with global growth now below 3%.
And by the following chart.
With the following chart depicting how this entire system breakdown impacts the solvency of a nation itself.
You can see from 1971 onward, the point we moved to a pure fiat currency, the nation’s fiscal condition began to deteriorate with a negative inflection in 2000 and an even more severe downturn in 2008, which is the year that really represents the economic event horizon. That was the year the legs simply gave out and there is no coming back from that event. Not under the same system.
Despite a valiant and unprecedented effort by the monetary policy tsunami pushing into its 7th year, the past 6 months has been an absolute economic collapse and is getting worse. The only thing preventing unprecedented asset destruction (and thus our experience today vs our experience at the end of 2008) is an entirely false equity market no longer based on efficient allocation of a finite resource (i.e. money) but on inefficient allocation of an infinite resource (i.e. printed currency). But it is mathematically a matter of time now. The data couldn’t be more clear.
The monetary system enacted in 1913 (and all fiat monetary systems), issuing currency backed by interest bearing indenture, was fatally flawed due to a requirement for its very survival to create an ever-increasing stock of money, without also providing the means for perfect investment, resulting in a system where debt ultimately consumes all profits and labour over time. Only a banker could dream up such a system. And so upon the system’s creation, its death was wholly predictable. The grand experiment proving an instrument of almost complete wealth destruction (via devaluation and debt) for all but the very architects of the system itself. For them, the system has, as was the sole objective, amassed wealth beyond the imagination of men and gods alike.
And so to conclude, the what and when is the culmination of time and the Fed’s fatal flaw. As I noted in a recent article, the data is telling us the Fed is out of Aces; the adjustments now impotent. Build your models to forecast the next 4 quarter period printing negative real output. That will be the ‘what’ marking ‘when’ gold plants its Liberty Pole. And to those who believe the system is infallible and simply must work because we’re told it will… don’t be daft. It was built by bankers for bankers. ‘Nuff said.
By Thad Beversdorf, Chief Global Economist for Allocated Bullion Exchange