Must Reading (Here I go Again)

What determines the price of gold? Unlike other commodities, it can't be eaten or drunk, it can't be used in construction, and due to its cost has limited industrial applications. Because it is malleable, doesn't decay, and because of it's beauty it has been used to create jewelry, and that use is still the source of the greatest commercial demand. While world-wide, this market is most vital on the Indian sub-continent and particularly in the spring wedding season.

Historically, gold was a medium of exchange, more efficient than barter and more transferrable than an IOU. Because it was universally valued and accepted in commercial transactions, the wealth of nations was defined how much gold was stored in its treasury. In fact it was only seventy-five years ago that nations stopped backing their currencies with stores of gold, and subtituted US dollars for gold as reserves in their treasuries. And it was only thirty-five years ago that the US government stopped backing its currency with gold in transactions with other nation's treasuries. So, until thirty-five years ago gold remained at the foundation of the world economic order.

America's preeminence as a world power enabled the US to declare that the dollar was to be substituted for gold and required no store of value to back up its worth. The US was supported in this bold assertion by an arrangement with monarchs of the Gulf oil states that the all oil sales would have to be transacted in US dollars. In return the US guaranteed the security of these ruling families. Thus every nation in the world needed dollars to pay for their oil, and oil was essential to economic growth in the decond half of the twentieth century. The Gulf states soaked up all the excess dollars in the world, and bought US Treasuy debt, funding the US governments deficits. It was a cozy relationship, marred only by the oil producing states banding together in 1973, and demanding that the price of their oil be increased from $3 to $12. Since then the price of a barrel has risen to over $60 per barrel. The oil producing nations knew that since going off the gold standard the US was printing more and more money which was worse less and less and they weren't willing to accept the new dollars as though they were pre-1971 dollars. This cloud had a silver lining for the US. Since other oil consuming nations had to pay for oil in dollars, the US could run large trade deficits and the nations ending up with an excess of dollars would spend them on oil, and the oil producing states would buy more bonds, continuing to fund the US governments growing deficits.

Other trading partners realized that the dollar was losing value as well. Our trade partners were willing to accept dollars of diminishing value in return for their exports in order to keep their factories running and their workers employed. Then they used the dollars to purchase the oil they needed. The problem is that this system worked too well for the US. Importing became cheaper than producing and US industries started moving overseas to hire cheap labor and export goods back to the US. Our trade deficits with the Japanese and Chinese grew to truly unhealthy proportions. But, as our European allies had previously done, the Asians continued to accept dollars in order to keep their factories running and their people employed. The Asian exporters found it worthwhile to accumulate more dollars even than they needed to buy oil, because they could use those dollars to build factories and infrastructure. At the same time the US corporations were giving the Chinese the technology to be as efficient as the most modern producers in the US.

In order that the American worker didn't realize that even though his wages remanined the same, he was getting poorer because the dollars he was paid in were worth less, the government encouraged the import of cheaper Chinese goods and we entered the age of Walmart. Even cheaper imported goods wouldn't have offset rising prices of oil and other necessities for the American worker so the Federal Reserve Bank created more money which became available to the public through agencies like Fannie May (The Federal National Mortgage Association) as mortgage money at very low interest rates. Folks maxed out their credit card, refinanced their mortgage at a lower rate, them did it all again. Other folks found out they could get a larger mortgage than they ever would have qualified for in the past and bought homes with adjustable rate mortgages thinking that in three years when the highter payments kicked in they could refinance because by then the value of their home would have increased and they would qualify for a better deal. It's not working out like they planned.

Another part of the unhappy picture is these things called private equity companies, sometimes referred to erroneously as hedge funds. With the Federal Reserve cranking out dollars like they were jelly beans, and billions of dollars piling up in Asia as a result of the trade deficits, the New York lawyers and bankers realized they could pay themselves tens of millions of dollars a year if they became private equity managers. The idea was to offer "sophisticated" investors who had a couple of million to invest the opportunity to buy into a partnership that would borrow hundreds of millions more and buy corporations. They would then make the corporation more profitable, usually by firing American workers and importing more products from overseas. They would pay themselves millions of dollars for this financial mastery. Eventually the partnership is supposed to sell the corporation for more than they paid for it and the private equity investors would reap above average return. These private equity deals by most accounts are what's holding the stock market up. Incredibly at a time when both the automobile and homebuilding industries are collapsing the stock market is hitting new highs weekly. Go figure.

Hedge funds are actually something quite different. Hedge funds traditionally buy and sell very large amounts of two investments which are expected to go in opposite directions in a certain situation. It's the managers job to figure out which one is going to go a little further and be more heavily invested there when the event occurs. The profit might be a small percentage of the total investment, but a small profit on a really big deal still adds up to a lot of money. The trick is again to have relatively little of your own money invested and a whole lot borrowed, in order that the return on your investment is quite a large percentage of your investment. Problem is that even if the hedge fund manager had a good plan and lost ten million on one side of his play and made eleven million on the other, what if the counter party, the one who is supposed to pay up the eleven million was wrong on his play and doesn't have the eleven million. It's happened before, in far less turbulent times.


What I'm getting at here is that the whole economy is running on borrowed money, more money than credit card customers, mortgasge borrowers, private equity companies, corporate bond issuers, hedge fund managers, state governments or the federal government will be able to pay back. The only way these entities and individuals can even hope to pay off what they owe is if the fed prints even more money and the debts are paid off with dollars that have been much further devalued. Most likely though there will be a crash because the Fed can't print money fast enough to pay off all these IOU's when they're due. but they'll keep furiously printing money in the futile effort.

When things start to come unglued and the dollar is losing purchasing power by the day gold will start to look like a good investment. When gold goes up a little while the stock market is falling, gold will attract even more investors. Then when coprporate and state bonds start going into default, gold will be all people feel safe holding onto, and the value of the dollar will be defined in terms of gold instead of the other way around. The gold standard will re-establish itself after a thirty year failed experiment in fiscal irresponsibility and monetary madness.


PS I got a little carried away in that last paragraph. It was late and I was tired, and I wanted to end with a rhetorical flourish.