Fiat vs. Gold

April 14th, 2013
in gold, syndication

Paper Power (Part I)

Written by Glenn Van Lendt

Little Aussie Battler (oi!)

COFER (Composition of Official Foreign Exchange Reserves), shown in the graph below, is an IMF database that keeps end-of-period quarterly data on the currency composition of official foreign exchange reserves. You can see how the line marked "other" has grown which is believed to be reserves held mainly in Australian and Canadian dollars. You can also see how the line marked USD, has fallen from 2001 which coincides with the upside breakout in the gold price (from 2001).

Follow up:

In the following four graphs the y-axis is AUD (Australian dollar).

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If you look at the four graphs immediately above, it is quite clear that the Australian Dollar (AUD) has broken long term down-trends around 2001, not just against major currencies such as the US Dollar (USD) and British Pound (GBP), but on a trade weight index measure (TWI) as well.

In fact, there is very little that it has not appreciated against and whilst this is mostly bad news for export related business, it's good news for many others (who hold the currency) as they can now buy foreign goods and services at increasingly cheaper values.

In fact, I would go so far as to say, that the Aussie is in for a multi-decade appreciation against other currencies, especially if "official" reserve currency status (along-side a basket of others) materialises at some point. The upside-break in the Australian dollar TWI since 2001, as well as the massive fall in 2008 followed by a regaining of footing soon after, is a good sign that it's in a strong and steady uptrend. In fact, I think it will move above its early '80's float level in 2013/14 and break the 100 index on the TWI before the end of this decade (see straight line forecast below)

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Whilst attempts to devalue currencies across the world are not appearing to work, an appreciating currency is generally not welcomed by governments these days. Nevertheless, currency appreciation can have major advantages for the holders of such currencies.

Holding an appreciating currency, whether in cash (or preferably a line of credit), is a good way of maintaining your purchasing power in a deflationary environment. In fact, cash is king during deflation, especially if you are holding an appreciating currency in one country and eyeing a depreciating asset in another.

Swapping your currency at the lows of a deflationary cycle for a devalued (real) asset and watching your asset rise as inflation eventually comes back, is a far better strategy than buying gold at this point in time (see reasons against buying gold, further down).

Currency Tug of War

I do not think that all fiat currencies will go to hell in a basket, not at the same time anyway. Some will perish, others will power higher and owning appreciating ones will open great opportunity, especially if holders swap their currency for beaten down real assets in a country experiencing currency stress or extinction.

Whilst abused fiat currencies are losing their appeal as a store of value and should be hedged against, less abused currencies will hold their value and even power higher. Besides, paper currencies make practical sense because their abandonment will take us back to the dark ages and we're not going there anytime soon.

Possible Paper Swap

Whilst the USD is more ubiquitous than toilet bowls and does not even match its contents in value, it derives its value from things other than the numbers of currency units in circulation (see ultimate irony below). Nevertheless, a sudden exit from the US dollar will force some currencies skyward as money leaving the world's reserve currency will seek a home in foreign assets. This will further appreciate some currencies such as the AUD, showing them to be a store of value whilst the GFC remains unsolved.

Be Bold, Be Bold, but Not to Gold

Now I don't know whether you'll be cool or come out of the bag at me as a result of the above heading, but........ the end of December 1979, you could purchase 1oz of Gold for about AUD 1,570. Had you held it for about 33 years, you'd now be able to swap it for about AUD 1,653 (Dec 2012). That's a 5% return in 33 years and when you take inflation and selling costs into account, you're into negative territory on your returns. Even if you consider the increase from the lows of gold in 2001 which has increased about 6.8 times in USD terms, in Aussie dollar terms it's only been about half of that (3.4 times) due to an increase (almost doubling) of the Aussie dollar over the USD since then.

When you look at the graph above, and consider the doubling of the AUD purchasing power over the period shown on the graph, you could presently (Dec 2012) buy a US median house for half its 2001 value, courtesy of a stronger AUD. Now whilst buying gold in 2001 would have been quantitatively better (3.4 times increase in AUD terms), you'd not be much better off when you take risk and capital gains tax into the equation, especially since the opportunity costs of holding AUD currency over the above period, was basically risk free (cash).

Reasons to Consider Not Buying Gold

  • Gold may not be someone else's liability, but what does that mean to you if the price is rigged as a result of a futures market you hardly understand?
  • I do not think that the gold price derives all its value from physical gold because we have.......
    • electronic gold,
    • unmined gold that gets sold by miners (with force majeure clauses) into the forward market,
    • leased gold, which is about to make the Germans who want their gold back see red, not gold!
  • Why would you buy gold after it's already increased about 6.8 times (in USD terms) off its 2001 low? In addition, it's only doubled in USD terms (to Dec 2012) over the past 33 years.
  • Are you sure that the metal was not oversold from 1980 to 2001 and is simply doing catch-up, and even after 11 years of catch-up (2001-12) and a major financial crisis, it still hasn't hit its inflation adjusted price as at the end of 2012?
  • When (or if) it spikes, are you able to sell your physical gold at its peak or will that be the domain of the professional traders only? (a spike may be very short lived).
  • If you bought gold at a low of $35 just before the US dollar left the gold standard in 1971, your gold would have experienced about a 10% compounded increase per year to 2012, not much different to the rate of increase in real estate in many countries around the world. In Australia, that compounded increase on property is still evident in many cities, despite four years of GFC stagnation.
  • Look carefully at the simultaneous 2001 upside breakout of gold and US dollar downside breakout on the COFER graph (above), and it may lead you to the conclusion that government collusion to alter the composition of foreign exchange reserves in favour of adding more gold, is mostly responsible for the increase in the spot price.
  • If a basket of reserve currencies were to materialise; soft commodities, hard commodities, precious metals, international trade contracts and everything measured in USD will be rapidly repriced.... downwards, on the premise that the basket will lose less value than the USD over time.
  • All governments need to do is agree on the point above, if they want to stop a rising gold price rise dead in its tracks. In fact, if they agreed to price gold against an index based on a basket of currencies namely; USD, Yuan, Yen, EURO, Sterling, Aussie, Canadian, Swiss Franc, Singapore Dollar, Korean Won and Taiwanese Dollar, they will deliver a sledgehammer blow to the price of gold and every other USD measured commodity for that matter.
  • If the rubber stamping of the GFC were to suddenly occur, financial assets would suffer serious fall out and we'll be welcomed to a new round of fear. Those who hold financial assets will (again) be caught with liquidity problems and margin calls would force sales on assets that have increased in value over the past few years (viz. gold). This will force the gold price down, not up! Many would expect a surge at this point due to fear, but the premium in the gold price is mostly due to speculators and hedge fund buying, and they will liquidate!
  • Does the modern world want a collectible (gold) backing its reserve currency(s) or is a powerful military preferred (see ultimate irony below)?
  • "Pump-and-dump" investments (of which gold is surely one) should be avoided like a plague by the little guy.
  • Are you sure you'd like to own the same asset that the people with the brown cardigans (government) are after?
  • Are you sure that gold & silver will not be outlawed as legal tender, requiring you to exchange your holdings with the government (only), at set government prices? I seem to recall a US executive order (1933) to confiscate the gold of US citizens and disallowed them owning it for many, many years.

The Gold Confiscation of April 5, 1933

To: The United States Congress
From: President of the United States Franklin Delano Roosevelt
Dated: 5 April, 1933
Presidential Executive Order 6102 the above and have a read of it.

I'm not making a case against gold as a store of value, or disputing that it may go much higher on a panic buy, but don't hold your breath as gold is now deriving much of its value from speculative buying, not just the "government put" out of China and Russia, or the fear of imminent death of the US economy.

I'm also saying that until the crisis that is dubbed the GFC is truly behind us, either as a result of a slow rot over many years or sudden rubber stamping, cash (in the form of appreciating currencies) will be king-of-the-hill most of the time and deflation will stick to us like white on rice.

The Ultimate Irony

Due to the dot points below, the US will continue to abuse its currency regardless of the consequences. The problem with the death of the USD is that whilst it is seriously and intentionally abused, it derives its value from sources more powerful than gold as a backing or the amount of units in circulation. (see below)

  • A military super power, with global reach (second to none) and hell bent on retaining that status.
  • The world's largest economy, by far (bankrupt or not).
  • The most technologically advanced country.
  • Owner of the petro currency, and will kill to keep it that way. (if only Saddam could confirm)
  • The most entrepreneurial country.
  • The country with the most scientists.
  • The country with the greatest intellectual capital.
  • The country with the greatest global business tentacles.
  • The country with the world's reserve currency.
  • The country that never gave a damn about its neighbours (bugger-thy-neighbour) in the past and will not in the future.
  • No real single currency alternative (pretenders maybe)
  • Finally, the country that wears its printing press like a moniker on its sleeve and polishes it in everyone's face (daily) without any shame.

Maybe now you can see why the USD does have value, despite being fiat trash for longer than anyone can remember, and faith has not been lost in her....yet!

I think one of the most important questions we need to ask with regards to assets (in general) is how they derive their values and if the underlying qualitative sources read like the dot points above, then the asset value would most likely be destroyed from the inside at time and choosing of its owners, rather than by others on the outside.

It appears that the modern world places more emphasis on sources such as a military backing a currency than a currency (gold) backing a currency (paper). After all, the USD has been a confetti currency for many years, not backed by gold since 1971 and still well sort after.

To compare the US currency to that of Germany's in the 1920's or Zimbabwe's of late, is like fly-fishing from a phone booth, it's ridiculous.

Read past articles as the GFC unfolded and you'd be excused for believing (then) that people would start using the USD to roll joints, but it seems that it's still doing the Elton John twist (still standing, better than it's ever been) and if the US gets it false recovery off the ground in 2013, waiting on its imminent death will leave you sadly disappointed.

This economic crisis will end sooner or later (with Japan and Greece being the most likely catalyst, if the US misses the chance to self initiate it) and there is a high likelihood that the dollar will be king-hit as this happens, but short of major near term surprises, commentary on the death of the US economy will turn to commentary on imminent resurrection as they (US) begin to puff their foul breath into the next bubble - US housing, believe it or not!

Who's Fooling Who

I think the US is actively plotting everybody else's demise and when that becomes evident, the hunted will become the hunter.

I'm also saying that there are other ways of protecting your purchasing power, ways that you are more familiar with and ways that you have more control over. There will be a shake-up of currencies, that's inevitable because it's the final frontier in an economic ruin brought about by excessive debt levels.

Yes, gold and silver are currencies, but they are competing currencies, not against fiat currency as such, but against the government's (fiat) currency. See the difference, the operative word is government. At-the-end-of-the-day, if there are no more huge global surprise events such as a sudden US, Euro or Japanese bond market collapse and everything is managed downwards over many years; gold will hardly break $2,200 and hardly stay above that for long before it takes a long slide towards "yawn".

It's also interesting to note from the above COFER database graph, 2001 seems to be rather pivotal in the downward movement of the USD reserves. It also marks the upside breakout of the Aussie Dollar and the gold price. This possibly leads to a new official basket of reserve currencies including a percentage of gold (10%) and if this eventuates, will result in a better composition of foreign exchange reserves for all countries.

Derived Value

The old world measured value mostly through quantitative methods such as; supply and demand, risk, return and others, but the 21st century is more likely to change that and measure value by including a greater content of qualitative means.

To determine an assets value (for example), you would have to analyse how its value is derived, and in the case of a national asset such as a currency, you would have to look at factors such as; military, alliances, global influence, immigration programmes, political stability and a host of cultural, social and environmental issues when making future value assessments....and Australia is rock solid in these areas.

A Currency on Steroids?

If the Australian Dollar is to attain "official" reserve status alongside a basket of others, you can almost bet that it will continue to appreciate for many years to come and anyone owning it (local or foreigner) will own a store of value and benefit from the maintenance of its worldwide purchasing power (oi!)

(Related Posts: Paper Power- part II)

Please note that this article is written for the purpose of information sharing and no responsibility is accepted for any losses incurred as a result of the author's opinion. Readers are always advised to consult with a professional advisor.

About the Author

Glenn Van Lendt is a Public Accountant and Registered Tax Agent who lives and works in the Perth metro area of Western Australia.

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