What happens to high-spending credit-dependent states when the market loses confidence in them has been evident in cases such as Ireland, Portugal and Greece? Among the big financial calamities of 2011 were notably government bond markets. Perversely, some of the big winners of 2011 were also government bond markets.

Market participants have so successfully been conditioned to believe in state bonds as safe assets that when some sovereigns go into fiscal meltdown it only serves as reason to buy even more bonds of the sovereigns that are still standing, even though their fiscal outlook isn’t much better. While the fate of Greek and Italian bonds should have cast serious doubt over the long-term prospect for Bunds, Gilts and Treasuries, it only propelled them to new all-time highs. Strange world.

All policy efforts are now directed toward keeping the overextended credit edifice from correcting. After decades of fiat money fuelled credit growth, the financial system is in large parts an overbuilt house of cards. The system cannot cope with higher yields and wider risk premiums. Those would accelerate the pressure toward deleveraging and debt deflation and default. “When they stop buying bonds, the game is over.”

They still bought bonds in 2011

2011 was another strong year for gold. Despite a brutal beating in the last month of the year, the precious metal produced again double-digit returns for the year as a whole if measured in paper dollars: up 10 percent. I believe that gold will continue to do well, as it remains the essential self-defense asset.

Amazingly, Treasuries did almost as well as gold (+9.6%) and TIPS (inflation-protected Treasuries) did even better. German Bunds benefited from the disaster in other euro bond markets. They pretty much matched Treasuries in terms of total return (currency-adjusted they did less well as the euro declined slightly versus the dollar). This is entirely unjustified because the EMU debt and banking woes will put considerable additional strain on Germany’s public finances. UK Gilts did better than gold and Treasuries, despite rising inflation in the UK, weak growth and a public debt load that is only ever going up.

This cannot go on for long. Bonds are fixed rate investments with finite maturities. The price gains of 2011 have lowered the yields to maturity, in some cases markedly so, and thus diminished the chance of additional gain. Does that mean reversal is imminent? No. Maybe the notion, or better the myth, that the bonds of the United States, the United Kingdom and Germany are risk-free assets can somehow be maintained. Maybe yields can decline even further. Who knows? Personally, I doubt it.

In the case of the US, the fiscal situation seems beyond repair. The Congressional Budget Office publishes its own projections on the long-term fiscal outlook. These are based on some overly rosy economic assumptions and still make for rather grim reading – hundreds of billions of dollars in deficits every year forever. The true path for the U.S.’s public accounts will certainly be much worse. The U.S. has now acquired a habit of running budget deficits to the tune of 10 percent of GDP year after year (more than $1.5 trillion in 2011) and there seems to be no end in sight. There is presently no deflation in the U.S. Neither does the TIPS market expect any. Yet, investors seem happy to hold U.S. government paper at what are certainly negative real yields. Investors are practically paying the U.S. government for the privilege of funding its out-of-control spending.

I have long maintained that government bonds are a bad investment because the endgame for them will either be outright default or inflation. In both cases, as a bondholder, you lose. The outcomes are either default or default. The idea that these debt loads could be elegantly inflated away is nonsense. They are already too big for that. So either you face outright default or, if authorities try to inflate, hyperinflation and currency disaster, and then default. In either case, you will not be repaid with anything of real value.

“Let them eat bonds!”

But are default or inflation and then default really inevitable? What if the present scenario continues forever? This seems to be the new “hope”. It is not a pretty scenario in that it involves the ongoing confiscation of wealth from bondholders but it seems to be less drastic than default or hyperinflation. Could we not work off the excessive stock of debt by suppressing bond yields below (moderate) inflation rates for an extended period of time? Of course, we cannot rely on the self-sacrifice of the bondholder, although he appears rather willing of sacrifice at present. So the government will have to use all its might to force bond-investors into accepting zero or negative returns for an extended period of time. After all, the state is the territorial monopolist of coercion and compulsion. It makes the laws. And controls the banks.

In a state fiat money systems banks must ultimately cease to be private, capitalist enterprises. Many banks have already been fully or partially nationalized. The remaining private ones are under tight, and ever tighter, regulation by the state. Should it not be easy for the state to force banks to invest more in government bonds, even at low or negative real returns? Should it not be possible to redirect whatever saving and credit there is from the private to the public sector?

Such a strategy has been outlined – not advocated- by Russell Napier of CLSA. He calls it ‘repression’. It ultimately involves rather draconian market intervention in order to continuously force the diversion of capital from private use to public use at artificially low levels of compensation. At some stage it will require capital controls.

But let’s face it: most of what we have experienced over the past three years in terms of government intervention would have been simply unimaginable only five years ago. We should therefore not be surprised if market intervention becomes ever more heavy-handed and is used increasingly to favour the funding of the public sector.

That such a policy will be implemented, and ever more boldly, I have no doubt. In fact, I predicted it in my book. See chapter 10 of Paper Money Collapse – The Folly of Elastic Money and the Coming Monetary Breakdown, in particular pages 226 -228. I called it ‘the nationalization of money and credit’. It is a phase in the crisis but it is not an endgame. Where I disagree with the above mentioned writers is the following: Repression, to the extent that it works, will not reduce government debt, and besides, it won’t work.

Consider the recent environment: Certain governments have been able to borrow directly from their central banks via quantitative easing and in the bond market at low or even negative real interest rates. Does that mean they have reduced the amount of outstanding debt? Are such hugely advantageous conditions used to cut back the debt load?

No. The opposite is the case. Access to cheap credit, whether that credit was provided by the printing press, obedient bond investors or hyper-regulated banks, has allowed states to run larger budget deficits and accumulate more debt. Remember, we are not talking here about the workout of a debt-situation resulting from a war, a natural disaster, or some other one-off event. We are talking about the modern welfare state with its ever-growing commitments and increasingly out-of-control spending. Only cutting off the state from cheap funding will ever constrain it, not giving it access to more resources more cheaply.

We do not live in Paul Krugman’s parallel universe of Keynesian fiscal stimulus, where every dollar spent by the government magically translates into 2 dollars of real GDP growth. Here, on planet Earth, the constant shift of resources from private markets to the state bureaucracy weakens the economy. Shrinking the private sector and growing the public sector kills economic growth. In the perverse logic of the modern welfare state. This then requires even more state spending in the next period. As the economy continues to struggle, public sector outlays will grow while tax receipts will shrink.

‘Repression’, to the extent that it succeeds in shifting resources from the private market to the state, makes the crisis worse. It must lead to more debt, more capital misallocation and a weaker economy. We will not save our economy by trampling on the remaining bits of functioning capitalism and by confiscating more resources from the private sector. ‘Repression’ is self-defeating.

Additionally, it won’t work. Private wealth-holders will not sit on their hands forever while their hard-earned savings are being confiscated by the state. If banks become mere tools to fund the state and thus provide zero or negative real returns to shareholders and depositors, shareholders and depositors will pull their money from the banks.

But there is no alternatives for the depositors, is there? Of course, there is: Gold.

As the enemies of gold in the establishment financial press never tire of reminding us, gold pays no interest and no dividend. Because of storage and insurance costs, it is a ‘negative carry asset’. But in an environment of ‘repression’, so are government bonds and bank deposits.

With zero or negative returns guaranteed on supposedly ‘safe’ government bonds and bank deposits, ever more investors, including small savers, will turn toward gold which has the additional advantage that its upside is practically unlimited – its price can double, triple or quadruple (all of which I expect) as long as paper money debasement continues (which I consider a near certainty).

Of course, a determined state will counter any evasion of controls with more controls. Maybe we will see taxes on gold investment or even restrictions on trading and owning gold. Via capital controls the country could be locked down. All of this is, of course, hugely destructive for the economy and ultimately self-defeating. I expect that we will see quite a bit of this stuff in coming years. Try and be prepared!

But this will not be part of the solution. It will make matters worse. And it means that the endgame is still either voluntary default or hyperinflation and default. ‘Repression’ or ‘nationalization of money and credit’ is a policy of desperation. It is not a solution. It won’t be the endgame.

Regards,

Detlev Schlicter

Paper Money Collapse

When the Bond Buying Stops, the Game Is Over was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.

Inertia weighs on an investor, trapping him in a state of paralysis and freezing his portfolio, almost forcing him to hold on to whatever he already owns – for no better reason than that he already owns it. He hopes that every one of his old shoes will go up, even if the reason for the purchase is long forgotten or the environment in which the investment might have prospered has vanished. People who substitute hope for cold-blooded analysis almost inevitably wind up losing money.

So, for the sake of argument, let’s look at where you might best put your money for the rest of the year 2007. To keep things simple, let’s assume you start by liquidating all the cats and dogs populating your portfolio, so that you have just a pile of cash. No, let’s not phrase it that way… because then you’re going to start wondering which of the securities you own really are cats and dogs. You might get bogged down. And then inertia will creep back in, and you’ll throw your hands up and do nothing. So let’s assume you sell everything, in true going-out-of-business style.

Now, what’s the smartest place to put that money? Let’s look at the alternatives.

Bonds? A disastrous sucker bet. Bonds, at the moment, are a triple threat to your capital. First, you have a huge risk with interest rates, which are still near historic lows; as they go up, the market value of your bonds drops proportionately. Second, no matter which of the fiat currencies you choose, you have a big currency risk; while the US dollar is on the fast train to zero, virtually every other currency in the world is being inflated along with it and is heading toward eventual oblivion. Third, you have credit risk; General Motors isn’t the only large company whose bonds may go into default.

Stocks? The general market is yielding less than 2% in dividends, less than 1/3 of what you typically see at major market bottoms. And selling for more than 18 times earnings—more than 25% higher than its norm. Worse, for those who might be buyers, the bull market of the century started in 1982 and, in inflation-adjusted terms, ended in 2000. You might not want to hear it, but stocks are almost certainly early into a bear market that could last another 5 or 10 years. By all traditional measures, chances are much better that stocks will drop 50% from here than gain 50%.

Cash? You could always just stay in T-bills. But they currently yield only 5%, before taxes. And inflation (notwithstanding the highly imaginary official figures) is probably running around 6% and likely to head higher.

Real Estate? At the present, at least in the U.S., this is probably the worst choice of all. The speculative boom crested last year, and the market, burdened by an immense amount of debt and overleveraged speculation, is likely to head down for years to come. Of course, there are places in the world, two of our favorites being Argentina and Uruguay, where there isn’t much of a mortgage market, so the properties aren’t overleveraged and values are still available. But unless you are looking to pick up cheap land in undeveloped, exotic countries that have avoided the credit-driven bubble, real estate should be last on your list of investments.

Mutual funds? Any mutual fund you’re likely to pick is just a way of buying one of the investments we’ve already dismissed. And paying all those fees and expenses that come with a mutual fund just makes the bet that much worse.

So What Should You Do?

Since 2001, we’ve been in a natural resources bull market. If you were one of the few who positioned yourself in gold, silver or pretty much any of the metals or energy commodities – either directly or through the shares in smaller resource companies, which is the preferred vehicle we have been recommending to subscribers of our International Speculator — you’ve already made the easy money.

At least to us, before the bull market kicked off, the opportunity in the sector seemed obvious, with many resource companies selling for less than the cash they had in the bank. Few people even knew the sector existed, and most of them thought it was a dead duck after the 20-year-long bear market it had suffered since 1980.

The easy-money stage of the resource bull ended in 2003, at which time we entered the second stage, where the market climbs a “wall of worry.” In even the most formidable of bull markets, this phase comes with inevitable corrections and scary downdrafts. Per its moniker, with each short-term setback in price, investors who were shrewd enough to get positioned early on into the long bull market fret that they might be wrong. Some are shaken out, but the smart ones buy even more on the dips.

But now, in my opinion, we are about to enter the third, and most important, stage of the classic bull market: the mania stage. This will resemble the tail-end of the Internet stock bull market. It’s hard to predict exactly what catalyst will set it off, but it will very likely be rising expectations for inflation. Fear will drive the foreigners who hold about $6 trillion to sell the greenback, and they’ll be joined by savvy Americans. Some will buy other paper currencies, like the euro or the yen. But those units are just backed by U.S. dollars themselves, so they really aren’t much in the way of an escape pod. Inevitably, much of the money now sloshing through the world will try to get into gold. While no one can say with certainty, I expect the metal to hit $1,000 within the next 12 months and go much, much higher by the end of the decade.

Is this an unreasonable prediction? No.

Most casual investors mistakenly look at gold and think it’s been a leader in this bull market when, in actual fact, it’s a laggard compared to the industrial metals that have been bidden up to extraordinary highs by soaring demand from China, India and other emerging markets.

To give you just a few examples, in the last five years, copper has been up 330%, nickel 560%, uranium 1,150%, zinc up 460%, molybdenum up 450%, and even lowly lead, the most basic of base metals, is up 425%. By comparison, gold is up only 100%.

That will change, however, because although gold has many and growing industrial uses, it’s main use is as money. It will dawn on the herd that the world is drowning in a flood of increasingly worthless paper currency, and they’re going to stampede toward the high ground of gold.

The metal isn’t just going through the roof. It’s going to the moon.

Gold Good, Gold Shares Better

When gold really starts to move, the mining exploration stocks are going to howl. That’s because gold exploration stocks are not just highly leveraged plays on the price of gold. They are capable of providing you with triple-digit gains based on exploration success alone.

Case in point, the last mining share boom from 1993-96, which occurred at the tail-end of gold’s 20-year bear market and carried hundreds of stocks with it, was driven entirely by a handful of discoveries. Since gold prices turned up, starting in 2001, a lot of money has been spent on exploration, and that work will inevitably lead to major discoveries and market excitement. Several of the companies we follow in our International Speculator are already drilling into what look to be monster deposits. Confirmation of a major discovery could well ignite a mania in the market.

While most other investments, such as bonds, industrial stocks, real estate and broad mutual funds are likely to be serious losers over the coming years, the bull market in gold and gold exploration stocks has still barely entered the public’s consciousness. Although the easy money has been made, the big money is waiting to be picked up.

Nothing in the investing world is ever a sure thing, but today the exploration stocks look to be as close as it gets. As for the inevitable corrections during this “wall of worry” phase, remember that the time to be timid is when everyone else is bold, and the time to be bold is when everyone else is timid. Sell-offs in the gold and gold mining sector are, to our way of thinking, gift-wrapped opportunities to buy.

Regards,
Doug Casey
June 15, 2007

Your Cash is Trash, and So Are Most of Your Investments was originally featured on Whiskey and Gunpowder. Visit Laissez Faire Books for the best selection of libertarian book titles.