Sunday, April 18, 2010

Life in the Ant Farm

Dear reader, is all of this Goldman Sachs securitization and interest rate swap business making your head spin? SPVs, SIVs, SPEs, PPPs, PPIs, PFIs, SPCs, CDOs, CDSs, ABSs, MBSs... whew! I know it's making me dizzy. And I find that when my head starts to spin it is useful to fire up the old hooch still and cook it down into something more easily consumable.

We all like animal analogies, right? I probably should have gone with rats in a rat race or hamsters on a treadmill, but instead I chose ants in an ant farm. Not very glamorous, I know, but let me explain why selected these robust yet delicate creatures.

Did you ever have an ant farm when you were little? An ant farm makes the ants' behavior easily visible and controllable. They are imprisoned in a two-dimensional world in which their decisions are limited and their needs are met by you! They can only go side to side and up and down. And up usually leads them to the leaf you dropped into the ant farm for their lunch! But in the wild...

Ants form highly organized colonies which may occupy large territories and consist of millions of individuals. These large colonies consist mostly of sterile wingless females forming castes of "workers", "soldiers", or other specialized groups. Nearly all ant colonies also have some fertile males called "drones" and one or more fertile females called "queens". The colonies are sometimes described as superorganisms because the ants appear to operate as a unified entity, collectively working together to support the colony. (Wikipedia: Ant)




Methodological Individualism)



In this way, humans are similar to ants! A normal IQ distribution among humans ranges from 60 to 140. To me as an average human this seems like a very wide distribution. The dumb seem very dumb, and the smart seem really smart. But in the big scheme of things the human intelligence distribution is not so far off from the ant "intelligence" distribution. In other words, the smartest ant in existence doesn't even come close to the "distributed intelligence" of a wild colony. And the same goes for humans!

But when we put ants into a two-dimensional, controlled environment, the distributed intelligence of the superorganism is stifled and nearly snuffed out. As a confined group they end up no smarter than an individual ant.



They are the people whose contribution to society exceeds their own daily needs, creating an excess of wealth. And the most important decision for the human superorganism is the savers' choice between hoarding their wealth, or deploying it into the economy!

It is this decision process, made millions of times at the individual level, that lends the superorganism its superior IQ. There is no single human that possesses an intelligence high enough to compete with the human superorganism, just as there is no single ant that is smart enough to make better decisions for the colony than the colony itself. In fact, there is not a single human that could do a better job running the ant colony, although man has written many complex algorithms trying to mimic and even improve upon the collective intelligence of ants.

Debt and Specialization

As it turns out, the people that contribute the greatest leaps for mankind often don't have the wealth to realize their dreams on their own. They must engage other people with wealth, who on their own don't possess the knowledge and ability to make great leaps for mankind. It is this "working together" that made things like electricity possible.

I said earlier that the most important individual decision is between hoarding and deploying one's wealth. Modern socialist thinkers will all tell you that hoarding is always bad for the economy. That the key to a thriving economy is the free (read: forced) deployment of all wealth back into the economy immediately once it is saved. But the problem is that removing the decision process from the savers changes the behavior of both the savers (lenders) and the debtors.

Debt becomes cheap and easy to get, therefore debtors no longer need great ideas like "electricity" to get a loan. And for the savers, the choice becomes as simple as a multiple choice test for a government job. The lowest common denominator rules the collective as those with a 60 IQ face the same choices as those with a 140: low yield (supposedly safe) or high yield (more risky). What is missing is the option to hoard, without losing purchasing power, which forces lenders to look at debtor's "proposals" more closely.



This GFC is the final stretch in the long evolution of money, spanning centuries, that led to a global monetary system in 1944, a purely symbolic fiat system in 1971, an electronic computer-assisted system in the 80's and 90's and today's insurmountably complex system of derivatives. With each step adding new layers of complexity and distancing finance from reality, the savers and the debtors have now become so disconnected from each other that our human superorganism is now literally dumber than the lowest functioning human. The collective IQ is now probably well below 50, thanks in large part to the "geniuses" on Wall Street who created SPVs, SIVs, SPEs, PPPs, PPIs, PFIs, SPCs, CDOs, CDSs, ABSs, MBSs... We are truly ants in an ant farm!

As Paper Burns

In Sultans of Swap - Explaining $605 Trillion of Derivatives, Gordon Long writes "The cheaper money is, the more borrowing will occur. Everyone is happy except the unwitting lender."

This line really gets to why all these "genius" Wall Street creations are such an explosive problem today. "Everyone is happy except the unwitting lender." The "unwitting lender" is all the savers and "super-producers" of the world. It is everyone you know who has a pension or a pension fund. It is everyone you know who has a 401K or an IRA. The "unwitting lender" is anyone and everyone who relies on the $IMFS and its network of specially trained and licensed financial advisors with official titles like RIA, CFP, CFA, CPA, ChFC, CRPC, RFC, MSFS, all of whom are practically bound by law and fiduciary duty to NOT tell you the true nature of the risk you are facing.

On the other hand we have the writings of one with remarkable wisdom, relegated to pseudonymous postings on an Internet forum, warning us more than 12 years ago of things like this...

Much paper value will burn before this fire is done!







During this result, all paper will burn and the world economy will start over. However, the BIS is buying gold for customer governments as they begin to lower the dollar. This action, began some months ago will bring gold up, perhaps to the middle $360 range. If the world paper markets do not destroy themselves, gold stocks may rise for a time. But, physical gold is the good hold for this time.

This kind of advice is all but illegal within the $IMFS! If it's ever even spoken, it is whispered and "off the record". But I guess that's why you're here, reading "voluminous posts" by a pseudonymous blogger, eh?

At the top of this section I mentioned Gordon Long. I recommend his recent articles for an in-depth yet digestible view of the head-spinning, mind-numbing world of "genius" Wall Street contributions to mankind, like SPVs, SIVs, SPEs, PPPs, PPIs, PFIs, SPCs, CDOs, CDSs, ABSs, MBSs...

Exponential Debt

One of the things Gordon writes about is probably the most catastrophic aspect of this mountain of debt: the maturity wall. This is the hurdle of old debt rollover that is facing us collectively right now, where all of the world's present saving must be compelled into the interest payments alone on the old debt. Talk about the unproductive and inefficient use of savings! What I can tell you is it ain't gonna happen. The system cannot be saved at this point.

I received an email from a reader, Lars Olsson, with a nice article he wrote about exponential growth and debt. Here is an excerpt from his piece with an exercise you can try at home to wrap your mind around what happens when savings are compelled into indiscriminate debt:

If you believe that 2+2=4, then you should believe the following. Compound interest at 2% is a miniscule interest charge measured by today's standards. Compounding the interest charged on a single unit of money can be written as follows: money-amount * 1.02 * 1.02 * 1.02 .... (adding another term for each year) .... and on and on. That is, if you can place your faith in mathematics and calculations and really "believe" that the calculator will return a correct result when you punch the buttons. We reckon our current time since the long ago birth of a civilization some 2000 years ago. History tells us they had money then. A functioning economy of sorts. Mediterranean trade. Payments for goods. Money of gold and silver. If any man would have placed only a fraction of his purse at interest, his descendants would be wealthy beyond imagination, and the world have been hollowed out.

Let me show you. Open the calculator function under Windows. If you run Apple you are smart enough to figure out a substitute on your own. You'll find the calculator under Accessories. Set the "View" to Scientific. Got that! If not, that's ok too, but you probably shouldn't be reading this. On the keypad, punch in 1.02, then hit the "x^y" button, then on the keypad punch in 2000, then hit "=". The display now shows you a large number. This is the multiplier for some amount placed at 2% interest for 2000 years compounded annually. On the keypad hit the "*", then punch in 0.01, then hit "=". Now the display shows you what one cent ($0.01) would have turned into. To make this a little easier to view, hit the "/" key, the on the keypad punch in "1","Exp","12","=" to get the answer in trillions of dollars. Yes. The calculator really does say that $0.01 placed at 2% interest for 2000 years turns in to $1,586 trillion, or $1.586 quadrillion, or a hundred year of US GDP. If you don't like 2%, change it. If you don't like 2000 years, change it.

What the previous exercise shows is that a purse of silver was certainly not placed at interest anywhere in the world 2000 years ago, and allowed to compound at 2% interest, since that numerical representation of wealth would today dwarf all known hoards of "money", electronic or otherwise. So compound interest is not a sustainable operation spanning millennia. Compound interest applied to any finite system will grow out of bounds, which is what we are experiencing today. The current "money" system, which is engineered with "debt/credit" as its foundation has breached its sustainable limit. Stimulating the economy without addressing the fundamentals of the "money system" decay will not restore economic prosperity. Money at interest, does not price risk in venture. A functional society requires an efficient "money system", but "money" can be made available through means other than extending fractional reserve privilege to the banking class and putting a price on the existence of money.

Lars' piece may seem simplistic, but I like it. I'll even take it a step further and say that a monetary and financial system that uses compounded interest cannot afford to compel all savings into the hands of debtors. It must have a means of hoarding wealth outside of the system in order to constrain the exponential growth function, or else the entire system will become retarded and then collapse. In return, this constraining function of "gold the wealth reserve" will restore intelligence to the human superorganism. Intelligence that has been sucked dry by Wall Street's systemic aggression against a free-floating physical gold price.



Thursday, April 15, 2010

The 21st Century Bank Run




Coming to terms with the dollar and with money
by Aragorn III

(a continuation from earlier)



















London unallocated: Fractional Fubar or Benevolent Banking?













Or maybe Recent Lessons Learned About Hedging (January 2000):



















Jim Rickards interview on KWN


















Saturday, April 10, 2010

GOLD & MONEY: More Than Meets the Eye

by Aristotle


Part 1 --- Stormclouds Gather...




Jelle Zijlstra, who became head of the Bank for International Settlements, said while with the Bank of the Netherlands in regard to the 1971 severing of Gold from the dollar, "When we left the pound, we could go to the dollar. But where could we go from the dollar? To the moon?"


Part 2 --- A Transition: Things Are what they Are...

Do you see the world as it is? Or, do you see the world as you are? A tough obstacle, to be sure, as our experiences weigh heavily on our perceptions, and many people have no practical earthly experience with real money. There is hope..."the Truth is out there!" as a popular show is quick to proclaim. Albert Einstein puts an interesting slant on this theme: "My religion consists of a humble admiration of the illimitable superior spirit who reveals himself in the slight details we are able to perceive with our frail and feeble mind."

So with a ready admission our minds are frail and feeble, let's prepare to tackle something so ponderous it must hopelessly remain an abstraction to us mere mortals. I refer to the U.S. national debt, expressed in dollars, that stands at 5.6 trillion. Wow! What does that really mean? To put it in some perspective, we will revisit the 1970's, and try to get our arms (and feeble minds) around some much smaller numbers, and yet numbers that themselves are large enough to be abstractions. Let's examine the incredible and overwhelming wealth and economics of oil.


I will talk about pricing and balance of trade in the next part...stay tuned for the biggest transfer of wealth the world has ever seen. The key-currency gets debased in 1971, and Gresham's Law rules the land.

Part 3 --- It's Only (a mountain of) "Money"...

Having purchased this Saudi Arabian concession, in subsequent drilling Socal's Damman Number 7 struck oil in 1937 (I believe old Number Seven is still flowing.) Socal partnered with Exxon, Mobil, and Texaco to form the Arabian-American Oil Company. Over a thirty year period, Aramco discovered petroleum reserves in Saudi Arabia in excess of 180 billion barrels...a quarter of the known reserves of the planet at that time. And as the world aged and changed, the amount of oil consumed daily in world trade climbed dramatically, from 3.7 million barrels per day in 1950, to 9.0 mbpd in 1960, to 25.6 mbpd in 1970, to 34.2 million barrels per day in 1973 during the first Oil Crisis.

Consider this for better perspective: the average yield per well at the end of the 70's in the United States was 17 barrels per day per well, in Venezuela (one of the co-founders of OPEC) it was 186 barrels per day per well, and in Saudi Arabia (the other OPEC co-founder) it was 12,405 barrels each day per well. Wow! Just imagine if the internet companies today issued new, additional shares each day at this same rate as oil consumption...the stock price would plummet! But unlike internet stocks, because this oil is consumed, it must be replaced (and paid for) every single day.


What does the Texas Railroad Commission have to do with this story? Plenty. So much oil was being produced in Texas in the 1930's that engineers were concerned about depletion and wastage, and the owners would fret over the effects of oversupply that would at times bring the price per barrel down to ten cents. Tiny independent producers were often drilling side by side with the majors, but when the price slumped their profitability suffered more because they didn't have income from the downstream processes like the majors did. Because some of the individuals operating these independent companies happened to be multimillionaires, their complaining voices were heard thanks to their political contributions.

The state government responded by giving the Texas Railroad commission the power to regulate drilling. And while they didn't have the authority to set prices, they could regulate production levels. By setting an appropriate rate of production, oil would be conserved and this restricted supply would achieve price levels high enough to keep the independents in gravy. This Texas price became the American price, and also the world price (in the 1950's the U.S. was producing half of the world's oil.) This meant pure profit for the major companies with overseas production that cost only ten cents per barrel. To keep the price of oil up, what started as a gentlemen's agreement among the American oil companies to limit the imports of cheaper oil later became enforced by the U.S. government--known as the "invisible dike" against the outside world of cheap oil. Throughout the 1960's, the Persian Gulf offered the world oil at $1.80, while inside the "invisible dike" oil was being sold to the nation at the Texas price of $3.45 per barrel by the end of the decade.


Now that we know a bit about the producers and the price and cost of oil during the era of "real money," let us take a look at the dollar itself. The dollar and the world was pegged to Gold via the post-WWII Bretton Woods agreement in which $35 was convertible to one ounce--but for foreigners only, not U.S. citizens. The rate for international currency exchange was coordinated through the International Monetary Fund (IMF), with each currency pegged to each other through the dollar and Gold. The U.S. economy steamed along nicely in the 1950's, producing half of the world's oil as I've already stated, and half of the cars that burned up this oil. By the arrival of the 1960's, American industry was buying foreign factories, equipment and raw materials. In addition, the government was spending for its foreign bases and troops, and Vietnam was funded largely in the red.




It is important here to realize the attitude of OPEC, and notably the Middle East. In the mid 1970's, the finance ministers of both Kuwait and Saudi Arabia stressed that their needs were only to provide for the welfare of their citizens, and that oil in the ground is better than paper money. Who from the West can argue with that? They called our money's bluff, fair and square. So in 1971, while the Texas price of oil was $3.45, OPEC re-priced their Middle Eastern oil up from $1.80 to $2.20 (such audacity, don't you think?) only to see the market price due to demand in 1973 overtake the official posted price, at which point OPEC saw the writing on the wall, and in October raised the price per barrel to $5.12 while curbing production. By December, the Shah of Iran called a press conference to announce the official price would now be $11.65. Well, why not? It's only paper to you if you are not in NEED of this currency through a debt to someone else. And so began the First Oil Crisis of the 1970's.

Just as America had been issuing claim checks on the national Gold throughout the 1960's, its spending habits didn't change with the advent of the all-paper dollar. As a consequence, the world's greatest transfer of wealth was underway. Watching the rising cost of real estate became a national pastime in the 1970's--an odd distraction from the gas lines and cost of fuel. By raising the price of oil $10, from $1.80 to $11.65, at those current production levels OPEC raised its annual revenues by approximately 100 billion dollars. Now recall from Part 2 where I promised you we would tackle some large numbers, though nowhere near as incomprehensible as the $5.6 trillion U.S. debt. Here we go...

How much IS 100 billion dollars per year? It can't be much, because we all know the Middle East is heavily in debt with struggling economies even now at the end of the 1990's. Right? Well, I invite you to follow along, and judge for yourself. Let's try to spend that $100 billion, and is 1974. And let's not waste time on small stuff, we'll go right for the big ticket toys.

How about some F-14's? Fully equipped (minus missiles because we are a peaceful bunch) they are ours for $9 million each. Grumman on Long Island assembles 80 each year. Hell, let's take 'em all for $720 million. How about some F-15's too? At $12 million each, we conclude our visit to McDonnell Douglas with 100 under our arm for a cool $1.2 billion. Let's take home the biggest brute the U.S. has to offer--a top of the line nuclear-powered aircraft carrier for $1.4 billion. Better yet, make that two carriers. Throw in some destroyers, some submarines...let's see... We've spent a total of $2 billion on a kicking air force and a little more than that on a fine little navy. How much money is left in round figures? About $100 billion. And this amount comes in not only this year, but the next, and the next, and the next... [a side thanks to Mr. Goodman for these historical prices.] $100 billion is a large annual paycheck, and we haven't even touched the $30 and $40 dollar prices brought about in the Second Oil Crisis. Now consider again that America has written future claims on $5.6 trillion dollars. Can you imagine how such a figure might be settled? Ouch.


Now that I have properly set the stage, in the next part I shall relate the really good stuff of Aragorn's tale suggesting where this money went, and how the system survived 20 years after the end was nigh, bringing cheap Gold crumbs for anyone mindful enough to pick them up. To quote that good knight, "With a payday reaching that magnitude, the question of destiny begs no answer. You set your own, and hope for nice weather."

Part 4 --- A 1970's History Lesson (without the disco)



So much money flowed in, and so much was lent in turn to the poor countries that could scarcely afford to buy oil with their meager exports, that the financial system became a large game of musical chairs, and the biggest risk was that the music might stop. There were no chairs to sit on! To protect themselves from the unthinkable--that the Arabs might pull their deposits out of an individual bank--the banks developed a system. This system provided for the relatively smooth inter-lending of funds. Because even though a bank can create new money "out of thin air," they have to have deposits in the bank as a starting point. If these funds were to be withdrawn, the bank must locate other deposits to cover their outstanding loans. If the money were pulled, say from a British bank, it had to go somewhere; the amount of money was too great to "hide" for long. This British bank could call around, and arrange to borrow the funds back from a Swiss bank, or German bank, by paying a nominal interest rate on this inter-bank loan. The important concept to grasp here is this: as long as the petrodollars stayed in the banking system, the banking system would survive.


When the First Oil Crisis caused a global tightening of belts, only America, as the issuer of the key-currency, could shamelessly create new money with ease to pay its bills. Other countries had to balance their own books with productive output, or else turn to the banks to borrow the needed funds. And borrow they did! Let there be no doubt that these petrodollars were recycled through the banking system. Throughout the Oil Crisis and the distractions of the Nixon Watergate scandal, the former Secretary of Defense under the Johnson administration, and then president of the World Bank, Robert McNamara, was focused on one thing only--maintaining the good graces of OPEC. McNamara had to ensure continued access to OPEC's funds. During 1974, the World Bank had drawn on OPEC for $2.2 billion, for a total at the time of $3 billion--one quarter of all World Bank debt. For Euroland banks, business was booming because lending was their business. And the IMF had its hands full trying to hold together the international currency exchange system.

Some of the countries that quickly found themselves behind the eight-ball: Brazil, Korea, Yugoslavia, the Philippines, Thailand, Kenya. (You can easily imagine that there aren't enough coffee drinkers in Saudi Arabia to achieve a meaningful balance of trade of coffee beans for oil for a country like Kenya.) So in a move driven more by politics than banking to ease the financial squeeze upon a nation's citizens and industry, the governments would turn to their central banks and to the international and multinational banks to secure the needed money. And the banks couldn't stop lending, because many countries relied on new loans to pay off the old loans in addition to their continued need for oil. Loans in default were simply rescheduled. There were no chairs, and the music could not be allowed to stop.

If a bank were to fail, what would the Arabs do with their remaining deposits, now clearly in jeopardy? Further, the inflationary impact of all of this borrowing was also a fact not lost on the OPEC nations. Many of the OPEC members' advisors and ministers held Ph.D.'s from prominent American colleges. They did not have their heads in the sand. The inflation would lead to a new price of oil just to recapture the value that was lost, and the cycle would intensify in the next round. OPEC knew the western currencies were depreciating faster they were compensating with price hikes. They were getting less "real" money as a result. Hopeless.



When the Ayatollah Khomeini's revolution deposed the Shah, Iran's 6 million barrel per day production fell off dramatically, and the resulting shortage sent the downstream processes scrambling for sources of oil anywhere to feed their refineries. Many turned to Rotterdam for oil, to fill their empty tanks. The deepwater port at Rotterdam was the principle harbor where huge tankers could be found to deliver oil on the spot, and hence the spot market for oil was often referred to as the Rotterdam market--but in truth, the spot market was available worldwide. This spot market was never meant to determine the price for oil, but was only supposed to supply day-to-day purchases.


Gresham's law can help explain this phenomenon-- bad money is spent and good money is saved. Oil was being bought and saved as a store of value, while paper money was spent. The flames of this Rotterdam inferno were eventually cooled as the last available storage tank was filled to capacity. This display of the spot value for oil reinforced OPEC's concept of value, and they had no qualms about raising the posted price to the spot value. Please recall, "We would rather keep the oil than have the paper money." Any student of history will also recall that the explosion in Gold prices also occurred in 1979 to early 1980, showing us Gold priced at $850 per ounce.

So what exactly has changed in the world since 1980? There haven't been any similar blowups in the pricing of important how was this wild tiger tamed? Is the money better than it once was? Or are the OPEC nations now suddenly and truly beggars upon the West's doorstep? What happened? Are the multinational banks (once scrambling to hold together the System) now calling the shots with nary a care in the world?

In Part 5, I put an end to this tale, and answer the biggest mysteries about Gold in the easiest of terms. The road will seem so straight and fair to travel, you will kick yourself for struggling through the brambles for so long, and wonder at your neighbors who STILL can't see the path, though it is truly a freeway.

Part 5 --- Gold, Money, and the Free Market

Before I conclude this commentary, let me first express my gratitude to USAGOLD for hosting this illuminating site, and for the tolerance I've been extended by so many here for my four long posts that up until this moment probably didn't seem germane to the topic of Gold.

On any journey, the first few steps are the most important, and in this case they were also the most difficult--to include enough for context without drifting off-topic. This last part is easy. The task at hand is to provide an explanation of Gold's pre-eminence as a monetary asset. Gold is, in fact, Money, while the dollar and others are merely currencies--an importance difference!



'The falling price of Gold has had various effects on people. The common person says, "Of course it is falling, because Gold has been demonetized." The Goldheart knows better, so the falling price has a more remarkable effect, bringing out insecurities and irrationalities of some. Though these people don't question that Gold is money, their insecurities start to question whether the world really needs money at all...that somehow this greatest device of mankind has been antiquated. Simply preposterous. If they knew the truth they would confidently buy today at triple the price and call it a bargain of a lifetime. People ask, "Why waste effort to dig up Gold from the ground, only to rebury it in vaults?" I say, "For the same reason the central banks toil to print millions of fancy notes that nobody reads. If you've read one, you've read them all." The effort is needed to prevent cheating, though we easily see the fancy cash does not stem the abusive tide of money from nothing. People also say, "Gold is a dead asset. It does not earn interest." What is the point of such a comment, to demonstrate their naiveté? Did banks not pay interest when coins were stamped from Gold?


With that, I will now conclude this tale that shows Gold functioning in its role as Money. And because preconceived notions of words often cloud a person's ability to see the case before them, I shall try to deliver this message with the slightest use of such terms as Gold loans, leases, shorts, etc. In fact, I will be so bold as to simply refer to Gold as Money (I will write it as "Money (Gold)" to ensure you know my meaning, but as you read, simply pronounce it as money). As far as what you might think is money (dollars, yen, pesos, etc.), I shall from this point forward not call them money, but refer to them by their given name (dollars, yen, pesos, etc.) or else will call them "fiat currency," or just "currency" for short. Fiat means "by decree, and fiat currency is currency because the government tells us it is.


We've already discussed much of the turmoil that resulted from consumption that outpaced ability to pay. Payment in Money (Gold) was terminated, and many payment scenarios were developed in addition to the ever rising prices in paper currency. While it can be suggested that currency is a reasonable means in which to track balance of trade accounts (equating oil exports with similar value of imports such as infrastructure improvements), it should be readily admitted that paper currency is an unacceptable means in which to pocket one's profits. Book the trade balances with paper currency, but pocket the profits (savings) with Money (Gold). That's what I do every month, too!


Back in the 1960's when dollars were still tied to Money (Gold) under the Bretton Woods agreement, the American penchant to spend for goods abroad led Kennedy's Undersecretary for Monetary Affairs, Robert Roosa, to fear a mass "cashing in" of these dollars in international hands for Money (Gold)--a run on the Treasury. Roosa created a new financial device, referred to as a "Roosa bond," which was a special issue of Treasury bonds that were denominated in Swiss francs. As the bonds were sold to the world, they would sop up excess U.S. dollars with the terms that repayment at a future date would be in a given quantity of Swiss francs. (Notice I said quantity, and not value.) While these Roosa bonds stemmed the tide of a possible run on the Treasury, they ended up costing America more because the Swiss currency appreciated versus the dollar during the life of the bond.



It is also important to realize that not all international arrangements are conducted on the open market. For example, to avoid the German mark from being bid up in strength with a result of ever more people bringing them dollars for an exchange, Germany's Bundesbank issued bonds directly to the Middle Eastern buyers, avoiding the marketplace impact altogether. This was at the time Saudi Arabia was swimming in cash and spreading the excess among the world's largest banks (as mentioned in Part 4). My point is this (which I shall expand on soon): don't be surprised that banks are far more creative in their operations than revealed in your common experience through savings and checking accounts and home loans.

Eliyahu Kanovsky, an oil economist, won renown by many for accurately forecasting long-term oil production and pricing trends by OPEC where all others had gotten it wrong. In the 1970's he maintained that economics, not politics, were the determining forces behind the decisions of OPEC. In 1986 he wrote in response to the prevailing notion that OPEC would eventually own the world as a result of its oil wealth: "It is, by now, abundantly clear that these forecasters committed gross errors not only in terms of magnitude of change, but, far more important, in terms of direction of change. Instead of increased dependence on OPEC and especially Middle East oil, there has been a very sharp diminution. ... Oil prices have been weakening almost steadily since 1981 and there has been a collapse since the end of 1985. Instead of rising 'petrodollar' surpluses, most OPEC countries, and Saudi Arabia in particular, are incurring large current account deficits in their balances of payments, and are rapidly drawing down their financial reserves."

In the 1990's, Kanovsky maintains that OPEC has lost its ability to raise income through raising prices, and that oil below $20 is virtually assured. (This should remind you of Milton Friedman's poor prognostication from Part 1.) Kanovsky claims competition among producers ensures an end to price fixing. They can only pump it and sell it for whatever the market will provide. He contends (rightfully so) that Iraq can be counted on to "pump like mad" upon lifting of UN sanctions. He also contends that with the current account deficits of many OPEC members, notably the Saudis, they have no option themselves but to add to the oil glut with overproduction to raise revenue.

Since it has been brought to our attention by Kanovsky, let's take a look at the Saudi budget, and the toll taken on it in the aftermath of the Gulf War. IMF data reveals that the Saudi deficit climbed from $4.3 billion in 1990 to $25.7 billion in 1991. Oil had been selling at around $14 per barrel until June 1990 when Saddam Hussein pressured OPEC to raise the price to about $20 to help repair Iraq's national budget (which had been wiped out and sent into the red by their 1980-88 war on Iran). Iraq's subsequent invasion of Kuwait in August 1990 temporarily spiked the price higher.


Historically, the price of oil had been simply posted by the producers for contracted delivery until it was unleashed to respond to daily supply/demand forces on the "spot" Rotterdam market, at which time the price exploded in 1979-80. Although the dollar had been historically fixed to Money (Gold), after it was unpegged in 1971, the currency price of Money (Gold) was determined by the daily supply and demand, similar to Rotterdam. Gold auctions began in May of 1978 because the U.S. had trouble getting international entities to accept its dollar currency. After "booking" their trade balances with dollars, the House of Saud, among others, wanted to "pocket" their profits with Money (Gold), and therefore competed with everyone in the world for Gold on the spot market. As the price shot right through $700 it was clear that every ounce purchased made it that much more difficult to purchase the next ounce. There was little trouble raising the price of oil as needed, except the financial structure of the world was coming apart at the seams. Each dollar withdrawn from international banks to buy Money (Gold) made life ever more difficult for the banks to square their books against outstanding loans or to write new loans. There had to be a better way...the return of Money!

The high price of Gold brought mining companies out of the woodwork. The Earth was suddenly crawling with geologists looking for the next jackpot Gold deposit. The mining companies needed capital to finance the construction of these numerous new mines. It's not strange to you to accept that banks can lend currency. It should not be difficult for you to accept that banks can lend Money (Gold) also. Struggling with that thought? Don't. They lent Money (Gold) in the days prior to Roosevelt's 1933 confiscation of Money (Gold) in exchange for currency, and they can lend Money (Gold) today. In fact, they can even create Money (Gold) out of thin air, in a manner of speaking, and I'll walk you through it.

Sometimes a parallel familiarity assists comprehension. Consider the existence of Government-Sponsored Enterprises (G-SE's) such as the Federal National Mortgage Association (commonly known as Fannie Mae). Fannie Mae is in the business of creating financing for people to acquire a house. The government's involvement in this affair is that they underwrite the risk of a default on the repayment of the loan. Dollars are borrowed, dollars are lent, and dollars are repaid. It doesn't matter what happens to the exchange rate of the dollars versus other currencies. A certain amount of dollars are owed, plain and simple, under the terms of the loan contract. If a home mortgage loan is sold on the secondary market, the purchaser of the loan is effectively buying not the house that was financed by this loan, but rather the rights to receive the borrower's scheduled repayments over a span of time.


As 1980 arrived, the Saudis naturally still wanted Money (Gold) for their oil, and the rest of the world was struggling with liquidity. Much currency "wealth" had already been transferred to OPEC, leaving many countries toiling to service their own debts--much of their credit existing as recycled petrodollars. Let the lending continue! Bullion banks would facilitate these deals, and central banks (CB's) would act in the same capacity as with the G-SE Fannie Mae, guaranteeing ultimate repayment in the event of a borrower's default. In this simple example, the House of Saud could be looked at as the principle lender (although the borrower doesn't see this)...providing the currency equivalent of the Money (Gold) borrowed by the mining company to pay for Caterpillar's equipment to build the mine. Because this is contracted as a Money (Gold) loan, Money (Gold) must be repaid over time. In a sense, from the Saudis' viewpoint it is similar to the Roosa bonds where U.S. dollars are paid for the bond, with a fixed amount of another currency (in this case, Money (Gold)) expected to be returned upon maturity.


There is nothing sinister in all of this. The price of Gold has fallen simply because anti-gold sentiment has been fostered throughout the common investment markets while the principle buyer at the Golden "Rotterdam market" had found another avenue in which to obtain the Money (Gold) desired in exchange for oil profits. This is very much like the off-market Bundesbank offerings that I mentioned about earlier. Please appreciate the patience in this approach, and the commitment it shows to Money (Gold), knowing full well that for many years it might be getting ever cheaper, while they would appear the fool for buying it from the top prices all the way down to the lowest. But the big payoff is in the end--which is near--and I'll get to that.

Now that you grasp the basics, let's take things up one level. So many Money (Gold) loans were written, that the House of Saud in our example spent down their past petrodollar surpluses. What now? It is time for banks to do what banks do best...create new money. This is the typical example I promised you earlier:

The miner approaches a bullion bank for a Money (Gold) loan. Let's assume the current dollar price of Money (Gold) is $400 per ounce, and the miner needs $20 million to pay Caterpillar for equipment. The bullion bank (such as can be found operating in the network of the London Bullion Market Association--LBMA) writes the Money (Gold) loan contract specifying the term of repayment of 50,000 ounces of Money (Gold) plus interest at 1% - 2%. The borrowing miner collateralizes this Money (Gold) loan with company stock, the deed to the mine, etc., and is sent down the road with $20 million in currency for Cat. Where did this cash come from? The bullion bank turned to the House of Saud, which is currently out of currency. However, using their oil in the ground as collateral, the bullion bank is able to write them a currency loan out of thin air (just like banks can do) with which the Saudis purchase the repayment rights on the Money (Gold) loan. They will be receiving future Gold for their future oil! As they sell oil, they will use their dollar revenue to repay their currency loans, and in the meanwhile, the miner's Gold loan repayments will be directed to the Saudis' account.

What does the bullion bank get for all this trouble? First, the central bank gets 1% - 2% for underwriting or guaranteeing the loan. (Just like the underwriting done with Fannie Mae.) The bullion bank had added on top of this low interest rate an applicable margin for its cost of funds to establish the final interest rate for the miner that borrowed the Money (Gold). This rate might run 3% - 5% (while currency loans would demand much more.) Each year the miner produces Gold, and after paying the required installment of Money (Gold) for the Loan, the remainder of his annual production can be sold on the spot market for currency used to meet business expenses.








It is this same currency, borrowed against oil collateral for the purchase of Gold, that has added the massive liquidity to the world over the past decade and a half that many people have used in turn to fan the flames of the stock markets here and overseas. That's a lot of cash born unto Gold, and were it not for the prospects of receiving the real wealth of Gold metal, this supply of currency would have been stillborn, and oil would likely only come forth by way of brute force rather than by civil, economic means. I realize that I have left a lot out, but this should get you started along the clear road traveled by smart currency. Now, knowing what you know, what would you do with your dimes? Because this is really his tale, not mine, I'll leave you once again with perhaps my favorite statement made by Aragorn one evening last month among his old friends. "If I were given a dime for every time I cursed the market for providing easier gold, I'd have a dime...and that one was found on my way over here."


Gold. Heading to the moon at a world near you. ---Aristotle


The above was written in June of 1999, in case you didn't notice. It is a repost on this blog from last July. The original can be found here.



US Mints ‘Gold Disks’ for Oil Payments to Saudi Arabia

The following speech, despite the fact that it was given at a "climate change" conference, contains some very interesting information about how the Saudis use their own oil. This is what I wish to draw to your attention in this video...
