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Justice Litle


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Exploding Debt Dynamics, Part II: The Golden Supernova

By Justice Litle      Printer Friendly Version
Oct 31 2008 2:57PM

www.taipanpublishinggroup.com

What do avalanches, black holes and supernovas have in common with the fate of the dollar and gold?  

 Because the world’s reserve currency is so widely circulated - held in large amounts by foreign central banks, used to price commodities and international goods, widely relied upon for third party transactions, and so on - great quantities of U.S. dollars are required at all times. Not just in U.S. accounts, but for matters of business all across the globe.

This makes it easy for Uncle Sam to abuse his envied position. He can issue large quantities of debt, pay off that debt with inflated dollars, and get away with it to a far larger degree than other countries... all because the U.S. dollar is the world’s reserve currency. The dollar’s role as “anchor” for the global financial system gives extra leverage to the U.S., just as the anchor tenant in a shopping mall has extra leverage over the developer.

For the U.S. Fed and Treasury, the trick is to see how deeply America can exploit this privilege without abusing it to the point of losing it. In the 1970s, Secretary of the Treasury John Connally famously told Europe that the dollar is “our currency, but your problem.” That kind of dynamic has gone on ever since.

Insufficient Funds

For many years, too, the U.S. dollar played the role of “funding currency” for various trades. During the boom times, investors and speculators alike went “short” dollars - that is to say, they borrowed them - in order to invest those dollars in all sorts of assets, from copper mines to canola oil.

Now, with the great unwinding that’s taking place - not to mention many a hedge fund shutting down or blowing up - all those investments are being dumped. Currencies, commodities and equity markets have dropped like stones in result.

But because the dollar was a “funding currency,” we now see the dollar shoot up as burned investors repatriate their funds and go to treasuries or cash.

The same thing is happening to the Japanese yen - the world’s other hugely popular “funding currency.” Roaring strength in the yen has scared the daylights out of Japanese equity markets, sending the Nikkei to its lowest point since 1982. But the yen rockets higher anyway, as all of those who borrowed in yen go to ground.

The Mother of All Short Squeezes

What we are seeing in the dollar and yen is, in a way, the mother of all short squeezes. The brutal nature of the squeeze reflects the depth and breadth of panic we are going through.

As Jeremy Grantham of GMO Advisors puts it: “This is a panic in the way of the fine 19th-century panics, where we all run around like headless chickens. I have been in the business for 40 years, and I have never seen anything like this.”

If you can believe it, Grantham may even be understating a bit there. What we’re going through is even worse than many of the “fine 19th-century panics” he refers to.

I say this because even in the great panics and depressions past - the Panic of 1873, the Great Depression of the 1930s, and so on - there were big players who came through the mess unscathed. The depression following the panic of 1873 was long, dark and brutal... a good bit more brutal, some would argue, than what occurred in the 1930s. And yet there were a number of banks that made it safe and sound through that time.

This time, it feels like nobody gets through unscathed. The degree of systemic infestation has simply been too great.

Ship of Fools

The sheer scale and scope of this crisis caught many observers flat-footed (yours truly included). Those of us who long foresaw the “Austrian Endgame” coming to pass were nonetheless stunned by such a high degree of violence in so short a time.

One big reason for the wrenching market violence is because the “powers that be” screwed things up far more than anyone suspected they might.

As I wrote to Taipan's Safe Haven Investor readers last week, “If Paulson and Bernanke were ship’s captains, they would make Edward John Smith (captain of the Titanic) and Joseph Hazelwood (captain of the Exxon Valdez) look like small fries.”

When all this stuff goes in the history books, there will be plenty of sorting out to do. (As a side note, I can only hope that Alan Greenspan, aka “Maestro,” gets his full portion of the blame.)

But for now, lets turn to gold and gold stocks. Hank and Ben have a lot to do with what’s happened there too.
As you know, gold and gold stocks alike have been mercilessly pummeled. For the purpose of illustrating sheer carnage, it’s hard to beat the Amex Gold Miners ETF (GDX:AMEX).

So why did this happen? Why has gold fallen so hard and so fast in a time of crisis? I see at least two reasons:

  • The violence of the great unwinding - the same phenomena that sent the dollar and yen rocketing higher - has led to a mass dumping of hard asset positions (including gold and gold stocks).
  • A rush of deflationary fear has taken the world’s breath away - and the inevitable outcome of mass paper stimulus hasn’t had time to catch up just yet.

An Asset-Dumping Avalanche

In reference to the first point, I believe that Bernanke and Paulson will be truly hated men after this whole mess is over. Not necessarily hated by the press, the public, or the world, mind you... but hated by their friends.

In trying to gauge how things would turn out, I expected the powers that be to try hard to save their friends... not out of moral principle, but rather out of a general understanding as to the Machiavellian principles by which the world works.

In order to save their friends, I thought, Paulson, Bernanke and company would do their best to ease us into a “managed inflation” scenario, thus sparing the holders of paper assets a mighty blow. But as I wrote to Taipan's Safe Haven Investor readers last week, that didn’t work out.

As we now know, [the managed inflation scenario is] not what happened. What did happen is that this credit bubble popped so viciously and violently - the air rushed out of it so blindingly fast - that even the networked and connected players could not be saved.

It’s an unprecedented thing. Normally the little guy gets hurt and the inside players make a killing. But this time, Hank and Ben’s “friends” have been utterly destroyed too... slaughtered like cattle in an abattoir.

It’s a wild list. Russian oligarchs, investment bankers (and the i-banks themselves), top hedge fund managers, media moguls, billionaire CEOs, connected politicians, family dynasties, ivy league endowment funds, you name it - all have seen hundreds of billions, perhaps trillions all told, go straight down the drain.

This ties into the hard asset carnage because connected players (the slaughtered, as mentioned above) held large quantities of gold and gold stocks.

In an ironic twist of fate, gold actually became a victim of its own popularity as an inflation hedge. Before the system went to hell, many smart asset managers loaded up on gold and gold stocks in expectation we would see the “managed inflation” scenario play out.

When Hank and Ben botched the rescue so badly as to let the system itself implode, then a vicious spiral was created. Most of the asset managers and connected players holding gold and gold stocks had to dump their positions - or at least trim them severely - as error and uncertainty raged through the system.

The fear of total systemic failure - brought on in large part by the collapse of Lehman Brothers - was like pouring kerosene on a fire. Things got so bad at one point that neither the investing public nor the asset managers themselves knew which holding accounts were safe from a Lehman-style freeze up... and which were at risk of immediate “lock up” via institutional failure or government decree.

This added panic factor - brought on by the utter hamfistedness of Hank Paulson - fueled an asset-dumping avalanche the likes of which the world had never before seen. Gold and gold stocks were not spared.

A Deflationary Black Hole...

As if all of the above weren’t enough for poor old gold, the global financial system’s near-death experience unleashed a vicious wave of deflation fears.

The fractional reserve banking system that the world now banks on (no pun intended) is one in which every new dollar of credit issued births some multiple of new dollars in the system. The same process works in reverse; when credit is cut off, extinguished or destroyed, so too is some larger quantity of dollars in the system.

And so, when traders and investors saw all the credit in the world seemingly evaporate at once, deflationary fears swamped every other consideration.

Try to imagine the global supply of money and credit as a collapsing star. If a real star’s collapse is powerful enough, gravity feeds on itself as the star grows ever more dense. The denser the star becomes as its matter collapses into a small space, the more the speed of collapse accelerates.

This is how black holes are formed... a massive feedback loop of density and gravitational pull that can turn a whole star inside out. (My advance apology to astronomy buffs if I’ve skimped on key details.)

Likewise, if there are no measures taken to halt a mass credit collapse, the same type of “black hole” result can engulf whole economies, resulting in depression. When central bankers voice their hatred of deflation, this is what they really fear.

...And a Supernova Response

Part of the reason gold has been so utterly crushed, I believe - in addition to the asset-dumping avalanche cited earlier - has been a market focus on the deflationary aspects of the collapse.

There has been little to no focus thus far, though, on the response to that collapse. In keeping with our star analogy, I believe that response will have “supernova” type qualities... and could ultimately result in a supernova-style rise in the price of gold.

Upon return to a more benign, back-to-normal, “managed inflation” type environment where the panic has passed, low-to-no-yield treasuries will be an awful choice. And the forced dollar buying / gold dumping will stop when the last distressed seller has sold.

But that’s if things get better. What if things first get worse? What if they get much worse?
If that happens, I believe, then all the printing presses go into hyperdrive. Of course, one could say we are already in hyperdrive. The Fed’s efforts to juice the money supply in the last two months alone. That’s an annual rate of increase approaching 350%!

So I ask you this: If that’s what the Fed has already done in terms of flooding the system with dollars... then what do you reckon they’ll do if things get even worse?

Massive Transition Ahead

In sum, I believe we could be headed for a massive transition in the market’s thinking on matters like the dollar and gold. Just consider:

  • We have seen the dollar (and the yen) skyrocket due to their roles as “funding currencies”, and the great unwinding that ensued.

  • We have seen the dollar further benefit from the knee-jerk comfort of U.S. treasuries, still the deepest and most liquid “go-to” market in the world for safety in a time of panic.

  • We have seen gold, gold stocks, and hard assets of all kinds get dumped over the side via the biggest avalanche of forced asset sales - involuntary asset sales - the world has ever known.

  • We have seen the world go white-knuckled with fear over the deflationary aspects of the credit collapse - without yet considering the supernova-style policy response that is sure to follow (and may now be in effect).

  • We know that the first three points above are temporary phenomena bound to end... and the fourth is a market mindset bound to change.

There Can Only Be One

We started off today by revisiting Uncle Sam’s privileged status as an issuer of the world’s reserve currency. This is a privilege that can be greatly exploited - but only up to a point.

If global economic conditions continue to deteriorate... that is to say, if things get a fair shake worse before they get better... then I believe the world’s faith in the dollar, as a proxy for the entire fiat currency system as a whole, could be tested to the breaking point.

What do I mean by “fiat currency system as whole?” I mean that if things get ugly enough, then all the printing presses go into hyperdrive. (The UK Telegraph, in fact, has already declared “Europe on the brink of currency crisis meltdown.” Banking panic has even spread to the oil-rich gulf via Kuwait.)

If this terrible testing of the entire fiat currency regime comes to pass - as could happen soon - then an old iron-clad truth will come back to light: in times of true deflationary downward spiral, gold is the only form of currency not subject to a printing press.

In conclusion: the dollar has stood tall, thus far, due to a massive funding-currency “short squeeze” and the various supportive elements mentioned. But in the end, the printing press is the only hail mary left... the only play the central bankers know.

So if things get better: the fever breaks, a managed inflation program returns to the fore, and gold benefits.

If things get worse: the U.S. Fed and cohorts go “supernova” in response, as they are already showing signs of doing... and gold ultimately does too.

Justice Litle
Editorial Director, Taipan Publishing Group

 

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Justice Litle is the Editorial Director for Taipan Publishing Group and the e-letter, Taipan Daily, the free financial e-letter that introduces readers to breaking global trends and investment strategies.