Read This Excellent Post by Erik T.

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Lemonyellowschwin's picture
Lemonyellowschwin
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Read This Excellent Post by Erik T.

The post below is reprinted with permission from the author, Erik Townsend.  The original post was in yesterday's subscriber forum.  I think it qualifies as a "must read." 

Of the several excellent points, one in particular stands out to me.  There is a great paradox developing in the Fed-governement's need to raise financing.  Simply put, their financing needs are rising substantially at a time when their source of credit may be staring to dry up.  This raises the prospect of increasing interest rates.  But they can't abide increased interest rates because that "screws up" their frantic effort to stave off deflation.  Where does this lead?

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The comments about the difficulty of gauging the actual numbers are valid and appropos. But in my opinion, the real risk lies more in what Soros calls reflexivity, i.e. the potential for formation of a viscious circle.

The scenario goes like this: The fed prints a whole bunch of new money, diuluting the value of the USD. Sovereign debt is being paid back in watered down dollars. But the fed continues to maintain its ZIRP to combat deflation. A few foreign holders of debt take a step back and say "Hey, the dollar is being watered down by QE and we're getting paid next to zilch for investing in it because of ZIRP. This is for the birds!". China may already be doing this as we speak. See link in today's daily digest.

So there are a few less buyers, and it starts to get harder for the U.S. to raise the money it needs through treasury auctions. The usual resolution to that problem is higher interest rates (treasuries are sold on an auction system), but if they let the rates rise, that screws up the deflation-fighting campaign. So they have to cut back on the amount of money they are trying to raise (reducing number of treasury issues offered at auction) in order to keep interest rates where they want given the reduced number of buyers.

So the only way to come up with the money they need is to print much more money, watering down the dollar even more. Now the larger majority of foreign investors wake up and smell the coffee, and decide they want out. So they not only stop buying new treasury issues, but they also start dumping what they already own.

In a normal free market, that would cause interest rates to go through the roof, and the fed doesn't want that because they're still fighting the domestic deflation fire. So they print even more money, and use it to buy their own treasury bonds to prevent (more accurately, delay) an explosion of interest rates.

The viscious circle will develop quickly, and its result will be a catastrophic collapse of the U.S. Dollar. Think of this like a riot breaking out at a crowded rock concert. All is well and everyone is behaving, but there is a lot of pent up energy in the house. We have that now in financial markets. Then one trouble-maker starts a fist fight that quickly grows to several people, and the whole thing is visible to everyone in the house. This would be equivalent to China deciding not to buy any more treasury debt. Everyone else in the house sees this, and it's the catalyst that causes everyone in the place to panic and revert inexplicably to anamalistic, primal behaviors and before you know it, the whole place is a riot scene and a few minutes later, dozens of innocent people lie dead in the aisles.

The catalyst is when a big foreign investor starts dumping treasuries. The reason this is a very special, unique situation is that in financial panics, institutional investors have been conditioned for decades to respond instinctively with what's known as the flight to quality trade, meaning sell risky assets and buy U.S. treasuries instead. But when U.S. treasuries are the risky assets, they won't have any idea what to do. There's no play in the playbook for that scenario. Gold prices will skyrocket, but wealth in "paper gold" will be lost to counterparty default or exchange default risk.

Cops who work concerts "get a feeling" when something is about to go out of control. It's not based on objective analysis of anyone's actions or statements. Rather, it's just a "feeling they get" that the crowd is not stable, and that a relatively small disturbance is likely to cause the breakout of an all-out riot. They get scared. I'm not a cop and don't have the professional experience in financial markets sufficient to claim analagous competence. But for whatever it's worth, this amateur "has that feeling", and it's getting stronger.

It all starts when one big foreign investor starts dumping treasuries. This market feels like a ticking time bomb to me.

Erik

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randallriggs
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Re: Read This Excellent Post by Erik T.

Erik:

 Great article...Thanks... One question..... what do you mean by "but wealth in "paper gold" will be lost to counterparty default or exchange default risk. "...................are you saying the GLD ETF funds I have will be worthless?

Randy

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Re: Read This Excellent Post by Erik T.

anyone else have a comment about this GLD ETF issue?????

Thanks.................Randy

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Re: Read This Excellent Post by Erik T.
randallriggs wrote:

anyone else have a comment about this GLD ETF issue?????

Thanks.................Randy

Randy,

Erik can share his thoughts, but I know Chris has expressed he prefers ownership in physical gold and silver over "paper gold".

I'd also recommend doing a search in the upper right corner and enter GLD.  There are a number of threads where GLD is discussed ... below are a couple of links.  The first one provides some of Erik's thoughts on situations where owning "paper gold" may be more advantageous:

http://www.peakprosperity.com/forum/smart-paper-gold-gld-vs-gc-vs-tgd-vs/10271

http://www.peakprosperity.com/forum/need-advice-precious-metals-ira-vs-physical-gold-vs-gldslv/10029

Hope you find this helpful.

Ron

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Lemonyellowschwin
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On the subject of paper gold

I would not want to put words in Erik T's mouth, but here is my answer to Randal's question and I would be happy if anyone wants to critique it.  Maybe I am wrong and/or ignorant.

ETFs are supposed to be backed by actual gold in vaults certified to be owned by the ETF.  They take pictures of it.  People swear to it.  It's a cross your heart hope to die kind of thing.  But . . . . ETFS are still not considered 100% safe simply because you cannot actually touch it.  Again, though, the ETFS own actual gold bullion, NOT futures.

By far the larger risk is with gold futures.  This is what is commonly called paper gold.  With paper gold, all you hold is a piece of paper that entitles you to take delivery of gold at some point in the future.  And for every futures contract you own, there is a seller of that futures contract who is obligated to provide that gold should you demand it at the expiration of the contract.  Now, typically these contracts are rarely redeemed.  People just trade them around back and forth as if they were gold.  It seems to be considered bad form to demand delivery of the gold. . . somehow the contracts are just rolled over month after month after month and traded around like they were actual gold (since, after all, they do entitle the holder to demand delivery).

But really, they are nothing more than contracts.  And the contract is only as good as the party on the other side being able to actually acquire and deliver the gold on the specified date should you demand it.  This gets us to the next problem -- a crucial one.  The gold futures system -- which is traded through an exchange called COMEX -- is like fractional reserve banking.  As I understand it, there are FAR more futures contracts out there being traded than there is gold bullion.  So, if a decent sized percentage of the holders of futures contracts began demanding delivery, the gold could not be delivered and it would bust the entire system. 

If gold skyrockets, the idea is that people could get so nervous that it would cause what amounts to a run on the bank.

I don't know of any reason why ETFs or mining stocks would not be safe in this situation but if someone can tell me how they might be unsafe I am all ears.

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Re: Read This Excellent Post by Erik T.

Hi Guys,

It's funny, LYS, when you e-mailed asking if it was OK to cross-post from the subscriber forum, I thought you were talking about a different post... Didn't think anything about this one was all that profound, but I'm flattered just the same! :-)

Re: Randy's question, I basically agree with most of what LYS wrote. Here's a little more perspective beyond what's already been said.

The big advantage of physical gold is that you have posession of it. For real, in your hot little hands. But if we're talking about a significant value, you wouldn't want to just keep it lying around the house. So you have to put it in somebody's vault, and that both costs money (storage fees) and cancels out some of the physical posession advantage.

If you're going to own "paper gold", the GLD ETF is probably the safest of the "paper forms", but it's not without risk. Much has been written by Chris and others about all the custodians and sub-custodians that supposedly have the physical gold. Are you guaranteed by law to get your value out of the ETF no matter what happens? Yes. Were Bernie Madoff's investors guaranteed by law to get their value out of his hedge fund? Yes. The point being, not everybody complies with the law.

The risk in the GLD ETF is that if there were a big systemic meltdown of the financial system, a whole bunch of counterparties who are holding the actual gold would have to be rounded up, and your investment would only be good if all of them actually produced the gold. Would they? Probably most of them would. But who is administering this whole thing, and how diligent would they be if the whole stock market had melted down? Anybody's guess.

Gold futures offer a much more leveraged, flexible way to own "paper gold", and if you're adventurous and willing to take on the much higher risk of speculating on gold prices (as opposed to just using gold as a store of value), they are by far the most flexible instrument. But if there were a systemic meltdown, counterparty risk would be extreme. A lot of the "sellers" of gold futures don't really have any gold to sell. As LYS described, they are selling contracts they can't deliver on with the intention of "cash settlement". In a meltdown scenario, they wouldn't have the cash to settle with. Listed futures traders are protected (in theory) from direct counterparty risk through the COMEX exchange mechanism, where the COMEX itself actually maintains a warehouse full of gold bars to settle contracts, even if counterparties default. But there has been a lot of recent talk about a "run" on the COMEX, which could never deliver against all the outstanding contracts if there were a massive systemic default.

So you can think of this as a continuum. Gold futures are the most flexible, most leveraged, and by far the most risky way to own gold. Physical gold in a vault (preferably offshore to mitigate confiscation risk) is the safest way to own gold. The ETF falls somewhere inbetween.

Erik

 

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randallriggs
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Re: Read This Excellent Post by Erik T.

Erik:

 Thanks for the explanation! I currently a lot of the GLD ETF but plan to get some gold for my personal safe keeping too. If the financial system started to collapse, don't you think the gold etf would go up a lot? I do. My plan has been to sell it when it hits my trigger of sa, 1500 or so. Some people say it'll go to 5k or more. I don't know about that. If it does go to 5K, I'm going to immediately buy the DZZ etf to capitalize on the fall which I'm sure will happen too.

Your thoughts?

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Erik T.
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Re: Read This Excellent Post by Erik T.

Randy,

You have the right idea, although in my personal opinion you might shoot for a higher price target. I think Gold could easily hit 2000 or so, and that can happen without the system collapsing in a way that would risk the security of your investment.

I also believe that the $5k+ price is entirely realistic for the physical metal, but for that to happen the rest of the system would have to be in an extreme crisis, and I wouldn't trust the ETF under those circumstances.

Overall, it's a really tough call. You pay a pretty steep premium for physical (vs. paper) gold, then you have to figure out how to store it securely. The paper options are much, more "simpler", but they cary very real risks in a systemic crisis.

Erik

 

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Set
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Re: Read This Excellent Post by Erik T.

I’ve been following this website for several years now and I believe it is one of the best gold related sites available. Jim Sinclair is encouraging anyone who can afford to invest one hundred grand to buy a futures contract or as many as they can afford and most importantly, Take Delivery. This, he maintains, is the only way to bring the naked shorts under control.

He puts his money where his mouth is and takes delivery of one contract each month. Additionally, he has a one million dollar bet that gold will be at or above $1650 before January of 2011. His only concern is that he has substantially underestimated the value by this date. The best part of buying gold at the COMEX is that you avoid any premiums at all.

http://www.jsmineset.com/

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Re: Read This Excellent Post by Erik T.

I don't understand why the government prints money to pay for bonds, which it has to pay interest on, instead of just printing money to pay expenses, employee payrole, government contractors etc. This alternative would still accomplish the goal of introducing new money into the system, but wouldn't cost the taxpayers interest. I also think this is less inflationary. Inflation happens when sellers want more money for their goods or services and buyers are willing to pay. Giving the new money to wealty bond holders is a group of people most able to pay inflated prices. Giving the money to employees as standard pay checks does not give them any windfall income, and these people will strongly resist paying more and thus not fuel inflation. I am not suggesting that all bills be paid this way, but just a similar amount as is currently created

This would also break the "vicious circle".

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Set
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Re: Read This Excellent Post by Erik T.
Roy wrote:

I don't understand why the government prints money to pay for bonds, which it has to pay interest on, instead of just printing money to pay expenses, employee payrole, government contractors etc. This alternative would still accomplish the goal of introducing new money into the system, but wouldn't cost the taxpayers interest. I also think this is less inflationary. Inflation happens when sellers want more money for their goods or services and buyers are willing to pay. Giving the new money to wealty bond holders is a group of people most able to pay inflated prices. Giving the money to employees as standard pay checks does not give them any windfall income, and these people will strongly resist paying more and thus not fuel inflation. I am not suggesting that all bills be paid this way, but just a similar amount as is currently created

This would also break the "vicious circle".

As I understand it, the government doesn’t print money to pay for bonds; the Federal Reserve does that.  The Treasury then trades interest bearing bonds for the Fed’s fiat currency and our taxes are used to pay the Fed interest on those bonds.  That is one reason why the Federal Reserve Cartel is a severe hindrance on our national welfare and should be abolished.  It serves the interests of politicians by allowing the Fed to create money or inflation, which is really just a tax in disguise.  Since most people don’t know this, the politicians and bankers make out great, but “we the people” suffer.  The Federal Reserve Act allows politicians to not raise taxes officially, which would make them unpopular and possibly prevent them from being reelected.  It benefits the shareholders of the Fed by allowing them to collect interest or more accurately, usury, on money that is virtually created out of thin air.   

A very interesting book is at the top of the recommended reading list and it’s called, “The Creature from Jekyll Island.”  Men such as Thomas Jefferson, Andrew Jackson, Abe, Lincoln, and many others understood the danger of allowing a private entity to create our money and to not back it by something tangible such as gold or silver like it even says it is supposed to be in our Constitution.  Today, when a politician such as Ron Paul suggests that the Fed be abolished, the vast majority ridicule him as though he’s suggesting something absurd and our main stream media which is controlled by corporations hurts the interests of the American people even further.   

In the late 1800’s the Supreme Court allowed for the creation of a “corporate personhood.”  This was a big mistake and should also be given a second look because it gives an enormously unfair advantage to the corporations.    

 

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Lemonyellowschwin
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Re: Read This Excellent Post by Erik T.

Actually, that's not a bad question.  When I was a kid one time, I asked my parents:  "Why doesn't the government just print money when it needs to do something?"  I can't remember the answer, but it was a legitimate question then and it's a legitimate one now.

Here is my stab at an answer:  All fiat currencies have a shelf life.  The best a country can hope for is to have its currency have a nice long prosperous life full of great accomplishments and fond memories. . . sort of ike my 100-year old grandmother.  Now, everyone knows deep down that printing money to excess destroys the money.  So if it's going to be done it has to be done in convoluted way that the masses don't understand, or else the gig would be up sooner rather than later and there'd just be no point to the game of seeing how long you can get your currency to last..

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