Monday, February 1, 2010

Eric Sprott On How Central Banks Are Setting The Stage For The Next Big Move In Gold

A brief look at the contentious gold/central bank history as it is about to rhyme all over again:

The Federal Reserve System was created in 1913 on a promise of stabilizing the banking system. What followed instead was an unprecedented growth in fractional reserve banking, as well as the money supply, which helped fuel the roaring 20’s. The aggressive money printing created inflated values in bonds and stocks, which peaked in 1929. When the market began its precipitous slide, and the public began to realize that stock and bond values were artificially high, the populace began to convert its cash holdings into gold. The government lacked the ability to satisfy that demand and was thus forced to renege on the currency’s founding promise of gold convertibility. It’s important to point out that without this original promise of convertibility for citizens, the currency may never have been adopted.

In 1933, The Gold Reserve Act was passed by Congress and formalized into law the breaking of the gold standard. This law provided for a controlled-currency issue through the Federal Reserve System which was non-redeemable in gold. Although the link to anything tangible had been broken, the citizens had little choice but to continue using these non-redeemable dollars as a medium of exchange. The currency had already been broadly accepted, proven convenient and a perception of safety had already become entrenched.

After forty years of continued dollar printing, in August, 1971, President Nixon effectively declared the US dollar to be a completely “fiat” currency by refusing to allow foreign governments to convert their US dollar holdings into gold. The right of conversion which had been granted under the post World War II, Bretton Woods agreement could not be honored because of decades of money supply expansion. The original ‘promise’, which had vaulted US dollar to its status as a global reserve currency and a stable store of value, was now completely broken.

These historical events resulted in a world in which all currencies are fiat; they are not backed by gold or any other tangible asset. The supply is infinite. In fact, the production of today’s newly created paper money in relation to historical commodity-based money is akin to counterfeiting. A US dollar printed today has no ties to anything tangible and as a result carries only four cents of the equivalent purchasing power of a gold-backed dollar of 1913. It is ironic that in a poor choice of wording on Wikipedia, the definition of counterfeiting states that “it is usually pursued aggressively by all governments.” It is only because the evolution of money has occurred slowly over generations that the obvious flaw with fiat currency is not widely understood.

Why Gold, as a consequence of 90 years of paper debasement, will be the next big thing.

We are gold investors because we have made a specific and calculated bet against paper money. Simply put, we are betting against paper money as a store of value. We believe its supply will continue to increase. We do not believe that the world’s major governments have any stake left in protecting it. Government debt loads have grown so massive that printing them away has become obligatory - there is no longer any other feasible option left. In our view, the savers of the world should already be outraged by the dilution they have been forced to suffer at the hands of the Central Banks. Are we to infer that the limited reaction of savers to the combination of zero interest rates and debasement of currency is a result of “learned helplessness”?

In our opinion, the lack of overt inflation to date due to the "successful" implementation of globalization, aka exporting inflation to China and anyone else who needs to purchase US securities, is the sole reason why there has not been an explosion in fiat-denominated prices to date. Yet as Zero Hedge has been pointing out for several months, the global trade picture is now dramatically changed, and China will need to look inward rather than outward. This means, that sooner or later exporting inflation as a fiat policy will fail. When pundits finally comprehend this and start blaring about it every day on CNBC, that is when the rush to gold (plated) safety will finally become acute.

And since in a fiat-debased world, everyone wonders where gold will hit (which in principle is the wrong question, as monetary representation of value will very likely cease should Central Banks finally lose control over the infinite dilution mechanism), here is what Sprott believes:

We also wanted to prepare our readers and clients for the next leg of the gold bull market as it will prove to be extremely volatile. Gold bull markets are unique in that buying becomes driven by both fear and greed. Gold is quickly moving into the hands of those who are unwilling to gamble on fiat currencies or bonds as a store a value. The new owners of gold are unconcerned with its lack of yield but instead are focused on its historic ability to preserve wealth and its unquestionable value. Given the difficulty we have valuing paper money, it becomes extremely difficult to come up with a reasoned price target for gold. Today’s gold market is significantly different from the gold market of the 1970s for two reasons: 1) Central Banks are more likely to be buyers of gold today and 2) They clearly have little ability to dramatically raise interest rates with the massive increases in government issued debt. Thus, it is easy to envision a similar twenty-five fold increase in the gold price that was seen between 1970 and 1980, which would result in a gold price today above $6,000 per ounce. We expect the often quoted “1980 inflation adjusted high” of approximately $2,200 to be achieved in short order. These targets may well prove to be irrelevant, however, as the quality of our lives will be more greatly impacted by the continued evolution of our money and how the general public chooses to value it, or not.

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