Thursday, October 8, 2009, Boris Borisov on the return to Gold Standard: "There is no spoon..."

Here is a very well articulated opinion on gold I found on the Russian site I've translated it with a few minor omissions. The Russian original can be found here: Выход из кризиса: кризис, кредит и золотой сценарий. An executive summary: the author views the present financial crisis as a crisis of the fiat money system. He sees no alternative to gold standard in the long run and estimates the resistance level of gold price at $10,000 per ounce in today's money. A broad brush picture of the post-fiat-money world is painted with a few zesty details.

Exiting the crisis: crisis, credit and the Gold Scenario

In order to understand what the present crisis is, one has to see it both on a real time scale and on a real scale of values.

Speaking of Time. The global economic history, the history of world trade -- that's many thousand years of goods exchange, a significant part of which, also measured in thousands of years, is the monetary phase. And all that time is the era of real values in circulation. The goods had real value and so did money -- gold, silver and the like. Up to very recent time, international credits used to be given and taken mainly in gold. A recently discovered gold-laden WWII ship, which was sunk on the way to the US, with several billion dollars worth of the yellow metal in today's money -- including our Russian gold to pay for military shipments -- is a good proof of the point. Gold was the main accounting tool and the main security of international exchange during both WWI and WWII. It is only for the past 60 years, following Bretton Woods, that we have a system of debt exchange in place of real value exchange in the international trade. That's a radical, qualitative change.

Circulation of debt instead of circulation of values and the consequences of the change of an economic model

Clearly, any bank note is debt, of either a bank or a state, in paper form, and a replacement of gold circulation by bank note circulation changes the essential grounds of the economy, and then, of the world order itself. The world center of power always moves toward the emission center, a change in the character of emission has changed the world economically, politically and in the military sense. In fact, after the war we got a debt circulation instead of real money circulation. Even before that, this happened inside the national economies, in the finances of the developed countries -- which was among the important reasons of the world crisis of 1930-s: both the Great Depression in the States and of an economic crisis in Europe.

Notice that the crisis of the '30s struck the groups of countries with the most developed financial and banking systems, where the real money circulation had been replaced by the debt circulation even earlier and on a deeper level -- and the crisis was to a large degree caused by the problems in the debt market. One has to understand that after several thousand years of real money circulation, only for a few decades have we had the pleasure of witnessing the beauties of the credit money circulation on a large scale. That's only about one percent of our time scale, while 99% of it is taken by the real money circulation. To conclude on such shaky and very short-term grounds that the world economy will continue to be a debt economy would be very imprudent. But that's not all. Notice the following. These sixty years consist roughly of two cycles, each one about 30 year long.

The first three decades after Bretton Woods -- that's the circulation of, for the time being, gold-backed debts, which suffered a crash by 1972, when the gold standard was abolished (that was a gradual, step-by-step process, but we will omit the details for now.) The second thirty years that finished in front of our eyes -- that's the crash of the fiat debt system as the basis of the international trade and money exchange. It is evident now, that this experiment -- the building of a global trade and exchange system on the basis of fiat debt -- has failed. We are witnessing this crash, the crash of fiat money economy. That is the essence of the present crisis. [...]

From the formula: "money is gold and gold is money" we went over to the formula "money is backed by gold" and later, in Bretton Woods, to the formula "US dollar is backed by gold while other currencies are backed by dollar" (initially, pound sterling was part of that formula as well, but it faded away later), and after 1972 we made a transition to the formula "money is backed by US dollar, and the dollar isn't backed by anything". Only a very, very naive person can be surprised that such a set-up ended in a crisis.

Speaking of how the situation might develop. The forecast of Mikhail Khazin and Andrei Kobyakov, as far as I understand, is that the dollar economy will crash and the world will unavoidably fall apart into several independent currency zones. This forecast was formulated almost ten years ago and the wave of current events confirms its main points. They believe that the present "anti-crisis measures" resemble attempts to "extinguish fire with kerosene".

Being solidary with their stance in general, I would like to note that generally speaking, one can extinguish a fire with kerosene. It depends on the amount of kerosene. If one pours a hundred liters of kerosene on just one liter that's burning, it's quite likely that the flame will be beaten off. My point, a remark on their stance is that I don't rule out a possibility that the USA will overcome this stage of the crisis as well, and will create another one -- a third one, in which not only will we see a circulation of fiat debt, but an exponentially growing circulation of fiat debt, and watching the charts of the rising US state debt, we clearly see that we are already in this third stage.

Elements of such an approach, such a solution to the financial difficulties have been seen in the policies of the world emission center for at least the past ten years. For reasons of pure mathematics, this can't last too long. Of course, for that one needs to pour on the presently burning fire of the economy not a mere trillion, but 10-30 trillions of dollars. As a result, the crash will be delayed and we will come back to it in a number of years, but with the sovereign debt of the US not of 10 as it is now, but perhaps 20, 30, 50 or 100 trillions -- that is, more than the world's GDP, which is variously estimated to stand now at 70 to 80 trillions by purchasing power parity. That's not a necessary, but a possible scenario. And only later will the predicted tearing apart of the world economy blanket take place, with the zones of influence of great powers and regional currencies. In other words, I state that the USA still have a chance to delay the end. They've even got some opportunities for counter-play here and there.

Gold as the basis of the new economic reality

In this scenario, a very important question is how these regional conglomerates of economies, the various currency zones will balance each other's accounts. My view is that in such a situation, gold will unavoidably return as the main tender of the global, inter-regional payments. One can't see even a slightest alternative to that.

The main argument of the critics of such a thesis is that "there won't be enough gold". In that, they price gold at its present level, not understanding that the change in the role gold plays, its return to the function of international tender, will unavoidably lead to a rise in its price to the level where its grand total price will dynamically match the price of the flow of goods and capital flows, which it will have to service. It is striking that the arguments in the spirit of "there won't be enough gold" are heard even from authoritative sources. This can't be explained in any way other than by their affiliation with the structures which in one way or another have their share in the profits of the dollar emission.

Recently we've seen the growth in the price of a barrel of oil from $15 (a year average for 1994) to $148 (2008), that is a factor of ten. Can gold appreciate ten-fold? Yes it can. Can it appreciate hundred-fold? Yes it can, provided there are economic grounds. One has to understand, that "there is no spoon" -- there is no upper limit to the gold appreciation. The price of mining does not limit such an appreciation in any way: we have seen the oil price near $150 while there are production sites where the cost of production is, say, $5 per barrel and that had no effect on the final price.

I would like to remind you that after abolishment of the gold backing of the dollar, gold quickly enough appreciated ten-fold (1970 -- $36 per ounce, 1979 -- $307 per ounce, year-averaged prices. In 1980, it got even to $613, but then it rolled back to the level $300-$400), and after the credit pumping of the US economy began in the early `00s, it appreciated three-fold in the decade.

There is no upper limit altogether. But significant economic consequences there are: we may soon see a group of "nuveau riche", rich gold-producing countries, which will take the place of today's Arab sheikhs. In the last two decades, only six countries produced more than 100 tons of gold per year regularly. These are South Africa (300-400 tons), USA (300 tons), Australia (300 tons), Canada (160 tons), China (150 tons), Russia (150 tons). South Africa will become world's richest country. Australia and Canada will strengthen their standing on the world arena significantly. A global change in the world-economy weight of countries -- and even continents -- is very much expected and unavoidable. Among the "nuveau riche", we will see Peru, Ghana, Papua New Guinea and some other ones which today are perceived as, pardon me, world's ass... Some countries neighboring South Africa, such as Angola, have considerable gold deposits, but their rise will depend on external security sponsors ready to install there "constitutional order".

In that sense, by the way, the answer to the question of "why Russia needs to build aircraft carriers" becomes a lot more evident, since only by maintaining a friendly regime in such countries by military force, can one expect to gain broad access to their resources. Right now, it costs a few dozen tons of gold to build an aircraft carrier, but in a new Golden Reality it will cost just a few tons. A military-political Gold Game abroad will be worth the candle and the cruise missiles.

Let me remind you that in the recent past, Angola hosted our strategic aviation base, which kept the southern Atlantic and the Indian ocean in check, while our interests there were guarded by units of Cuba army, ethnically more close to the local populace and without a "white colonizer" stigma. That's to the question of why Russia needs Cuba, and how our immediate future can be arranged. In our near abroad, counting on the Gold Scenario, a lot more attention needs to be payed to Uzbekistan which now produces almost 100 tons of gold per year, which is comparable to Russia and Central Asia in general.

Note that when I say gold, I mean all noble metals and even precious stones, including silver, platinum, other metals, diamonds and other precious stones. The appreciation will touch them all, although not evenly. Therefore for Russia it's likely fortunate despite the tiny size of our bank reserve of gold, since Russia has considerable reserves of gold in poor mineral deposits, and even in the XVIII-XX century dumps (tailings), which are uneconomical to develop at the current level of gold price just yet.

It is clear that within the framework of such a forecast, the approaches toward international politics undergo substantial changes. The African direction becomes one of the key ones in the world politics, rather than an honorable demotion for diplomats. In such a vision of the world, Africa is the future field of confrontation of the great powers, and one needs to begin establishing beach-heads there already now, until it is too late. By the way, we will have to lock horns there not with the US, but with France, which continues to consider Africa to itself something like what we consider Central Asia to ourselves.

Meanwhile, the role of oil will be gradually, slowly but steadily decline -- but that's a special long discussion. In essence, we are now living in the years of peak oil or close to that -- in the years of both maximum physical oil production and of maximum impact of the oil factor on the world politics and economics. And while today's physical oil output may be exceeded, its relative share in the world economy will begin to decline gradually in the XXI century -- just like it happened to coal in the XX century, even as the physical output of coal was growing, and growing quite fast.

While the role of, say, uranium will grow, which to a large degree is an African (and Central-Asian) theme. The Russian president recently expressed something along the lines that sooner or later the crisis would be over, and one needs to get out of it having gained in strength. First of all, I want to say, of course: "Gentlemen! You want to get strengthened, not weakened? Very good. Increase the fraction of gold in the gold and foreign currency reserves, to begin with, at least ten times. You will gain in strength all right." That's another theme, not the main one, of course -- the main ones are within our own economy -- but quite a working one -- to go to Africa. Having come to Africa in all seriousness and for a long time (that's gold, uranium and diamonds) we will exit the crisis in a completely different weight category. Yes, it doesn't hurt to make a dozen or so coups d'état there. There are huge discounts on them and a broad selection of offers. It's a buyer's market, if you will. And the buyer, as we know, is always right.

Gold as the world money

What will happen if the gold becomes world currency? If will begin gaining in price. How much? We can do quick math. Russia's gold reserves were about 500 tons in 2008. That's about 3% of our gold and hard currency reserves, which is very, very, very little. And this is while we are producing 1,500 tons every ten years, and can produce more. Speaking of the period before 2006, when gold went from the level $300 per ounce to $500 and continued to grow up to the present price of about $1000. The average gold price for the first half of `00s was $400 per ounce, $13.4M per ton to be exact. Russia's gold and hard currency reserves at the end of 2005 were $180B, out of which gold was a tiny fraction. Had the money been invested not in the American paper of various sorts, but into gold-group metals, Russia would have had by now extra $250B or gold and hard currency reserves, plus about $150B which could have been raised in the second half of `00s. Russia could have had a positive balance of gross national debt (sovereign and private) of about $500B (alas, today the debts and the hard currency reserves are about equal) and could have been watching the global crisis like an entertaining movie from a VIP lounge, having grabbed a cup of pop-corn. [...]

World's top three gold reserves:

USA: 8,135 ton
Germany: 3,428 ton
IMF: 3.217 ton

In reality almost all this gold is physically in the US, including the German gold. On balance, there are about 15 thousand tons of gold in the US, not counting that belonging to banks and private parties. Counting private gold, the total may be close to 20 thousand tons, which is about half of the global gold assets (and the global reserves count about 30 thousand tons in state reserves and about 10 thousand tons of private gold). About 80 thousand tons of gold globally is immobilized in jewelry, according to GFMS, it's on fingers and ears and we don't have to count it -- without hunger, war and plague it will not enter circulation. All that gold -- all the global gold not counting jewelry -- now, at the current price of $30M per ton -- is only about $1.2 trillions. [...] Of that gold, about half is in the US and a quarter is a property of the US government. Note that Germany which does not mine gold, having a GDP similar to ours, has seven times more gold reserves.

Based on these numbers, we can estimate the growth potential of gold in the scenario when it turns into international tender. Of course, this is a very approximate calculation, based on the balance between dollars and gold. The dollar banknotes, the little green pieces of paper, are not too numerous in the world. In January 2009, according to the Federal Reserve Statistical Release, the M1 aggregate was at 1575.0 (roughly, $1.5 trillion, year-on-year rise was 15%, out of which $800B was cash), the M2 aggregate was at 8244.0 (roughly $8 trillion), the M3 aggregate is no longer published.

By the way, quite recently, in 2006, data were published, according to which 2/3 of US dollar cash was circulating outside the US. The global economy demand for international tender along with gold and hard currency reserves can be estimated to be of the order of $10 trillion(currently these transactions are settled in US dollar, Euro, barter and partly in gold), which indicates that in the gold-based model of the world economy, gold can appreciate about an order of magnitude compared to today's price. That's a very rough estimate, but it's on target. More accurate estimates are practically impossible. In this case the USA will make a few trillions only on the dollar appreciation, which is about half the present federal foreign debt. One can not ignore this when evaluating the prospects of the USA in the Golden Economy. Let me emphasize once again that the USA has a good counter-play no matter what course the events take. Whether they will play their cards right is another question.

Gold production and emission

To check the gold forecast, let's compare the investment potential or fiat money with that of gold. Emission of fiat money (in reality, the predominant part of monetary emission is bank accounting records, not cash, therefore a more accurate term would be credit emission) fluctuates strongly year by year. The numbers for the US have been quoted above. On gold: 2.7 thousand ton was mined globally in 2007, which in today's prices (of around $1000 per Troy ounce or $30M per ton) is about $70B. Metals of gold-group have to be added to this amount, of course -- in total, we obtain about $100B of yearly emission in gold. Out of that, industry consumes about 1000 ton.

If the global GDP will, as in the past years, grow at the rate of 2-3 trillions a year, and the regular demand of new money emission globally will be about a trillion dollars (in today's purchasing power), then the potential, the upper limit for the gold's appreciation in case of a transition to gold-based transactions is up to ten times compared to today's price. Of course, the new price ceiling will pull into active use those gold deposits which are at the present level of price uneconomical to develop. (Today's global average production cost of gold is about $10 per gram, which is about $300 per Troy ounce, with large spread country to country). This will change the accumulated reserves little, but will affect new gold entering circulation which possibly will not let gold reach the upper limit of $10,000 per ounce. But under any scenario, we confidently forecast the gold price to increase by a factor of several times in the coming decade.

If you've got other assumptions, other input to apply when determining the "fair price" of gold, I will be glad to hear them. Of course, a change in the world economic order may decelerate the global economic growth very much (and during the recession phase, gold may not appreciate at all), but in general, our preliminary estimate that in the gold standard framework the appreciation of gold will be bounded in a broad corridor from today's price gradually upward to the resistance line at around $10,000 per Troy ounce -- that forecast is confirmed by the emission-based calculation as well.

Obviously when I say "an ounce of gold may enter the level of $10,000" I mean its purchasing power in the global commodity markets -- energy, metals, food -- in other words, an ounce of gold will be able to buy the same basket of commodities which now sells for $10,000. How much the dollar itself will be worth, and whether it will survive as a legal tender in the international transactions, can not, in my humble opinion, be subject to any forecast at all, since the gold volume is physically limited while the dollar emission is not. To economists of the 1960s, today's dollar emission numbers would read like letters from the madhouse.

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