Gold and Silver Historical Declines
Part 1 – The Dollar Does Matter
20 August 2008
The weekly closing spot price for gold and silver in mid-March 2008 were something to cheer about. Gold hit a new all time high of 1,003.50 and silver was trading at prices not seen in 28 years. But that was 24 weeks ago. Now in mid-August 2008, gold and silver prices have dropped like a rock for weeks as the dollar rebounds. I don’t blame anyone who wants to say “Ouch,” but this is not the time to say “Uncle” and quit on gold, silver or the mining shares. History will tell us why.
The most important thing to realize is that the US dollar as currently constructed has problems that are challenging to say the least.
The above chart shows the buying and selling of US Treasury obligations (US bonds) by the Federal Reserve in their open market operations. Since 1971 when the dollar was finally decoupled from gold to the present, it has been backed principally with AAA rated Treasury debt. The above chart is a 61 year record of the Federal Reserves Open Market Committee’s execution of their “monetary policy” using their portfolio of Treasury debt.
Think of the chart above as an EKG of the “Engine of Inflation.” Each time the plot strikes the 0% line, we see the Fed increasing the money supply to a new all time high via its purchases of US Treasury debt. The Fed can also remove dollars in circulation by selling this debt. Note that from September 1949 to May 1950, the Federal Reserve sold 25% of their US Treasury bonds. However, remember that in 1949 US reserve gold was also used in “monetary policy.” So from 1947 to 1971, this chart lacks important details of the Federal Reserve’s and US Treasury’s operations in the central bank market for gold reserves as well as omitting the Fed’s ability to dictate interest rates to accelerate or de-accelerate economic activity.
But it is a fact that that when the plot rests upon the 0% line, these are periods of easing monetary policy where the Fed is expanding the money supply. Easy money produces good times, bull markets and regrettably, inflationary price increases in goods, services, financial assets or all three.
The plot’s down-strokes inform us, in negative percentage terms, what portion of US bond reserves the Fed sold back into the bond market. When the Fed sells its US bond reserves they are tightening monetary policy by contracting the money supply. The down-strokes indicate times of tightening monetary policy. Tight monetary policy results in recessions, bear markets and deflationary price decreases in goods, services, financial assets or all three.
However, when we examine the actual values of the Fed’s bonds held outright (blue plot below) we see that on balance they have purchased significantly more bonds over the decades than they have sold. That was until August 2007.
The chart above includes a second plot labeled “Total Fed Credit.” The Fed holds monetary reserve assets other than US Treasury debt.
The Greenspan Fed’s policy favored using other reserve assets in its management of the money supply. The chart below plots Total Fed Credit (also called Reserve Bank Credit) backing the US dollar. Reserve Bank Credit comprises US Treasury debt as well as other reserve assets the Fed deems appropriate.
The point to understand from the charts above is that the US dollar’s reserves have had an unprecedented re-shuffling since August 2007. We see a 40% reduction of US Treasury bond reserve from a year ago while Total Fed Credit has actually increased. From the end of World War Two to the present, nothing like it can be seen in the 6 decades of “Open Market Operations” recorded on these charts.
Damn Irregular!
The Chart below plots the ratio of US Treasury bonds to Total Fed Credit.
Recalling a year ago (August 2007) when the “sub-prime” credit crisis became widely known, and the Federal Reserve became involved finding solutions to the credit crisis, these charts assume a new significance. Since 1947 the Federal Reserve has had to deal with many difficult situations. But the record shows that no previous difficult situation had forced upon the Fed so drastic a solution.
People should wonder what happened to those Treasury bonds. Importantly, what did our “monetary policy makers” purchase as the replacement for those Treasury bonds they sold? Is the US dollar now backed with sub-prime assets that the Fed knows are worthless but are holding for reserves at full face value? In any case, something replaced those US Treasury bonds as Total Fed Credit has increased over the past year.
Some will examine this information and with no more questions asked, believe our “monetary policy makers” have diverted the dollar’s reserve assets into Wall Street’s slush fund. But most people wanting to be fair will not jump to conclusions damning an institution they have been taught to trust. And that trust is important as in reality it is not liquid or illiquid debt that backs the dollar but the trust of billions of people who use the dollar as a financial asset.
Seeing the unprecedented actions the Fed took as a result of the current credit crisis, prudent people should pause to consider what is coming next. There is good reason to believe that the sub-prime mortgage crisis is just the first wave of defaults to come. Will the Fed be forced to purchase even more toxic waste from Wall Street’s balance sheets? After all, it is only one year into the crisis and the Fed has lost 40% of their Treasury bonds. If another crisis arrives, how far down can the Fed sell down their portfolio of Treasury bonds and still maintain the all-important trust behind the dollar. The concept of “too big to fail” may become too big to save.
Whatever is still to come, it will not be gold or silver becoming worthless.
My next article in this two part series will be looking at historical norms of the price of Gold. No one can doubt that since March 2008 the price of precious metals has gotten a good spanking. But gold has traded for decades and we should see what has happened in the past. We need to put the past few months into a historical context before we come to a firm opinion of how bad the last 5 months has been. In Part 2 of this series I will do just that.
Email this Article to a Friend 
Printer Friendly Version