The Alchemy of Financial Checkmate

Part - I

December 29, 1997

The key to financial independence is to know who will win the hidden battle between the U.S. dollar and gold.

This article is dedicated to the gold analysts at Gold Eagle, to whom I am indebted and humbled by their astute insights. In the spirit of academic debate, I welcome your comments or rebuttals to the arguments I present, in a spirit of seeking truth and wisdom.

The word alchemy is defined by Webster's as "an early form of chemistry, with philosophical and magical associations, studied in the Middle Ages: its chief aims were to change baser metals into gold and to discover the elixir of perpetual youth. Alchemy also refers to the seemingly miraculous change of a thing into something better."

In this article I will present two hypotheses on the potential outcome of the current battle between gold and fiat currencies. The first theory I call the "Kutyn" theory, after the astute Gold-Eagle analyst John Kutyn. This theory is based on the premise that gold will again resurrect itself as king of the financial world in the wake of defaulting currencies and economies ruined by unsustainable debt loads. The second theory, I call the "Alchemist" theory, after George Soros, is that the fiat alchemists will succeed in establishing a one world currency/electronic transfer system without gold. I will attempt to present arguments which support and refute both theories. I admit that I place my trust in gold, however, I am left with a nagging feeling that this trust is nothing more than a "fertile fallacy" (the words of Soros).

To begin this inquiry I draw your attention to the remarkable musings of George Soros in his book, "The Alchemy of Finance." Soros, the high priest of currency alchemy, presents provocative insights into the behaviour of markets and human fallibility. Soros presents his remarkable theory of market behaviour and history, which he calls "reflexivity" theory. Soros claims that the market is driven less by economic fundamentals than by the participant's perceptions which help to determine reality. Reflexivity is, according to Soros, a two-way feedback mechanism between thinking and events. Soros argues that his reflexivity theory has been helpful in developing a theory of history and is the basis of his success in the financial (currency) markets. He argues that the belief that markets are driven by the economic theory of supply and demand and that supply and demand are independently given cannot be reconciled with reality of the financial markets. Therefore, Soros argues, to understand markets requires a study of social science. He notes that it is the "observations" (or perceptions or feelings or bias) of participants that creates the effect and thus affects the "price" in the market. These remarkable insights should not float lightly past your intuition. What Soros is implying is that price itself may become, at certain reflexive moments, the key fundamental which leaves a "perception" or "feeling" or "bias" in our minds upon which we make our decisions. Is not today's gold market ruled more by the observation of "price" than by the economic fundamentals of supply and demand?

Soros argues that life itself is like a shoelace pattern where "when a situation has thinking participants, the sequence of events does not lead directly from one set of facts to the next; rather, it connects facts to perceptions and perceptions to facts in a shoelace pattern." He goes on to argue that the main force of history is the participants' bias and that the ideas that make history consist of "fertile fallacies." "A fertile fallacy is originally conceived as an insight. Only when it is translated into reality do its shortcomings become apparent. It then begets another fertile fallacy that is antithetical to it, and so it goes." He argues emphatically that what really drives both history and the markets is the participant's bias. Soros's brilliant insights into the workings of the market are matched only by his arrogance. In the epilogue of his book he brags that he likens himself as Keynes, Einstein or as a "god."

The Kutyn Theory: Gold is King; The Fiat Emperor Has No Clothes

The first hypothesis, I call the "Kutyn Theory", is that the world will once again wake up to the value of gold in a world awash with unsustainable fiat currencies and debt. That when the fiat currency game's bluff has been called, the price of gold will reach the moon, and that the fundamentals of supply and demand will once again rule the day. That gold will again usurp itself as the world's monetary standard or asset which gives value and support to any future medium of exchange. This is predicated on a faith that history will again repeat itself, that the laws of mathematics and physics will again rule in gold's favour.

The insightful works of John Kutyn on Gold-Eagle best represent this expectant theory of gold, although I would include Milhouse, Miller and most gold analysts and investors on Gold-Eagle in this philosophical camp. Kutyn's words best sum up this theory:

"if we accept that government bonds and currencies are at best an illusion of wealth, and that stock markets trading at 5 times book value may be over-priced in view of falling profits and currency upheaval, then the only investment alternative is gold. Realizing this, governments have driven down the price of gold. In order for the world to continue to believe in the government promoted illusion, the price of gold must continue to fall. If the world were not on the edge of an economic collapse, the price of gold would not be so low.... on a daily basis, we see a quickening of the impending doom. Soon the world will realize that the king (ed. notes: fiat currency) has no clothes... that which was, is no longer. It is then that gold will rise to incredible heights."

Many gold analysts on Gold-Eagle present impressive economic statistics and arguments to support this argument. That history will again repeat itself. Gold analysts are armed with statistics that show unprecedented imbalances between the purchasing power of the U.S. dollar and gold; unprecedented disequilibriums between the price of silver and gold; unsustainable imbalances between gold demand and supply. They present persuasive arguments that the launching of gold is only a heart beat away. But is it?

Kutyn in The Domino Effect article writes:

The demand for gold is now the highest it has been in the history of mankind. At the time demand is increasing, central banks around the world are telling people that gold is a terrible asset, while they flood the market with their gold loans to drive down the price. If ONLY 1% of the U.S.$12 TRILLION in Japanese savings moves into gold, this represents a demand for 400 million ounces at today's price. This will force all shorts to cover, which are reportedly as high as 8,000 tons. Combined with normal industrial demand, this would explode gold demand to a level equivalent to 10 years of mine production. Should more than 1% of Japanese savings, or other investors in the world purchase gold, even this number will be ultra-conservative. Having said that I must observe that in the short-term, the price of gold may continue to suffer... due to the public's current mis-guided perception of gold. NONETHELESS, it behooves us to understand and appreciate that the short position is so huge that it cannot possibly be covered. Therefore, the only hope for salvation of the shorts is (try) to destroy the value of gold.

Milhouse in his article "Gold versus the Dollar" writes:

If doubt arises regarding the quality of the debt which provides the asset backing for a currency, then capital will shift from that currency into an alternative investment. Gold, a tangible asset which has been valued as a store of wealth for thousands of years, provides an ideal alternative.

Both Kutyn and Milhouse present rational arguments, that on the surface, appear sufficient in explaining that the reason the sentiment towards gold must remain depressed is in order to maintain the illusion that the emperor still has clothes, that the U.S. dollar and other unsustainable fiat currencies are still king. Again, in this sentiment lies a belief that a shift in the bias of the participants will only occur when the confidence wizards have lost control of the system or the faceless, ruthless currency traders, like Soros, will pass judgment on these fiat systems that are inherently unsustainable.

Kutyn makes a very rational argument, which aligns with my own thinking about physics and the laws of thermodynamics. Kutyn writes:

The laws of economics are like the laws of science. They are based on logic and reasoning and pure mathematics. When man chooses to ignore these laws or create new ones unto himself, he must face the ultimate consequence. One day we will go to sleep as the world is now. And when we awaken, it will have changed in a manner that will never be the same."

In the end, finance comes down to simple mathematics, nothing more nothing less.

Why should we believe that under the conditions of today's markets, that mathematics, like some rational police officer, will preclude the alchemists of fiat currency systems to continue to achieve dominion with paper currency? While I too am mindful that the powers of magic, illusion and financial alchemy, which are the basis for our exponential liquidity and which rule today's financial world, are out of step with the laws of physics, including scarcity of resources and entropy energy laws. While I would like to believe in the laws of science and mathematics passing judgment on the unsustainable alchemy of our current fiat currency system, I am still left wondering whether the opposite is not possible.

Enter Milhouse's ominous argument (Gold versus the Dollar):

Those who are advocating the Central Bank conspiracy theories are failing to appreciate a very important point : The primary reason to own gold as an investment is because it is not controlled by central banks and governments. We are about to witness the transfer of wealth from the many to the very few. The savings of the many have been spent building and investing in assets that are now worth far less than the savings of the many. However, in a financial collapse, these tangible assets, the buildings and manufacturing capacity will be the only assets remaining. Whoever owns these assets will control the wealth of the world.

Indeed, Milhouse seems to have foreshadowed what is now taking place in South Korea through the IMF bailout and has occurred in New Zealand. The savings of the average South Korean has been rendered worthless, the government is nearing bankruptcy, and the won has been nakedized. Yet the IMF agrees to bail out the South Koreans with demands for collateral that include wholesale restructuring of their "unsustainable" financial systems, plus tangible assets (buildings, factories) which provide the basis for future economic activity and manufacturing capacity, Indeed Milhouse is right, whoever owns these assets will control the wealth of the world. I ask a simple question: who owns or runs the IMF and what is their agenda? Shouldn't we ask these questions given that other governments turn a blind eye to the plight of their Korean brethren, yet the IMF are willing participants in throwing them a life-line, with enormous strings attached. Could the IMF constitute the same merchant banking fraternity that manages the Bank of International Settlements?

Milhouse's point that the majority, some two thirds of the world's gold supply is actually in private hands should not go unmentioned. I have always wondered how it is that if the world's central banks claim (I mean "claim" since their official supplies remain unaudited) they hold one third of the world's supply how they can have more impact on the "perception" of gold than the two-thirds majority private holders?

Milhouse is also clear and correct on another major issue, that what we are witnessing is a war between the U.S. dollar and gold as part of a major confidence game. Milhouse notes:

The entire US financial system is based on confidence - the confidence of foreign investors who continue to pour money into US dollar assets, and the confidence of local investors who are betting their life savings on a continued stock market boom. Recent experience in Asia suggests that this extraordinarily high level of confidence in financial assets may be overdone. In the near term, the above-ground stock of gold will most likely continue to be a hindrance to any sustainable rally in the gold price. The supply of gold will probably increase over the coming months as European CBs sell gold in the lead up to selection of the initial EMU participants in May 1998. At the same time, uncertainty regarding EMU and on-going problems in Asia should continue to support the US dollar. However, it must be remembered that there are 3.8 billion ounces of gold in the world and the supply is increasing by 1.75% each year (probably less for the next few years due to mine closures), whereas there are 5,300 billion US dollars in the world and the supply is increasing by 9% each year. The end result is obvious.

Kutyn offers one of the most important pieces to understanding the war between gold and fiat currencies:

World wide currency values are presently extremely unstable. Fluctuations will increase until most currencies in Asia are destroyed. Will commerce then take place in U.S. dollars, or a currency backed by gold? Possibly, the financial chaos in the world will be blamed on too many unstable currencies, the only solution being a common world wide currency. Whoever issues money has many economic and political advantages. We are presently seeing a hidden battle between gold and the U.S. dollar. This battle will continue to intensify until the crash in Asia is complete. The key to financial independence is to know who will win this battle."

Kutyn's provides wisdom where there is currently noise and confusion. I personally believe Kutyn is right that a one world currency is in the making by those who understand its economic and political advantages. The key question in my mind, which is the basis of my second theory is: does this new currency require gold to support its value?

China has only 2% of its Total Foreign Reserves in gold.