Maybe There Is A Way Out

March 24, 2009

People everywhere are depressed and confused. Their depression is due to their net worth being severely lacerated and their confusion arises as a result of not knowing what to do next. The true predicament for the world resides in the fact that huge pockets of negative equity in the system rob the borrowers of any reward if they were to pay off a home worth less than the loan and threaten the survival of the lenders if the borrowers were to vacate their homes and ignore the bank. Because we are ultimately all linked by debt, the danger is that the loose threads will eventually lead to the whole fabric being pulled apart.

The central banks of the world in combination with various governments have attempted to overcome this predicament by lowering interest rates in the hope that if debt can become serviceable it will in turn underpin the value of the underlying asset. This would normally do the trick, but the existence of trillions of dollars of credit default swaps, CDO's, rising unemployment, falling consumption, failing banks and huge trade and fiscal imbalances have so far outweighed the positive effect of interest rate reductions.

Various governments are now introducing a stream of initiatives to remove these "toxic assets" from the system but even this may not do the trick and in fact may exacerbate the problems we are experiencing. More schemes, more cash and nothing to really show for the effort and the complexity. The positive reaction of the Dow Jones Index to Geithner's new plan could be as short lived as the response to his appointment as Treasury Secretary. Time will tell.

Unless the "solvency" issues of banks AND borrowers are dealt with, the current economic slowdown in process cannot be arrested and will in time become the greater problem and will cause a second round weakening of an already battered banking system.

So what comes next?

The world in my view lacks a common denominator. Real estate, stocks, bonds and currencies are in constant flux between regions. On one day you are holding a diamond and the next a piece of coal. This is not an exaggeration. Speak to the companies that have had their assets taken over by the government in Venezuela or the holders of certain bank shares in the USA which have seen values plummet deeper than a South African gold mine.

The common denominator used to be the US dollar whilst it was anchored to the integrity of gold. The beauty of this system was that in reality ANY currency could be a common denominator as long as it too was anchored to gold. This system failed for reasons that have been clearly explained by numerous learned individuals such as Dr Fekete and Darryl Robert Schoon. The gold standard's beauty did not lie in the gleam of gold but in the restriction it placed on the printing of paper into money.

As a result the world is in a Mexican standoff. Will the Chinese pull the trigger and lose their biggest customer as well as destroy their collection of American dollar bills? Will the US similarly pull the trigger and raise trade barriers whilst charging China with currency manipulation? Either act has the potential to leave the world without a reserve currency despite its sickly appearance and performance.

Around these two titans there are hundreds of nations watching with baited breath with no barrier between them and the possible fallout. The fingers of all players nevertheless remain on the trigger.

So what is left?

Once again the simple answer is gold and silver or at least a system or asset that can mimic their qualities in terms of uniformity, scarcity and general acceptance.

But how can gold and silver alleviate the current mess?

A PLAN FOR ESCAPING THE MESS

The various initiatives to date have proven about as effective as a one legged ballerina dancing with an armless male partner. Had the Federal Reserve and the Bank of England (amongst others) really understood the complexity and extent of the damage they would not have flip-flopped all over the place during the last twelve months.

The course of action I have sketched out below is very basic and would require significant refinement. In point form the following steps are proposed:

  • Governments worldwide would revalue all gold and silver by a factor of say 10 or more.
  • All gold and silver mining companies to be bought out by government also at 10 times the current stock value.
  • All mines that produce gold and silver as a by-product would require some sort of formula.
  • Holders of this gold would be obliged by governments to hand over their gold in return for a bank account with a credit for the gold sold to the government.
  • The holders of this account would not be able to make cash withdrawals. All they could do is buy foreclosed real estate (or certain distressed asset classes) for at least 110% of the value of the mortgage. Even though the value of mortgages is quite often more than the value of the real estate, the tremendous windfall from the sale of the gold would more than makeup the difference. The extra 10% would be for the mortgagor, providing the property was left intact and not vandalised.
  • This would remove from the market all the foreclosed properties which could then be rented or lived in.
  • The banks would then no longer be carrying the non-performing and negative equity loans. They would simply be entitled to make a withdrawal from the gold holder's account.
  • I presume that the sub-prime debacle which arose from the packaging and re-packaging of these sub-prime loans could then be unwound as the "cash" would exist to redeem these loan products. I acknowledge of course that the various layers of "pass the parcel" that were created could pose difficulties.
  • The credit default swaps time bomb would also be largely defused as companies would at a lower level of danger of default and therefore firms that had purchased CDS cover would no longer be entitled to a payout. Anyone who had purchased a CDS without having any exposure to the loan being insured would be told to "tear up their betting ticket".
  • The US government (and presumably all other governments adopting the above approach) would have its currency backed by gold and silver. In fact all banks internationally would be backed by precious metals. As long as nations did not once again resort to the printing press, nations could exchange currencies for payment. If there was not enough trust, then payment in gold could be demanded. No gold, goods or trust, then no trade. Any country crazy enough to run a balance of payments deficit or crazy enough to extend credit to such a nation or which kept accepting its paper would be asking for trouble. Everyone now lives within their means.
  • Once the danger was defused, the government would have to impose strict leverage limits on banks and other financial institutions. Lending would be limited to borrowers with at least 20% down-payment and so on.
  • Simultaneously, Credit Default Swaps could only be issued to parties that have lent funds and not to those companies which want to make a bet on the viability of the borrower.
  • Finally, the USA and other debtor governments with sufficient gold in their hands could reduce or eliminate the amount of foreign debt on their books.

I acknowledge that such a proposal as outlined above would all but eliminate the gold jewellery market but one cannot expect a flawless outcome. Many would argue that a revaluation of gold to such an extent would simply be another bubble. I largely disagree. We would simply be blowing up the gold balloon to its true capacity. In any case there could be many variations to the theme outlined above. In a nutshell I believe that the above proposal addresses the predicament of both lenders and borrowers, gives a reward to those holding precious metals and provides governments (and the IMF) with a substantial asset that is uniform, liquid and generally acceptable.

The decks have to clear and if this is to be achieved by some means other than a quick general collapse of mammoth proportions, then I see very little else that can be done to get things started.

The purity of gold is measured in carat weight.

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