Game Plan

by Kevin D. Freeman

  Bear Market Redux

  One way to set off the domino effect is a “bear raid” targeting one or more systemic companies. This is what George Soros says started the 2008 crisis, as we’ve discussed.50 While some argue that bear raids do not exist, most on Wall Street realize they can and do occur.

  Unfortunately, none of the safeguards necessary to prevent future bear raids has been implemented. The so-called price test rule or uptick rule, as we’ve discussed, has been rejected. The only rule in place, an “alternative” rule that applies only when the price of a share drops by more than 10 percent, “would not have stopped the bear raid on Citigroup on November 1, 2007,” says Professor Yaneer Bar-Yam of the New England Complex Systems Institute. “This is only one example of the deleterious effects of the weakened rule. The overall effect of unregulated selling of borrowed shares is surely much larger and continues today.”51

  Most assume that bear raids are carried out for profit. But as I demonstrated in my Pentagon report, they could also be used as weapons of financial terrorism or economic warfare. A bear raid targeting a systemic company has the potential to destroy the entire economy. That was true in 2008 and is perhaps even truer today. The initial effect would be deflation.

  In the case of a bear raid, you want to be out of stocks initially and look for bargains among companies that can survive any short-term collapse. These would be fiscally sound companies with strong earnings power even in the event of extreme economic weakness.

  No Longer Solvent

  An entirely different form of collapse could occur if the banking system suddenly became technically insolvent because of loan defaults on a massive scale. Systemic bank insolvency may sound unlikely, but there are persons who would like to see it happen. Stephen Lerner, the ferociously anti-capitalist head of the Service Employees International Union, has called on state and local governments to cut off all business with banks that don’t pay confiscatory tax rates, don’t slash interest rates, or refuse to forgive homeowners’ mortgages. What he is encouraging amounts to a countrywide strike against the banks.52

  The effect of such a run on the banks would be insolvency. Bank account balances over the FDIC guarantee level could be confiscated. More troubling still, the FDIC has enough money to cover only a small portion of the nation’s banking deposits. As Peter Schiff says, “While the FDIC currently has about $25 billion available to bail out failing banks in the event of isolated events (mainly held in U.S. treasuries that would need to be sold), it insures more than $10 trillion in deposits. Clearly it lacks the resources to cover major losses in a systemic failure. A failure of just one of the nation’s forty largest banks could swamp the resources of the FDIC.”53

  As with a network collapse, a major banking failure would make it nearly impossible to get cash out in a timely fashion. It would also hit stocks and bonds. This type of calamity would be deflationary at the onset.

  Interest-Rate Jump

  Since the 2008 crash, the Federal Reserve has kept interest rates artificially low, making it easier for the government to finance its massive debt. At one point, Treasury rates were as low as 1.6 percent.54 Over the past hundred years, ten-year Treasury rates have averaged 4.9 percent. If rates simply went back to their hundred-year average, the federal government’s costs would increase dramatically. While not all federal debt is funded by ten-year Treasuries, as an illustration, an increase of 3.3 percent in the interest rate on almost $17 trillion in debt would cost an additional $561 billion. That is about 20 percent of the total federal tax collections expected in 2013.55 And if rates ever approached their peak of 15 percent from the early 1980s, the added cost would roughly equal 85 percent of all expected taxes in 2013. And that is not even considering the effect of higher rates on the economy, which would undoubtedly depress tax collections. The reality is that higher interest rates would dramatically hurt bond prices. That is because bond prices fall as interest rates rise.

  Most stocks perform poorly when interest rates are rising. But others can do well. Cash becomes more valuable when rates are rising. The prices of gold and other precious metals can either rise or fall, depending on what else is happening. Real estate may be more difficult to purchase when rates increase, hurting prices. Initially, of course, people may try to buy as soon as possible when they see rates rising, but at some point the higher cost of property ownership from higher rates will discourage buyers.

  What if Nobody Wants Dollars?

  As we have explained in detail, one of the greatest risks we face as a nation is the possibility that the U.S. dollar loses its status as the preeminent reserve currency of the world. The problem is that our nation depends on maintaining this status. Without it, it’s doubtful that we could sell our debt to anyone other than the Federal Reserve.

  According to Dick Bove, one of the top banking analysts, “If the dollar loses status as the world’s most reliable currency, the United States will lose the right to print money to pay its debt. It will be forced to pay this debt,” Bove said. “The ratings agencies are already arguing that the government’s debt may be too highly rated. Plus, the U.S. Congress, in both its houses, as well as the president, are demonstrating a total lack of fiscal credibility.”56

  The implications are huge.

  For investors, a loss of reserve status would be deadly to bonds, as the currency would collapse, ushering in massive inflation. On the other hand, the right stocks could do very well, as would hard assets. Cash would lose value rapidly if the dollar lost reserve status, while gold, silver, and foreign currencies would jump higher, at least in dollar terms.

  Head for the Hills: Hoarding and Other Dangers

  Financial terrorism or economic warfare could lead to hoarding. Even the fear of an economic problem can cause hoarding, which in turn could trigger a collapse. Historically, nothing destroys an economy as surely as hoarding. The Roman Empire may have fallen because its citizens hoarded bullion while the barbarians looted the treasury. That meant that there was not enough money in circulation to create a functional supply-and-demand economy. Economists of the Chicago school have made this case about the Great Depression as well. Noting Roosevelt’s tight-money policy, Milton Friedman and others suggest that the Federal Reserve’s failure to inject liquidity into the system drove the economy over the cliff.

  Hoarding kills exchange, which is the oxygen required for economic life. Many items can be hoarded—money, food, and ammunition among them. The best thing to own at the start of a hoarding crisis is the item that will be hoarded. Of course, at some point, all hoarding will end. When it does, the price of the hoarded item will collapse.

  Given the variety of risks, it is obvious that there are no simple answers that apply to everyone in every situation. Over the next six chapters, we will review the advantages and disadvantages of major asset classes and the risks each holds. Flexibility is crucial. You have to know when and how to use each of the investment approaches if you are to navigate the coming turbulence safely.

  CHAPTER FIVE

  The Gold Rush

  You’ve seen all those ads for gold on TV: people telling you that it has never been worth zero, that it’s a hedge against inflation. And you’ve seen those commentators on TV telling you that putting money into gold is a fool’s errand, forcing your cash into a physical asset instead of into investments that could bring a return.

  Who’s right?

  Nothing sparks a debate in financial circles like the subject of gold. John Maynard Keynes thought gold was a “barbarous relic” that makes no sense. Fed chairman Ben Bernanke, predictably enough, said that he doesn’t think gold is money, and that people only think of it that way because of tradition. Milton Friedman said that gold could be money, of course, but that “money is what money does”—meaning that if it’s used for currency, it is currency.

  More recently, Warren Buffett has also expressed serious skepticism about gold. “Gold gets dug out of the ground in Africa, or someplace. Then we melt it down, di
g another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head,” he famously said. Buffett thinks that investing in gold works for the short term but fails for the long term since gold has no productive value. “What motivates most gold purchasers is their belief that the ranks of the fearful will grow. During the past decade that belief has proved correct,” he said in 2012. “Beyond that, the rising price has on its own generated additional buying enthusiasm, attracting purchasers who see the rise as validating an investment thesis. As ‘bandwagon’ investors join any party, they create their own truth—for a while [emphasis in original].”1

  There’s only one problem—over the long term, Buffett has been wrong. He said that gold “never interested me . . . even when it was at $35,” since gold “just sits there, and you hope somebody pays you more for it.” But, as Mike Fuljenz of Moneynews.com points out, “Most gold investors are satisfied to hold gold with the hope that the price does not soar too far too fast, since that would represent a world in crisis, hurting most of their other investments. Buffett has been wrong about gold for over 40 years, ever since it was $35 per ounce. Even with the recent price correction, gold is still up 35-fold.”2

  Some very serious economic thinkers—Peter Schiff and former congressman Ron Paul, for instance—disagree with Buffett about gold’s utility. Schiff said in early 2008, “Gold is money. And money retains its value, that’s the good thing about money. The problem is that what everybody is using that they think is money, dollars, doesn’t retain its value because Ben Bernanke is printing it like crazy.” Schiff predicted that, without inflation, Fannie Mae and Freddie Mac would go bankrupt, adding that America should go back to the gold standard. “We wouldn’t have had a NASDAQ bubble, we wouldn’t now be on the verge of an unprecedented collapse of the American standard of living because of years of monetary excess,” Schiff said. “If we were on the gold standard, oil would be about $3.50 per barrel.”

  Former Fed chairman Alan Greenspan eventually strayed from his core beliefs about monetary policy, but he originally believed quite strongly that gold was not just money, but the best basis for any currency. The criteria for currency, he wrote in 1966, were materiality, limited quantity, homogeneity, and wide acceptance, among others. Gold fit the bill. “In the absence of the gold standard,” he said, “there is no way to protect savings from confiscation through inflation. There is no safe store of value. . . . Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists’ antagonism toward the gold standard.”3 Unfortunately for all of us, as chairman of the Federal Reserve, Greenspan inflated the currency. That’s because he was right: without something backing the currency, the government will do anything it can to keep itself in power.

  A Brief History of Gold

  Let’s take a look at the price history of gold over many centuries, converting values to modern-dollar equivalents. In 1263, gold would have traded at approximately $4.10 per ounce. Gold steadily rose in price to $20.40 per ounce in 1696. During the American Civil War, the price of gold jumped to $45.40 per ounce, but then it returned to its stable prewar value of twenty dollars. It remained at that price until 1932. In other words, for hundreds of years, gold was relatively steady. Then the government decided to inflate the currency by centralizing gold. The price was suddenly raised to nearly thirty-five dollars per ounce—after the U.S. government confiscated the supply. It stayed there until the advent of the Bretton Woods system, when gold was unmoored from the dollar. Gold has risen to almost $2,000 per ounce.

  So what happened? To understand gold, you have to understand human history. Egyptian goldsmiths first smelted gold in 3600 BC, but it took a thousand years for gold to become common in jewelry in the Mesopotamian empire. From there, it took another two thousand years for the first international gold currency to take shape under King Croesus (hence the phrase “rich as Croesus”); the currency was called the Croesid. For the next two and a half thousand years, gold was the centerpiece of all monetary trading, until “full faith and credit” of governments took its place, unmooring value from a hard asset.

  In 1300, Goldsmith’s Hall in London established the first hallmarking system, meant to ensure standards of gold purity and prevent counterfeiting. In 1717, Britain moved to the gold standard, fixing the price of gold at seventy-seven shillings, ten and a half pence per ounce of gold. It could do this because of the great scarcity of gold on the planet—the chances of a huge vein of gold being discovered were minute. Naturally, a gold rush began all over the planet to search for more of the mineral. In 1848 thousands Americans went west in search of gold, finding their dreams—and more often, a stake of land—in California during the gold rush. Two years later, California became a state. A gold rush began in South Africa in 1885, drawing thousands of miners. During this period, every major country but China joined the gold standard.

  During World War I, the British government, pressed by wartime spending, delinked the pound from gold. Inflation spiked—almost 11 percent in 1919—so Britain returned to the gold standard and pegged the price of gold at seventy-seven shillings, ten and a half pence per ounce. Sound familiar? That’s the same price as two hundred years before. Stability in currency matters.4

  The Founders’ View

  Historically, money was precious metals. The word “dollar” comes from “thaler,” a German coin named after the Joachimsthal, the valley in Bohemia where the silver from which it was minted was mined. The Spanish dollar, which circulated widely in the British North American colonies, was likewise minted from silver. In 1792 the fledgling U.S. government adopted the dollar as its unit of currency, defined as twenty-seven grams of silver. In 1834 the United States went to gold as the single monetary standard.

  The founding generation recognized the danger of a currency not backed by precious metal. Thomas Paine wrote, “Gold and silver are the emissions of nature: paper is the emission of art. The value of gold and silver is ascertained by the quantity which nature has made in the earth. We cannot make that quantity more or less than it is, and therefore the value being dependent upon the quantity, depends not on man. . . . Paper, considered as a material whereof to make money, has none of the requisite qualities in it. It is too plentiful, and too easily come at. It can be had anywhere, and for a trifle.” The evils of paper money, said Paine, “have no end. Its uncertain and fluctuating value is continually awakening or creating new schemes of deceit. Every principle of justice is put to the rack, and the bond of society dissolved. The suppression, therefore, of paper money might very properly have been put into the act for preventing vice and immorality.” Paine called such currency a “presumptuous attempt at arbitrary power” that would undoubtedly remove freedom.5

  Thomas Jefferson agreed with the evils of paper money: “Paper money is liable to be abused, has been, is, and forever will be abused, in every country in which it is permitted.” He warned, “We are now taught to believe that legerdemain tricks upon paper can produce as solid wealth as hard labor in the earth. It is vain for common sense to urge that nothing can produce but nothing; that it is an idle dream to believe in a philosopher’s stone which is to turn everything into gold, and to redeem man from the original sentence of his Maker, ‘in the sweat of his brow shall he eat his bread.’”6

  George Washington held similar views: “Paper money has had the effect in your state that it will ever have, to ruin commerce, oppress the honest, and open the door to every species of fraud and injustice.”7

  Because the Founders distrusted paper fiat cash, the Constitution explicitly addresses gold and silver coinage for the states. It is clear that the Founders wanted the nation and also the states to avoid the pitfalls of fiat currency. Here is Article I, Section 10, of the Constitution: “No State shall . . . coin Money; emit Bills of Credit; m
ake any Thing but gold and silver Coin a Tender in Payment of Debts. . . .”

  The reason for the Founders’ antipathy is that “fiat” money had a spotty history. Paper currencies had a nasty tendency to collapse. As Nathan Lewis writes, “the [American] colonies had a wave of hyperinflation in the 1740s, and again in the 1780s. There was another round of currency devaluation during the Civil War. However, after the smoke cleared, they returned again and again to the stable gold dollar. . . . Capitalism, as we know it, was based on the foundation of the stable dollar.” Lewis predicts that the floating currency system in place since the Nixon administration will eventually be seen as an aberration.8

  Confiscation

  With the advent of the Great Depression, however, governments began to recognize that the presence of gold in the economy was a threat to government spending. At a time when they wanted to spend enormous sums, governments found themselves limited to what they could collect through taxation, since inflation was out of the question. The followers of Keynes who came to power—men like Franklin Delano Roosevelt in the United States and Ramsay MacDonald in Great Britain—believed that only the confiscation of wealth and an injection of cash into the economy could spur recovery.

  The logic went something like this: If average citizens were allowed to hoard gold, they wouldn’t spend it. Instead, they would stick it in a mattress for a rainy day, depriving the economy of the cash flow necessary for growth. By grabbing wealth and forcing it to be spent, the government could stimulate economic growth. Deflation was the fear of the day, and they felt that only government-created inflation could combat it.

  There is only one problem with this idea—it doesn’t work, at least over the long term. It doesn’t work when President Obama tries it, just as it didn’t work when Franklin Delano Roosevelt tried it. Investors prefer opportunity to gold, especially if there is stability. But massive new government programs and regulations, the seizing of assets, and extravagant federal spending do not inspire confidence. Radical change can bring uncertainty, and uncertainty kills investment.