A Golden Solution to a Global Crisis

Kathy Derbes, CEO of KDerbes Precious Metals, is a bullion dealer offering services to a broad range of clients from individual investors to hedge funds

After an extremely volatile and mixed 2011, gold and especially silver are off to a very positive start in 2012. Last year both metals achieved new price highs which were followed by violent declines. In April, silver soared to nearly $50 an ounce and tested its all-time high set nearly three decades ago only to fall sharply in both May and September, ending the year with a loss of 10.5%. Despite eclipsing $1900 and posting its best-ever price in September, gold suffered two sharp declines of several hundred dollars each but still managed to post another positive year of just over 10%. The volatile price swings of the precious metals in 2011 reflected the extremes in investor psychology caused by the uncertainty of a world torn between implementing austerity and bailing out failed governments and institutions.

Throughout 2011 Europe took center stage as its banking and sovereign debt crisis escalated, threatening the world with yet another global financial crisis. Confidence in a cohesive, credible solution eroded as the year progressed, and the bond markets in several European countries rebelled by driving higher rates across a broad spectrum of offerings. China and the emerging world slowed while the U.S. struggled with persistent unemployment and anemic growth. As the slowdown became ever more apparent, markets grew ever more volatile. Commodities suffered through a tough year, particularly natural gas and a few of the "softs" like cotton and sugar which struggled as demand faded. One by one the world's economies have been afflicted by the financial crisis which initially engulfed the large, western economies of the world. Few, if any, markets are immune.

Global Response

In an interconnected world, a regional financial crisis, especially in a significant economy such as the United States or the Euro zone, can spark unforeseen consequences that reverberate globally. The same holds true for any response to the crisis. Today's mountain of unserviceable bank and sovereign debt in most of the western world has been treated with an egregious dose of liquidity by central banks and other monetary authorities. In fact, in 2011 the liquidity effort became global and coordinated. Bad debt was removed from the balance sheet of banks and dumped to perhaps its final resting place—the balance sheet of central banks (R.I.P.). In addition to the ECB, the Bank of Japan and the Bank of England also engaged in QE, while the normally prudent Swiss printed gobs of their own currency by pegging to a broken Euro. Even the Royal Bank of Australia lowered rates to soften the effects of a global slowdown. Yes, dear reader, despite the headlines of austerity, years from now 2011 may be reflected upon as the re-birth of the 2008 print fest.

Perversely, the Euro Crisis has steered safe-haven capital to the U.S. and has enabled the Federal Reserve to remain on hold for now, but with a more dovish Fed in place for 2012, QE speculation is ramping up (and apparently after the Fed's chairman's press conference yesterday, is knocking at the door). In a leveraged economy the Fed must keep interest rates low or get incomes to grow if it is to prevent another catastrophic collapse. Quit hoping (but certainly keep trying) for the old-fashioned way out of this mess, ways that would include the hard work and sensible policies embraced by our grandparents, as we now live in a world predicated on taking the easy way out. While additional liquidity may or may not be called QE or be announced as a big bazooka, it will surely have QE-like characteristics and consequences. With the U.S. debt, deficit and unfunded liabilities skyrocketing in a near hockey stick formation on a chart, it's just a matter of time before the U.S is recognized to be just as bankrupt as our European ancestors. By then it is likely that we, too, will experience a funding crisis.

The Real War: Paper vs. Physical

So what's the solution? How can this over-indebted world ever return itself to a sustainable, healthy economy? In simple terms, the world needs to save, produce, and invest in order to procure a stable future. What better way for the world to build a healthy foundation than to embrace a monetary system founded on a sound currency such as gold? Instead, governments around the world are attempting to devalue their paper currencies to spur growth in exports—not exactly what Adam Smith had in mind. The other choice being advocated is an austerity program that fails to include economic reforms. Simply imposing austerity (shrinking the size of government) while maintaining a burdensome tax structure and heavy regulatory environment (which shrinks private sector) is a recipe for disaster, unless social unrest is the ultimate goal. Welcome to modern day Greece! But the Greek people are not alone in their revolts as they have had plenty of company in selected bond markets. With these two feeble alternatives on the table, it's no wonder that the world clamors for additional QE.

It seems ironic that, at the end of 2011, gold was sold in what was seen as a "risk-off" trade. But really this is no more ironic than the fact that the U.S. dollar has maintained its status as the world's safe haven currency solely because the U.S. Fed has printed more quickly and vigorously than others when faced with a financial crisis. In an unstable world predicated on intervention, cause and effect can be temporarily confused. Clearly, the nation that prints the most should not be bestowed with a strengthening currency. Similarly, the world's most inversely correlated assets—the true stores of value which are gold and silver—should not be lumped in with the "risk on" trade. Eventually, the reckoning of debt will happen, and with it will come the realization that paper currencies are worthless. It will then be even more obvious that we cannot print our way to prosperity. The growing need for the discipline imposed by gold and silver will become a stark reality not only for responsible governments, but also for investors who seek safety in their portfolios during unstable times.

2012: A Bullish Set-Up for Gold & Silver

As the calendar turns into 2012, the total liquidity programs generated by the ECB (especially LTRO, the newly announced three year buying program), the IMF, and the coordinated intervention by various central banks around the world, have allowed investors to breathe a sigh of relief that the world—and especially Europe—will not end abruptly after all. Consequently, the precious metals, along with many equity markets, have caught a bid and talk of $1400 gold and $21 silver has suddenly vanished.

The problem with markets dominated by government intervention is that policy, not necessarily fundamentals, drives prices. It was only weeks ago that economists and investors were convinced that the economy was mired in an endless liquidity trap emanating from a divided Europe that seemingly refused to address the solvency of a banking system laden with bad sovereign debt obligations. To make matters worse, the Fed had found itself to be under the political "macroscope" and temporarily became less accommodative in the tone of its language toward future easing. However, what better opportunity than a potential crisis to finally force action by the Europeans and also to open the monetary door for a Fed governor who is intent on preventing a deflationary depression?

Just yesterday, Fed Chair Ben Bernanke unveiled his more transparent agenda at the January Fed meeting. The markets were pleased to learn that the Fed governors are very concerned about the anemic growth rate that threatens our economic future and are not too worried about the threat of inflation which they believe to be subsiding. In fact, the Fed not only downgraded its growth forecasts for this year but also for next. Perhaps this helps to explain why the Fed felt compelled to extend its policy of financial repression at least another year, through the end of 2014. In the Q&A session, Bernanke even suggested that the Fed might tolerate a bit more than its targeted two percent inflation rate if employment were to remain weak.

Walla! After a few quick get-togethers in Europe and the U.S., suddenly the market's perception has changed. It's amazing what reaction a simple pledge of future intervention can evoke. Whereas yesterday bad news was a negative for the precious metals because it was interpreted to mean that the economy was cascading into a deflationary abyss, now, because of the Fed's new tone, bad news should be considered to be good news, at least for the holders of gold and silver. This is because we have been assured by our chief money printers that when the going gets tough (in Fed speak this means that when a single, very distant cloud appears on an otherwise perfectly sunny day), the central bankers of the world are going to do what they do best—crank up the presses! The policies of money printing and financial repression mostly work to aid both capitalists with large dollar-denominated debts and those who have prepared themselves by accumulating gold and silver. But for the little guy and savers of the world, this plan only makes life more miserable by making everyday things more costly and the future more bleak.

Some postulate that the Fed is trying to drive economic activity simply by pledging ultra-low rates for at least another couple of years and by promising even greater liquidity should the economy stall. If this plan succeeds, the Fed may not need to print as the economy could self-ignite just knowing that the Fed has our backs. These precious metal naysayers claim that if this happens you can kiss the precious metals bull good-bye. Not so fast. If the economy does pick up without additional stimulus, the velocity of money would likely increase. While this may obviate the need for the Fed to print again, it might also re-kindle inflationary pressures that are lurking beneath the surface of the Fed's fictitious accounting measures (inflationary forces which the common person encounters at every grocery store, gas station, and doctor's office).

In another scenario, and certainly not the least likely, the economy could stagnate while inflationary pressures build—the dreaded stagflation of the 1970s. The worst case scenario would be if the velocity of money were to increase to such an extent that businesses fail while inflation runs rampant ending in a Latin American (or Weimer Germany) style hyperinflation.

This does not mean that there are not risks for the precious metal holders of the world as anything can happen in the aftermath of a world trapped in a debt bubble. If Europe reverts back to its squabbling ways and refrains from action, its sovereign debt crisis might perpetually re-erupt and cause a 1930s style deflationary depression. Or perhaps the Fed might discover religion and repent for its money printing ways (bets anyone?). However, as we learned from the MF Global Fiasco, it is the paper money world of derivatives and fiat currencies that is most at risk if things do collapse. Investors would be well-served to beef up their physical precious metal positions and emulate the policies of central bankers in the developing world who are vigorously hoarding physical gold (and with good reason).

It's not just central banks who will eventually drive up the price of the precious metals. Recently, Sprott Physical Silver Trust filed roughly a $1.5 billion dollar shelf registration and used it to raise nearly $350 million to purchase additional silver. Only a few years ago, Sprott helped to ignite the silver market to a doubling in price by investing just over half a billion dollars. It's no wonder that the silver market has now caught a strong bid after falling about 50% from its peak 2011 price. If history is any guide, a much brighter upside awaits gold's shiny cousin.

Until the turn of the year, investor sentiment in the precious metals had precipitously plummeted. Gold and silver equities, particularly the junior sector, posted substantial losses in 2011. This is hardly the giddy environment that one associates with a market top. While those involved in the real economy have every right to be peeved at the capital misallocations caused by today's meddling central bankers, precious metal investors can rest assured that the fundamental case for owning gold and silver only grows stronger. Indeed, 2012 may mark the beginning of the end of our failing fiat monetary system which is fraught with an inherent counter party risk and suffering from persistent currency devaluation. Central banks and smart money around the world are accumulating physical gold and silver as a means to protect themselves. Shouldn't you?