The obvious takeaway is to notice just how tiny the spending cut is compared to all time record high inflation adjusted spending. (If I could nitpick a bit, it’s not just Obama calling these cuts catastrophic, but the Democrats, most Republicans, and every mainstream news source.) Compare that tiny sequester cut to the roughly 70% budget cut we had in 3 years after WWII. (Contrary to popular delusion, it was those dramatic spending cuts after the war coupled with being the world’s only producer with factories still standing that got us out of the depression, not the Wartime spending.)

Next, please note that this chart is of inflation adjusted federal spending. In other words, if per capita federal spending were to stay about the same we would expect a gentle rise in line with population growth. In 1913, the year the Federal Reserve Bank was created and the income tax was created, Federal Government spending was $715 million. Adjusted for inflation that equals $16.8 billion. There were 97 million Americans back then, meaning that in 1913 the Federal government spent $173 per person in today’s dollars.

Today, the Federal government spends $3.8 trillion annually (not counting what it owes to SS and Medicare trust fund) and the population is 314 million people. Today the Federal government spends $12,100 per person. That’s 70 times what we spent in 1913. If we include what the government should be putting into SS and Medicare each year to be actuarially sound, Federal spending would be around $9.5T or $30,000 per person or 175 times the spending of 1913.

Another important factor to notice is that the slope of the graph is increasing. In other words, the rate of the increase of inflation adjusted government spending is increasing.

However, there’s one more factor that could be playing a role in the astounding rise in government spending per person. That is, the CPI is not fully discounting the inflation rate. As I discussed in a post called Government Numbers, the government has an incentive to understate (i.e. hide) (i.e. lie about) inflation and has even changed the methodology for calculating inflation over the past few decades. If we used the same CPI deflator methodology we used in 1970, which I believe is more accurate, we get a per capita spending in 1913 of $668 or 18 times less than what we spend today. Better than 70 times, but still absurd.

In Summary:

1. All this talk of draconian cuts of the sequester is a load of crap.

2. The fact that we can’t cut even a tiny amount without inducing panic reflects just how fragile and over-leveraged our economy is.

3. The inflation adjusted federal spending since the inception of the Federal Reserve and income tax has been rising at an accelerating rate. And if we use GAAP (i.e. non-fraudulent) accounting the government spending is so mind bogglingly disgusting the mind rejects it.

4. One more bit of evidence that the official CPI is suspect at best.

“If these draconian budget cuts go through,” said a source who wished to remain anonymous, “many of the 52,000 Dept. of Homeland Security agents, who sit on remote mountain tops scanning the night sky with binoculars for alien warships will need to be furloughed. This will greatly hinder our ability to detect an invasion in a timely manner which could lead to the total destruction of life as we know it and enslavement of the human race by alien ant overlords.”

A high ranking officer at the Dept. of Defense echoed those concerns. “The devastating cuts would cripple our military to such a degree that we’d practically be inviting space aliens to attack. With no means of defense from the world’s lone super power, the entire human race would be doomed. Even if space aliens don’t attack, these drastic and irresponsible cuts would mean we could only wipe Iran off the map 375 times.”

White House Press Secretary, Jay Carney, summed up the sequester debate in a recent press conference. “The choice is simple, we can either take responsible measures to avoid these draconian, meat-cleaver cuts, or we can follow the republican plan in which space aliens eat our men and enslave our women and children.” He latter added, “Draconian!”

However, brilliant economist and Nobel Prize winner Paul Krugman sees a silver lining in an attack by space aliens. “While I generally abhor these draconian and stupidly irresponsible spending cuts, the good news is that a prolonged alien attack would destroy vast amounts of property and infrastructure. This would allow us to print tens of trillions of dollars to build up a massive arsenal to fend off the attack and then provide millions of jobs for years to come as we rebuild our scorched cities. While the loss of life would be unfortunate, it would really jumpstart the economy.”

……..

Ok, so CNN actually didn’t report any of the above, but it’s not far off from the devastating picture the media is painting about the so-called sequester. (Yes, I actually watched about 15 minutes of CNN coverage the other day.) For a good tally of all of the ways the sky will fall, check out the ABC News piece: 57 Terrible Consequences of the Sequester.

Is all of this Chicken Little reporting warranted? Let’s assume the sequester goes through as planned. First, it’s important to note that the federal government will still spend more in 2013 than it did in 2012 and increase spending in every subsequent year. The 0.4% increase in spending in 2013 is less than the 2.8% increase without the sequester which counts as a spending cut in Washington D.C.  However, to be fair, the cuts are mostly in “discretionary” spending which does actually decrease by 5.6% from 2012 spending.

To illustrate how “draconian” these cuts actually are, let’s lop a few zeros off the budget and pretend it’s a family budget. Last year, this family earned $24,490 and spent $35,380. They used their credit cards to pay the difference and have for the past several years so their credit card balance is now $160,000 and growing by over $10k per year. (luckily, they are able to keep finding new credit cards with a teaser rate so their interest payments are pretty low for now.) On top of that, they were supposed to have been paying into a fund for their retirement and future medical bills each year, but haven’t so that fund is now $2 million short of where it needs to be to provide their expected future payments. (They rarely mention this fact to the kids.)

In 2013, they expect to get a raise and earn $27k. They had hoped to spend $36,380 this year–  $21k of that is mandatory spending they have already agreed to pay each year for grandma’s medical bills and living expenses as well as supplemental living expenses for a poor neighbor. $2,200 is interest on the credit cards. (As usual, they’re going to skip the roughly $100K they should be putting into their retirement fund this year because after all, that’s a long way off.)

Here is where the sequester comes in. Little Susie noticed that Mom and Dad aren’t managing their finances very well. She is going to be stuck with a huge bill in a few years when they retire with no savings, huge debts and enormous medical bills. So last summer she asked Mom and Dad if they could work on the budget deficit. “Don’t worry sweetie,” they said, “We will find some cuts we can both agree on and if not we will automatically reduce spending on the things we each love most by $850 in 2013.”

Well, it’s 2013 and Mom and Dad couldn’t compromise so it’s time for the automatic cuts.  They call little Susie and Bobby into the living room for a family meeting. “Kids, we know we said we cut our spending this year but this is a critical year for us and if we make these  draconian cuts it will be devastating. We have promised to cut or purchases of milk, eggs, meat and vegetables from Mom’s shopping, gas for Dad’s commute, babysitting for the kids, and our alarm system for the house. If these cuts happen, we will all go hungry, your dad won’t be able to drive to work as much which will decimate our income, there will be no one to take care of you when we aren’t home and criminals will break into our house and steal everything. (And space aliens may attack.) So you see, we need to avoid these cuts now so we can work out a long term solution when our situation improves.”

Susie and Bobby have a few questions:

“Are you really suggesting we can’t cut $850 out of a $13,000 discretionary budget? Out of a $36,000 total budget? If cutting $850 is so draconian, what hope do we ever have of balancing the budget?”

“Why don’t we give each section of the budget some leeway on what to cut? Mom could cut out junk food instead of milk and we could eat out for dinner one less time per month. Dad could still buy gas to get to work but forgo a second new business suit this year. (or go to Joseph A. Bank) We kids could go with a few less toys and instead of dropping the alarm system we could get a cheaper cable package or just do a better job of turning out the lights when not in use.”

“If things were so critically tight, why did you just give Bill next door $500 in January to clean up his yard from the storm? Come to think of it, why do we give $230 every year to that family clear across town? They don’t even like us.”

“What happens if our credit card teaser rates go from 1.5% to 4.5% or perhaps 9%? wouldn’t our yearly interest go from $2200 to $6600 or even $13200? That seems like a bigger problem than $850.”

“If nearly 80% of Dad’s salary automatically goes to pay Grandma’s medical bills and chip in for the poor unemployed neighbor, and both of those expenses are expected to rise at a much faster rate than Dad’s salary, won’t automatic spending soon eat up our entire income? If that happens won’t the credit card companies jack up our rates or cut us off? Grandma is a lot richer than us kids (considering we are $2 mill in the hole for Mom and Dad’s retirement) can’t she pay for some of her medical care when she can afford it? That poor neighbor is able bodied; wouldn’t he have more dignity and be a more productive member of society if he got a job instead of sitting on the couch collecting a check from us?”

“And, I know you don’t like to talk about it Mom and Dad, but what happens when you boomers retire and you’re expecting to get certain payments for your medical care and living expenses? We’d need $2 mil in the bank now earning interest and we’d need to add another $80k-$100k each year to keep up with your future payouts, but Dad only makes $27K. And we kids are already in debt for $10,000 for our tuition bills with a weak job market. Do you think maybe we need to reexamine our long term strategy a bit?”

…….

“I, for one, welcome our new insect overlords!”

To back up a bit, most people are shocked when I tell them I think the federal government should be about 5-10% the size it is today. At a time when Democrats and Republicans in Congress can’t seem to find areas to even slow the growth of the budget, I would lop off 90-95% of federal spending if I were in charge. If we returned to the government laid out by the Constitution, I argue, the tiny federal government would provide national defense, (the kind that defends U.S. soil from invading armies, but does not police the world and embark on wars of aggression and empire) it would have a small court system to prosecute a few federal crimes like treason, ensure free trade among the states, and deliver the mail (although, nowadays they shouldn’t be doing that either). Then the tiny state governments could fill in the gaps by protecting property rights, enforcing contracts, and prosecuting violent crime.

Since nearly everyone wants more government than I do, I’ve heard all of the arguments from that side of the ledger. They’ll argue, “But of course we need the government to… (insert government program here). Don’t you want… (roads, clean air, education, a safety net, people not to become drug addicts, poor people not to die in the streets)” Well, of course I do; I just believe that there are better ways of achieving those ends than through a state controlled monopoly that uses force and coercion as its means.

As I hear the tiresome arguments for more government control and centralized power I just shake my head and think to myself, “Common, Bob (or Joe or Sally). You’re a smart and creative person. Can you really not rack your brain and come up with any way we might educate our kids other than having Washington DC take a chunk of everyone’s paycheck and then dictate the curriculum for union teachers to regurgitate on a chalkboard? Can you not imagine how potholes might get filled or food might grow without federal subsidies? Do you not realize that we didn’t even have an income tax for the majority of this country’s existence?”

Back to the radio show, as I listened to Mr. Molyneux discuss true freedom from a philosophical approach and explain why he viewed “the state” (i.e. government) as immoral, violent and unnecessary, I began to wonder, “Was I guilty of the very same unquestioned acceptance of the need for “some” government as the big government people I had so smugly deplored?”

It occurred to me that while I understand that government is violence, that government is inefficient, and that government distorts and stifles the economy, I still just accepted that we needed the government for some things like national defense, police, and court system to protect us from violent crime and fraud. Just as the big government person probably hasn’t spent any time considering how the poor might be taken care of if the federal government didn’t do it, I hadn’t given more than a passing thought as to whether or not the state was the only way to handle national defense or law making.

My rationale for these beliefs, which seemed self-evident, was that we needed some level of government to protect us from violence and fraud, and that the writers of the Constitution did a pretty good job of drawing the line between a government that protects us without encroaching on our basic freedoms. In short, as a nation, we voluntarily agreed to relinquish a tiny and precisely defined bit of freedom to elected officials in exchange for a functioning society. If we could just get back to that strictly limited government of the Constitution, 99% of our problems in society and in the economy would be improved or disappear completely.

I still believe that a Constitution sized government would alleviate most of the problems we face today. But after listening to several of Mr. Molyneux’s podcasts and learning more about anarcho-capitalism through the works of Murray Rothbard and others, I’m starting to wonder, “If getting rid of 95% of government would be great, why stop there?”

By now you may have visions floating around your head of teenage hooligans with black bandanas across their faces throwing bricks through windows, or African warlords driving around in Jeeps smoking weed, blaring music and shooting at people for fun. At least that’s the vision I used to get when I thought of Anarchism. But what the anarcho-capitalists are presenting is something entirely more civilized. There are still rules, contracts, property rights and societal norms for moral behavior, only they would be enforced by private entities in the market that people interact with voluntarily rather than government agents who are granted a legal monopoly on the use of force.

I realize it’s a hard topic for most people to wrap their head around. Heck, I’m a longtime  libertarian (not sure how I missed Rothbard’s views on this) and the idea of a completely stateless society is a mind bender for me. At first, the whole idea raises more questions than it answers. Who writes the laws? Would we even have laws? How do you enforce them? What if someone invades us? In the absence of a government wouldn’t some warlord or dictator just rise up and grab power? But the more one learns, the more one opens up to the possibilities of how society might function in the absence of a formal state.

Am I a converted Anarcho-Capitalist? Not yet. I’m just getting started in my learning on the topic. I certainly need to bone up on my Rothbard. I will say that I have begun to question my beliefs on the best way for society to function. I’ll also say that the more I have learned, the more I feel that not only might a stateless society be possible, but it might be vastly superior to any type of government. I think the picture at the top of this page say’s it best: government is a gun, the market is a voluntary exchange. (If you don’t believe me, try not paying your taxes.)

If your curiosity has been piqued, the clip below is an introduction to how a stateless society might function, by Stefan Molyneux. It’s almost a half hour and requires some concentration so I’d recommend listening when you have some quiet time.

If you are interested in learning more, I’d recommend checking out the Freedomain Radio podcast. Mr. Molyneux is extremely smart, and well versed in philosophy, psychology and world history. His podcasts are entertaining, challenging, compelling, quirky, and above all, genuine.  I learn something new every time.

A few words of caution: He tends to ramble a bit (ok a lot) and often doesn’t provide supporting facts mainly because he’s mostly concerned with morality and logic and also because for many of the podcasts he’s doing it while driving home from work. He is rigid in his morality and ruthless in his condemnation of religion, war and military people, and abusive parents (his definition of abusive parents is pretty broad) so if you are sensitive about these topics consider yourself warned. Also, there are over 1000 podcasts so you will want to be selective. Perhaps select the category:anarchism on the right side of the page to find the podcasts on this topic.

The above poll is a bit facetious. It’s more of an exercise to get your mental juices flowing and hopefully put you in a bit more introspective state of mind as you read this post. My goal for this post is to present a compelling case to invest in gold based on the fundamentals and current macro-trends in the gold market. I hope to have you asking yourself, “Why don’t I own gold? How much should I own? How can I find out more?”

I use the term “invest” in gold, but I don’t really consider gold to be an investment. Gold is money. It is savings or a store of value. But unlike every other form of currency, including the dollar, it can’t be devalued by a central banker printing more of it. In times of money printing and economic uncertainty, gold can gain substantially in purchasing power making it seem like an investment.

In part 1 of this post, I outlined why the prices of gold and silver have come off their highs and have been in a holding pattern for the past 16 months even as the fundamental reasons for owning gold have improved substantially. In this post, I hope to explain why gold and silver could shoot up at any moment like a beach ball that has been held under water as the water level rose around it.

As I discuss in a recent post titled “Understanding Gold Pricing” the price of gold, like everything else, is determined by supply and demand. Below are some emerging and/or poorly understood supply and demand fundamentals that will push gold higher.

Demand

1. QE4infinity and the new debt ceiling debate will light a fire under gold starting NOW.

The chart below is all you really need to know about gold pricing. Everything else in this article is just icing on the cake. When we discuss demand for gold, we are talking about the number of dollars chasing gold. It stands to reason that if the number of dollars increases, more of those dollars will chase gold. There are several different measures of the money supply depending on what types of currency and debt instruments you include in the measure, but historically gold has had a strong correlation with base money as represented by the balance sheet at the Federal Reserve.

The chart above overlays the gold price and the Fed balance sheet. (The bottom axis seems to be skewed by a year but we’ll let them slide.) In the 1990s, gold was a forgotten asset class having bubbled and popped in the early ’80s. Beginning in 2000, gold began it’s steady climb to begin catching up with steady money printing in the ’80s, ’90s and ’00s. The financial crisis temporarily caused a major dip in the gold price, but as the Fed cranked up the printing presses to fight the financial crisis, gold began to rocket higher. As we begin 2013, the fed has just announced QE4infinity, promising to print $85B per month (or $1T per year) until the economy improves. This is illustrated by the red dotted line and we are right at the beginning of that line.

Look again at the chart. Notice how the gold price responded to a modest $2 trillion increase in the balance sheet in four years. Now project ahead to guess how gold might respond to the red dotted line.

But the U.S. doesn’t have a monopoly on money printing. Central banks around the world including Japan, the ECB, the BOE and China are actively debasing their currencies in what Jim Rickards describes as currency wars. The only currency they can’t print more of is gold

If you’re not sold on the correlation between the Fed’s balance sheet and the gold price, perhaps you’d prefer the correlation with US debt as shown by the chart below. The last debt ceiling debate we had in Summer of 2011 saw gold run up from $1500 to $1900 in two months. Of course, if you think the US will begin paying down its debt any time soon you may not be that bullish on gold.

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2. New big buyers appear poised to enter the market.

Central Banks- For years, central banks of the world were net sellers of gold. Then in 2009 they became net buyers for the first time in 20 years. The World Gold Council estimates the central bank net purchases will top 500 tons in 2012. While this trend has been going on for a few years, it seems to be accelerating as central banks around the world, primarily in emerging markets scramble to increase their holdings.

The People’s Bank of China in particular will continue to be a large buyer. With over $3 trillion in foreign reserves they are estimated to hold between 2%-5% in gold with a stated goal of getting to at least 10%. That’s a minimum of $150B of gold demand in the next few years.

Japanese Pension Funds- Japanese investors traditionally stick to domestic stocks and bonds. The Wall Street Journal recently reported that for the first time, some Japanese pension funds are looking for alternatives, specifically gold, to diversify out of bonds that yield nothing in a currency that is actively being debased. From the article:

TOKYO—A small number of pension funds in Japan have started to invest in gold for the first time, largely to mitigate the damage from possible market shocks.

Japanese pension funds invest mainly in domestic stocks and bonds. Until recently, none have looked to gold or other physical assets.

Generalists- (aka fund managers who don’t specialize in gold.) It’s important to realize that despite talk of gold being in a bubble, the truth of the matter is that almost nobody owns gold. Sure there are a few gold bugs and the rare fund manager that allocates some of his portfolio to gold, but as the chart below shows, gold represents less than 1% of global financial assets.

Keep in mind that slow rise in gold percent of assets over the past decade happened while the price of gold increased from below $300 to over $1600 so much of the allocation rise can be attributed to the price going up, not more people buying gold.  With bond yields around the world at record lows, economic uncertainty, and global money printing on a never before seen scale, does it make sense that fund managers may start looking to diversify more than 1% of their assets into gold?

Anecdotal evidence from industry insiders such as reported in this article, suggests that fund managers’ interest in mining companies and the metals themselves is starting to pick up rapidly. From the article:

“What is occurring due to the extremely low valuations of gold and specifically quality silver producers,” he explained, is that “general market growth and value-focused funds are now eyeing these companies.”

When asked how many generalist funds are quietly calling silver producers during this time he responded, “It could be hundreds…or thousands. We’re talking pension funds, mutual funds, value funds…guys who move the price of the stock and move the price of silver itself…those who need a week or more to take a position” 

If these “generalist” fund managers decided it’s prudent to up there gold allocation to just 2%, there’s simply not enough gold for them to buy at today’s prices. The only way that can occur is with a sharply rising gold price.

Banks and Large Financial Institutions-

The global banks are regulated by banking guidelines established by an international group called the Basil Committee on Banking Supervision. The third iteration of these guidelines, Basel III, is scheduled to be implemented in stages from 2013-2019. While the details seem to be continually evolving, the new regulations will require banks to gradually increase their capital reserve and liquidity reserve requirements. Basel III also reclassifies gold as a Tier 1 asset which means banks can count 100% of the value of their gold holdings as capital whereas in the past, they could only count about 50% of the value of their gold holdings. For a good summary of how Basel III may impact gold, check out this article.

In short, this puts gold on the same footing as cash and U.S. Treasuries when it comes to the leverage ratios they can have. Banks now have a choice if they want to diversify out of some of their Treasury assets yielding a small percent, into gold which has yielded 16% per year compounding interest for the past decade. At the very least, this is a gentle tail wind for gold moving forward, and potentially a big price driver if more banks decide to hold gold as an asset.

The “old buyers” aren’t going away-

These “new” buyers identified above are in addition to the steady demand from India and the rapidly increasing demand from a billion Chinese citizens who are gaining wealth and at the same time, being provided with more and more ways to purchase gold.

Supply

Gold Supply from new mines is facing serious constraints. According to Jamie Sokalsky, CEO of Barrick Gold:

“It’s getting harder to find large deposits and to get those deposits into production takes at least twice as long as it might have taken a decade ago,” Sokalsky said yesterday in an interview. “We’re not going to see new mines coming in as fast as we thought to replace old mines that are closing.”

“Getting mines permitted, dealing with the government and the communities, environmental issues, all of that takes so much longer,” said Sokalsky, who took over as CEO in June after his predecessor Aaron Regent was fired. “It also costs multitudes more to build a mine and to finance that.” full article

In addition to new mines struggling to keep up with depleting mines, the cost of mining gold is rising. Rising energy and labor costs coupled with lower and harder to reach ore grades have caused a steady rise in production costs in the past few years and a big spike in 2012. Industry insiders estimate the per ounce production cost for 2012 to be around $1000-$1200, up from $662/oz in 2011.

Another interesting trend in supply story is the China factor. China has become to worlds largest producer of gold, but none of that production leaves the country. On top of that, they are also the worlds largest importer of gold. The Chart below from Casey Research shows the total gold supply (mining and recycling) has been leveling off, but if you subtract out what China is taking off the market a different picture emerges

.

But as the article points out, the Chinese are not just content to buy up gold already on the market. Since 2011, Chinese companies have been on a shopping spree, buying up gold mines around the world to ensure they meet their gold needs in the future.

Physical off-take

New mine supply, and recycling is only part of the supply picture. Since virtually all of the gold that has ever been mined still exists in above ground stocks, the flow of new gold is only a small fraction of the stocks of gold held by central banks, private investors, and increasingly ETFs and other gold funds.

But those stocks of above ground supply are not all created equal. Bullion bars held in a private vault or a gold bug’s basement need a lot of coaxing to make them available for sale. On the other end of the spectrum, gold in Western banks can be loaned into the market and rehypothicated, and gold in futures exchanges can be levered up many times adding to supply.

But as Western economies become more indebted and markets less trustworthy, more people are demanding physical gold. Hugo Chavez made news when he repatriated $11B of Venezuelan gold from Western central bank vaults. Since then, other governments and citizen groups from Ecuador, Netherlands, Switzerland, Germany and others have taken notice and are realizing that storing all of their gold in an account at the Fed or BoE might not be the best idea and have taken steps to repatriate (or at least audit) their gold.

The embargo on Iran may or may not have an impact on Iran’s nuclear ambitions, but it has had an impact on their gold trade. Since Iran has been shut out of the banking system for international trade, they have been forced to trade with barter agreements and gold. As I discussed in an article called “What if OPEC Nations Demanded Gold for Oil” any shift away from the petrodollar towards a gold trade would have devastating effects on the dollar and drive gold prices higher.

Finally, market debacles like the MF Global theft, the London Whale fail, and blatant market manipulations like the midnight gold slams are causing more investors to eschew counter-party risk and demand physical. As Mike Maloney likes to say, “If you can’t hold it, you don’t own it.”

Leverage is a double edge sword. As gold moves out of the banking system the amount of gold that can be levered up shrinks which can have a big impact on supply.

Conclusion

Ok, I feel like I’ve rambled on enough. Hopefully, I’ve addressed some new reasons (or at least reasons I haven’t discussed before) for buying gold (and, of course, silver). If your salary, savings, stocks and bonds are all dependent on the U.S. economy and U.S. dollar I hope you will at least take some time to consider that fact. And take action to rectify it.

I am now fully desensitized to any sale by Macy’s since I’m sure the next one will be right around the corner just as sure as Joseph A. Banks will be having a three-for-one special on men’s suits before I finish typing. It’s kind of like the boy who cried wolf.

I bring it up because several times in the past few years I have recommended buying gold and silver (since they were at $1155 and $18 respectively) and I hope readers don’t think I’m crying wolf when I say (once again) that this may be your last great chance to buy gold and silver before they take off and don’t look back. 2013 is shaping up to be the perfect storm for a rising gold price. Silver, which trades in lock step with gold but with more volatility, is poised to do even better in my opinion. For this article, I will focus on gold but in general these ideas hold for silver as well.

There are several fundamental factors which will help to drive gold higher. Many of them have been in place for several months while others have yet to really kick it. But before I get to the reasons gold will rise, I’d like to first address the reasons why gold has been in a range bound holding pattern even as the fundamentals for gold have been getting markedly better since August of 2011. And I’d particularly like to address the inexplicable beat down in gold (-7%) and silver (-15%) surrounding the Fed’s announcement of QE4eternity. The two main reasons gold hasn’t really done much in 2012 despite record money printing are investor psychology and active manipulation (and manipulation to affect investor psychology).

Why has gold stalled and what’s with the recent beat-down?

I had the privilege of seeing Rick Rule speak at the Hard Assets conference in San Francisco last month and he used a story to illustrate investor psychology. A man purchased $1000 of a speculative mining stock for $1.20 a share. That same day, his wife went shopping and picked up a few cans of tuna for $1.20 each. The next week the stock price had gone up 50% and was trading at $1.80 even though nothing had fundamentally changed with the company. The man was thrilled with his performance and what a good stock he picked so he bought another $1000 worth. In the mean time, his wife went back to the store and noticed that the tuna had risen to $1.80 a can. She was furious. Not only did she not buy any, but she complained to the manager. Apparently, many of the other shoppers felt the same way because the next week when she went back to the store, tuna was on sale for $1.00 to clear out the old inventory. She promptly bought three times her normal tuna purchase. Unfortunately for the husband, that same week his stock had taken a tumble and was now trading for $1.00. Not liking where this was headed, he sold all his shares. “The question,” asked Rule, “is who made the smarter decisions?”

The point of the story was that when it comes to investing, our natural instinct is to want to buy when things are going well and sell when an investment hasn’t been doing well. When our stocks are doing well we feel smarter; we get emboldened. Instead, assuming the fundamentals of the investment remain the same, we should treat investments like a can of tuna and stock up when it goes on sale and stay away when it’s overpriced.

In the case of gold for the past 16 months, the price has come off its highs and hasn’t really threatened to break through to new highs so much of the quick profit seeking hot money has gotten bored with gold. But if you look closely at the charts for gold and silver you will also notice several periods of sharp drops in the price in a very short period of time. These drops can be nerve racking and scare away weaker investors.

That brings us to active manipulation of the gold and silver markets. To understand the manipulation one must first understand three things about the gold market. First, the price is not set by physical gold trading hands; it is set by paper contract representations of gold that often trade at many multiples to the actual gold available for trading. Second, gold futures and options are traded on leverage, where a small amount of collateral can control a large position in paper gold, but small dips in the price can wipe out that collateral. Third, much of the short term trading is done with computer algorithms that try to ride the gold price up and protect the investor from downward trends through stop losses and other automated rules.

For several years, market followers such as GATA, Ted Butler and more recently, whistleblower Andrew Maguire among others have been presenting evidence to suggest that there is active manipulation of the metals markets. Much of the evidence is circumstantial and involves connecting some dots so it’s hard to definitively prove. However, as the evidence mounts, and the instances get more intense, it’s hard to deny that something is going on. In the most recent instance, as Chris Martenson notes:

…in the run up to the QE4 announcement and then in the days right after, some entity has been selling literally thousands and thousands of gold contracts into the thinly traded overnight markets so rapidly that we have to use millisecond charting to see it for what it is.  Again, there is no other legitimate explanation for this activity of which I am aware, besides having an intent of pushing the price down.

As he alludes to, no seller in their right mind, trying to get the best price for their gold would dump a huge amount of contracts all at once at thinly traded times when there are few buyers to absorb their gold. (And yes that includes the rumored forced liquidation in John Paulson’s hedge funds and gold investors looking to book some gains ahead of the fiscal cliff tax increases.) Yet this is exactly what has happened, repeatedly in the past few weeks both in late night trading and right before the COMEX open. But who would want to push the price down? There are three potential culprits.

The first potential culprit is the large commercial banks who hold large concentrated short positions in gold and silver futures. Their large positions allow them to game the system. The idea is that when the price rises to a certain point, they flood the market with short sales which smashes the price triggering stop losses which add to the selling triggering yet more stops. Then they cover their shorts at the lower price when many buyers have been scared out of the market and let the process recycle. Alternatively, or perhaps in addition, the sellers may have options that payout big during high volatility and so they are willing to sacrifice some of the futures positions for larger gains in options.

The second potential culprit may be the U.S. Government or Federal Reserve itself. The idea is that the Fed has a vested interest in keeping the gold price low (or at least appreciating at a controlled rate) because gold is the best barometer of how much value the dollar is losing. The dollar (actually all fiat currencies) and Treasury bonds are based on confidence which would be badly undermined if gold were to rise dramatically, say after a QE announcement that the FED will be printing $1 trillion per year from here to eternity. One way they could keep the price in check is by strategically leasing the government’s gold to bullion banks, thus adding to the supply of tradable gold which can then be rehypothicated and levered by the banks in the paper markets. A recently leaked document from the IMF showed that central banks, including the FED, put up quite a fight to be able to list their physical gold holdings and gold loans and swaps as one line item on their balance sheets since disclosing gold loans would be “highly market sensitive.”

A third potential culprit, which was recently posited by Lee Quaintance and Paul Brodsky, that I find intriguing is that China and other Eastern central banks have the greatest incentive to keep prices low so they can quickly acquire as much physical metal as possible. The whole article is here but here’s a snippet:

“We certainly agree that gold should fundamentally be priced much higher than where it is and that the way gold futures seem to be reliably stepped-on before Treasury auctions and Fed meetings is a bit snarky. But as for the progenitors of the crime? It might be better to look east.

“Conspiracy theorists should consider foreign dollar reserve holders that would like to take delivery of as much physical gold (and silver?) as possible in a very short time, and do so at cheap prices. It would be simple to do: Fund offshore hedge funds that continually short gold futures through U.S. bank accounts, thereby keeping the spot price and London fixings down. Physical gold could then be delivered to sovereign accounts directly from mines and through exports at the suppressed prices.”

Again, no real hard proof, but it’s hard to imagine that foreign central banks don’t see what the Fed is doing and want to diversify some of their trillions of dollars of foreign reserves. Another dot to connect in the China theory is a comment made recently by Steven Leeb who said that he was talking with a Chinese diplomat who let it slip that China was looking to acquire gold to back the Yuan (before backtracking and saying, “No it’s not to back the Yuan. It’s because of jewelry.”) Interesting.

In any case, whether it’s commercial banks gaming the futures markets, the Fed trying to perpetuate the dollar ruse, the Chinese central bank biding time while they acquire real, tangible assets, or some combination of the three, the important thing to realize is that manipulation can’t go on forever as eventually reality always catches up. That appears to be happening as the physical market is starting to diverge from the paper market as more and more investors want to hold their gold.

But even if there’s no manipulation and it’s simply John Paulson forced to sell his levered positions to cover fund redemptions, or sellers cashing in their gold to avoid higher taxes, or hot money just forgetting about gold because it hasn’t done much lately it doesn’t matter. Don’t look a gift horse in the mouth! The price of gold is way too low for the fundamental factors already baked in the cake. As Rick Rule would say, gold and silver are on sale.

But this sale won’t last for long. In part 2 of this post, I will outline the many new developments that are coalescing to create the perfect storm for gold (and silver).

Intuition tells us that since drugs can be extremely harmful, they should be illegal. We should discourage people from using them in the first place by making their use illegal, and we should have harsh penalties for anyone who tries to produce or distribute these dangerous drugs. It’s common sense…

And it’s completely wrong. The “war on drugs” has been a complete and utter failure based on every objective measure. Since the war on drugs was first declared, drug use, drug abuse, and especially drug related crime has surged. America now has the highest incarceration rate on the planet. After 50 years of data, it is clear that the war on drugs has achieved the exact opposite of what it intended.

Don’t believe me? That’s understandable. It’s hard to overcome 40 years of government propaganda through our school system and media in a single blog post. Perhaps, this Incredible one hour documentary, Breaking the Taboo, can help convince you that there’s a better way to deal with narcotic drugs. Even a former drug warrior like Bill Clinton has changed his mind after seeing how his own policies didn’t work (and now that he doesn’t have lobbyists whispering in his ear). From the documentary website: “We must seriously consider shifting resources away from criminalising tens of millions of otherwise law-abiding citizens, and move towards an approach based on health, harm-reduction, cost-effectiveness and respect for human rights.”

There is a huge vested interest in keeping the drug war in place. Police and Federal agencies get massive windfalls from confiscation of property suspected of being involved in a drug crime. Private prisons profit from outsourcing their slave labor. There have even been allegations that the CIA is actively involved in the drug trade. Politicians can exploit the issue to get elected and grow their power.

The only way we will see an end to this destructive war is if a large majority of the voting public learns the truth and demands a change. The truth is this — drug abuse is a health problem and criminalizing the activity of drug use creates a deadly criminal infrastructure and destroys people’s lives.

Please watch the trailer below and then visit the breaking the taboo website to watch the whole film and sign the petition. And if you like it, please pass this along.

Cartoon by Henry Payne

This week’s post election hangover edition of the newswire discusses pot legalization in CO and WA, the REAL U.S. debt, a scary student loan delinquency chart, the death of the penny, and a little treat from The Onion.

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Colorado Legalizes Marijuana: Your Move Eric Holder
libertyblitzkrieg.com, November 07, 2012

My friends whom I watched the election with were a little surprised to find out that I didn’t really care who won the Presidency, but was extremely interested in the outcome of whether Colorado and Washington would legalize pot, especially since I don’t really smoke pot and I live in California. This article from Libertyblitzkrieg.com sums up precisely why I think it was such an important victory for liberty.

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Cox and Archer: Why $16 Trillion Only Hints at the True U.S. Debt
The Wall Street Journal, November 28, 2012

We hear a lot in the news about our $16 trillion national debt. But that’s just the tip of the iceberg which only includes on-ballance sheet items. If the government had to follow the same accounting rules as businesses, the real debt would be closer to $90 trillion (or much more depending on who you ask.) to account for the money that should be in the “lock box” for Social Security and Medicare as described in this article. In fact, the real debt is actually higher than that when you include the guarantees behind student loans, the FHA,  the FDIC and other backstops which are on the verge of kicking in.

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The Scariest Chart Of The Quarter: Student Debt Bubble Officially Pops As 90+ Day Delinquency Rate Goes Parabolic
The Liberty Crier, November 28, 2012

As I alluded to above, the Federal Government (i.e. the taxpayers) backstops student loans issued before April of 2010 and has issued most of the loans since. This article contains charts that show that delinquencies in student loan payment have recently spiked. This is not inconsequential for taxpayers considering we are on the hook for nearly $1 trillion (and growing) of these loans.

Much of this delinquency spike is due to the fact that students are having a hard time finding jobs in this “jobless recovery” with their DDWs (degrees of dubious worth). Some of it may be due to an Obama executive order limiting payments on student loans to 10% of discretionary income and forgiving debts after 20 years. With those limits, it is less consequential for those already deep in debt to rack up massive late fees and interest payments. While it’s clear from the charts that our Federal student loan program is hurting taxpayers, check out my post, “Student Loan Debt Slaves” to see how these loans hurt the very students they are supposed to help.

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Bid Farewell to Pennies and Nickels
Wealthwire (via goldsilver.com), November 26, 2012

“According to U.S. Treasury Secretary Tim Giethner, our U.S. Mint intends to remove the penny and nickel coins from circulation beginning early in January 2013…  2011 marked the sixth consecutive year that pennies and nickels cost more to produce than they were worth in the market. In fact, the Mint posted a loss of $187.7 Million last year – more than triple the losses recorded associated with coin minting in 2010.”

This is just one more indication of how much the value of the dollar has fallen. In fact, for certain people with a small amount of savings and some extra storage space, hoarding nickels can be a zero risk way to save and invest because the value will never fall below $.05 but the melt value of the coins could increase substantially as the dollar continues to decline. If we see high or hyper-inflation, the copper and nickel in the coins will maintain their purchasing power while the dollars in your wallet and bank account steadily decline. You can find today’s melt value here.

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Global Warming
The Onion Book of Known Knowledge

The Onion never disappoints and the excerpt on Global Warming from the Onion Book of Known Knowledge is no exception.

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“Uh oh! We better stay on the current path.”

Even before the last balloon hit the floor at President Obama’s victory party, the media had already shifted its focus to the looming fiscal cliff. The chorus call from the mainstream media is that our political leaders need to “come together” to “compromise” so that we can avoid going over the cliff. Failure to avoid the cliff, they say, will be a disaster.

But what exactly is the fiscal cliff? It’s a roughly $600 billion yearly deficit reduction through tax increases and discretionary spending cuts starting in 2013. To be more specific, it’s about $400B in tax increases, $100B in spending cuts that aren’t actually cuts but a reduction in the amount the spending will increase, and about $100B of estimated revenue from economic growth. You can find out the exact numbers elsewhere. Wikipedia has a good summary. The purpose of this post is to add some perspective on what the fiscal cliff really means in the greater scheme of things.

The best way to think of the fiscal cliff is as follows: The politicians, with the tacit approval of the voters, have created a government which now spends $3.8 trillion a year in on-budget spending. In fiscal year 2012, the government collected $2.47T in revenue which means they had to borrow $1.33T to pay for the rest. The fiscal cliff simply means that Americans will have to pay a bit more out of pocket for the government they are getting each year instead of putting it on a credit card.

“Well that seems reasonable,” you might say, “so why is the financial world so terrified?” They are terrified because the economy is already weak and the increased taxes and decreased spending from the government sector will cause a drop in the GDP, sending us back into a recession. (On a side note, the fact that actually trying to pay for our government causes such pain proves just how out of control our spending really is.)

The media, politicians and mainstream economists are obsessed with the economic indicator known as the GDP. Unfortunately, as I explained in an earlier post titled Government Numbers, GDP is simply one metric of economic health, and a pretty bad one at that. If they insist on just looking at GDP, I would suggest they should look at what I call SGDP, or Sustainable GDP. As I plan to describe in a future post, SGDP is calculated by subtracting out the increase in government debt from the GDP to determine the economic activity that was generated without stealing from the future. If you look at SGDP we are already in a massive recession and have been for years.

“Ok, so how did we get into this mess called the fiscal cliff?” If you recall, back in 2011, there was a debate in Congress about raising the debt ceiling. Some of the more fiscal conservatives realized that if we just raised the debt ceiling without providing any measures to work towards reducing the deficit in the future, the ratings agencies and lenders might catch on that we have no intention and no ability to pay back our debt. So Congress agreed that they would try to agree on some deficit reduction measures, and if they couldn’t reach a compromise they would bind themselves (actually future congresses) to automatic spending cuts and tax increases. Well, Congress failed to reach an agreement and the fiscal cliff is simply those binding cuts going into affect. Or, as Peter Schiff aptly pointed out, the fiscal cliff is the can we kicked down the road back in 2011. We just caught up to the can. Ironically, we caught up to it just as the new debt ceiling is about to be reached.

“So what should we do?” I actually agree with the media that Congress does need to do something to “fix” the fiscal cliff, although my idea of fixing it is probably different then theirs. Both the Republicans and Democrats (and I) agree that raising taxes on the bottom 98% of taxpayers would hurt the economy. The Republicans (and I) argue that raising taxes on the top 2% also hurts the economy and probably to a greater degree. Unfortunately, their idea of compromise is that we won’t get any more spending cuts to balance out the $400T in lost revenue, and we will delay any tax increases and push spending cuts out into the future kicking the can down the road once again.

More importantly, as the cartoon above depicts, the fiscal cliff is simply a small bump in the road in the grand scheme of things. Fiscal cliff or no fiscal cliff, the debt will continue to rise until we hit what Schiff calls the “real fiscal cliff.” That is the point when our government can no longer continue to borrow, not because of a self-imposed debt ceiling, but because people and governments are no longer willing to lend to an insolvent institution at negative real interest rates.

At that point, the Federal Reserve can either let interest rates rise to meet the market or they can keep rates low by becoming the lender of only resort. If interest rates rise, the interest payments on our massive short-term national debt will rise substantially, assuming a larger and larger percent of the federal budget, and may even eclipse all federal tax revenue. If the Fed keeps rates low by buying Treasuries, it will jack up inflation, destroying the purchasing power of every American who holds dollars. Either way, we are coming to the end of the road.

[Editors note: This is my first attempt at my own political cartoon. I hope you like it. Feedback welcome.]

Vote your conscience!

Your vote isn’t going to swing the election one way or another. Even if you gather a hundred of your friends and have them vote with you it won’t swing the election. And unless you live in one of the eight or so swing states it won’t even mater if you gather up 1000 people to vote with you. The President is elected by the electoral college and in most states, the outcome is set in stone.

The whole Red Team vs. Blue Team is just psychological BS propaganda that has been programed into us by the media and entrenched interests. Don’t fall for it!

If you really think Obama is the best man for the job then by all means vote for him. Same goes for Romney. I, for one, think there is maybe 5% difference between them. I would urge people to look into the third party candidates and find the candidate that best matches their beliefs. The chart below shows how one of those candidates, Gary Johnson stacks up to Obomney.

I will be voting for Gary Johnson and I think he would do a fantastic job as President. I know he won’t win, but I will be voting with a clear conscience. Check out this campaign ad for a little more on his background.

A libertarian vote is particularly important this year. The Ron Paul Revolution has introduced hundreds of thousands of voters to the concepts of liberty and the Libertarian Party has an opportunity to reach some important milestones. If Gary Johnson gets 1% of the vote he will be only the second Libertarian to reach that mark. If he gets 2% he will be making history. If he gets 5%, the Libertarian party will be considered a major party and get the same federal campaign funds that the Democrats and Republicans have been stealing from voters receiving for years which will dramatically help their ballot access efforts in the future.

One more recommendation for voters in SF: John Dennis is an excellent Ron Paul Republican running against Nancy Pelosi. I will be happily voting for him.

Aside from the people on the ballot, there are several interesting and important statewide ballot initiatives to consider. I am particularly interested to see what happens in the nine states voting on nullification measures, especially those voting on the legalization of marijuana.

If you would like to see where the Libertarian Party stands of the ballot measures in your state check it out here.

Happy voting.

Aside from the obvious personal and financial damage from the storm, one downside of natural disasters that particularly irks me is the inevitable bad economics and political grandstanding that fills the airwaves after such an event. It bothers me because it is a self-destructive response that has real negative consequences on people’s lives and that it is completely avoidable if people only took the time to understand basic economics.

There are the Keynesian economists like Paul Krugman who jump at the chance to decry that the storm, while bad, will at least stimulate economic activity, so there is a bright side. This dumb idea, known as the “broken window fallacy” has been well explained and debunked by economists like Bastiat and Henry Hazlitt.

Then there are the big government lovers who pound the table that we need to expand FEMA and other federal programs to aid disaster victims. These include the politicians who like to show how caring and generous they are by pledging to spend (other people’s) money to help the victims. But as Katrina demonstrated, FEMA is just another bureaucracy that hinders real aid from occurring. The government programs for flood insurance subsidies and other programs create a moral hazard that encourages people to build in risky areas. The topic of how Federal programs for disaster victims are negative to society and how the free market can, and has, handled disaster relief much better could fill a book and is not the point of this essay.

The topic I want to address here is “price gouging” because it always comes up, and it seems so obvious to people that raising prices on essential goods when people are already in a desperate situation is just evil. In fact, far from being evil, it is simply a market response that helps get goods and services to people who need them most as efficiently as possible.

Lets take a simplified example of a store selling batteries for $5 a pack. The storm hits and everyone in town loses power. Obviously, there will be a spike in demand for people needing batteries for flashlights, radios, etc. Supply will be constrained because the roads are out, making deliveries tricky. Economics 101 tells us that in a free market, when demand rises but supply stays the same, prices need to rise until supply and demand match. (Even Krugman understands this one.)

But say the store owner wants to be nice and help people out since they are in need and decides not to raise his prices on batteries. We will give people the benefit of the doubt and assume they are not panicky and in a frantic race to get all the supplies they need before others scoop them up. What will be the result? People will go to the store and buy a bunch of batteries. They will buy enough to make sure they have a good supply in case the roads stay closed for a long time. They might even buy some extra in case their neighbor needs to borrow some. Some enterprising (evil) people may even buy up a bunch of batteries and then sell them at a higher price down the block. Soon, all the batteries will be sold out and any new customers who desperately need batteries will be SOL. Clearly this isn’t a good result. (Perhaps that’s why in real life, people do panic and rush to get their hands on whatever supplies they can.)

OK. Let’s say the store owner wants to be nice by not raising his prices but also be smart about it by limiting customers to just one pack a day so everyone can have a chance to get them. Well, the people who need more than one pack immediately won’t be able to get them in time. They will have to come back tomorrow, spending valuable time getting batteries when they could be shoring up their property. They might bring their kids and friends to wait in line with them. Long lines develop and people waste time and resources waiting in line. This is true anytime an essential good is rationed, either by acts of nature or government decree. Many remember long lines for gasoline when it was rationed in the 1970’s and those same lines are appearing today in New Jersey. This scenario is better than some people having no batteries (or gas) at all, but still very inefficient. That entrepreneur from the first example may simply pay some kids a few bucks to wait in line and buy batteries for him so he can sell them down the block, similar to how many ticket scalpers operate.

Gas line in New Jersey.

As inefficient as the store owner not adjusting his prices and/or rationing sales is, it’s much better than when the government passes a law or temporary rule to fix prices or ration goods. At least the store owner knows a bit about his customers and how many batteries they may need and can adjust his allotment if supplies start to run thin or he expects a new shipment soon. He can make an exception if a nurse walks in needing to purchase 20 packs of batteries for hospital equipment. If he is restricted from raising his prices, even though it costs more to get new batteries over flooded roads, he will lose money and his supply lines will dry up.

With a top-down government decree, there is no feedback loop from the market. It’s all arbitrary price and ration levels set by someone not intimately involved. Not to mention the moral issue of a government telling one individual who wants to sell a battery to another individual who wants to buy that battery, that they are not free to make that voluntary transaction.

So… if price controls and rationing aren’t ideal, how would the free market handle things? First, the store owner would raise prices to more closely match the demand for batteries with his supply. The market might dictate that in this situation he could raise prices to $20 a pack. $20 dollars for a pack of batteries? That’s gouging!!! He’s taking advantage of these poor people’s situation. Well maybe, but raising prices to what the market will bear to maximize his profits has several advantages.

First, it should be noted that there is a limit to how much he can raise prices. If he raises them too high, say $30, people will simply walk further down the road or use candles instead of flashlights. Also, the crisis will be gone in a week or two and he doesn’t want his customer pissed off at him for gouging them and not shopping at his store in the future. So in reality, his prices will likely be lower than what he could squeeze out of his customers if he really wanted to gouge them for some short term gain, perhaps $15. ($15, that’s still gouging!)

Second, the higher prices will make people think twice about how many batteries they buy. If the prices are normal there’s no downside to buying more than you need just in case. If prices are $15 instead of the usual $5, people will only buy what they absolutely need, leaving more batteries on the shelf for the next customer who really needs them. In other words, people buy only what they need and everyone can get exactly what they really need. Sure, they may pay a bit more for a few weeks but does an extra $10 really matter when you desperately need light?

Third, since he’s selling batteries at or near the market price, there’s no incentive for a black market to develop such as someone buying up all the batteries and then selling them around the corner for $15 when he might get stuck holding a bunch of overpriced batteries.

Uber explains how increased prices increases supply. The last tweet shows the negative affects of well meaning price controls.

If we dig a little deeper we find even more advantages to the free market. When battery suppliers in Pennsylvania get wind of the fact that batteries are selling in New Jersey for $15 a pack, they will load up their trucks and brave the flooded roads to deliver more batteries to that area. Even if they are doing it out of their own greedy desire for profit it doesn’t matter, as the net result is that more batteries will quickly flood (no pun intended) into a region that desperately needs more batteries. This influx of supply helps bring down prices. If batteries had stayed at $5 there is little incentive to take the time, effort and risk to drive to a dangerous, flooded area when they can sell batteries for $5 out of the comfort of their store.

If we dig even deeper we find a tertiary benefit. If people know that batteries (or water, or toilet paper) are going to become very expensive in the case of an emergency, they are more likely to stock up on those items during normal times. Then when the storm hits, there will be less of a spike in demand for essential goods so people who really need then can get them without having to pay a huge markup. It’s the markets way of helping people plan better for disasters. This is the opposite of the moral hazard that develops when the government distorts the market.

This example discusses batteries but the same is true for other essential goods and services such as water, gasoline, generators, construction workers, electricians, or anything else that is in demand.

And while the article mainly discusses price controls and rationing, the same principles apply to any instance where the government distorts the market and doesn’t let the free market operate. Like in Katrina, when volunteers flocked to help, but were turned away by FEMA officials, or when perfectly good trailers and other temporary housing arrived days after the storm but couldn’t be used because it hadn’t been pre-approved by government officials. Or in New Jersey where stories are already emerging of electricians and other volunteer workers being turned away because they weren’t in the local union.

It’s always the same. The free market works better than well intended government “solutions” no matter how many pundits and politicians want to take advantage of a disaster to demonize it.