John Embry: Debt saturation ensures much higher gold and silver
Remarks by John Embry
Chief Investment Strategist, Sprott Asset Management, Toronto
California Investment Conference
Cambridge House International
Hyatt Grand Champions Resort, Indian Wells
Saturday, February 11, 2012
It is once again a great pleasure to address the attendees at this conference following the GATA Workshop I participated in this morning. I'd like to thank Bill Murphy for his kind introduction. As many of you may know, Bill and I have become great friends as the result of our mutual struggles in the gold and silver markets over the past 13 years. That struggle has simultaneously represented the most exhilarating and the most frustrating experience in my nearly 49 years in the investment business.
After acknowledging my longevity in the business, I'd love to say that I started when I was 12 years old but that unfortunately is not true. I'm just getting old, which, at least so far, beats the alternative.
The main subject I want to address today is the staggering debt situation throughout the industrialized world and the impact it will have on the value of paper money and by extension, gold and silver. However, before I get to that topic, I would like to make a few comments about the price action of gold and silver in the last four months of 2011, price action that incidentally set the stage for the explosive price rises we've seen in the first six weeks of this year.
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Up until Labor Day last year, gold was enjoying an excellent year, rising by comfortably over 30 percent in price in eight months. This strong advance reflected the turmoil in Europe, the U.S. debt rating downgrade, excessive money creation worldwide, and widespread economic and financial deterioration generally. Ergo, gold was acting exactly as it should in these circumstances.
However, this also represented the worst nightmare for the powers that be, essentially revealing to the public that all was not well.
Thus, in response, the Western world governments, their central banks, and their bullion bank allies sprung into action. Gold plummeted nearly $300 in a month and silver dropped by a third despite not an iota of visible improvement in the world economic and financial backdrop. It was just the same tired old criminal drill that we have seen throughout the more than decade long powerful bull market in gold and silver. These muggings took place primarily in the paper markets of the LBMA and the COMEX while the regulators, most particularly the Commodity Futures Trading Commission here in the U.S., blissfully slept on.
Then, after gold subsequently re-established its equilibrium above $1,700 and silver bounced back into the mid 30s, both collapsed again in the wake of a totally failed European summit in early December. In the absence of any palatable solutions to their many intractable problems, the Europeans undoubtedly knew the scope of the quantitative easing they were going to have to unleash to hold things together. Thus, they and their American counterparts deemed it essential that gold and silver not be seen as an attractive and essential alternative to their beloved pure fiat currency system, which was failing rapidly in plain view. Gold dropped well over $200 and silver fell by 20 percent in a three-week period, with much of the damage occurring in the traditionally very quiet week between Christmas and New Year's Day.
Desperate people tend to do very stupid things and I can assure you that the powers that be are getting increasingly desperate.
Despite these offensive raids, gold still posted an 11-percent year-over-year price gain in 2011, marking the 11th consecutive year the price had been up, a feat the venerable investment letter writer Richard Russell termed unprecedented in any significant asset class.
However, in spite of this exemplary performance over the past decade the vast proportion of society remains blithely unaware of what is unfolding in the gold and silver markets. This stems from many sources, the first being the relentlessly negative press from the mainstream media on the subject. How many times does the public have to be subjected to the views of the likes of Jon Nadler of Kitco and Jeff Christian of CPM Group, to name but two? They are not true analysts but purely and simply establishment propagandists whose sole purpose, in my opinion, is to provide disinformation to keep the unsuspecting public away from precious metals.
Then the anti-gold cartel, with its insidious paper raids, creates wild volatility and totally counterintuitive price action that further discourages all but the most knowledgeable and committed believers in the only real money, gold and silver.
In reality, to date, the public hasn't had a chance. Whenever they have stuck their toe in the water, almost without exception they have been burned as yet another raid knocked them out of the box. When that happens often enough, most people just give up and go away and that is exactly what has occurred.
However, there is more than enough very large, very smart and well informed money in the world that is relentlessly soaking up the rapidly shrinking quantities of gold and silver that are available and, as a result, the prices of both have risen and will continue to inexorably rise, albeit accompanied by stomach-churning corrections. The corrections don't bother the real serious buyers in the least. They see the irrational vertiginous price drops as just providing another wonderful inexpensive buying opportunity. At the end of the day, the big smart money to which I am referring, will own virtually all the gold and silver and the rest of the population will be stuck with rapidly depreciating, soon-to-be-worthless paper money. At that point the public will wake up, but it will be too late.
However, enough of that -- let's talk about why the well-informed big money is buying.
Unfortunately the subject is really disheartening, and that is the relentless growth in debt throughout the world. In the wake of Global Financial Crisis 1 in 2008 (and I can assure you that the next one is coming very soon) there has been much talk of debt deleveraging. To be fair, in the private sector, there has been some evidence of that in the U.S. and Europe, although most of it has related to outright default rather than the old-fashioned practice of saving current income to pay down existing debt.
This minor event, however, has been totally overwhelmed by an explosion in sovereign debt as governments worldwide have been forced to step in to save their essentially insolvent banking systems and prop up their foundering economies.
I regret to say that it doesn't take more than a cursory examination of the facts to conclude that the problem is endemic throughout the industrialized world and is even affecting some of the key emerging economies. More importantly, I am afraid it will be terminal for the financial system we have known since the end of World War 2.
The poster child for this development has been the good old U.S.A., and in case you think I am anti-American, I must hasten to tell you that I was born in the U.S.A. exactly nine months before Pearl Harbor and spent the first eight years of my life in the environs of Washington, D.C. Since then I have lived in Canada, always within 100 miles of the U.S. border, and I have always viewed the country at close quarters with great fondness. Having said that, the dramatic financial deterioration that I have witnessed in this country over the past several decades has been truly astonishing and most discouraging.
There is always some arcane statistic that really makes a point and I think the one that resonates with me is that when Ronald Reagan assumed the presidency 31 years ago, the gross federal funded debt was $907 billion. This amount had been accumulated in a little less than 200 years, a period that encompassed two major world wars, a civil war, numerous other skirmishes, several financial panics, and a horrific depression in the 1930s. Now, a mere 31 years later, the U.S. is chalking up more than that amount in a six-month period.
It was just mid-summer last year that the agonizing debt limit debate was resolved and the limit initially rose by $900 billion in two tranches. Well, that has already been exhausted and now the hope is that another $1.2 trillion increase will get us through the November election. I think that is unlikely.
What I find amazing is that remarkably few people seem to find this unusual, although I must admit that I think very few people even actually think about it. However, I believe in the immutable law of mathematics and when you reach the point of no return, there is obviously, by definition, no going back. In my estimation, the U.S. debt situation is so far beyond the point of no return that you can't even catch a glimpse of it in the rear-view mirror.
The actual funded federal debt of over $15 trillion is just a small part of the problem. The state and local governments are in various states of disarray. As an example we are currently in the epicenter of dysfunctional finance, the otherwise wonderful state of California. Then there are the off-balance sheet items of the federal government such as government-sponsored entities like Fannie and Freddy which have many trillions of debt supported by very dubious assets. But the true elephant in the room is the unfunded liabilities for social security, Medicare, etc., which, using the most conservative estimates, easily exceed $50 trillion.
Thus, without even stretching, the total federal government debt liabilities in the U.S. are, at a bare minimum, more than five times the current nominal GDP. One of the few reasons that this remarkable debt edifice is still standing is the Fed's Z.I.R.P. undertaking (I love that acronym), the zero interest rate policy, which Fed Chairman Ben Bernanke recently announced, would be extended until 2014, in conjunction with massive Fed monetization of Treasury debt, has kept the interest rates on government debt ridiculously low, and thus the charade has been allowed to continue.
Mark my words, if the interest rates on U.S. government debt truly reflected both the real level of inflation in this country and the rising risk of some form of default, rates would already by sky-high and the U.S. would resemble a massive Greece.
I do believe that this whole process has a very limited shelf life at this point, which is neatly encapsulated in the economist Herbert Stein's timeless comment in 1986: "If something can't go on forever, it will stop." I think that we are very close to that unhappy moment and the implications for the U.S. dollar and economy are simply horrific.
However, lest I be accused by being unkind to the U.S., let us move on to Europe, which is constantly in the headlines today, for very good reason. The subject of Greece and its impending debt default has been old news for a while, but there is one aspect of it which has had me scratching my head from the outset. When it was determined that a country of 11 million essentially indolent and corrupt individuals had run up hundreds of billions of euros in debt, it became immediately apparent that the chances of servicing it, let alone paying it back, were zero. Thus it was decided that a writedown of said debt, which began at 50 percent and has now reached 70 percent or more, would be necessary.
The fact that following the writedown, imbedded debt levels would still be well over 100 percent of GDP is laughable, but the Europeans will peddle anything to keep up appearances. No, the baffling part of this whole exercise to me was that it would be described as a voluntary default by private-sector creditors and, accordingly, would not trigger the credit default swaps written against the debt.
My initial reaction was that I thought that was the reason CDS's were created, to protect bond investors against default, and if 50 to 70 percent defaults don't qualify, what does? The inimitable Jim Sinclair shed some light on this when he stated unequivocally that 97 percent of the CDS's on Greek debt were in the hands of five major U.S. banks. It is these very same banks that control the International Swaps and Derivatives Association (the ISDA), the organization that rules on what constitutes a default that triggers a CDS activation. Amazing stuff, eh?
Ironically, Greece despite its travails, is really a rounding error in the European scene and, as we make our way up the food chain, we encounter larger and larger entities with ever-greater quantities of questionable sovereign debt accompanied by essentially insolvent banking systems. The great fear is contagion and the supposed antidote is to build firewalls around the smaller miscreants so the risk can be contained and not topple the larger entities.
So far most of the solutions advanced are ludicrous. The idea that austerity can solve anything in countries that are as far gone as Spain, Portugal, Italy, et al., is preposterous. As an example, Spain already has 22.5 percent unemployment with a staggering rate of more than 50 percent in the critical 16-25 age bracket for males. In addition, the real estate morass is imperiling the entire smaller and mid-cap bank sector that financed their outrageous real estate bubble, and the federal government is just discovering the extent to which the local governments have run amok financially.
I find what has unfolded in Spain to be mind-boggling but generally representative of the overwhelming financial irresponsibility of the peripheral European countries once they were under the umbrella of the euro, which facilitated cheap financing.
I could go on for hours about the position that the PIIGs now find themselves in, but it may be more instructive to consider Germany which is viewed by all and sundry as the model of financial rectitude on that continent. What, in fact, is the reality? I recently read an essay by an astute German economist, bemoaning the deterioration in German government finances. He pointed out that not a single German finance minister has balanced the budget since 1970. As a result, the Germans have now accumulated sufficient government debt that it comfortably exceeds 80 percent of nominal GDP -- not in Italy or America's league, but remarkably similar to France, which is currently being targeted for a debt downgrade by the ratings agencies. In addition, like most industrialized nations today, Germany has huge commitments to retirees and future medical requirements that apparently are not well documented anywhere.
However, the real Achilles' heel of the German situation is their banking system. While the citizens and the government maintained a considerable degree of financial restraint when the global credit bubble was inflating, the German banks went hog-wild. They financed Irish real estate, the bonds of peripheral European governments, U.S. sub-prime debt via CDOs, etc., while leveraging up their balance sheets to unconscionable levels.
Thus the Germans may currently be talking tough, but I suspect, in the end they will be forced to bend in the direction of the bankrupts in Europe and that means further massive quantities of money creation. The long-term
refinancing operation we have seen to date is just the tip of the iceberg.
The European elite, who crammed the euro down the throats of their somewhat reluctant citizens, have invested far too much time and effort in their dream to quit now. That simply means creating whatever amount of paper necessary to keep the sovereign debt afloat and to allow the crippled banking systems to function.
However, this is not just a crisis for the Western industrialized world. A close examination of the Japanese situation is sobering, to put it mildly. Japan has by far the largest embedded federal debt-to-GDP ratio in the
industrialized world (more than 200 percent and rising rapidly) but has always benefited from the Japanese public's thrift and their propensity to buy the government's bonds. However, in the face of the world slowdown, the continuing deflationary issue, and the ongoing impact of last March's terrible natural disaster, the fiscal picture continues to deteriorate.
The real short-term problem, though, is the remarkable strength in the yen. This is having an extremely adverse impact on many Japanese companies and exacerbating an already difficult financial situation.
Looming over all of this is a longer-term problem that, in reality, may be much more serious. This is the rapid aging of a shrinking population. This would suggest that the relentless bond buyer of the past, the Japanese baby boomer, will be cashing in his bonds shortly to support himself in his old age. In the absence of domestic buyers and with the existing massive debt overhang, Japanese interest rates are fated to rise and this could prove catastrophic.
At this juncture, it seems obvious to me that in a world of increasing competitive currency devaluation, the Japanese will have to get in gear very shortly and, as things continue to deteriorate, I fully expect they will. Thus they will represent just another major world economic entity turning the monetary spigot wide open.
This brings me to the key economic player on the planet at this point, which is obviously China. China is easily the most controversial because its fate doesn't seem sealed like the other three main economic engines on the planet, the United States, Europe, and Japan, where stagnation and unsustainable levels of debt ensure quantitative easing as far as the eye can see if a deflationary collapse is to be averted.
There are many opinions on China, but the one where I tend to agree with the consensus is that China will be the economic powerhouse of the 21st century, just as the U.S. was in the 20st century. But people sometimes forget that, despite the U.S.'s clear leadership in the 20th century, it wasn't a smooth ride, particularly in the first half of the century, when the country had to endure two world wars and a decade-long depression.
I think it is unrealistic to think that China won't experience considerable turmoil along the way as well and we may well be approaching a large bump in the road. It must be recognized that China has dined out on the West's profligacy in the past 20 years and became the world's de-facto manufacturer by maintaining an undervalued currency while rapidly ramping up its manufacturing capacity and using very cheap labor. That labor was arriving from the rural areas by the tens of millions through the 1990s and the first decade of this century. This whole process created a remarkably unbalanced economy with well over 50 percent of GDP being generated by net exports and capital spending on plant and equipment, housing and infrastructure, all of which tend to be very cyclical.
They avoided the worst of the 2008 global financial crisis by embarking on a historic bank lending spree, which resulted in mounting inflation, a dramatically weakened banking sector, and a truly historic housing bubble. Now, as they are attempting to maneuver a listing economic ship, commentators are predicting a "soft landing" for the Chinese economy in 2012. I don't know about you, but when I hear that expression invoked following a huge debt-fueled boom, I become very uncomfortable.
The idea that the Chinese can easily morph into a consumer-driven economy to offset a sharp decline in net exports and dramatic overcapacity in many areas of the economy seems to be a bit of a stretch, given that the consumer is the same individual whose services may not be needed in the export or capital spending sectors to the same extent as previously.
Compounding this whole conundrum is the fact that the ruling Communist government has been dependent for popular support on economic growth and job creation. In its absence, the fractious population may be hard to keep under control.
Thus my suspicion is that when push comes to shove, the Chinese authorities will provide whatever amount of fiscal and monetary stimulus that is required to keep the economy moving forward at an acceptable clip. This, I firmly believe, will ultimately be hugely inflationary.
To me, it all seems crystal clear at this point. To avert a near-term economic and financial implosion the authorities throughout the developed world will have to hold their noses and stimulate to whatever degree necessary. No politician today wants to see the system collapse on his watch, so the world will risk eventual hyperinflation and a collapse of the present currency regime rather than voluntarily accept a debt deflation.
Ironically this was all foretold many years ago by Ludwig Von Mises, the founder of the Austrian School of Economics, which, incidentally, is the only economics I have discovered in my lengthy search for reason that makes eminent sense to me.
Von Mises, in his epic book "Human Action," published in 1949, stated succinctly:
"There is no means of avoiding the final collapse brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency system."
Given that this credit cycle has dwarfed anything seen in the history of mankind, its resolution is going to be something to behold. Global Financial Crisis No. 1 in 2008 was merely the hors d'oeuvre and we are now awaiting the main course.
I envision something along the lines of a hyperinflationary depression accompanied by the final denouement of the latest experiment with pure fiat currency -- that is, the worst of all worlds.
In the event that I am right, I can assure you that the demand for physical gold and silver is going to overrun all possible sources of supply and even the most outrageously bullish price projections for gold and silver may be exceeded.
To conclude, I would like to quickly mention two other subjects.
The first is cognitive dissonance. When I try to convey the seriousness of this whole issue of monetary debasement and its disastrous impact on society, most people are resistant or, more often than not, seem indifferent to the whole subject.
I attribute this to a state of cognitive dissonance, which unfortunately appears to affect the vast majority of society. Basically, most individuals when confronted with an unpleasant issue that is at odds with what they choose to believe go to great pains and extreme lengths to deny it. They are hugely biased to think of their choices as correct, irrespective of any concrete contrary evidence which is provided. My younger brother, who it pains me to say is a whole lot smarter than I am, has done a fair amount of research on this subject and has concluded that there is essentially some sort of blocking mechanism in most human minds which permits people to stick their heads in the sand rather than confront a difficult issue before it is too late.
I think a fascinating example of this phenomenon appeared in Michael Lewis' latest book, "Boomerang," which I highly recommend. The hedge fund manager Kyle Bass, who is rapidly becoming legendary, had arrived some time ago at the same malign conclusions about sovereign debt that I have just described to you. He took his findings to the Harvard professor Kenneth Rogoff, who along with Carmen Reinhard, was just preparing to release a new book, "This Time It's Different," about national financial collapse. When Bass revealed his numbers on the subject to Rogoff, the professor responded, "I can hardly believe it is this bad." Bass' reaction was: If this guy is the world's foremost expert on sovereign balance sheets and he isn't prepared to deal with reality, what hope is there? Bass was astounded.
Finally, I can't make a speech about our terminal financial state without a couple of points on derivatives, which continue to proliferate. The justly reviled ex-Fed Chairman Alan Greenspan used to extol derivatives as vehicles for spreading risk and making the system more resilient while he strenuously opposed any attempts to regulate OTC derivatives. This was just one of his many damaging initiatives and history has completely refuted him. In fact, derivatives have tended to concentrate risk as a large majority of them has ended up in a few hands, creating too-big-to-fail financial entities that are imperiling the whole system.
The idea that they net out and thus it is really a zero-sum game is equally ridiculous. Since every derivative has a counterparty, to suggest that an investor is satisfactorily hedged because derivatives offset a long with a short is simply wrong. If the counterparty fails on either the long or the short, the entire notional value is at risk. Given that the notional value of all outstanding derivatives would easily exceed a quadrillion dollars had not the Bank of International Settlements changed definitions to intentionally understate the true amount, the toxicity of this garbage is obvious.
It wasn't without reason that Warren Buffett many years ago termed them "Financial Weapons of Mass Destruction." If sufficient liquidity is not continuously made available in the entire global system, a potential implosion of derivatives would be activated and rapidly annihilate the entire global banking system.
Just another reason why quantitative easing to infinity is virtually assured.
I believe that investors can't own enough gold and silver. Don't be concerned about daily fluctuations in price. Focus only on how many ounces of gold and silver you own and, above all, make sure it is in physical form or in a well-documented fully allocated paper vehicle. Avoid at all costs paper gold and silver, which isn't what it purports to be and is, in effect backed by gold and silver that has been hypothecated and rehypothecated so many times that there is almost no backing whatsoever.
Thank you very much. It has been a pleasure to speak to you.
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