Creative Destruction: Alasdair Macleod suggests a Path toward Monetary Gold & Silver

This letter has been written since October 15, 1981, by yours truly because I took an interest in the connection made by a history professor of mine named Dr. Payton Yoder between a healthy and prosperous nation using sound money and a nation in decline using a currency being debased. Although President Franklin D. Roosevelt took the first step toward destroying America’s currency and thus its work ethic and morality in general, a final nail was hammered into the coffin of monetary destruction by President Nixon in 1971 when he unilaterally caused the U.S. to default on its obligation to back the U.S. dollar with gold. So for instance, if someone submitted 35 dollars to a bank, the bank would have had to pay the person 1 ounce of gold for every 35 dollars, because the dollar was defined by law as a set amount of gold per dollar. Dr. Yoder’s thesis predicted the demise of the U.S. dollar. Out of interest, I watched what he predicted come true. In fact, that interest turned into much of my life’s work—writing this letter and investing in gold exploration companies.

Until now the process of a declining work ethic and moral standards appeared to be taking place gradually. With the exogenous Coronavirus shock, I believe that this week we have been witnessing what Alasdair Macleod described as Scene One of the final Act of a global financial tragedy unfold before our eyes. In fact, I am going to provide a summary of Alasdair’s great essay dated March 12, 2020, titled, “The journey to monetary gold and silver,” as well as some of my own thoughts.

Setting the Scene

During past financial crises, the U.S. dollar has been the safe haven. And for the longest time, it has served that

function as the sanctuary from lesser currencies in order to have the liquidity to pay the coupons on their dollar debts. But rather than showing signs of sanctuary status, the dollar has rather suddenly plunged into a new bear market, much as Alasdair Macleod and Michael Oliver have been predicting on my radio show. The chart on your right illustrates that point.

The Coronavirus is certainly a black swan that has hastened the decline of America’s financial markets that were bound to collapse at some time in the near future. But the Coronavirus is actually more than just the trigger to this unfortunate turn in our markets. Even before the Chinese finally revealed it was incubating this dreaded disease, there was plenty of evidence that the global economy was slowing down. With supply chain disruptions and entire industries basically now shutting down, not only are companies facing major accounting losses, but the lack of cash flowing into highly leveraged banks from plunging business revenues is threatening to trigger a massive liquidity related collapse of the financial system.

Starting in the final days of February into this week, the equity markets are getting hammered harder even than in the 1929 crash. Of course, the first reaction is to apply proceeds from the sale of stocks to buy what Keynesian propaganda has always assured us is the ultimate safe haven—namely, U.S. Treasuries. As a result of those money flows combined with market manipulation by central banks, the value of the U.S. Treasury markets has become totally detached from the reality of the real economy. Amazingly, because of the Keynesian indoctrination, almost no fund manager in America has purchased physical gold, which has been the number one proven safe haven for centuries. For reasons I will explain later, that may change—not by choice but due to market forces requiring Keynesian economists to own up to their errors. For now, realize that the most exciting profit opportunity in the gold mining sector during my 73 years on earth is shaping up in large part because gold is so out of favor. In fact, Amex gold bugs index (HUI) is now standing at about one-third of its 2011 peak, while the gold price is in a new high ground against nearly all fiat currencies.

Monetary debasement will really accelerate from here!

The Coronavirus has triggered a chain reaction that is beginning to ripple through the global economy and financial markets. Here is how Alasdair explained it. Companies still have fixed costs when they have no sales, either because customers are not turning up or their supply chains have stopped delivering products. Where companies have cash at their banks, they will draw it down, forcing their banks to go into the money markets, either through LIBOR or repos to make up the balance, sell government bonds, or foreclose on borrowers. Where companies do not have cash, they will test their working capital facilities, likely to force their banks to cover increased lending in wholesale money markets. Where banks experience draw downs on both sides of their balance sheets, outstanding bank credit contracts, sending the sort of signal that terrifies central bankers. In fact, you can bet your bottom dollar that the Fed itself is terrified by this process because suddenly there is a huge lack of liquidity in the financial system. On Thursday shortly before 1:00 PM, we saw the first policy reaction from the Fed in which it promised to pump $1.5 trillion into the financial system in an effort to calm the markets. As the one-day charts on your left reveal, the $1.5 trillion stimulus didn’t work.

Treasuries rose sharply during the same time interval but in less than an hour peaked and at one point shortly before the close, were down on the day—meaning rates had actually risen.

Gold also rose sharply from shortly before 1:00 PM but it peaked most quickly before falling back near its low for the day.

Actually, Thursday was the second day in a row and a third time this week that the Fed pumped money into the repo markets in an effort to add liquidity into the system. While there is little doubt that a massive reduction of business activity from the Coronavirus is adding to illiquidity problems in the banking system, as will be noted shortly there have been growing liquidity issues before the Coronavirus issue rose its ugly head. And so, as the charts on your left reveal, the respite from the announced $1.5 trillion was short lived. Stocks rose most sharply but that lasted for less than a half-hour before the S&P started down to finish at a low for the day. It ended down 9.51% on the day. If the promise of $1.5 trillion goes up in smoke in less than an hour, one wonders what it will take to turn things around, if indeed any amount of “stimulus” can end this carnage. Is it possible that, as with any narcotic, at some point a level of ingestion is reached in which its effectiveness wears out or that vital organs in the system are so damaged from abuse that the entire system shuts down?

Actually, because of global trade, the Fed will have to worry about liquidity not only within the U.S. but globally as well. The only way the Fed and other central banks can provide liquidity is by printing money and since the Fed is in charge of the world’s reserve currency, the lion’s share of responsibility falls on the Fed. It has no alternative but to print trillions upon trillions of dollars. If Thursday’s results are any indication, there will need to be countless trillions of dollars created just at the time the dollar is entering a bear market. (See chart on first page of this report.) As the currency is debased it may help lift some financial assets higher, but measured in sound money (gold), these asset values will fall.

So that is what Alasdair describes as Scene I of the impending Financial Tragedy. Scene II begins with the wholesale liquidation of U.S. Treasuries by banks in New York and by foreign governments in order to obtain dollars to satisfy their liquidity demands. The Fed will be forced to supply as much credit as required by American banks and to keep the Fed Funds Rate down, to discourage the sale of Treasuries by the banks.

As for foreign countries that have USD liquidity swap lines set up through their central banks since 2013, it seems fair to assume dollar liquidity will be met through that mechanism for those countries. So the European countries as well as England, Canada, Japan, and Switzerland should be able to tap in directly to the Fed for their dollar needs. However, other countries with U.S. dollar-centric supply chains, like China, Korea, Taiwan, and others, will likely need to sell their Treasuries and T-Bills. Thus, in addition to QE, the Fed will have to buy back massive amounts of Treasuries sold by these countries. Yes, it is true that foreigners have dollar obligations, but they also own dollars. So contrary to most American media who think foreigners will be buying U.S. Treasuries, they are wrong. With the U.S. being the largest net debtor nation in the world, foreigners own a lot of U.S. dollars. We have been living beyond our means for a long time because foreigners have been willing to lend us money at very low rates. Those days now appear to be ending, and that spells big trouble for the U.S., its credit markets, and its currency, because it means that more and more dollars will have to be created out of thin air for the U.S. to mete fund its out of control spending habits.

But that’s not all. There is an unknown number of FX swaps out in the market by hedge funds around the world who have been borrowing yen or euro, both of which have negative interest rates. Then they sell those euro and yen for dollars to buy U.S. Treasuries with positive rates. That trade works well as long as the U.S. rates pay a higher yield and as long as the dollar remains strong or at least stable, relative to the euro and yen. But now the dollar is getting weaker relative to the yen and euro, and U.S. interest rates are falling like a rock! So a reversal of that trade means even more Treasuries will be sold that the Fed will have to buy. And it means that there will be downward pressure on the dollar. It is estimated that around $25 trillion of such trades is on the books or at least was until recent events made such FX swap arrangements unprofitable or at least less profitable. The unwinding of those FX swap lines may be part of the reason that Treasury rates have risen even as the stock market collapsed. 

Then there is the Trump deficit that is a minimum of $1 trillion annually and likely much higher, given endless spending programs aimed at helping workers and companies being hit by the Coronavirus, as well as the spending that kicks in as we enter this new recession. So the Fed will have to create fantasy money for that in addition to trillions of dollars it needs to pump into the system just to try to keep the entire financial system from collapsing. There is going to be an avalanche of money printing, the first of which was the ineffective $1.5 trillion promised on Thursday.

In theory, the Fed could decide to protect the dollar by allowing interest rates to rise, as was permitted by Fed Chairman Volcker in 1980. But you can rule that option out because if that were to happen the U.S. finances would be in shambles, not to mention a deep depression that would result with surging interest rates. Keep in mind that a 1% rate with a $22 trillion debt load means that the U.S. would need to raise another $220 billion annually, or the Fed would have to monetize it. Alasdair figures that the true market rate of interest in the U.S. is around 10%. So for the market to prevail, it would mean $2.2 trillion additional expenditure just to pay interest on a free market price for U.S. Treasuries. The Fed will never go that route. Instead it will with 100% certainty print the dollars until a hyperinflation results and ends dollar hegemony. 

Inevitable Failure of the Dollar

We can be sure that the Fed will not be able to keep asset prices elevated, at least in terms of a stable currency that retains its purchasing power like gold. Alasdair makes the following well reasoned arguments as to why, when the dollar rapidly approaches total debasement, there will no other fiat currency that can survive as the dollar falls into the dustbin of history with all past fiat currencies. 

  • The valuations placed on government bonds are so divorced from economic reality that after the initial shock in equity markets has passed, they will be exposed to a seismic downwards adjustment in prices. (In other words, U.S. Treasuries are headed for a horrendous bear market and interest rates will rise to their equilibrium levels.)
  • Corporate bond markets will face an even greater collapse as risk premiums widen, leading to a spate of bankruptcies in the private sector and losses on collateralized loan obligations held by the banks on a systemically threatening scale. (In this environment there will be no money printing for bailouts.)
  • Hedge funds which have taken out fx swaps have already lost the interest rate arbitrage opportunity following the Fed’s recent cut in the funds rate. Furthermore, with T-bills yielding only 0.37%, further cuts in the funds rate are a racing certainty. Unwinding these fx swaps is one factor that will put significant downward pressure on the dollar. (Hedge funds sell their dollar denominated Treasuries and use the proceeds to repay their yen or euro loans.)
  • A reduction in outstanding derivatives will be the consequence of banks desperate to free up liquidity for their own balance sheets. The cost of hedging risk will increase significantly and in many instances become unavailable. Hedge funds and the like will be forced to restrict their activities, raising the possibility of widespread losses and potential failures in financial asset markets.
  • A glance at their share prices confirms that major European banks are already in trouble and they have long been at severe risk of failure, a fact which has been concealed by the ECB’s provision of liquidity. If nothing else, a new escalation of non-performing loans brought about by the coronavirus now threatens to collapse Italian, French, German, Spanish and other eurozone nations’ commercial banks despite the ECB’s efforts. A coordinated G-20 global bank rescue scheme involving open-ended monetary expansion by central banks is likely to be instigated in a widespread act of currency inflation. (Your editor heard from a trusted source that Deutsche Bank’s derivative book blows up if their stock falls below US$6.45. It closed at US$5.53 on Thursday. We shall see.)
  • A general liquidation of foreign-owned dollar assets and selling of dollars is likely to follow. 
  • Only then will the wider public begin to realize that the full faith and credit in their governments and currencies, which they take for granted, are worthless.

Alasdair noted that, The confluence of these threats to financial assets and the world’s reserve currency makes it almost certain that this time attempts to rescue the world from another financial crisis will fail. The twin pillars in the Keynesian endgame, whereby the future of financial assets has become tightly bound to the purchasing power of currencies, will both be destroyed by market forces acting like Sampson pushing the pillars apart until the temple’s collapse killed all the Philistines.

Fiat Currency is a loser!

Figure 2 above shows the decline in the value of major currencies since the London Gold pool failed to keep the price of gold suppressed in the late 1960s. The most debased currency is sterling, which retains only 1.19% of its 1969 purchasing power, followed by the euro at 1.56%, the dollar at 2.22% and the yen at 7.4%. If currencies lose so much purchasing power, why have citizens remained so content to own it? I think the answer to that has a lot to do with the pace of purchasing power losses in the currencies. It also has to do with government and central bank propaganda. John Williams, who has been on my radio show many times (I should have him on again sometime), is in agreement with Alasdair in suggesting the actual cost of living inflation is closer to 10% than 2%. But when your government tells you over and over again that it’s 2%, people tend to believe that, at least if prices are rising slowly.

But Figure 3 shows that the pace of the loss of purchasing power for fiat currencies is quickening. Compared to the stable purchasing power of gold, these major currencies (USD, EUR, BBP, Y, JPY) have lost an enormous amount of purchasing power in just the last five years. Sterling has lost ~45%, the U.S. dollar ~35%, the euro ~32%, and the yen ~24%. No wonder central bankers want people not to ignore gold! As the pace of money printing begins now to explode exponentially, driving gold to much higher levels amid collapsing power of fiat currencies, I think we can expect a change of heart even by the masses of folks not intimately plugged into the financial markets. 

Alasdair believes and I concur that the next phase will come with a collapse in government bond prices as the world’s reserve currency declines. As this economy heads into a recession or worse and countless trillions of fiat money is created out of nothing, leading to rising producer and consumer prices that are totally out of sync with bond prices, there can’t help but be a rebellion on the part of bond holders. Money printing will be tried but there will arise another market to bypass the phony government/central bank-manipulated markets that are denying the economic realities of price inflation. Totalitarian tactics may be tried by governments and they may keep the elite in power and riches for a while. I hope and pray that doesn’t happen, but witnessing the behavior of the Deep State, I don’t see why we shouldn’t expect that in America’s future even as propaganda suggests what is killing us is in our best interest. It is entirely possible that those of us who have long seen this coming may not be treated fairly with respect to our gold holdings, as was the case in the 1930s when gold was confiscated prior to revaluing it higher afterwards. But keep in mind that is one other reason to own gold shares. Gold will always be of value so I expect our government will allow mining companies to continue to operate. In the 1930s, when the Dow lost 90%, Homestake Mines rose by more than 500% and paid huge dividends! 

In looking forward, Alasdair offered the following developments that he thinks are likely in the coming months, listed in the order he perceives they will take place. Some of these events may already be underway. 

  • Base money will be increased substantially to offset a contraction in bank credit and to give banks extra liquidity to compensate for becoming deficit agents as supply chains dislocate and retail sales of non-essentials goods and services collapse. We have already seen daily repos by the Fed increasing from about $40bn in recent weeks to between $130bn to $200bn currently. 
  • “Helicopter money” in various guises, such as deferral of tax payments and business rates to help provide liquidity, will shift to governments some of the deficits building up in businesses. Mortgage payment holidays are offered in some countries. Helicopter money is already being provided to investors through share support operations, such as the Bank of Japan’s purchases of ETFs, which is likely to be expanded. In Hong Kong, each citizen is being given HK$10,000. 
  • Within a month or two there will almost certainly have to be bank bailouts in Europe, which will require additional monetary commitments by the ECB and the national central banks. This will likely lead in turn to widespread liquidation of euro commitments for speculation and arbitrage. Loans in the trillions have been taken out in euros as the counterpart in fx swaps to the dollar. As these positions are squared the euro will rise and the dollar will fall, transmitting a eurozone banking crisis into liquidation of UST-bills and short-term US Government coupon debt by US hedge funds. A heightened risk of counterparty failure in fx swaps could spread to other derivative markets, requiring bailouts of non-banks, including major hedge funds. Failure to do so or a bungled operation such as tinkering with mandated bail-ins could hasten the collapse of stocks and other financial assets. 
  • A declining dollar will increase portfolio liquidation pressures on foreigners, leading to indiscriminate offerings of US Treasuries, agency debt and equities. The Fed will have to take on not only the financing of an increasing budget deficit, but also absorb foreign sales of dollar-denominated securities if it is to retain control of prices. 
  • At this stage it will become increasingly obvious to domestic bank deposit holders that the dollar’s purchasing power is being destroyed by the Fed’s escalating asset support commitments. In effect, the Fed will be the only significant buyer of financial assets, paid for through quantitative easing on a far greater scale than that which followed the Lehman crisis. 
  • In the absence of other buyers of US Treasuries and the loss of purchasing power for the dollar, bond prices will sink, which will make it virtually impossible for the US Treasury to fund a ballooning deficit. An election year creates extra difficulties leading to uncertain political outcomes. But by the time President Trump is due to stand for re-election, over a million elderly and poor Americans might have died from the coronavirus, socialist Democrats might be in the ascendant and the dollar could become worthless. 
  • With the dollar as the world’s reserve currency and nearly all other fiat currencies having taken their cue from it since the Nixon shock in 1971, they also seem doomed to failure with the dollar.

Alasdair compares the current system to the Mississippi Bubble orchestrated by John Law, in which interest rates were suppressed. He notes that in this system, an asset and monetary collapse, apparent wealth simply vanishes, destroyed along with the medium of exchange. In summary, Alasdair makes the point that whether the Deep State likes it or not, wealth will in the end be transferred from fiat money to gold (and silver), as honest, asset-backed money retains its wealth while fiat becomes worthless. Some governments like Russia and perhaps to a lesser extent China will be in a better position to build productive economies by establishing gold-backed currencies while western countries that have become slaves to socialist thinking will find it almost impossible to do. Only God knows the ultimate outcome of all of this. But all of history suggests it’s better to own gold, which will retain its purchasing power as long as this earth lasts. And quite frankly, I think it makes a great deal of sense to diversify your gold holdings by owning gold in various forms in various locations if you are fortunate enough to do so, and to own gold shares, which in the 1930s certainly made holders of those shares very wealthy even as the Dow lost 90% of its value. History never repeats but rhymes so there are no guarantees. But diversification seems to be very good advice.

About Jay Taylor