The One Reason You MUST Own Gold and Silver (the impending sovereign debt default of the west)

Analysts and pundits provide various reasons for the bull market in Gold. This includes emerging market demand, low interest rates, money printing, central bank accumulation, central bank policies and falling gold production. These are all good reason but there is one reason which stands apart and will drive precious metals to amazing heights. It is the impending sovereign debt default of the west, led by the great USA.

Government finances have reached a point where default and/or bankruptcy is unavoidable. After all, we’ve already started to monetize the debt. The inflection point is when total debt reaches a point where the interest on the debt accumulates in an exponential fashion, engulfing the government’s budget. When this occurs at a time when the economy is already weak and running deficits, there essentially is no way out.

Significant runaway inflation and currency depreciation result from a government that essentially can no longer fund itself. It starts when the market sees the problem and moves rates higher. The government then has to monetize its debts to prevent interest rates from rising. Let me explain where we are and why severe inflation is unavoidable and likely coming in the next two to three years.

In FY2010, the government paid $414 Billion in interest expenses which equates to 17% of revenue. When you account for the $14 Trillion in total debt, that works out to be 2.96% in interest. In FY2007, total debt was $8.95 Trillion, but the interest expense was $430 Billion and 17% of revenue. That accounts for an interest rate of 4.80%. Luckily, rates have stayed low for the past two years.

However, in the next 24 months the situation could grow dire. At least $2 Trillion will be added to the national debt. At an interest rate of only 4.0%, the interest expense would be $600 Billion. Even if we assume 7% growth in tax revenue, the interest expense would total 22% of the budget. An interest rate of 4.5% would equate to 26% of the budget.

As far as what level of interest expense is the threshold for pain, Russ Winter writes:

Once interest payments take 30% of tax revenues, a country has an out of control debt trap issue. When you think clearly about it, this just makes sense, as the ability to dodge, weave and defer is pretty much removed, as is the logic that it will be repaid in a low-risk manner. The world is going to be a different place when the US is perceived to be in a debt trap.

Is there anyway out of this? Either the economy needs to start growing very fast or interest rates need to stay below 3% until the economy can recover. Clearly, neither is likely. As you can tell from the calculations, interest rates are now the most important variable. If rates stay above 4% or 4.5% for an extended period of time, then there is no turning back.

Judging from the chart below, the secular decline in interest rates is likely over. It is hard to argue with a double bottom, one of the most reliable reversal patterns.

In 2011 and 2012, the Fed will have two new problems on its hands. First, the Federal Reserve will be fighting a new bear market in bonds. They will be fighting the trend. They didn’t have that problem in 2008-2010. Furthermore, the interest on the debt will exceed 20% of revenue, so the Fed will have to monetize more as it is. Ironically, the greater monetization will only put more upward pressure on interest rates, the very thing Captain Ben and company will be fighting against.

As you can see, there is really no way out of this mess, which also includes the states, Europe and Japan. This is why Gold and Silver are acting stronger than at any other point in this bull market. They’ve performed great when rates were low but are likely to perform even better when rates start to rise. This is why we implore you to at least consider Gold and Silver.

Go elsewhere?

Let's say I want to buy gold today, but I don't like the current price ($1,200 per ounce or something.) Where can I go to buy at a better price? (No, I'm not willing to travel to Africa or Siberia and mine it myself.)

It is also important that in the disaster scenario people won't be able to casually go somewhere as we do today. Gas will be very valuable, some stores will be closed, and it will be plain unsafe to drive around the town; there will be plenty of people interested in your car and your gold and in anything else that you might have that they like.

I don't say, of course, that paper money will be of any value. The comparison is all about various "hard" currencies - including barter items (which are consumed directly, as opposed to being only used for exchange.) Cans of chili (or some other food) will be more valuable than gold certificates or even the gold itself. Not only because you can eat chili; it's also because it takes some effort to verify that your gold is really gold, and not gold-plated lead. (All PCB houses have gold-plating technologies, so this is not something unique.)

With regard to the possibility that the catastrophe is not uniform and some people will be gathering gold in exchange for food, I can't reject that - it certainly can be. People bought and sold for money throughout the history, including some tough times.

But to see what that buys you you don't need to go farther than the fantasy section of your local library. Grab some typical "road adventure" and see what the protagonist pays with at taverns. He often pays with copper, seldom with silver, and never with gold. Gold is reserved for a banker, or for some trusted moneychanger.

In other words, there must be an established monetary system based on gold. You can't pay for a meal with a gold bar; the tavern owner doesn't earn that much in a year; what will happen is that he gets greedy, and doesn't charge for the food. But you will meet his "friends" soon enough, in some dark corner. So a functional society must offer ways to exchange gold for silver, silver for copper, and those must be all good coins - because money has to be accepted on sight, without lab scales and cups of water. So you may have gold, and you may have a moneychanger ... but what will you get from him for your gold bar? Most importantly, what can he give you, besides a sack of paper money that you can't probably lift and can't probably find anyone willing to take. There isn't enough of silver coinage (hardly any!) to change the gold with.

So all in all, there is only a handful of universal barter items that anyone will gladly take and give - canned, non-perishable food items or gasoline or just aspirin. Ammo is also in this category. They are durable, they are immensely useful, and they can change many hands without any decrease in value. Most importantly, when you use these items for trade you don't need to count on a future expected value of an item (like in case of gold) - you get an item that already has a well known value and can be instantly traded for other items.

There is one very relevant literary example - the fate of Baron Danglars:

While leaving Rome, he is kidnapped by the Count's agent Luigi Vampa and is imprisoned the same way that Dantès was. Forced to pay exorbitant prices for food, Danglars eventually signs away all but 50,000 francs of the stolen five million (which Dantès anonymously returns to the hospitals).

The dialog there is very simple: "I want to eat" - "Sure, this chicken costs $1,000,000 francs." Danglars at first was rejecting the offer, but in a few days he had no other options. You can have your gold for a while, but the other guy will have his food for a while too, and when you are ready to trade he will take you to the cleaners. He has an advantage - his product is of inflexible demand (people need to eat) but your product is not only of a flexible demand (optional use,) it actually has no direct use at all. The best the farmer can hope for is to find someone else who sells him diesel fuel and takes gold in exchange. In a good economy that's exactly what happens; but in a bad economy barter is preferred. The stability and consistency of the value of gold is the difference between "good" and "bad" economies.

Aren’t those who are pushing people to own gold really only trying to drive up the price of their own gold?

That is highly likely. The price of a good depends only on how much the buyer is willing to pay. It has little in common with the amount of labor that is needed to produce the good. These numbers get close to each other only when the product is a commodity, available from many different vendors who all try to offer a good price, or else they can't sell. A market of Chinese TV sets is one such example. A market of diamonds, on the other hand, is under control by one company. The rule of thumb is simple: if there are only few sellers they can dictate the price.

Let's see how many gallons of gas one ounce of gold buys you in the year 2000 and today.

Year 2000: gas=$1.30/gal, gold=$300/oz. One ounce of gold buys you 300/1.30 = 231 gallon. Great.

Year 2010: gas=$3.50/gal, gold=$1380/oz. One ounce of gold buys you 1380/3.50 = 394 gallons.

What do we see here? We see that oil increases in price faster than the gasoline. And gasoline is a finite natural product, in high demand, and with the world production going down.

There goes the argument of gold bugs that an ounce of gold could buy you a suit 100 years ago and today. This is not true. A fair price of gold (assuming year 2000 as a reference) would be $3.50/gal * 231 gal/oz = $800/oz. This is because the gasoline price increased by 269%, so the gold price should also increase the same - from $300 to $807. But in reality gold increased 170% on top of that - nearly twice as much! Either the world is awash in free, unwanted oil, with poor Arabs selling it for a song, or something fishy is happening in bullion markets.

The relative stability of ancient, precious metals based monetary system largely depended on the fact that all those metals were hard to obtain (really impossible for a peasant; mines were owned by aristocracy.) Even a King [of France] couldn't make money out of thin air if his gold supplies are gone.

If the disaster strikes tomorrow we cannot anymore depend on coins that are hard to manufacture - modern technology can easily do that, and counterfeiting factories may be the only ones that can afford to run. It will take not more than a week to flood the market with counterfeit gold and silver bars and coins, not even mentioning copper or nickel - those can be made by anyone, anywhere, on a benchtop arbor press. And there is no King (or the government) to chop your head off if you get caught; if you know "the right people" then you are safe.

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