Gold Confiscation and Prospects for Soaring Prices

I had a conversation with a new reader who told me that he has been invested in gold since 2001, when gold was under $300 an ounce. Instantly, he became my hero. It seemed that we both had similar reasons for investing in gold, except for the fact that he sold his gold in 2009, about the same time I was going all in. He cited concerns about the fact that the government will manipulate whatever outcome they want, and had the ability to suppress the price of gold. He also had concerns as to what he could actually do with the gold if need be, and if there was an Armageddon scenario, how easy would it be to convert your gold into something useful.

Of course, this was following the financial crisis of 2008/2009 in which the government did manage to manipulate many things, including the value of senior debt of GM and Chrysler bond holders, and played God in determining which insolvent financial firms would live, who would die, and who would be taken over by another firm. Clearly the government has been able to manipulate many things, and in fact, they have the wherewithal to buy or sell gold, and manipulate its price as well.

However, the government cannot create more gold out of thin air, and this is where it becomes interesting. Since the government has been creating money out of thin air, it stands to follow that the price of gold should go up while the government is printing money. In fact, since 2008, the Federal Reserve has increased the size of its balance sheet from $900 billion to $2.8 trillion, for over a 200% increase. During this time period, the price of gold has risen from $900 to $1500, or a 67% increase, and the price of silver rose from $15 to $35, for a 133% increase.

Conspiracy theories have been circulating for the last 2 decades that the government has been using its stockpiles of precious metals to keep the price of both these metals suppressed. The short explanation of the conspiracy theory is that the government has either sold its gold and silver, or has been lending their gold and silver to the large banks, which in turn use that supply to sell into the market to meet demand for the actual physical gold.

Accordingly, the government might own an IOU from the banks to return the gold, and if that is the case, then it is just that, an IOU (sometimes referred to as paper gold), and not actual gold. While Texas Congressman Ron Paul has not espoused any of these conspiracy theories, he wants to first hand see that the US’s 264 million ounces of gold, do in fact exist. As the Chairman of the House Financial Services Subcommittee on Domestic Monetary Policy, Ron might get his wish to have the nation’s gold audited.

Here is the point I want to make, and that is that the government cannot create gold out of thin air, as it can print money. Since 2009, the price of gold has risen 67%, and since 2001, it has risen 500%. What is driving this rally? My best answer is that the rally reflects the demand by the world for an alternative way to hold its wealth, savings or reserves, other than US dollars. Over the last few years, Central banks have been replacing dollars with gold on the margin, and India and China, two of the most populous countries in the world, have liberalized laws to allow its citizens to own gold. During repressive regimes, gold is something which the government makes illegal for its citizens to own, since the government needs the wealth of its citizens to survive. This has happened through the history of governments.

In fact, there is a very well known crises which occurred in France in the early part of the 1700s. Toward the end of this crisis period, 1719-1720, it was declared illegal to own precious metals by law. Citizens were forced to turn their precious metals in, in exchange for a burgeoning supply of bank-notes, which were quickly devaluing. This followed a period in which the French government had used up much of its resources by fighting overseas wars over the previous 60 years, and had issued massive amounts of debt to its citizens, and dramatically increased the money supply.

One of the premises of John Law, who was behind much of this scheme is summarized by this quote: “An abundance of money which would lower the interest rate to 2% would, in reducing the financing costs of the debts and public offices, etc… relieve the King. It would lighten the burden of the indebted landowners. This latter group would be enriched because agricultural goods would be sold at higher prices. It would enrich traders who would then be able to borrow at a lower interest rate and give employment to the people.”

Does this sound familiar? Isn’t this what the Fed has been doing? John Law espoused the same trickle-down theory which our government has done with respect to rescuing the banks which put the country’s financial system at risk. The bottom line is that France had extended itself with decades of foreign wars (sound familiar) and had gotten to a point where it needed to confiscate the wealth of its citizens.

The reason why it worked for some time is because its citizens never thought the government would do that to them. If they had concerns, then capital would have fled the country. To put the French situation in perspective, and what might lay in store for us, here is a brief chronology of what happened in France in the early 1700s: 1701-1704 – The government starts issuing debt. In 1704, the debt is declared to carry an interest rate of 7.5%, to make holders comfortable with the new form of money introduced by the government. This debt can also be used to pay taxes. 1708 – Government debt runs up to 800 million livres (the official currency of France.

In the late 900s, King Charlemagne established the livre as the currency of France, and equal to one pound of silver). This is about $460 million using the current price of silver. The government debt which now equals 800 million livres, is converted to T-Bills with a value of 250 million livres, and the interest rate is reduced to 4%. The new T-Bills however cannot be used to pay taxes. The new T-bills trade at a 50-80% discount to their stated value. In short, this is the government’s first devaluation of its debt. 1715 – Government debt now adds up to 3.5 billion livres, which would be $2 trillion according to today’s value of silver.

The government instituted various schemes to convert the existing debt into new debt, and from what I can tell, there was some level of arbitrariness to the process. 1716 – John Law creates the Royal Bank, with its capital being funded by 25% species (silver or gold) and the rest with government debt (which was really worth 30 cents on the livre). This bank was allowed to issue bank-notes and established a silver/gold standard whereby holders of the new bank-notes could convert the banknotes for species on demand. For 31 months, the convertibility worked fine, and this confidence attracted holders of species to convert precious metals into bank-notes. By 1717, the government forced the use of these bank-notes throughout the country and made all taxes payable with these bank-notes. 1717 – Law also creates the Mississippi Company whose shares could be purchased with government debt as well.

This was in effect, a GSE. The company had the right to trade with the new world; that was its primary asset. Along the way, Law established various schemes to enhance the value of the Mississippi Company by allowing stock to be purchased on an installment plan, declaring a 12% dividend, and the like. Eventually he used money raised by selling more shares in the Mississippi Company to buy up the debt of the government.

What exactly happened sounds like a bizarre sequence of schemes upon schemes. All told, the debt of the government was mostly replaced by shares in the Mississippi Company and bank-notes issues by the Royal Bank. Additional edicts by Law caused the holders of government debt to exchange their debt for stock in the Mississippi Company. Along the way, the Royal Bank kept pumping out bank-notes without precious metals backing, to the tune of over $2 billion livres (which would be worth $1.1 trillion in today’s dollars).

With all this money in circulation, the price of the Mississippi Company kept rising, and some holders wanted to take profits. However, the scheme would not hold up if people wanted to cash out of the Mississippi Company, whose stock had no real fundamental value, except for various government franchises, such as new world trading rights, the ownership of the Royal Mint, etc… Accordingly, there was not enough metals around to support all the currency which had been created. This is when the government resorted to forcing its citizens to abandon their ownership of precious metals, by newly implemented laws.

Over the course of 4 years while this was occurring, commodity prices rose 100%. For a concise description of this situation and others, check out the book “Early Speculative Bubbles and Increases in the Money Supply” by Douglas E. French. I do not have data on what the price of gold or silver did in France from 1700 to 1720, but my guess is that if you were able to hold onto it past the confiscation period, that it was ultimately worth a lot more after 1720 than in 1700.

Does this script sound familiar? It is all the same, yet different. And how many of you had your parents tell you about what happened to Uncle Pierre in 1720 in Paris? This history is lost and not part of our consciousness. My guess is that in 50 or one hundred years, people will look back on the desperate attempt by the US government, the Federal Reserve, the EU, the ECB, etc.. to hold together an otherwise insolvent monetary system during the 2008/2009 crisis, and during the next crisis which is right in front of us. I am sure the folly of the European Monetary Union will be revealed for what a joke it truly is. In any event, layers upon layers of schemes were hatched to print new money and eliminate government debt in France from 1715 to 1720, and then the scheme collapsed. This does not look too different from what has been done by the authorities over the last few years. *

The really long term cycle: According to Robert Prechter, the period from 1720 to 1780 was a 60 year period of stagnation. In the context of his grand super-cycle, this was a 60 year depression which followed hundreds of years of rally. Ultimately, this lead to the French Revolution in the late 1700s, and the end of the monarchy.

Prechter also thinks we are embarking on a long term decline, following the 5 wave rally which has the markets have peaking, according to this super-cycle perspective, which has run from in 1789 to 2000. The inference would be that we are ready to embark on a 60 year period of stagnation/depression. Forecasting 60 years of stagnation is difficult for anyone to fathom, and the bottom line is that this takes most of us past the end of our lives, so on some level, it is irrelevant.

Nonetheless, just as the unraveling of the French monetary system helped usher in decades of depression, so could an unraveling of the US’s monetary dominance. Meanwhile, the US government has not owned up to how it is going to solve its fiscal problems, and for my 2 ounces (or kilos) of gold, I would rather hold these in an off-shore bank which is beyond the legal reach of the government.

Is there any guarantee that the US government will not be able to reach into foreign bank vaults for the wealth of its citizens, when push comes to shove? I would hope not, but we do know they can force citizens to turn in their domestically held precious metals, as they did in 1933. So is the reader who abandoned gold in 2009 correct in his assessment that the government is going to create whatever reality they choose.

Will the US resort to forced redemption of gold as France did in 1719/1720, and as the US did in 1933? As with everything else, it depends on what is going in at the time and what our leaders choose to do to float a sinking ship. The most relevant sign-post as to the arbitrary nature of what the government does can be seen in how the 2008/2009 crisis was handled.

Some financial firms were rescued by the government, while others were left to die. As for the car companies, a good portion of the rights of senior bond holders were subordinated to government mandate. First, the government gave the companies a life-line of cash through the winter of 2009, establishing their first lien against the assets of the car companies, and then in March of 2009, the rights of the unions, which should have been taken down to nothing, were given significant ownership in the revamped companies, while senior bond holders received significantly less than if the companies were allowed to go into bankruptcy earlier in the year.

My point is that the rules of engagement in business, commerce and property rights during normal times get thrown out the window when the government’s existence is called into question. I expect more government led shenanigans to occur as the stock market sinks over the next few years. Financial firms and sovereign countries will fail, and the governments of the world will conspire to keep the system propped up.

There is just too much debt out there which will not get repaid. If the government allows a 1930s style depression, then everything goes down, and precious metals stays about the same. If instead we have more of 2008/2009, or France during 1715-1720, then precious metals will soar. You make the call. * I had a meeting with a financial planner earlier this week, and when asked to describe my portfolio, it was very simple, precious metals, cash and some foreign currencies. I explained I was being defensive. That is the first time he heard anyone describe such a portfolio as defensive. *

On the website, zero-hedge.com, yesterday, Tyler Durden subtitled Bernanke’s press conference: “I have no idea why the economy will get better, but it will” I wish I thought of that synopsis. Remember that Bernanke is the same guy who told us that subprime was not a problem in 2008, and that the GSE’s were in fine shape prior to their collapse. Have a great day – Rick