Is It Time to Buy Gold?

Gold bugs are believers, that's for sure. The question is: are they wrong?

One must correctly perceive what is happening, and what is being done about it, in order to predict what will occur.

Recall, the initiating event for this crisis was a "credit crisis". What is a credit crisis? It is the disappearance of credit from the system. Credit is not cash money, and it is not capital, it is debt born of capital in a leveraged system. “Credit” then goes out into the system and acts like money.

Banks pursue leverage in a fractional reserve system at the rate specified by the Fed, 10:1. In other words, banks use capital to give birth to credit at 10:1. Unregulated financial institutions pursued leverages much much higher, 30:1, 40:1, and in the case of certain credit insurers, 180:1. These high leverages were used in "blowing a credit bubble", fueled by Fed easy money policies (borrow short and lend long) and by Congressional incompetence in their "oversight" of Fannie (FNM) and Freddie (FRE) leverage.

Now that credit has begun contracting, the bubble can no longer be supported and is collapsing. Leverage ratios are now unsustainable. Collapsing leverage is called "unwinding". Remember, the credit that is disappearing from the system is the credit that had been created at 30:1, 40:1, and even 180:1. This highly leveraged credit had gone out into the system and acted like money; people bought things with it. It is precisely this highly leveraged credit which is disappearing from the system. With all this "credit-money" vanishing, price pressures are vanishing as well. We see this as falling house prices, etc. Since these elevated prices were used as the basis for still more leveraged lending, prices must be supported by central bank and government policy to reignite lending and credit.

Here's the problem: there are no more "Investment Banks" that use high leverage, and Fannie and Freddie have just been put directly onto the US balance sheet. All of the major sources of high-leverage credit have disappeared. In order to reinflate the system, Bernanke is pushing new money (capital) into the banks in the hopes of getting them to lend it out at 10:1 in order to replace all the credit that has disappeared from the system at 30:1.

How much new money will Bernanke have to print in order to do this? Early estimates (April '08) of the amount of capital destruction ran in the $1.5 Trillion range. Roubini stopped estimating at $2 Trillion, so let's say that $2 Trillion of capital has disappeared. If that $2 Trillion blew a credit bubble at an average 30:1, you have an approximate estimate for the value of global economic activity, so the scale of this number is probably correct. Now, if $2 Trillion in capital has vanished, and if that $2 Trillion had been lent out to create "credit" at 30:1 ($60 Trillion worth of credit), how much new capital will Bernanke and the rest of the central bankers have to print in order to replace it at 10:1? Answer: $6 Trillion.

The central bankers have already done this "back-of-the-envelope" calculation. Bernanke has already, in two months (September '08 to November '08), expanded the Fed's balance sheet by $1 Trillion, from $1 Trillion to $2 Trillion total. He is nowhere near finished.

Final question, for extra credit: what will the net effect be of this increase in the supply of capital? After all, it’s easy to recognize that it’s not real capital, it was just printed up in the basement of the Fed. What is the dilutive affect of all this brand-new faux capital? As I have asked elsewhere many times, how long until a currency crisis is initiated? The central bankers, in my opinion, hope to mask this capital dilution and stave off a currency crisis by debasing all currencies cooperatively and equally; you can see this cooperation now in rate cuts and stimulus packages around the globe.

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