“Why is the U.S. economy so strongly dependent on international capital flows? The reason is that after the decoupling of the U.S. dollar from the gold on August 15, 1971, the U.S. economy gradually gave up production in kind and left the real economy.” — Luke Gromen

What would happen if no one except the Fed was willing to buy U.S. debt? This is not an economic question, but a psychological one. What trust do the other economic powers have in our ability to manage the world’s money supply? How well does the dollar serve their interests? Is using them still a privilege or a burden? Answer these questions in the context of a creeping loss of faith in US financial stewardship, as well as our government’s weaponization of the dollar around the world.

One helpful metric to evaluate our country’s financial health is to look at the ratio of US Debt to GDP. The official U.S. outstanding debt now stands at $24 trillion while our GDP last year was $21.44 trillion. That means that as a nation, we have more total debt than income. In the post WW2 boom years, our debt was far less than our GDP. But this ratio has been slowly climbing. Before the Coronavirus pandemic, US Gov’t debt was 106% of GDP. Now it is even higher since $2 trillion in stimulus has been rolled out and GDP will dip sharply. The major problem with a high debt to GDP ratio is diminishing returns you get for the same input. This is an entire area of study that I don’t have room for here, but the contour of the problem is outlined in this image from Charles Hugh Smith.

“Central State spending has reached the point of negative returns: money is dumped into cartels but the yield on the investment is near-zero. This is the point of stagnation, where spending keeps rising but tax revenues are no longer keeping pace because the State has become an enormous drag on the economy.” — Charles Hugh Smith

Topping the list of problems from high debt to GDP is the increased cost burden of interest payments. As this chart shows, by 2022 the interest alone on the national debt will exceed our total military budget (last published figure for military expenditures was $567 billion).

This explains why the United States cannot allow interest rates to rise. It’s because our government is forced to refinance a huge portion of its total debt every year to avoid paying the balance. If rates rise, then interest payments on the newly refinanced debt will rise with them. It is of existential importance for our government to keep interest rates low into perpetuity.

In a permanently low-interest environment, gold becomes competitive with bonds due to gold’s monetary characteristics, which among other things, is a lack of default risk and lack of inflation risk. My favorite take on gold comes from Luke Gromen who calls it “a zero interest bearer bond of infinite duration which carries zero risks of default.”

2— HOSTILE ENVIRONMENT

While threats to the U.S. dollar come mostly from within (our government’s inability to function without resorting to money printing at the Fed, which in turn fuels the selective inflation I talked about above), there are external threats to the dollar as well.

Other governments around the world are desperately in search of a global reserve asset that is not controlled by the United States since they have grown resentful of their role in directly funding U.S. fiscal irresponsibility and hegemony. I count at least three open fronts on the war against the US dollar as the world reserve currency:

China and Russia looking to throw off the yoke of the US dollar as a global settlement currency and for pricing oil. China is definitely working on a digital version of yuan and could potentially open this up to the rest of the world once it launches.

“To effectively contain the United States, other countries shall think more about how to cut off the capital flow to the United States while formulating their strategies…That’s the way to control America’s lifeblood.” - Maj. Gen. Qiao Liang, a professor at the People’s Liberation Army (PLA) National Defense University

2. Central Bank Digital Currencies — Former Bank Of England Governor, Mark Carney, at a recent speech at Jackson Hole, floated the idea of Central Banks everywhere banding together to issue their own digital currency so that they “could dampen the domineering influence of the US dollar on global trade”. There are many in Europe and at the IMF who are actively studying this and making plans.

3. Corporate Currencies — like the cryptocurrency Ethereum and Facebook’s newly Libra.

3— CURRENT DOLLAR STRENGTH

Though I have revealed threats to the dollar both internal and external, there exists a signal in the market today which directly contradicts the narrative I’m weaving. The dollar is currently rising in value compared to other currencies. You may interpret dollar strength as a comfort, and if you’re holding a lot of cash at the moment it is good news. However, my belief is that this is a temporary phenomenon due to the U.S. dollar being the “least dirty shirt” in the hamper. Translation: all fiat currencies are entering a period of turbulence, largely due to the fact that foreign central banks have copied the American playbook, which is to stimulate their flagging economies via artificially low-interest rates and zero cost bond funding for the government by the central banks. This trend had accelerated even before COVID-19, but the pandemic has made the situation worse.

“Global policymakers have rolled out unprecedented stimulus measures in the past few weeks, cutting rates sharply and injecting trillions of dollars to backstop their economies as many countries have been put under tight lockdowns to contain the pandemic.” — REUTERS 4/14/20

And yet another dimension to this global dollar problem is that many foreign entities (governments, corporations, banks) take out loans not in their own currencies, but in dollars. When the local currency falters, dollars become, in a relative sense, much more expensive. An inability to make interest payments requires either MORE borrowing or default. This is the mechanism behind the strengthening dollar: a global shortage due to the fact that everyone’s either maxed out on loans and/or diluted their local currency via inflation. So while this dynamic is fueling an increase in the relative value of U.S. currency, it’s also putting non-US economies in greater peril. A series of defaults or a replacement currency could end the rush for dollars. Being the least dirty shirt buys us time, but it’s is not a long term fix to the monetary conundrum the world now faces, which is the long term stability of the dollar.

At the moment we are seeing the value of the dollar and the value of gold rise at the same time. This is an uncommon phenomenon and indicates that gold buyers share my suspicion that dollar strength is not built on sound financial footing.

4 — INTERNATIONAL TRENDS

China and Russia have been aggressively buying gold. I am not an expert in either of these countries, but I have been seeing headlines like these for the past couple years:

I assume that if these reports are true, it’s because our adversaries understand everything that I outline above regarding the United States’ deficit spending, and our reliance on financing those deficits from buyers of U.S. Treasuries (i.e. foreign central banks, pension funds, retail investors, and increasingly, the US Federal Reserve).

5— WHY I LIKE GOLD

If I had to pick one thing about gold that’s most appealing, is that it’s a bearer instrument, meaning that its value travels with it. There’s no third-party responsible for redeeming your gold. Owning gold is “final settlement”.

Gold and other bearer assets are final extinguishers of debt, as payments in them carry no associated liability. — Robert Breedlove

Gold really shines when you consider some of the important characteristics of good money.

Scarcity — This is the defining attribute of gold. Scarce money is impossible to inflate because of its “unforgeable costliness.” I have a separate section devoted to scarcity below. Divisibility — you can buy and sell gold in large and small increments. Liquidity — Gold can be sold to anyone in the world in large amounts. Portability — Can be carried with you across national and international boundaries. Durability — can be passed down from generation to generation and due to its atomic stability, it does not deteriorate or corrode.

Gold vs. Stock Market

In the long term, a successful corporate stock should outperform gold. Gold, after all, does not produce a dividend. For this reason, I see gold as a strategic portion of your portfolio to hedge against currency risk, and as a counterbalance to a falling stock market. One note of caution here is that gold does not always rally when the stock market tanks, so an inverse correlation should not be assumed. I will go into much greater detail on this in the final section of this paper.

Gold vs. Bonds

In an era where bond yields are trending towards zero, gold becomes more and more attractive. When and if bond yields begin to rise, and IF they are issued in a currency I trust then I might allocate more to bonds and less to gold. Part of the gold vs bonds question also lies in the fact that gold is a global market, and bonds are not equally attractive when offered in places like the EU where bonds have a negative yield. Negative bonds reward borrowers and punish savers. I don’t know if we’ll ever have negative-yielding bonds in the US but many other places already have them and those markets participate equally in the gold market and help to support the price.

Gold vs. Cash

My strongest rationale for owning gold is that I believe it will hold its value better than cash in the long run. This has a lot to do with our long term debt picture in the US. It is my belief that someday, due to the US Government’s inability to pay its debts, it will devalue the currency. My gold allocation is a numerical expression of my belief in how pressing this problem is (i.e. 2.5 percent likelihood increasing to a 5 percent likelihood).

Gold vs. Real Estate

Real Estate has taken on a money-like or Store Of Value role in our economy. This is now deeply ingrained and I don’t necessarily see it abating. But gold has many advantages over real estate, namely it has much lower carrying costs — no property taxes, no maintenance costs for gold. There is no financial barrier to entry for gold. You can start owning gold in the sub $100 dollar denominations. The resale market for gold is much larger than the local market for a house, and because of its portability, you can take it with you if you leave home and travel to another market.

6— SCARCITY

I don’t think that gold evolved into global money because it’s pretty and shiny. That may have been why primitive men picked it up off the ground and began to polish it and make jewelry. But the reason gold works as a monetary media is its scarcity. Over the last few centuries, the inflation rate of gold has hovered reliably between 1.5 and 2 percent. This is due to the difficulty of extraction, the energy required, and how much exists in the Earth’s crust. All monetary value, at the end of the day, is driven by scarcity and demand. This is why I have come to appreciate gold over all other monetary metals. It has the highest ratio of existing stockpiles divided by net new inflows of gold per year. This is referred to as the Stock To Flow ratio. Below is a chart of the monetary metals Stock To Flow (with Bitcoin as well)

Gold currently has a Stock To Flow ratio of 63, which means it will take 63 years to double the world’s stockpile of gold.

“ Humanity has been accumulating an ever-growing hoard of gold in jewelry, coins, and bars that is never consumed and never rusts or disintegrates. The impossibility of synthesizing gold from other chemicals means that the only way to increase the supply of gold is by mining gold from the earth, an expensive, toxic, and uncertain process in which humans have been engaged for thousands of years, with ever-diminishing returns. This all means that the existing stockpile of gold held by people around the world is the product of thousands of years of gold production, and is orders of magnitude larger than new annual production.”- Saifedean Ammous from his article “The Bitcoin Halving and Monetary Competition”

Bringing it back to dollars, the United States is currently on track to double the supply of dollars in just 8.8 years.

The bottom line is that if the world had to vote tomorrow morning on a non-sovereign reserve asset to replace the US dollar, the winner would be gold. Some day I think it could be bitcoin, but the world is not there yet.

7- HOW TO PRICE THE RISK

Being an amateur, I can only offer this blunt tool to assign a relative value to this. You have to take in all the information and make some kind of probabilistic call regarding your likelihood of my thesis is true, and then the likelihood of my thesis affecting you within your time horizon. So let’s be generous and say that after reading this document, you conclude that there is 75% chance that I’m right. However, you feel in your heart that there is only a 10% chance that these trends will affect you within your investment horizon. Then your allocation would be ten percent of 75 percent, which is 7.5%. So if your net worth is $500,000.00, you would put $37,500.00 into gold.

Without access to an enormous amount of data and any trustworthy mathematical models, there is no way for me to actually calculate respectable values for these percentages. I’m going entirely off my gut instinct and I recommend you do the same.

8 — PHYSICAL, PAPER, OR CUSTODIAL

The factors to consider when owning gold are confiscation risk, default risk, abrogation risk, liquidity, effort, and security.

Physical ownership in your own vault or safe has the lowest confiscation and abrogation risk. I’m not too worried about the government confiscating gold, but it should be noted that they have done this in the past and if there were to be a crisis there is a non-zero chance it happens again. But I deem this to be the least likely thing you’ll have to contend with so I would not make a decision based on this fear. Owning your own gold comes with significant effort and my your case, being older and having frequent visits from caregivers, I would not consider this very secure.

Paper gold in the form of gold securities or ETFs is easy to buy and very liquid. If you need to sell you are merely trading numbers in a ledger. Default risk, to me, is much higher with paper gold and grows considerably with the value of the gold. Should the price of gold skyrocket for whatever reason, especially political reasons, some gold-based securities could find reasons not to pay you. They might not actually own the underlying gold they think they own. They may have loaned their underlying gold to another party or multiple parties, or have borrowed it from someone who has a similar chain of custody problem. Furthermore, the government has the power to close the exchanges where these products are traded. Trading paper gold is like trading warehouse receipts. Unless you have a lot of faith in the warehouse, you might get caught with a meaningless piece of paper. I also believe that paper gold products carry abrogation risk. This is when the government intervenes to nullify a contract between two private parties. This happened in 1933 when Congress nullified ANY AND ALL CONTRACTS AND GOVERNMENT BONDS which stipulated payment in dollars or “gold equivalent.” This was done in the name of saving the economy. Debtors, the US government included, if forced to pay in gold, would have been impoverished by such payment burdens. After devaluing the currency, congress declared all contracts containing the gold clause to be void. All that being said, I own some gold ETFs and I think that some exposure to these instruments is fine.

Custodial services actually warehouse the physical gold for you, and you pay a fee for the service and for insurance. Since there is, ostensibly, actual gold with your name on it somewhere, these services generally provide physical delivery options should you decide at some point in the future to take custody of the gold. If you can find a reputable service through your investment advisor I think this is a great way to go.

There are also some securities that have a mixture of the above qualities. Decide which mix is right for you and ask your investment advisor what products they offer.

9 — WHEN TO BUY AND HOW LONG TO HOLD

When I began writing this, despite my positive view of gold, I was actually under the impression that gold was not advantageous to own during the vast majority of the broader economic cycle. Making another gut calls, I assumed that for 95 percent of the time you don’t want to own gold. And what I have been trying to explain to you is that we are now entering what I thought was the 5 percent window of opportunity when you do want to own gold. Then a friend informed me that I was vastly underselling the importance of gold and that I should look at a historical chart of the Dow Jones/gold ratio. These charts have led me to conclude that gold is much more practical to own for a much greater percentage of the economic cycle.

This is a 100-year chart of the Dow Jones Index divided by the price of an ounce of gold. The vertical grey stripes are recessions and I’ve taken some notes on it in green. The chart works like this, when the blue line is sloping upwards, that means the value of the Dow is increasing relative to an ounce of gold. When the blue line is sloping downwards, that means that gold is increasing in value relative to the Dow. When looking at the historical relationship ratio between the Dow Jones Index and gold, there are periods which last multiple decades, especially after an economic shock, when holding gold has been more profitable and more stable than owning stocks. So for the period of August 1929 to February of 1933 (3.5 years), the Dow lost value to gold. Same with March 1966 to Feb 1980 (13.9 years), and again with the period of August 1999 to August 2011 (12 years). Adding these up gets you a total of 29.4 years out of the last 100 where gold gained in value relative to the Dow.

I’d like to zoom into this chart and look at what happened around the Great Depression, because in the context of a true crisis that may be the most instructive.

The green line above is drawn between two points on the graph where an ounce of gold was of equal value relative to the Dow. To understand this green line I will tell you the story of the hypothetical case of James, a 1920’s investor who wanted to hedge his investments. He saw the stock market attaining unimaginable heights at the beginning of 1929 and he thought “I should take some of these gains and put it into gold”. So in March of 1929, seven months before the crash, James took $100,000.00 out of his stock portfolio and put into gold. Here’s what amazes me. If he traded his gold back into stocks at any point before October 1958, this would be a profitable trade, and he would get more stocks back than he sold in 1929. That’s a 29-year window of opportunity!

One cannot necessarily plan to be like James, however, because that would mean predicting the top before it happened. This is especially true if, as I believe, the top of the recent bull market has already passed us by.

So let’s consider the pink line, which is the story of Nettie, who was totally blindsided by the crash of 1929. She kept thinking that the market would rebound, but eleven months into the slump, in September of 1930, Nettie decided to cut her losses and sell $50,000.00 worth of stocks and buy gold. Nettie’s gold would continue to purchase more shares of stock than she sold until 1954, which is still a 24-year window! Keep in mind that during this entire period, for both Nettie and James, the price of gold was fixed by the gold standard at $34, so neither Nettie nor James would have gained anything in fiat terms. However, now that the price of gold is allowed to float against fiat currencies (thanks to Nixon in 1971), a similar post-crisis allocation to gold should be profitable and more competitive not only in comparison to stocks but in fiat terms as well.

You might consider the stories of Nettie and James to be all too convenient, or unfair because I cherry-picked the dates to illustrate the ideal narrative for gold. This is true. My thesis for gold does involve a timing component. My belief is that for the past year we have been at exactly the right time to make an allocation to gold and that we are still within the window of opportunity.

A note of caution, all economic advisors I have ever talked to recommend never trying to time the market. But with gold, I don’t think you need a high degree of accuracy. In my examples, James was 7 months early and Nettie was 11 months late. Even if you believe, as I do, that the sun may be setting on the dollar’s reign as a world reserve currency, this process will take many more years.

Don’t be distracted by the fact that I’m writing this during the COVID-19 pandemic. My thesis for gold began over a year ago when warning signs were clearly present already. The most notable of these signs was the fact that the Fed was cutting interest rates during an economic boom. As economist Milton Friedman has pointed out, low-interest rates are not a sign of easy money. They are an indication, rather, that the money is tight, and that people are borrowing less. So the Fed lowers interest rates to artificially spur more borrowing, which pushes more money into the economy. The fact that this was happening when the stock market was a decade into a record-setting bull run was the tipoff that something was wrong. Furthermore, with interest rates so low, the Fed is now out of policy levers to pull when the inevitable downturn arrives. These are more examples of the diminishing returns I mentioned in section 2. What happens in the wake of COVID-19 is not the story, even if the crisis has the effect of hastening us towards the endgame.

As for how long to hold, I would suggest you take note of the Dow/gold ratio, or dollar/gold ratio. Write down what it was when you started averaging into your gold position. Hopefully, that ratio will improve in favor of gold for the next few years, or however long you own your gold. At some point in the future as that ratio returns to the point at which you entered (like the green and pink lines above), start averaging out of your position.

Since I don’t think that gold will become actual money at any point, it will have to be converted to be of use. If you want to keep gold as a permanent part of your portfolio, a simple re-balancing strategy is the best way to manage your position size until either a) the need arises to convert it to currency or b) it becomes appropriate to reevaluate the gold thesis entirely because something else has taken its place.

10— HOW I MAY BE WRONG AND RIGHT AT THE SAME TIME

Here’s another actual possibility. There may never be a crash in stocks. The Fed has essentially sworn an oath to protect the stock market at all costs. This is also of existential importance for our government due to the increasing proportion that capital gains taxes represent in year over year growth in federal tax revenue. Neel Kashkari, president of the Federal Reserve bank of Minneapolis went on 60 minutes on March 23, 2020, and said: “There’s an infinite amount of cash at the Federal Reserve.” His comment was about the safety of people’s bank accounts, not the Fed’s quantitative easing program, but the psychology behind this statement pervades everything the Fed is doing. Because of this, we may never see stocks plunge the way they did in the 1930s. The stock market may actually become a thing that ignores the economy completely.

But within this “solution” to stock market volatility is contained the very problem that will tie my thesis together. A stock market that never goes down can only exist in a regime where an endless supply of dollars is created to prop up it up.

We saw this dynamic play out in the Venezuelan stock market during their currency crisis earlier this decade. Depreciation in the Venezuelan currency made these gains moot, however.

Depreciation of a currency wipes out real-world purchasing power for the citizens who use it. The chart on the left shows the real-world purchasing power of 1 British Pound, relative to the number of pennies (pence) in the same currency from the year 1750. Note the steep decline in value as the Pound lost world reserve status in the years after World War 2.

It’s time to start finding ways to protect yourself from the inevitable loss of the dollar’s status. It won’t happen overnight. But if it does, scarce assets like gold (also real estate, bitcoin, etc.) should appreciate significantly in real-world terms, not just dollar terms.

Your wealth represents your precious time. Money that erodes in value robs you of that time. Assets that cannot easily be inflated protect it. I wish you all the best in preserving the wealth you’ve earned throughout your productive and creative lives.