What is Freegold? Or, Can the Debt Grow Forever?

HERAT, AFGHANISTAN – FEBRUARY 27: Afghan women look at gold in a window of a jewelry shop February 27, 2010 in Herat, Afghanistan. As the ongoing war in Afghanistan enters its ninth year the instability in the region has shaken the trade market and in most gold shops business is down 90 percent. Many Afghans have fled the country in fear and with international gold prices around $1,000 dollars an ounce many gold traders are without customers to sell to. Gold plays an important ritualistic purpose in the Afghan culture and have long bought gold as a store of wealth. (Image credit: Getty Images via @daylife)

I recently read a great post over at FOFOA, titled “The Debtors and the Savers 2012“. I’ve been reading a lot of FOFOA lately, and learning more about the “Freegold” thesis. The essence of the thesis, as I understand it, lies in the following chain of events:

1. The U.S. economy is currently running massive deficits, with a trade deficit in the hundreds of billions and a federal government deficit in the trillions. These deficits have been funded through debt, and this debt has enjoyed a significant degree of support in the past decade from big players such as China.
2. The U.S. holds the unique position as owner of the world’s reserve currency, a status which it has enjoyed due to the unique historical circumstances of the 20th century. This could even be called an exorbitant privilege.
3. Political and structural support for holding new debt flows is fading.
4. As 3rd parties reduce their purchases, the Federal Reserve will have to take up the slack.
5. Diminishing confidence in the U.S. dollar will eventually lead to a significant loss of value.
6. This loss of value will cascade, leaving a path of financial destruction in its wake. With the loss of confidence in the U.S. dollar, the U.S. government will no longer be able to export inflation to the rest of the world and enjoy consumption without corresponding production.
7. Out of the ashes of this old monetary system, a new one will rise. Instead of holding sovereign debt for the long term and thus promoting profligacy, savers will prefer to store their savings in gold. As the dollar falls, gold will rise, and purchasing power will shift from those with debt to those with assets.

I believe that understanding this chain of events, how it’s going to play out and acting on this knowledge could be one of the most important decisions of our lives.

This is not a gold standard

This will not be a return to a gold standard: a gold standard does not work, because it fixes the price of money in terms of gold, and price fixing leads to severe imbalances over time. It also leads to a conflict of interest, because the politicians have an incentive to debase the store of value in order to fund the expansion of government. There are also far too many influential economists out there that hate the gold standard. It’s not going to happen.

At the same time, production needs to return if consumption is to follow. The more a country decides to fund itself through debt instead of production, the more that the economy gets skewed, with significant expansion occurring in financial, insurance, and real estate, but not enough occurring in the areas of the economy that actually improve the standard of living and keep people alive. With the economy becoming more of a mirage as the debt expands, unemployment increases and living standards eventually start to decline.

Is it harder on young people today than it was for people in their parent’s generation? Could it have something to do with this exorbitant privilege?

Is the shift already happening?

Is appetite for the U.S. debt already starting to decline? Here are some interesting articles of late:

China Trade Deficit Spurs Concern – The Wall Street Journal

Japan’s May Trade Deficit Larger Than Expected – WSJ.com

Obviously, on a global scale, trade deficits and trade surpluses need to net out to zero. If one country consistently runs massive trade deficits, well, someone else needs to work hard to produce and make up the slack. What happens when the producers start to run trade deficits themselves? Who picks up the slack then?

Gold needs to be set free

If debt is no longer acceptable as a long-term store of value, due to the problems that it causes, what will take its place? Fiat money is still convenient, as it helps to lubricates an economy and enable easy transactions, so it’s great as a medium of exchange. Perhaps the key to resolving the conflict is to bifurcate the monetary system. One system as a medium of exchange, and one system as a store of value. Instead of returning to a gold standard, gold will instead be freed to act as a counterweight to fiat money. People will freely choose it to store their savings, because it will be the best vehicle for doing so.

Gold is a timeless historical asset and has been valued for its excellence as a store of value for over thousands of years. This is as true today as it was hundreds of thousands of years ago, even if small savers have allowed themselves to be misled by the mainstream media and the political bias against gold. The value of gold lies in the fact that it cannot be inflated away nor manipulated to the degree that a fiat currency can. It is the ultimate settlement of payment and store of value.

The eastern world has always understood this. Gold has retained a special place in the hearts and minds of easterners, who understand that gold is an ultimate store of value whose purchasing power cannot be confiscated or inflated away by the political elite. It’s only in the western world, and only in North America in particular where gold has come to be looked at as something “weird” or “shady”. It’s now looked at as normal to be forced to place all of one’s money in the stock market, just to keep up with inflation. Everything is highly leveraged, including the gold markets themselves through the expansion of paper gold.

Reserve currencies do not last forever, and neither do pure fiat currencies. The world is changing, and those that follow in the footsteps of the giants are less likely to be caught on the wrong side of that change. The greatest value of gold lies in its ability to best reflect the subjective valuations of people and protect the purchasing power of the producers.

Problems for those who believe that the status quo will remain the status quo

Can the status quo remain the status quo forever? I have a few issues with that:

• Interest rates are just about as low as they can get. What happens if they go back up? What happens if they continue to remain as low as they are?
• What use would China and other countries have in accumulating another few trillion dollars of U.S. debt? These countries are far more industrialized than they used to be, and they have an internal market of consumers now.
• If there is a severe crisis (whether in the Euro zone or not) which causes the value of gold to spike, what does that do to the Euro? What does it do to the U.S. dollar?

In the long run, everything will be fine

English: The skyline of Shanghai, China. (Photo credit: Wikipedia)

I remain a long-term optimist. The U.S. will need to reduce its consumption and fund it from production, but that’s fine. People might not get to drive around large gas-guzzling SUVs like they used to, but here are some of the great changes that I can foresee:

• Without excessive debt driving costs through the roof, a lot of things would become more affordable again. People will no longer need to mortgage years of their lives to go to school or buy their first home.
• Entrepreneurship will explode, as traditional models shift toward more sustainable models. People will no longer put up with slaving away in a job that they hate in order to live in a home that they can barely afford, because the easy credit to finance such a lifestyle will no longer exist.
• Both the U.S. and Canada have a wealthy abundance of both natural and human capital. An economy based on a sustainable balance between consumption and production will better allocate these resources where they are happiest and put to the best use.

I see it as a future where people live happier, healthier lives, and where the political influence of special interest groups is greatly reduced. The U.S. can become a productive country once again, people can find work, rebuild their communities, and live fuller, healthier lives. The way there isn’t through protectionism, mercantilism or nationalism. Rather, it will come about through the simple realization that “in the long run, we’re all dead” is not true for our generation, and our children’s generation, and in the long run, we must all live within our means.

How will you take action?

If you believe in a more sustainable future, one where people do not have to slave away their lives for debt, then the best way to vote for that future is to put your money where your mouth is and start saving in physical bullion. Paper derivatives will not do.

If you like the current system and the U.S. government’s profligacy, then by all means, continue to support the system by purchasing more of the government’s debt and letting your money depreciate in the banks.

What are your thoughts? Do you think that we’re going to enter another 20 years of immense expansion of the economy and of paper wealth, as we saw in the 80s? Or, is it true that change actually does exist, and the people saying “this time is different” may have a valid point?