Sunday, May 5, 2013

Bitcoin: What Why and How.

What is Bitcoin
Bitcoin is a virtual currency. It's management is completely decentralized and done by open source software running on millions of nodes on the bitcoin network. The production of bitcoins depends on finding a block of data which has a certain property. When such a block is found the bitcoin network awards the finder with a number of bitcoins. At first the award was 50 bitcoins, but at present it is 25 bitcoins. Every 4 years the award reduces to half. In the first 4 years 10.5 million bitcoins were created. There exists about 11 million bitcoins at the present time. By the year 2140 all the bitcoins (around 21Million) will have been generated.

The creation of bitcoins is controlled through a parameter called difficulty. The difficulty is adjusted in such a way that only one block can be found every 10 minutes. The whole things depends on an algorithm called SHA-256 (Secure Hashing Algorithm version 2 with 256 bit output). This algorithm is as yet unbreakable. Its not clear whether quantum computers would break it. But in any case they are too far off in the future.

The task is to find a block which results in a hash value that has a predetermined number of zeros at the beginning of the 256bit hash output. Since there is no way to determine what block will have this property, so all sorts of blocks must be tried till one such block is found. The difficulty is directly proportional to the number of zeros in the hash. The difficulty is recalculated after every 2016 blocks are generated. This event would be after 14 days if the networks computational capability did not change.

The network's computational capability is calculated in Hashes per second. Currently the network capability is around 75TerraHashes/sec or 75 Trillion hash computations per second. As more computers are added to the network, its capability increases, and the corresponding difficulty must increase so as to keep the block generation capability constant. Currently the difficulty is nearly 9million.

To find the blocks we use a software called miner. It is a software that searches for a block that has the required difficulty. The block is basically a piece of data plus a nonce. This nonce is a 32 bit integer which is incremented every time to get a new block. As such 2^32 blocks can be generated. Hashing functions have the property that even a single bit change will cause the hash output to change completely. So big changes are not really necessary.

Initially people were using their PCs to compute the hashes, and that was enough. Then some people ported the miners to GPUs. These provided a big jump in hashing capability. Next the miners were ported to FPGAs. These resulted in an even bigger jump. The latest machines in town are the ASICs. The CPUs on the PCs are long past their usefulness. You will spend more money on power bills than you will make money from the bitcoins they generate. GPUs are also on the way out. They are profitable at the moment, but in a few short months they will not be anymore.

More info in this link.

Why the interest in Bitcoin
Bitcoin is an internet currency, which has same property as any other Store of Value item. Its supply is more or less fixed. It cannot be generated at will. This makes bitcoin similar to gold, but with a new property of being trade-able in the digital world. Currently it is under the radar for most of the people. As more and more people realize its benefits, its value will increase.

Its value has been related to recent crises. During the Greece crisis its value had risen 35 times, from less than a dollar to 30$, after that it came back down to about 10$, with an effective jump of nearly 15times. Then during Cyprus crisis it jumped from around 12 dollars to 240$, a jump of 20 times, and then settled down at around 130$ presently, an effective jump of 10times. I believe that the jumps have been due to the requirement of moving money offshore during these crisis.

I am expecting that during the coming financial meltdown lots of money will be looking to move. This will attempt to go into bitcoins, as gold will not be available. This will cause bitcoins to jump a whole lot. I would think on an unprecedented scale.

A unique thing about Bitcoins is that they can be traded by speculators, and still retain its store of value property. For gold to be traded, we need to have paper contracts. Since in the future paper contracts for gold will be frowned upon. The traders are likely to move to Bitcoins, and gold will serve as the international reserve. If this is true then bitcoins are poised to become an international currency competing with other currencies of the world.

Currently there are about 11million bitcoins, with the market price of around 140$/bitcoin, the market capitalization is around 1.5Billion$. This is way too less. The market capitalization must grow many many times to achieve the required capitalization. I would expect atleast a 1000times increase in the long term. And around a 100 times during the crisis.

If the price of a single Bitcoin goes to 10,000$, one would think how the trading for smaller items will be done. Actually there is no problem. A single bitcoin is made up of 100 million Satoshi's the smallest unit of bitcoins. At 10,000$s a microBTC will be equivalent to 1 cent. Even at that level Bitcoin can accept a 100times further increase, without it being a problem.

There are two potential problems. One is that the same theory that brings about Bitcoin can be used to create other virtual currencies. Actually there are several now, but none of them are anywhere near Bitcoin. And are not expected to grow up to challenge Bitcoin. As time goes on, it will become more and more difficult for an incumbent to overthrow Bitcoin. The second issue is quantum computing. Quantum computing is still in its infancy. It will be probably at least 20 years before it is able to cause big problems for the current Public Key Cryptography, which is the most vulnerable. By that time we will probably move to QC resistant algorithms. Ultimately Quantum Computers may allow a much faster generation of Bitcoins. This is not a problem in itself.

Both of these do not look very problematic at this time.

Probably the most serious problem is that govts can try to clamp on bitcoin exchanges. These are the entities that allow exchange of bitcoins with local currency. This has been tried by the govt of Canada, and others are thinking about it. But their main motive would be to prevent black marketing in the bitcoin world. These bitcoin exchanges actually allow the govt to make sure people do pay their taxes, and they can track the transactions. People looking to avoid taxes will be trading on other P2P networks. Only time will tell, but I expect that the govt will not try to stop legal exchanges as they result in people using legal methods of transactions. Preventing exchanges will make people move to illegal methods.

Bitcoin is not anonymous. Bitcoin uses the Wallet Address for transactions. This wallet address can be changed for every transaction, but the wallet address can be linked to the IP Address. To avoid using your own IP Address you can use tor to anonymize the transaction completely.

Bitcoin is an open source currency, so stopping it is near impossible. Remember MP3. The Media companies managed to shut down several companies that allowed sharing of MP3, but eventually they had to give up. Same thing will apply to govts, if they try to go against people's will. This does assume that Bitcoin is as useful as MP3s. It is not going to be beneficial for them in the long run. Better would be go along and keep the maximum people in the taxnet.

As compared to gold, gold is expected to not have any taxes once it becomes the international reserve. But bitcoin will continue to attract capital gains tax. This will make Gold a better store of value, but bitcoin should not be a bad store of value.

The last problem with bitcoins is that a certain technical understanding is required at the present time. The situation will improve slowly. There is a bitcoin card introduced recently. Paypal is also thinking of getting into Bitcoins.

Now that I have put some wildly optimistic spin on Bitcoins, lets have a look on how to use them.

How to use Bitcoins
You have to first create a wallet. There are two ways to create them. You can go to any number of internet websites that allow you to create the wallet, or you can download the bitcoin software and create a wallet on your own computer. A wallet is defined by a large number called an address. Bitcoin transactions happen between two wallets. So when you buy some bitcoins, you give a person some money via credit cards, or some other means and your wallet address, and the person transfers bitcoins from his own wallet to your wallet. The amount of bitcoins your wallet contains is known to the network. Because of this nobody can forge your wallet. But if you lose your wallet address you will lose your bitcoins, so it is a good idea to keep it safe somewhere, not easily hackable. Encrypt it preferably.

To obtain bitcoins you can buy them on an exchange or you can also create them. For that you will need to buy a mining hardware. The most advanced machines are ASICs, and are in very high demand these days. The technology is very new so there are delays in making them as well. But hopefully the situation will improve in a few months. Of course the difficulty will rise very fast. But I don't expect it will rise as fast as the value of BTC. It will still be wildly profitable.

There is a tradeoff, if you buy the mining rig, and the crisis comes too fast, you won't be able to collect enough BTCs, so it might be beneficial to directly invest in Bitcoins. If the crisis is far away, it is probably better to go with a mining rig.

Ofcourse the mining rig option is only open for technical people. There are some companies that are providing mining rigs on rental, so they manage and you can earn the BTCs produced by the mining rig and pay the managers some rent.

Friday, January 11, 2013

What happens if Gold Price goes too low?

Many people fear if the gold price will become too low and they will lose their investment. I, on the other hand, am waiting for the Gold price to get too low :-).

People who fear gold prices getting too low are thinking in terms of currency. This is the wrong way to look at gold. Gold is the currency that measures other currencies. Measuring it in terms of other currencies is a mistake.

If you look at the amount of gold held by Central Banks you will notice that they have increased their holdings since 2008. If the value of gold could drop, why would Central Banks increase their holding?
Bron Suchecki of Perth Mint has written a nice summary of the CBs activity over the past decade. You can also look at the data per country, almost every country has increased.

Now lets look at how the price can drop without crisis and why it will be a good thing for physical gold holders.

The first thing to understand is that gold price at the present time does not depend on physical gold demand, it depends on paper gold demand. There is a huge amount of paper gold trading that goes on in the world and it dwarfs the physical gold trading 1,500,000:4,500. My number in previous articles was way too low. Wikipedia also corroborates those numbers.

Currently the price of gold is down, and has been down since Sept 2011. This does not mean that there is no demand for physical gold, it just means that there is little demand for paper gold. If the demand for paper gold keeps on reducing the price of gold will drop. Lets see what will be the consequences of such a drop.

There is 4500mt of gold traded in the world. Of this 2500mt comes from mining and 2000mt is from scrap. Scrap means the gold sold by people. Of the 4500mt, over 2000mt is used in Jewelry. The jewelry use is typically by Asian people. This demand is very inflexible, as in it cannot be replaced by paper gold. Another 1000mt is used by bullion investors. This demand is somewhat flexible, as it can be replaced by paper gold. But note that people who buy physical gold are paying extra costs for it. If they really wanted it for short term trading they would not be buying physical gold and instead would buy paper gold. So the majority of this demand is also inflexible. About 300mt is industrial demand which is very rigid.

It is very likely that if the price of gold goes down demand of physical will go further up. The Indian govt is trying to convince people to buy paper gold, but unfortunately you can't make jewelry from paper gold :-).

Now lets see what other effects happen when the price of gold goes down.

Mines are affected with a low price of gold. There are two kinds of costs that we read about in the mining industry. Cash Costs, that are actual running costs. These costs are minimum, and are required for running the mines. Below these costs the mines will not be able to run. But this is not the actual costs at which the mines will close down. There are other costs involved, exploration, and profits. No business will operate at no profit. Even share holders want profits. The total of these is the Running Cost of a mining company.
Running costs are probably crossing 1500$/oz at the present times. Cash costs were nearly 700$ in 2011, and are now upto 900$-950$/oz. Barrick Gold had a cash cost of only 460$/oz in 2011. The present price of gold is around 1650$/oz. It is expected that the mines will be in deep trouble at 1350$/oz.

What happens if the price of gold is 1350$/oz? Or if the costs of mines increase further owing to inflation, reduction in yield, and reduced exploration.

The mines will start closing down, reducing the mining output. If the Output goes much below the current level, the demand for physical gold will outstrip the production. This can only be managed with a higher price, but the problem is due to a lower price. The demand for physical cannot be reduced by unavailability of physical from mines, because there is a huge above ground stock in common people's hands.

What will happen is that some people will be willing to sell gold at a higher price than what the paper gold market suggests, and Asians (particularly Indians) will be willing to pay the higher price. If this is done commonly and openly, the price of paper gold and the price of physical gold will diverge. It is highly likely that this problem happens in India, because the Indian Physical market is much more active than the rest of the world. At that time true value of paper gold will be revealed which is zero.

Once the paper gold's value is revealed, immediately the value of physical gold will rise. There will be a discontinuity as the physical gold will more or less disappear from the market as lots of money will be after gold, and slowly the real price will be arrived at in the actual market.

Remember the above treatment is done in the case of no crisis situation.

The above case is highly improbable. It is highly likely that if this situation happens, the 1.5million tonnes of paper gold which is equivalent to 70T$, more than the global GDP, will be gone. This will cause a major disturbance in the Economic health of the world. It is highly likely that we will plunge into a crisis situation.

Because of this consequence to the world economy, the price of gold will never be allowed to drop so low that mines start closing down, or people wanting physical are not able to get their physical easily. The price will drop when the crisis happens, in that case lots of paper investments will become worthless, including paper gold. Note: Stocks are not paper investments, but you do need to have the papers in your possession. The crisis will happen overnight as it is a consequence of loss of confidence, which happens overnight.

Another issue is China. China is at present the largest producer and consumer of gold. It is actually turning into a black hole for gold. It has been buying a whole lot of gold via Hong Kong. It is also buying up large mines in South Africa and elsewhere. Rest assured it is not buying these mines to sell the gold in open market. China seems to be intent to have 10,000tons of gold as reserve. Once the effective production of gold (not including gold in Chinese control), gets too low, the economy is in trouble. The Chinese have already shown that they are now, not too much concerned about the economy going south. China was the country that bought US Treasuries in the last decade to allow the system to survive for so long. Since Sept 2011, it has stopped providing that support. Since then China's UST hoard has been reducing.

The countries worst affected by the economic downturn are US, UK and Japan, so these countries can help keep the price of gold up. Of these really US is the only one which can actually do something about it. It seems Europe has also given up. There was no surge in the price of gold before the 4th Jan ECB's quarterly update.

My estimate for the crisis is between 2 to 5 years. Possibly earlier than later. It seems to me that UK will be the first to plunge into crisis, and then trigger the rest.

Monday, October 29, 2012

Understanding Budget Deficits, and how it causes Hyper Inflations

Govt is always a net consumer. The govt taxes the production of its citizens to obtain money for its expenditure. If the taxes collected and the expenditure balance out then the budget is balanced. But we have a problem, people do not want to pay more taxes, the people want some freebies ie subsidies and other free stuff, and the govt is inefficient and govt servants maybe siphoning out the money. This means that its difficult for the govt to balance its budget, and most likely it results in budget deficits.

The Central Banks (except the special case of ECB) are under the directive of the Government. They must provide money to the Government as much as they require. The govt will give some collateral to the bank, in the form of a Debt Note. The Central Bank will then try to sell if off, to whoever may buy it. Normally banks buy them, because they are safe investments. The govt will be able to pay off the loan, because they can issue another debt note to the Central Bank, and the Central Bank will provide the govt money to pay off the loan.

Money is created when the Central Bank gives it to the govt, and it is destroyed when the govt returns money to the Central Bank. Most of the time the Govt is just receiving money from the CB. The money provided by the CB is called base money. Money can also be created by a normal bank, when it loans more money to the people than it has. This money is called credit money. Base money most of the time grows. Base money is critical to understanding HyperInflations. Credit Money have little impact on it, as during HI, the normal banks do not make loans.

The govt pays money whenever it buys something or pays salaries to its employees. If this money is in excess of what it received from the citizens as taxes, there is more money in the market. The govt gets this money from the CB by issuing the debt note. This debt note is sold by the CB. The people deposit the money they received from the govt into banks. The banks use this money to buy the debt note. It is no risk investment for the banks. As long as this process works, there is no extra money in the market, and there is no added effect of inflation.

The debt selling is basically kicking the can down the road, as the debt must be payed back in the future when it matures. The govt may again create more debt to pay off the maturing debt. There by kicking the can further down the road. Another option would be to reduce the deficit and actually pay off the debt from the money from collected taxes.

It never makes sense for the govt to increase taxes and fire their employees and tighten their budgets. The people do not like it. So the only option for the govt is to kick the can down the road. The ability to receive free money, allows the govt to grow, to unsustainable levels. The people also love it as there is more spending for the masses. The actual producers have higher taxes, but not high enough that they care too much. Eventually the debt becomes so big that the govt cannot service the interest payed in the debt, within the tax collected. When this happens the govt must reduce the interest rates so low that it can service the interest.

When the interest rates reduce, the banks reduce the loan rates to match and start paying low interest on their deposits. Due to low interests people start taking more loans and stop depositing money in the banks. Now the banks do not have enough money in the banks to buy debt. They need to sell it, so the govt can no longer sell more debt to banks. The Central Bank at this point must buy back the debt, providing money to the banks. Once this starts to happen, the money stays in the economy. Due to the easy access to money the govt has increased its expenditure to enormous levels. The govt cannot easily reduce the deficit. There is also no point in tightening budgets at this point, as the production is not enough to pay off the debt. At this point Hyper Inflation becomes inevitable.

Peter Bernholz studied a number of hyperinflations and came to the conclusion that the point of no return is when Debt grows more than 80% of GNP, and deficit grows beyond 40% of Budget. If the deficit is reduced again, then the problem can be contained, but unless it was due to a war, it is not possible to reduce the deficit.

The hyperinflation does not start as soon as govt starts to buy debt from the banks or it goes beyond the limits given by Bernholz. Even though the money is entering the market, it must be chasing ever lesser number of articles, for hyperinflation to start. If the money stays in banks, then there is no problem. The banks are also not paying much interest and they are fearful of lending it to people, as they are risk averse at this point. The economy is not doing well during these times. That is part of the reason for the increasing deficits. So the money can stay in the banks for a long time. Actually due to this risk averseness, the economy may face a deflation, causing the govt to pump out more money, in an effort to prevent deflation.

If the banks are allowed to trade in the markets, they start to buy stocks and other assets. This causes the market value of those assets to rise. Due to the rise in these assets companies start to get more money. They are able to hire more people and give larger salaries. The market enters an upbeat mode. People get more money, and they start to buy stuff. This allows spending to increase. The excess money starts chasing real day to day objects. The inflation may pickup at this time, depending on whether there is enough objects in the market. As long as everybody can get what they need there is no problem and the prices will not rise. The country starts to buy stuff in the international market with the created money. As long as the international market perceives the currency to be trustworthy, the country can import stuff, and the inflation is not a problem.

Basically at this point, inflation will happen in whatever stuff is not easy to get at. If that stuff is not important, people will move to other stuff. As availability gets lower for more and more stuff, the public starts seeing high inflation. Eventually the inflation rate gets high enough that people do not want to hold the currency. At this point they will buy anything that they can get their hands on. This is the point of runaway inflation, or hyperinflation. The govt must support itself, so it must print ever higher amounts of currency to pay salaries to its employees. Credit money disappears, as the banks no longer give out loans, and they basically become a part of the govt. The govt starts to take over many failing businesses that it needs for its employees to use.

Eventually the govt employees do not earn enough money from the govt, and they start doing other stuff. The govt starts downsizing. This is the end phase of the hyperinflation. When enough people have left govt jobs, the deficit can be controlled. The govt can start a new currency, and restart the economy.

Lets see how this relates to the US.

The 70s saw US Government get into perpetual deficits. They have been in deficit for 40 years. Initially Europe and Japan where absorbing the deficits in the form of Treasuries and bonds. After 2001 when Euro was formed, Europe backed out from buying Treasuries. Then China started buying the treasuries. The debt became too big to be processed in 2005, and that year saw the interest rates dropped down to near zero. The banks started to fail in 2008, which required the govt to start buying debt.

China stopped buying debt/treasuries in Sept 2011. The govt started Operation Twist to buy long term bonds and convert them to short term debt. As we can see in the following graph it was increasing base money.



Now the only way some of this deficit is being absorbed is through Currency War. Some countries notably Japan, Brazil, Australia are devaluing their currencies by buying USD, so that the USD does not depreciate in their currency. Then they have to buy treasuries from the USG against those USDs. In QE3/4 FED has announced that it will buy 85 Billion USD worth of Mortgage bonds every month. In the graph above we can see that it has already printed 300B in the last 3 months.

The HI in US economy has been inevitable for at least the last 5 years. But now the vicious cycle has started as the govt has started buying 85 billion USD worth of debt every month. The US population has been a non-saver for a very long time now. So the deficit has been bought by foreigners rather than US people, for a very long time now. Notice that during this month the stock market has finally started to go up. This is due to the massive printing by govt. The next stages are clear. US should start to get some sort of inflation in daily use items. But this may take some time as the USD is the reserve currency and the US is able to buy things from the Rest of the World using those USDs. So it will be able to buy stuff, to prevent the prices to rise in the market. So before inflation sets in, the Rest of the World has to stop selling stuff to US. This can only happen if they remove their dependency on USD, which is actually dependent on the Middle East which sells them oil for USD.

The Middle East actually wants gold, so they will only sell their oil for USD till they can buy gold in USDs. This is the basis of petrodollar. So the trigger can be one of two things. 1) Panic in the trading world, due to collapse in UK or Japan. 2) Collapse in the price of gold, and gold goes into hiding.

1) Remember UK and Japan are considered safe havens, but their economies are in nearly as much bad condition as US. They will also undergo hyperinflation. They are not protected like US, as their currencies are not the reserve currencies. The condition of UK is a bit worse, and they have also started US style printing. Japan is a bit behind, and they are undergoing deflation, because they haven't been printing enough. That is about to be rectified. If one of these country's economy collapses, it could trigger the rest of trio to collapse as well.

2) Paper gold market is dropping a lot now. This is seen in the gold prices. At lower gold prices Asians buy a lot more physical gold. This means that physical gold supply becomes tight. If the price of gold goes even lower, the mines can shut down, resulting in even lesser availability. Also the western people that are dishoarding lose interest in selling their gold, because they think that they are making a loss by selling at such cheap rates. If the gold supply disappears, middle east oil nations will not get gold for dollars, and they will be less inclined to support US dollars.

We are basically in the last stage of the collapse. And gold will not be available for much longer.

There is a way in which normal people can break this cycle. The way is to not store money in banks. The money stored in banks WILL be used to buy govt instruments, which allow govt to do deficit spending. The only way out, is putting your money in stocks, land and gold. Never in bank instruments, Fixed Deposits, Mutual Funds etc. Also invest only in companies that create something, not in stock of banks.

Monday, October 15, 2012

What is money?

Lets say there is a carpenter who needs rice for food. The carpenter must find a person who has more than enough rice, but also simultaneously wants his services. This is called double coincidence of wants, as both people need to want the things that other person has. This is pretty difficult to do, and is one of the main problems in a barter system.

Its quite obvious that it will be beneficial to have something that holds value. Lets call this something as X. So that the carpenter can sell whatever things that he makes and sell them for some X. Then he can go to the farmer and buy the rice and give him X. The farmer can then find somebody who will take this X and sell him something that he needs.

This X is called Money. It can be anything. Obviously to be of most use the item X should not have any quality issues, ie all instances of X should be equivalent.

Money has 3 functions, lets look at them closely.

1) Unit of Account (UoA): Money should be able to quantify the value of each object. To do this the money should be accurately measurable. eg. if a gold coin is money, then we can measure the value of all objects in multiples of the gold coin. Nowadays Paper Currency notes serve as the UoA. An important requirement is that the value of the money item should be relatively stable. If the value of the item used for money fluctuates a lot, it cannot serve the function of UoA very effectively.

The best way to keep the value of money stable is to have a central bank follow the price of everything and see how it varies. Then it should modify the money supply to keep the value of money stable. Basically increasing the money supply reduces the value of money, and reducing the money supply increases the value of money. Paper money fulfills this property best as it is infinitely printable. Anything that cannot be printed at will cannot fulfill this property very well, as it will not be completely flexible for Central Bank.

If the value of money is very stable, people start storing it for future use. This makes it difficult for the central bank to determine the effect of money supply. Basically the money supply is only completely effective if all the money is in the market. If some of the money is not in the market and is being saved by the people, then the central bank must increase the supply for the same effect. This saved money will eventually arrive in the market, and possibly at an inopportune moment and cause the central bank to lose its control of the value of money.

Because of the stability of money value tends to make its future unstable due to the tendency of people to store it, no UoA can be stable in the long run. The central bank should strive for a slow inflation, so that people are discouraged from storing the UoA.

2) Medium of Exchange (MoE): The function described in the beginning of the article is basically MoE. The Money should be exchangeable for any product or service. It should be what is called a legal tender. This means that everybody is bound by law to accept this form of money. This money is also called currency. For a long time Paper Currency notes have been used for this purpose. Before Gold and Silver coins were also used.

In most of the cases MoE is also the UoA, except in the case when there is a loss of confidence, and an external currency is used for UoA, and the local currency is used for MoE.

3) Store of Value (SoV): A SoV item should keep its value for a long time, so that people do not lose their wealth through lost value. SoV items need not be accurately measurable or that all their instances be equivalent. SoVs should be least affected by production. Another important property of SoVs, as these are meant to be stored for very long times, is that these should not be used in industry. Otherwise the industry will face artificial shortages, because of the hoarding. The best SoVs are rare items, like antiques and objects of fine art. Some metals like gold and silver that are very low in earth are also good SoVs. Silver is slowly becoming bad for SoV as large scale industrial applications have been developed. The SoV should never be in the govt control, otherwise it will not be able to store Value for the long term.

In all the 3 functions of money, it is very good if the items used for money, are not useful in other ways.

In most of recorded history, gold or silver have served all three monetary functions. During the last 100 years slowly paper money became important and lately since 40 years it has fulfilled all three monetary functions.

During a hyperinflation the 3 uses of Money trifurcate. A foreign stable currency becomes the UoA, as the local currency is too unstable. The local currency remains as the MoE, as it has legal force behind it. The foreign currency can fulfill the role of SoV, but it generally is not available in quantity. This forces the people to buy anything and everything physical as SoV. Even the most mundane things for example Toilet paper becomes a SoV.

Friday, October 12, 2012

Gold: Why is it too cheap

In this article I will try to explain why I think that gold is way too cheap at this time. This is very long, but I guess there is no way to say this in a short few words. There are so many misconceptions about saving, investing, gold, money, and you need to clear so many concepts that this still will be too short.

Lets see some numbers first.

There is 170,000mt of gold in the world.
The mines bring out around 2,500mt every year.
4,500mt is used in major transactions around the world.
100,000mt is the total gold trade which includes paper gold.

I hope you know that price of any object is determined at the margin. Basically the amount of an object on sale and the amount of object required increases or decreases the price of the object.

So the price of gold is decided based on the 100,000mt on sale, of which less than 5% is physical gold 95% is paper gold. So what determines the price of gold, paper or physical? I guess its obvious that paper decides the price.

The interesting thing is that the vast majority of the paper gold is NOT a proxy for physical gold, ie the owners do not ever want the physical gold. It is just used for trading. But still quite a bit of the paper gold is as proxy for physical gold.

When the crisis happens, paper gold will collapse, because people will be getting out of all kinds of paper instruments including paper gold. At this time the price of gold will drop very fast, because it is determined by paper. It will go below the production cost of gold and mining production will stop, reducing drastically the physical available. Gold prices will continue going down, but you will not be able to find gold in the market, because nobody is selling it at that price point. At this time you still should be able to sell the gold at a much higher markup. But you will not be able to buy, unless you find a person selling it to you. Anything that goes to the jewelers will be absorbed by somebody running the show.

ECB marks its gold to market and its reserve depends on the price of gold. If the price of gold (due to the burning of paper gold) goes too low, ECB will be forced to cause a revaluation of physical gold. This will cause the price of gold to shoot up many many times.

We will do the calculation of how much a little bit later.

For now lets look at the price of gold from a different angle.

Why do you buy gold? Is it a life's necessity? Is it necessary in any industry? No. The total requirement of industry per annum is less than 10% of the output from the mines, ie less than 200tonnes. This is nothing. And much of the use can be replaced with something else. So in effect it is a useless metal.

So why do people buy gold. You will say jewellery. But why do you buy gold jewellery? Because you think it will be useful at the time of need. Basically you are storing your savings in gold. Indians have suffered under oppressive regimes for a long time. Independence did not give us much respite, with the high inflation. So people who are in their traditional businesses still value gold. The neo rich are the ones that are aping the west and have lost the traditional wisdom of why to save your worth in gold. I personally didn't know anything about gold a year ago. Many people don't invest in gold because they only know banks, stocks and land as possible investment venues.

When do you sell your gold? Only when you need the money right. If you are a trader you are better off with the paper gold, as you have no transaction costs. But most people are not traders. They buy gold to store their extra income. They might stupidly sometimes think that the gold will go down and sell it at a high, so that they would buy more later, but they are not traders.

So how does demand and supply affect gold? How does demand and supply affect the value of the piece of paper you call a 1000Rs bank note. The bank note is worth 25 litres of full cream Amul milk. Who gives this value to the bank note? Is it the govt, or is it the people. If Amul tried to raise the price of milk would you reduce your consumption or look for something else. The govt only says that its value is 1000Rs. It cannot say that the value of 1000Rs is equivalent to the 25litres of milk. Amul itself cannot set this value. It is you who give it this value. The govt also affects it by deciding how many Rupees are in circulation. If there are more currency notes in circulation the value of the currency notes will go down. How many are sitting in a politicians bed mattresses do not matter. The notes which matter are in circulation.

Similarly who decides the value of gold? You do. If you save in gold, the price of gold will go up. If you save in paper instruments it will go down. Paper gold brings it down much faster than any other investments. If you sell your gold it will also go down. Does the production and consumption has any effect on the price of gold? Not really. The production is only 1.5% of the worlds stock. The consumption is a measly 0.1% of the global stock. So what should be the price of gold. It is completely arbitrary. It depends entirely on peoples requirement for liquidity and people's extra income.

Gold is bought in currency terms not in weight terms. So if average saving of the world increases, the price of gold will increase, as much of the world's stock is not on sale. The gold's price must directly be related to prosperity, which inturn is directly related to technology.

Currently very rich people have a problem, they are not able to store their wealth in gold. If the very rich try to buy gold with a large part of their income, gold prices will increase very wildly, and will cause issues for USD. This inability increases the price of other store of value items like fine art and antiques. This is the reason why Scream fetched 25 million$. Auctions these days are fetching more money than would normally be expected.

The best thing about gold is that it is not used in any industry. It is basically as worthless as the Scream. The benefit is that like Scream its price can be whatever you want it to be. You can hoard it without holding hostage any industry. If you wanted to revalue gold 100x you can do so without damaging any industry. If you wanted to do the same with Silver, there are a number of industry that will be affected wildly. Gold is like paper money, but with the advantage that it cannot be printed. It has other benefits like fungibility and durability. Silver was also used the same way.

There are actually 2 reasons why Gold is much better than Silver. First is the above point. Second is that it requires much less space to store the same worth, presently 50 times.

This also means that Silver will lose its current store of value status. No wonder that No CB in the present times stores Silver. Silver will probably loose lots of its value, and the current 50x ratio will probably go much beyond 1000x.

Another question; do you think people will sell more gold if you raised the price of gold. Yes possibly, but the increase will be very small, because people sell gold when they need money. They will actually sell less in weight if the price of gold increases. In the crisis the gold on sale will increase, but the people wanting to invest in gold will increase many many fold. The price in effect will increase wildly.

Since most people do not store their worth in gold, would you say it is expensive. Not really. The other problem is that a major financial crisis is around the corner, where it is likely that a huge amount of paper investments will be lost. What will happen to the attitude of people towards gold. It will undergo a sea change.

Many people think that storing their wealth in gold is morally wrong. This is not a good position. The important thing to understand is whether you know where you are investing. If you are investing in a bank (ie savings account or fixed deposits or any other scheme), the bank is investing as a proxy for you. Do you think the bank is making the right decisions? The bank loans the money you invested to some person who will hopefully give interest to them. The person who got the loan may not invest in something productive, but may give it to a person to buy a house. This loan increases the price of house, as there is more money now chasing the house. Do you think this is a good use for your money? What happens if the person loses his job? Or if the person is not honest. Do you think the banks know very well if the person is honest. What happened in the USA in the housing bubble? Do you think they cared where the money was going? This investment even raises the price of house, which you might want to buy. Yes it will become easier but at the cost of making you a slave for a long time. When the person who buys the house gets the money, he in turn puts it in bank. So the bank gets the money back, it can now invest in other ventures. The Reserve Ratio forces to put some money behind to avoid the case where you come back and ask for your money. The ratio in India is less than 5%. This means that money created by the RBI is multiplied 20 times. Think about that.

When you put your saving in the useless metal gold, you are giving your money to somebody who needs the money. People do not sell their gold for trivial needs. They sell it only when they think they have a perfect opportunity to make money or they are in dire need of money. This way the money gets utilized very efficiently. Saving the worth in a useless metal does not impact anybody else. Its like storing our worth buying antiques or fine art. These are also useless. If instead we were to invest in copper or iron, we would impact the industry, if we really had much money. So saving in gold is good for the economy. Hoarding any useful thing is not.

I hope I have explained the basics of the value of gold. Now lets get a ballpark number of how much gold should increase in value. The price again cannot be predicted, because most currencies are likely to devalue highly during the crisis.

I would expect only around 1/5th of the existing paper gold to be a proxy of physical. This would mean that the gold will revalue at least 4 times the present value, in current currency terms, if nothing else happened.

During the crisis, people would be looking to put their money somewhere stable, so they are likely to put it in gold. Yes, real estate and other physical plane assets will also increase a lot.

Due to this change in perception and the revaluation due to paper gold crash, the value of gold is likely to shoot up 10x from present times.

During the crisis people will lose a lot of worth in paper instruments, but they will get a lot of worth from their gold. From this people will learn that they should not save in paper, and gold is a very good store of value. People will start using gold for storing their wealth. This is called Freegold.

Gold will be free of any shackles of paper. There will be no gold standard, and there will be no gold certificates. Not because govt will ban them, but because people will not accept them.

We will no longer get into a similar arrangement as we had with USD, ie there will be no reserve currency that is used by a country, not Euro nor Yuan. Central Bankers' are quite well aware of Triffin's Dilemma. We could possibly have SDR, but that is not likely to stay for long as it still doesn't solve Triffin's Dilemma completely. The biggest problem with that would probably be that nobody will be able to agree, on the actual content of it.

No country is likely to accept Gold Standard, because it is very much inferior to the way Euro is setup. Euro has about 70% of reserve as gold. This provides them the flexibiility of an inflatable currency, and also the safety of gold. The interesting thing is that they started with only 15% gold, and they did not buy much gold. The change is entirely due to the increase in the price of gold, and reduction in the worth of all other reserve assets. Most currencies are likely to move towards that. India is also setup that way, we also mark our gold to market, and have about 10% reserve as gold. This would go to nearly 100% during the crisis.

Another interesting thing will happen due to people understanding the worth (or the lack of worth) of paper investments. I am not talking about interprenuers or Investors, they will still continue to take risk and invest in worthwhile businesses. Investors know what they are doing. I am talking about ordinary people, and businessmen. These people do not know what they are doing when they start investing in stocks. These people will start storing their excess produce in gold on a regular basis. This would mean that people in countries that are having a surplus will naturally import gold, while countries which are running a deficit will be exporting gold. This will extinguish balance of payments naturally.

Since gold import/export will directly shows the worth of a currency, Gold will come to define the value of a currency. In effect countries will start valuing currencies, based on their price in gold, aka Reference Point Gold. If SDR is chosen, gold will likely get higher and higher weightage as time goes on.

Gold will become the most important asset for storing value. This effect will further raise the value of gold possibly to 30x, from present. This last valuation may take several years, depending on how much gold matters in international trade.

If you think this is just pipe dream, see what Central Banks are doing. They are buying gold since 2008. This is precisely, because they know that the system is at the brink of failure, and gold will be required to rebuild everything. Lots of People in the western world blame the Central Banks, but those are the good guys. The politicians are the bad people. They are not going to get any benefits of the revaluation. They have a job to do, ie keep the economy running smoothly, and gold is required for that.

The huge increase in gold prices means that jewelers will become very rich, but it also means that people will stop using gold in jewelery. It will be too expensive.

I hope this helps you get ready for the future.

Thursday, October 11, 2012

FreeGold: An overview

I have talked about the 3 functions of Money, in the "What is Money?" article. The Unit of Account (UoA), the Medium of Exchange (MoE), and the Store of Value (SoV).

Freegold is basically a situation where gold is the preferred SoV of the world, while Paper currencies serve the function of UoA and MoE. Gold in this situation is free to float against currencies. Gold can only float freely if there is no paper that does the function of physical gold, ie no paper gold.

Till 1930s, all the three functions were fulfilled by Gold, as part of Gold Standard.

Since 1971, all three functions have been fulfilled by Paper currency.

Now we are near the transition to Freegold. Previously transitions had been smooth, as Dollar slowly shifted from being Gold based to being plain unbacked paper. Now the reserve system based on Dollar is going to go away. This is happening because of the underlying problem of unbacked paper. You cannot make enduring castles on paper.

So the system is just stacking more paper over more paper. This will continue till the whole system collapses under its own weight.

This transition is not about only a collapse of the IMFs. But a collapse in the faith of people in Paper backed promises.

Till now people have been "saving" their excess production in paper, in banks. This is not really saving. It is investing, people are investing in the ability of banks to pay an interest on the capital you have invested in the bank. After transition most people will prefer to save in valuable commodities, like precious metals, property, antiques, rare objects, pieces of art, etc. An object that can act as a suitable Store of Value, is something that does not have any other uses. Gold is the only precious metal that has no (or very limited) other uses. And the fungible properties of a metal makes it superior to other forms of SoVs.

Remember stocks are not plain paper, as they are backed by means of production. But Currency, Treasuries, Debt are all backed only by more currencies. This whole system is backed only by paper.

When you read the promise of the Governor of RBI on a 1000Rs note, where he promises to pay 1000Rs, what does that actually mean. Can the governor give you anything other than the same paper currency that you hold? No it is just a paper promise backed by nothing.

During the transition quite a few currencies will fail. It is expected that USD and Pound will fail. There may be a few surprise casualities, including our Rupee. In any case the world will be split into two types of situations, some countries will undergo hyperinflation and will lose their currencies, other will have massive deflation. ie there will be wide spread loss of jobs and living standards will drop significantly.

Due to the crash in currencies many people will lose everything they have saved. Also most countries will lose their social security net. The money that was saved in social security will be lost.

All these damages will force people to realize that saving in paper is not a wise thing. And people will move back to saving in precious metals and land, as Indians have been doing for a long time.

Since the reserve system will fail, the countries will start trading in their individual currencies. The money will be received by the people, and the excess production will be converted to precious metals and land (due to the loss of faith). Gold will rise to prominence as it is the best medium for storing value. It is kept stored by central banks because of this reason. When excess production is moved into gold, gold will need to be imported.

Due to the loss of faith, banks will not be getting excess production. So they will be short on money. They will need to charge a lot more interest, and will need to make sure that they get paid. There will be two effects due to this, first the interest on loans will rise, and the banks will not give loans easily. Basically loans for consumption will cease. People will not be able to get loans easily for buying houses. The prices of houses will drop. The ratio between rent to Price of houses will rise. Currently there is no benefit in owning houses for giving out as rent, but this situation will improve in the future. This also means that property prices will drop, compared to other precious metals. Gold will be the major benefactor of the transition.

Since it will not be easy to get loans for consumption, consumption will require selling precious metals and property. Gold will flow out of a high consumption zone.

Gold flow will define the value of a currency. A country where gold is moving in, will see a rise in the currency value with respect to gold and with respect to other currencies. While their will be a drop of value of currency where this gold moves out from. A higher currency value will make exports more difficult, as it will be more expensive for other countries to import them, while making imports cheaper. The situation will be reverse in the high consumption zone.

This will allow a normalization of trade naturally.

When people will not save their excess production in banks, the govts will not be able to get the benefit they get currently when they devalue the currency. Any excess deficit comes from printing of excess currency. If the excess currency is absorbed by the banks, through the savings of people, then it does not result in inflation. When the excess currency does not get absorbed because it does not go into the banking system, then it causes inflation. People do not like inflation, and the govts are wary of inducing inflation. When deficits directly get related to inflation, the govts will try to avoid creating budget deficits.

If you have followed the above, freegold is a utopia. It depends on producers to save their excess production in gold and not in banks. Of course like all utopia, things don't happen as the ideal situation. But the transition will make people understand that there is benefit in not saving excess production in banks, which will take us closer to the utopia.

Explaining the crisis to a non-believer

The crux of the problem is that US is adding roughly 1 trillion dollar external debt per annum. Read this article to understand the deficit numbers. The deficit in 1945 was internal and due to the war.

Contrast this with the deficit of Japan which is 200% but almost all is internal. Internal debt is not as bad as external debt.

India is in a much smaller external debt, but our currency is undergoing devaluations due to Balance of Payements problems. A look at the External debt of India.

The question is why does India suffer from the deficit, but the US does not. The answer is that Indian debt is not considered good while US debt is being taken in by some countries.

Lets see why US debt is so much in demand, and what we can project for the future. US Dollar is the reserve currency. So nearly all international trade happens in USDs. US is also the largest consumer. So the surplus countries get US Dollars. They cannot do much with it. So they have to give it to the US, and get Treasuries instead. This is how China, Japan have collected so much US Treasuries. We can say that the major export of US is US Treasuries, which costs nothing for US to create.

This obviously is not sustainable. US is continuing its high consumption, while China and other countries are providing the surplus to balance this out. Starting September last year, China turned around and started consuming the excess USDs it was getting by buying different commodities. China is on its way to becoming the largest importer of gold.

The year ending June, Japan was the major importer of treasuries. Now Japan is on the brink of a collapse. It is interesting that Japan has been giving so much money to US, but is still not able to balance its budget. The real problem is that Japanese have been trying to keep their currency low value by selling Yen and buying USDs. This is how they are getting the US Treasuries. But this does not help them.

China is spear heading a drive to get into Currency Swap agreements with different countries, in an effort to increase the distribution of its currency. The more Yuan there is in the world, the higher impact China will have in world affairs. It has achieved agreements with 20 countries including Germany, Japan, Russia, UAE, Brazil, etc. Lots of important countries.

Euro already has a decent distribution in the world. There are 3 important currencies in the world now, including the USD. The more these two currencies find acceptance in the world, the less use the world has for USDs.

The reason why the world needs to get away from USD, is the same problem as Japan is facing. They produce excess, but they have problems meeting their budgets. Slowly and slowly countries will move away from the US. The current US deficit is expanding. The QE3 introduced creates about 1 Trillion USDs a year. This is exactly equal to the deficit. Which means that the structural support provided by China for the last 10 years is gone. US is on its own now. Due to the QE3 USD has started to drop in Value, which is why we are seeing Gold rise again. Rupee is also rising but due to the various measures taken by our Govt.

The US govt will use these created USDs to bid for consumer items from around the world as it has been doing for the last 40 years. QE3 shows that this money is not being stored anywhere, so whoever gets them will try to get rid of those USDs as soon as possible by buying stuff from other countries. Since nobody wants the USDs the prices of stuff will rise quickly in USD terms. This causes inflation in USD terms. But this is only an international phenomenon. Now countries will be in a fix as their ability to export is diminishing, some countries will stupidly try to devalue their own currency in a bid to increase export. This starts a currency war devaluing all such currencies. This war is already being waged, it will intensify. The high prices in the international market will increase the prices in the local market in USA and other countries involved in the currency war. This quickly becomes a vicious cycle, and results in a hyperinflation in USD terms. Countries will slowly realize the outcome of this currency wars and will drop out of it.

Hyperinflations take a couple of years to unfold. Initially inflation lacks money printing, as has been happening till now, but soon with the loss of trust, it over takes the money printing, and then inspite of having a huge amount of currency, there is no liquidity. US will be forced to print faster and faster to create enough liquidity. As countries stop the war, the hyperinflation will be pushed back in the USA.

Since the whole world has been living on a mountain of debt, as the USD goes into hyperinflation, the debt will lose its value. And the whole world will plunge into the greatest depression yet. Several currencies with large debts will hyperinflate away their debt. While creditor nations will plunge into deflation. Effectively the depression will be a global phenomenon.

Due to the high inflation or deflation people will stop spending anything on non-essential items. Consequently only companies that produce essential items and those that produce items for the govt will survive. The govt is not affected by the high inflation as it can print as much as it needs. This is not true of the Eurozone as ECB will not be printing to fund the govts. So they are left with the option of deflation and austerity. This is what is happening in Greece, and moving towards other Eurozone countries. But countries that can print will print to maintain their lifestyles. And those that do not curb their lifestyle will experience hyperinflation.

People working in non-essential non-governmental jobs will lose their job. This will result in lots of people with very little money. They will sell their non-essential items at very cheap rates and there will be a glut of cheap second hand iphones, ipads, computers etc.

Reserve status of USD hinges on Oil. US has zealously guarded USDs exclusivity for oil. It attacked Iraq when it tried to sell oil, in Euros. Now it is attacking Iran because it is also selling oil in other currencies. The next country to do this will be Russia and China. They have an agreement to sell Russian oil in Yuan, by 2014. This is actually a preparation for a post USD world.

The USD hyperinflation is not likely to take more than 3 years. The over high inflation should be visible beginning the next year. Unemployment will probably rise precipitiously in another year. The period after that will be very bad with food riots, arson becoming very common.