David Levenstein: Debt Ceiling Driving Investors to Gold as a the “Ultimate Asset”

JOHANNESBURG – The price of gold rallied above $1,600 an ounce Monday, as concerns about the Eurozone debt crisis and the lack of agreement on raising the U.S. debt ceiling prompted investors to seek a safe haven in the precious metal. Spot gold pushed through the $1,600 an ounce level and at the time of writing made new record highs in US dollars, ($1608/oz), euros (€1,141/oz), and sterling (£996/oz), mainly due to the growing risk of a systemic financial collapse and fiat currency crisis. 

While it is almost certain that the US government will raise the debt ceiling, the implications of this will mean that the US Federal Reserve is going to buy some of that government debt and run the printing presses again. And, all this additional money creation will only cause the value of the greenback to decline even further against the other fiat currencies. And, this monetary expansion will certainly have an inflationary effect as we have already witnessed during the last year.

For those people who understand the effect of inflation, and in order to protect against the erosion of their wealth, these prudent investors will buy more gold and silver. Through both good and bad times, gold has endured. While market cycles go through periods of boom and bust, gold has maintained its long-term value. In contrast, currencies tend to lose their value over the longer-term due to the monetary policies of governments. This is why gold is often purchased as a hedge against inflation and currency fluctuations. Investors around the world see gold as the “ultimate asset.”

Despite the fact that the Fed Chairman recently said that gold is not money, prudent investors and individuals who know otherwise will buy gold. Though gold has not yet become a widespread medium of exchange, that is, used to transact in the marketplace, or used to price goods as a unit of account, it certainly seems to have re-emerged as an international store of value.  It seems that in these times of tumultuous change, more people around the world are becoming less comfortable holding dollars than almost any other asset class and would rather hold gold. And, from recent reports it is evident that central banks are also becoming weary about holding too many US dollars.

Central banks hold gold as part of their international monetary reserves as its value has remained remarkably stable throughout history and not because of tradition as the US Federal Reserve Chairman, Ben Bernanke suggested at a hearing of the House Financial Services Committee when questioned by U.S. Rep. Ron Paul.

Congress must raise the $14.3 trillion limit on America’s borrowing by August 2 or the government will run out of money to pay all its bills. The White House and Republicans are wrangling over spending cuts and higher taxes in addressing how to bring down the deficit.

The two major ratings agencies warned they will strip the United States, of its top-notch credit rating if it does not increase its borrowing limit to avoid a default.

There is a growing view that while a United States default would hurt the credit-worthiness of Treasuries, it would devastate stocks and risky investments even more, making investors scramble for Treasuries to store cash. But, why would investors want to put money into US Treasuries? Will the US government default? I doubt it, but there have been times when the United States did default on its financial obligations.

The first default of the United States was on its first issuance of debt: the currency emitted by the Continental Congress of 1775. In June of 1775 the Continental Congress of the United States of America, located in Philadelphia, representing the 13 states of the union, issued bills of credit amounting to 2 million Spanish milled dollars to be paid four years hence in four annual installments.

The next month an additional 1 million was issued. A third issue of 3 million followed. The next year they issued an additional 13 million dollars of notes. These were the first of the “Continental dollars,” which were used to fund the war of revolution against Great Britain. The issues continued until an estimated 241 million dollars were outstanding, not including British forgeries.

The notes progressively depreciated as the public began to realize that neither the states nor their Congress had the will or capacity to redeem them. In November of 1779, Congress announced a devaluation of 38.5 to 1 on the Continentals, which amounted to an admission of default. In this year refusal to accept the notes became widespread, and trade was reduced to barter – causing sporadic famines and other privations. Eventually, Congress agreed to redeem the notes at 1,000 to 1.

In addition to its currency issuance, the Continental Congress borrowed money both domestically and abroad. The domestic debt totalled approximately $11 million Spanish dollars. The interest on this debt was paid primarily by money received from France and Holland as part of separate borrowings. When this source of funding dried up, Congress defaulted on its domestic debt, starting on March 1, 1782.

After the Revolutionary War, the Congress of the United States made only limited issuance of debt and currency, leaving the problems of public finance largely to the states and private banks.

In August of 1861, this balance between local and federal finance switched forever; the Civil War induced Congress to create a new currency, which became known as the “greenback” due to the green colour of its ink. The original greenbacks were $60 million in demand notes in denominations of $5, $10, and $20. These were redeemable in specie at any time at a rate of 0.048375 troy ounces of gold per dollar. Less than five months later, in January of 1862, the US Treasury defaulted on these notes by failing to redeem them on demand.

During World War I the US government financed merchant-fleet maintenance and operation, production of ammunition, feeding and equipping soldiers and many other expensive things it had never done before or done only on a much smaller scale. To finance these activities, Congress issued a series of debentures known as “Liberty Bonds” starting in 1917. The preliminary series were convertible into issues of later series at progressively more favourable terms until the debt was rolled into the fourth Liberty Bond, dated October 24, 1918, which was a $7 billion dollar, 20-year, 4.25% issue, payable in gold at a rate of $20.67 per troy ounce.

By the time Franklin Roosevelt entered office in 1933, the interest payments alone were draining the treasury of gold; and because the treasury had only $4.2 billion in gold it was obvious there would be no way to pay the principal when it became due in 1938, not to mention meet expenses and other debt obligations.

These other debt obligations were substantial. Ever since the 1890s the Treasury had been gold short and had financed this deficit by making new bond issues to attract gold for paying the interest of previous issues. The result was that by 1933 the total debt was $22 billion and the amount of gold needed to pay even the interest on it was soon going to be insufficient. So, Roosevelt decided to default on the whole of the domestically held debt by refusing to redeem in gold to Americans and devaluing the dollar by 40% against foreign exchange. By taking these steps the Treasury was able to make a partial payment and maintain foreign exchange with the critical trade partners of the United States.

The Treasury of the United States accidentally defaulted on a small number of bills during the 1979 debt-limit crisis. Due to administrative confusion, $120 million in bills coming due on April 26, May 3, and May 10 were not paid according to the stated terms. The Treasury eventually paid the face value of the bills, but nevertheless a class-action lawsuit, Claire G. Barton v. United States, was filed in the Federal court of the Central District of California over whether the treasury should pay additional interest for the delay.

The government decided to avoid any further publicity by giving the jilted investors what they wanted rather than ride the high horse of sovereign immunity. An economic study of the affair concluded that the net result was a tiny permanent increase in the interest rates of T-bills. (Source of information A short History of US Credit Defaults by John S. Chamberlain on July 15, 2011).

According to Murphy’s Law, when things are really bad, they generally tend to get worse. This most certainly applies to the Eurozone debt crisis.

In spite of massive bailout packages, the Eurozone still looks very precarious and Italian and Spanish government bond yields risen sharply. Ongoing uncertainty over the ability of European officials to agree on a second aid program for Greece and stop contagion from Greece’s troubles to other countries such as Spain and Italy continue to worry investors. 

On Friday, the results of a stress test of European banks were released.  Eight of the 90 European banks surveyed by the European Banking Authority failed the stress tests, well below market expectations that as many as 15 lenders would need more capital to withstand a prolonged recession.

Eurozone leaders will meet in Brussels next Thursday to discuss a second bailout package for Greece and the financial stability of the euro area, European Council President Herman Van Rompuy said on Friday.

As far as I am concerned, the problems in the Eurozone and the US are a lot worse than they were a year ago. And, I cannot see these issues being resolved for a long time to come. In fact, I cannot see one single reason why I should believe that these problems will improve by this time next year. And, while I am not sure what will happen to the global monetary system as I have never seen anything like this before, I continue to urge my investors to diversify into gold and to stop listening to portfolio managers who only understand the traditional means of asset diversification that is equities and bonds. What is important at the moment is the preservation of wealth.

TECHNICAL ANALYSIS

Now that the price of gold has made a decisive break through $1550 an ounce and is pushing through $1600/oz setting new record highs, the next leg up is underway.

About the author

David Levenstein began trading silver through the LME in 1980, over the years he has dealt with gold, silver, platinum and palladium. He has traded and invested in bullion, bullion coins, mining shares, exchange traded funds, as well as futures for his personal account as well as for clients. www.lakeshoretrading.co.za

Information contained herein has been obtained from sources believed to be reliable, but there is no guarantee as to completeness or accuracy. Any opinions expressed herein are statements of our judgment as of this date and are subject to change without notice.

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