A Dollar Endgame Long Desired By Gold Investors

Gold has reached a new record low. Not in nominal terms, of course. The Coinage Act of 1792 defined the dollar as 24.75 grains of gold, or $17.72 per ounce, gold's original and lowest price. The first major change in the worth of the dollar occurred in 1933. President Roosevelt confiscated Americans' gold and then devalued the dollar to $35 per ounce. That price held until August 13, 1971, when Nixon ordered the Treasury "to suspend, temporarily, the convertibility of the dollar into gold."

In his televised address to the nation, Nixon proclaimed: "Now, what does this action, which is very technical, mean for you? Let me lay to rest the bugaboo of what is called devaluation." And so the devaluation of the dollar began. Since Nixon's order, the dollar has fallen 97.2%, from 1/35th of an ounce of gold to 1/1250th of an ounce.

The cause of the dollar's decline is clear. Since its founding in 1913, the Federal Reserve has been printing money ever faster, making each dollar worth less, causing prices to rise. This is the simple perspective, and it is largely correct. But, there is a more sophisticated way to analyze the Fed's influence on the dollar.

The purpose of the first banks was to enhance liquidity. In ancient China, the most important commodities were copper and rice, both of which are bulky per unit value. Private warehouses would issue paper receipts entitling the holder to take delivery of commodities at certain dates. Trading the paper was much easier than trading physical commodities, and these warehouse receipts became the basis of the first paper money.

Similarly, the purpose of the Bank of Amsterdam, founded in 1609, was to issue receipts against the deposit of various gold coins minted by diverse European rulers. Merchants preferred the gold receipts because they were more liquid than physical gold and could be redeemed upon demand.

Ancient bankers were well aware that the liabilities of a bank cannot be worth more than the assets backing them. As Chinese scholar Wang-k'i recorded in the 14th century: "The private persons who managed this issuance took care that the notes came in when the metal when out, whereas when the notes were issued the metal deposited, and in this way metallic money and notes circulating side by side measured all merchandise of the empire, and in those days there was not the least reason why they should not circulate."

It should be obvious that "printing" bank notes does not change their value, as long as the new liabilities have new assets to back them. This is why Fed Chairman Bernanke is correct when he claims that quantitative easing "is not printing money," merely swapping assets: "if you think of the Fed's balance sheet, when we buy securities, on the asset side of the balance sheet, we get the Treasury securities, or in the previous episode, mortgage-backed securities. On the liability side of the balance sheet, to balance that, we create reserves [i.e., dollars] in the banking system."

But, what if, after a bank issues a liability in the form of a banknote or reserve, it loses the asset backing its liabilities? If the warehouse holding the rice burns down, presumably the warehouse receipts to that rice become worthless.

This is analogous to what is now happening at the Federal Reserve. In the past two months, since Bernanke suggested the Fed might slow its rate of bond purchases (even though it hasn't), interest rates have cracked higher, sending the value of the 10-year Treasury bond down over 6%. The mortgage bonds the Fed holds are similarly affected.

This is just the start. Interest rates are destined to go much higher and bonds much lower. The Treasury market is nothing more than the $16.7 trillion debt - and growing - of a profligate Congress that can never repay. Despite the Obama tax hikes and remittances from various Federal agencies, which produced record revenue in each of the first five months of the year, May's deficit was still the fourth largest ever.

The only reason traders buy Treasuries is to flip them to the Fed for a profit. If that trade ends, there will be a panic for the exit. Worse, as rates rise, interest payments required to service the debt will increase, forcing more borrowing, making the Fed's Treasuries worth still less. Meanwhile, even though the value of its assets is shrinking, the Fed continues to create $85 billion of new liabilities each month.

There is only one asset on the Fed's books the value of which is not determined by Congressional spending habits and is not sensitive to interest rates: gold. Gold has served as the basis for money for thousands of years because it is the most liquid element. In fact, the market demands that currencies be backed by some percentage of gold.

Looking at annual financial statements of the Federal Reserve and the Bank of England going back to 1720, gold backed the monetary base of the dominant issuer by 35.2%, on average. This figure isn't an artifact of the gold standard. Since 1971, during which time market forces were free to set the price of gold, the average gold backing of Fed liabilities has been 29.1%.

This week gold traded down to $1250 per ounce. The Fed reports it has 8,133 tons of gold among its assets, balancing its $3.4 trillion of liabilities. At current prices, the gold backs less than 10% of Fed-issued money, a record low.

There have only been eight times since 1720 that the gold backing of the dominant central bank has approached this level: the 1742 charter renewal controversy, the Dutch banking crisis of 1763, the suspension of convertibility during the Napoleonic Wars, the Panic of 1826, the beginning of the dollar crisis in 1969, the beginning of the current gold bull market in 2001, the financial crisis of 2008, and this week.

Shortly after every instance of gold being valued so little and paper promises so dear, the two asset classes have experienced a sharp reversal. And, in the modern era, the only way to increase the gold backing at the Fed is for the market to increase the price. Gold must triple, at least, to return to the post-1971 average backing.

The current generation of bankers has no memory of the 1970s, when bonds were called "certificates of confiscation." They have established the use of government bonds as the ultimate collateral. As bonds fall, clients must liquidate assets, including gold, to meet their margin calls.

But balance sheets must balance, including at the Federal Reserve. When the forced liquidation ends, the falling Treasury bond market will precipitate another dollar crisis. The Fed will either have to expand quantitative easing massively to force Treasury prices back up, or watch as rising yields tank the economy, puncture the Fed's balance sheet, and pop the various domestic and international asset bubbles blown up over the past decade.

This is the dollar endgame for which gold investors have been waiting.