Granny's 'Irrational' Gold Obsession Is Wholly Rational

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At his Senate testimony yesterday, Chairman Bernanke stayed mostly positive about the good work he and his colleagues have been doing, as they understand it. Part of that, according to his manner of ideology, is the recent drop in gold prices. To the modern central banker, gold is anathema to successful economic management because it represents a partial rebuke by financial participants. I say only partial rebuke because, as the Chairman noted, "nobody really understands gold prices."

Indeed, there is a lot of truth to that statement, but not for reasons that can be easily incorporated into the modern monetary mind. Chairman Bernanke's understanding, in conjunction with pretty much all of conventional economics and monetary "science", views gold as a relic from the Bretton Woods framework. The aftermath of the Great Depression represented, to this view, freedom from the mystifying shackles of the gold standard. But freedom for central banks is the opposite of freedom from government interference, and thus the conventional monetary impulse cannot understand the alternate.

What is really interesting about this comparison is the evolution of monetary "science" in parallel to technology and innovation in related fields. For the most part, monetary operations in the "old days" were nothing more than the management of patterns, primarily the seasonal flow of money to and from New York City (real money, not credit production). As social engineers became more aware of how these patterns played out in all manner of economic factors, they became increasingly (hubristically?) confident in the means to model the complex system that is the economy. Confidence in modeling and assumed understanding leads eventually to the belief in systemic control.

The advances in pattern recognition and the related mathematics would not have been possible, at least in the forms they took, without leaps and bounds in disciplines like cryptography. At the same time economists were optimistically reshaping the global financial order through a more heavy-handed approach, cryptographers were busy tipping the scales of World War II in our favor.

At the time, William F. Friedman was perhaps the greatest mind in cryptography and codes. At only 30 years old, in 1921 he had become the chief cryptanalyst (a term he himself coined) for the US War Department. He would also lead the Signals Intelligence Service, the forerunner of the now infamous NSA.

In 1939, as war became a growing reality, the SIS had set about to decipher codes of the Axis powers, including the Japanese. The Japanese diplomatic service had just replaced their "RED" codes due to the inability of the US government to hide the fact it had broken them. In their place, the Japanese implemented the "PURPLE" code system, which was, at the time, the most advanced codes outside the US (and arguably more advanced than what Friedman had developed for the US).

It took some time, but eventually Freidman and his team broke the PURPLE code, something that the Japanese refused to believe even after the war ended. Friedman himself actually suffered a mental breakdown in the pursuit of PURPLE, due to his singular obsession with cryptanalysis.

Ironically, that obsession began in his childhood when he read a short story by Edgar Allen Poe. Poe had essentially invented the modern detective story, so it was no coincidence that it would have been of interest to a young boy in that time period. But Poe also introduced the public to the first real writing about codes and cryptography, including the term itself.

The story that got Friedman so interested in patterning and coding first appeared in three installments of the Philadelphia Dollar Newspaper in 1843. Poe gave the saga the title, "The Gold-Bug".

The Gold-Bug revolves around a mysterious golden bug that apparently "bites" the protagonist (William Legrand) and sends him off on a treasure hunt, obsessed with finding pirates' golden riches around Charleston, SC. For the narrator and the only other major character, this golden obsession borders on, and passes into, the delusional, as they cannot believe that a formerly rational man would turn to such one-dimensional madness. They are the Bernankes of their day, totally mystified as to why anyone would absorb such durable dedication to the yellow metal - it had to be the assumed bite from the mysterious gold bug.

But it was no such thing at all. In fact, the bug was simply the means through which Legrand discovers the treasure (which he does find). Seeing this mysterious bug that appeared to be golden in color and character, Legrand picks up a piece of parchment lying around the woods to capture and examine the bug. The parchment turns out to be a coded message for the location of the treasure - a substitution cypher. So it was not Legrand fixated irrationally, it was the other characters in their derision and ignorance groping for some explanation that fit their own incomplete view of the situation.

The gold bug seemed overly suitable to that foolish sense of what was taking place even as Legrand solved the riddle and found the pirate treasure. He even went so far as to play into the illusion the other characters had created for themselves, using the gold bug as a prop to further confuse their sensibilities for his own amusement. The more convinced they became he was deranged in his pursuit of gold through the hold of the bug, the more they became deranged in their desperation for understanding what was taking place.

In those moments of witlessness, convinced that Legrand was losing his mental capacity, they instead revealed their own. Because they could not see the knowledge that Legrand had painstakingly revealed for himself, they could not understand why he went to such lengths for what they were sure was a fool's errand. But they were the fools as the Gold Bug obsession was not his; it was theirs. They eventually saw the golden light of treasure and success. Wounded pride was a small price to pay for being so closed-minded, particularly since Legrand gave them a share of his new-found wealth.

What was a mess of encryption in the story was really just the failure to imagine something outside assuredly comfortable perceptions of systemic reality. That is true of cryptography as it relates to patterns and information beyond the closed-minded grasp of the over-confident, such as the Japanese clinging to their PURPLE codes. It is also true of economics and finance.

The modern system as it evolved past the initial Bretton Woods period left fewer and fewer options for protection against deluded sensibilities and over-confident managerial assessments of self-ability in monetary authorities. Gold was not an unreasonable obsession that poorly performed in this technological age; it was an alternate form of money that subjected all paper currencies to Gresham's Law. As long as gold held some direct link to paper, there was an alternate means of monetary exchange that held the government's monetary power in check.

From the perspective of the central banker, that was wholly undesirable. There can never be an alternate means of money since central banks and governments are serially irresponsible stewards of money. Far easier to appeal to debasement and inflation than to tax or implement true austerity. Gold was the last line of defense against this appeal, as the markets had a real alternative and thus a veto of such irresponsible politicking in financial affairs.

So it had to be fully removed lest it force government, even the US government which was among the worst offenders, toward more responsible behavior. Once the two-tiered pricing structure appeared in March 1968, it was the beginning of the end for Gresham's Law and the US dollar. There have been no substitutes for US Federal Reserve fiat since then. There is no monetary anchor since gold is no longer used functionally as money (again, it should be money, but it simply isn't).

In that respect, you might see why the Fed Chairman and his FOMC compatriots are puzzled by the attraction of gold, as if the Gold Bug has reincarnated, en masse, to affect so many monetarily disaffected. But there is a pattern that also escapes his hubristically self-assured grasp.

In an unbelievably condescending article in Bloomberg, fittingly titled, "Granny's Gold Bars Are Key to Vietnam Push to Boost Dong", the unstated author gives this game away. "Granny" doesn't want to give up gold because of experience, including recent experience, of high inflation and devaluation. Should Granny just sign up for the poorhouse because the Vietnamese central bank wishes to "defend" the dong via financial engineering? Might Granny's irrational obsession with gold, as the article tries to portray, be actually rational self-interest lying beyond the grasp of conventional economic theory's own self-obsession with socialized economics? The central bank has been bitten by the Gold Bug, not Granny.

If the dong was "worth" what its central bank believes, they should have no trouble with Gresham's Law confirming as much. But "they" care not about value or even Granny, only the ability to control the financial destiny of their own system - socialized economics over individual rational self-interest.

What is true in Vietnam today is equally comparable to every developed nation under the thumb of central bank unilateralism. To this even Bernanke admitted the appeal of gold against "extreme events", which fully contrasts with his puzzlement. But where this partially reconciles in the modern economic canon is that he trusts his own abilities to perform as central planner, while discounting that so many may not (he has a Princeton pedigree, after all). In the conventional narrative where gold is a misunderstood asset class, the Federal Reserve is populated by heroes that saved us from the mess of banking and free markets.

We know better, as banking has not been about free markets in a long time, most certainly under the interest rate targeting schematic, and the desperate crises that continually roil into volatility are the handiwork of unilateral management of fiat without competition. If gold was actually money today, paper dollars would have been spent into oblivion.

The patterns here are fully recognizable to anyone with an open mind. Central banks say, "trust us", but then intentionally rid the world of any choice. That is fully incongruous behavior and doesn't lead to trust, but some kind of Orwellian dystopian fantasy of control that is largely unobserved (it is here that financial complexity is most dubious). For the uninitiated, dollar denominated asset classes appear to provide varying degrees of protection from the "occasional" central bank misstep. But, as 2008 should have shown without ambiguity, there really is no place to hide inside the dollar system.

The obsession with gold is not really the obsession with gold; the Gold Bug is Bernanke's fear that the world will wake up to the fact he gets it wrong far more than he gets it right (stock prices vs. SNAP, or worse, stock prices on a 13-year chart vs. SNAP and wage growth). That cannot countenance an alternate lest Gresham's Law extinguish his entire profession. Like Greenspan before, the past few decades are rife with the monetary illusion. Gold must be contained and intellectually discounted because it shines the bright light on the asset bubble record, including the current unbelievably poor economic performance (if current estimates are even close, GDP will be at or below 2% for five of the past six quarters, an unbelievable string of bad economic "management" in the face of such massive "stimulus"; this used to be called the economic danger zone).

Economics and finance, much like cryptography, are about pattern recognition. Modern monetary "science" is becoming singularly dedicated to discounting and disavowing obvious patterns, such as the focus on "tail risks". That is the only way social economics can continue to override monetary choice - real money, not credit. Legrand wasn't crazy; neither is Vietnam's euphemism for Granny.

In the fullest light of codes and patterns, Bernanke is both ideologically blind and obsessed with gold. The history of the US dollar under the Federal Reserve reads like Poe's Gold Bug as US central bankers fixate over losing the battle with its biting potency as a substitute monetary control mechanism. There is, however, no happy ending in this story, at least not yet; only mystifying malaise, a preponderance of "unexpected" headwinds, that beg for something other than central and social economics. Once politics is freed from the spell of central planning under the guise of monetarist ideology, the search for monetary substitution will give us our happy ending. The Gold Bug has bitten both parties, not in pursuit of gold but its banishment (sadly, the Gold Commission under Reagan is a prime example).

Free market capitalism is the answer here, not statism's false choice of one form of government intervention or another. There is no detective story to unravel and it really shouldn't take a cryptographer to demonstrate it to the political powers that be. If there does exist a Gold Bug on the "gold side", it is the singular and rational focus on something that will provide an alternative and limit to the Bernanke's of the world and their still unrequited record of such obvious failure: truly free markets, including a real market for money.


Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners, a registered investment advisor. 

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