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Sunday, February 28, 2010

The Gold Tax

The $64 Trillion Question

What do rational savers and investors do in an environment of zero percent interest rates, where the daily headlines speculate how long major currencies (like the U.S. dollar) will hold their value as national debts mount?

Switch (at least) a little of their holdings to gold.

Even if that amount is relatively small -- say, 5% of liquid assets -- the effect on global commerce could be huge.

That's because 5% of global liquidity is still a huge number, and it's magnified many times that by something called a "fractional reserve banking system."

"Fractional reserve what???"

If you're not an economics wonk, stop here; however, if you can handle a little bit of brain teasing . . . . read on.

Global Money Supply: How Much?

To figure out how much 5% of the world's money supply is, one first has to estimate . . . the world's money supply.

If you know, send me an email.

However, as best I can tell, a working estimate is about $30 trillion.

That consists of both coins and legal tender, as well as short-term banking deposits, money market funds, CD's, and the like.

While definitions vary, to be included in the foregoing number, the instrument must be liquid -- that is, easily converted to cash and spendable.

Bottom line, defensive savers reaching for financial insurance conceivably could switch something like $1 - $2 trillion of their former paper money reserves into gold.

Or already have.

That's against a backdrop of recession-anxious consumers already upping their "rainy day" funds in case of extended unemployment, unexpected (and uncovered) medical bills, etc.

Cash vs. Gold

What's the big deal if people effectively put a trillion (or two) in their mattress?

Due to something called "fractional reserve" banking -- the system in developed countries today -- $1 on deposit at a bank theoretically can support $20 of loans. That's because banks typically only need to keep $1 in reserve for every $20 they lend.

So, a $1 trillion withdrawal potentially has the effect of reducing lending activity by $20 trillion.

That, in an economy where assets like stocks and housing have already taken multi-trillion dollar hits the last two years or so.

Missing Drain Plug?

To combat this contractionary dynamic, the Federal Reserve and other central banks have been, shall we say, "aggressively" increasing liquidity -- printing money.

Unfortunately, as central bankers have poured money into the global currency "bath tub," they haven't seem to notice that there's a big hole in the drain plug -- if indeed there still is a drain plug.

Ironically, it may even be the case that the more "fiat" (paper) money central bankers create, the more people defensively convert that money to non-fiat forms -- like gold -- to protect themselves.

Addressing this vicious circle -- and removing the "gold tax" -- would seem to be the biggest imperative for today's monetary policy makers.

P.S.: economists have various terms for times -- like now -- when monetary policy seems to be impotent (or worse). They include "pushing on a string," "liquidity trap," etc.

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