The Penalty – and Payoff – for a Loss of Faith in Currency

Adam Lass, Senior Editor, WaveStrength Options Weekly
Source: http://www.taipanpublishinggroup.com/taipan-daily050610.html

image: currencyThe ascending dominance of the “Currency Contagion” meme will raise the selling price of this asset 197%.

It’s all about faith, my friends. And unfortunately, that’s an increasingly rare commodity these days.

A body participates in a system if they have reasonable faith of making a decent return. If they have no faith – no expectation that the system will honor and reward their participation, they will eventually cease to take part in it, and the system will collapse.

Dogs pack up, because they figure that they might lose a piece of their next meal to the pack’s alpha male, but they have faith that the pack is the best way to assure that there will be a “next meal” on a pretty regular basis.

The Cost of Failure

It may take a while before they notice that they are missing out on a regular basis. But it is a given that a pack that does not expect adequate food will begin to slowly lose members. When things get bad enough, the remaining dogs will gang up and expel the failed Alpha.

Similarly, human participation in transactional relationships requires a certain measure of faith.

On the simplest level, one must have faith when one is trading goats for wheat that the gentleman across the table from you will not smack you upside the head with a large stick, and walk off with the goats, the wheat and perhaps your clothes, stone axe and mate. Thus we have open palm salutes and handshakes, wherein we establish to one another that we are not concealing a weapon of some sort.

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Currency: A Valuable Fiction

Now let’s take things up a notch in complexity. Some say that currency exists because it is a bit of a pain dragging around goats and carts of wheat with you all the time. But really, currency exists because it allows for specialization of labor.

I might be particularly good at raising goats, while the fellow across the way is better than I am at keeping bugs out of the wheat. Neither of us makes a halfway decent boot mind you, but that’s OK, because a chap in the next town is a whiz with a scissors and a hammer.

A currency of some sort allows each of us to focus on what we do best. It also allows a body to store wealth without worrying about the smell a pile of dead goats inevitably generates.

However, any currency, be it shells, beads, coins or pieces of paper, requires a great deal of faith. One must trust that each iteration of that currency, each bit of specie will retain its value over time, or it cannot possibly be an adequate storehouse of value.

One must have faith in the creator of said specie, or the whole system falls apart, and we are stuck hauling about cartloads of stuff again. Worse yet, I would have to make my own shoes, and I am quite sure that my feet would suffer awfully.

The Gold Bug Fallacy

As long as we are discussing currencies, I’d like to take a moment to address a common fallacy. Many folks in this business like to label all command currencies as fictive and therefore undeserving of your faith.

They frequently have a good point there, as most every government has inevitably debased its command currency so as to ease the burden of paying its debts. In plain English, they borrow goats and print bucks to pay off the loan.

But these same folks will point to certain minerals as having “genuine value.” Gold and silver are the usual favorites because of their pleasant coloration and heft and relative resistance to corrosion. However attractive these bits of rock may be, their ability to retain value is simply a meme, a thought shared by millions perhaps, but still just as fictive as any paper currency.

But Can You Eat It?

A friend asked me recently if I concurred with the idea that “all hell was about to break loose,” and what they might to do about such things. They thought that perhaps they ought to convert a substantial portion of their holdings into gold coins of some sort.

I am not so sanguine as to the eventual fate of our current systems as to completely disregard his point. But I did suggest that if he really thought that our civilization was verging on one of its periodic dark ages, he might do better to invest his money in a few courses at his local community college.

In particular, he should acquire the ability to grow corn, clean and patch wounds (and given a little more time, deliver babies), prop up roofs, and brew alcohol (the basis of most all chemistry). Learning to make shoes wouldn’t be a bad idea either.

In a real crisis, you can’t eat gold. At best, I suppose you could put a chunk or two in a sock and kill marauders with it.

As much as it is romantic to ponder such dramatic turns of affairs as dark ages and depressions, I am not really looking to address such complete societal breakdowns in today’s column.

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The Price of Faith…

Let’s presume for a moment that we will indeed be able to buy shoes for some time to come, and focus instead on the decline of the meme of faith as it pertains to certain of our fiscal systems.

Currencies are not the only fiscal contracts that require faith in the issuing party. The same is most certainly true for both stocks and particularly, bonds.

No one in their right mind would lend to a company, town or country if they had no faith whatsoever in the borrowing entity’s intent or ability to repay that loan, preferably with some interest. But these things are seldom absolute, so we posit an inverse relationship of faith in repayment against additional cost asked of the borrower.

…And the Cost of Risk

Right now, for example, the more fiscally sound portion of the EU (read as Germany and France) is pondering how much interest it must charge the less sound “PIIGS” states in return for lending them adequate funds to avoid bankruptcy.

The problem is, very few honest observers have any faith that Greece et al. will ever change their spendthrift ways. So if Germany and France participate in a rescue package, will this increase faith in the European Union’s future? Or will the rest of the world lose faith in Germany and France as well?

And once this “Loss of Faith” meme begins to ascend and replicate, will it become dominant within the “Menome,” the total global kettle of conscious thought? Once folks start to ponder the ability of sovereign governments to honor debt through their own specie, the illusion of both debt and command currency (always a bit tattered around the edges) begins shred entirely.

A Dangerous Descent

The last time we saw such a breakdown was the Asian Contagion episode of 1997, wherein faith in the ability of government to control the ability of currency to act as a reservoir of value was stretched to the breaking point. And that time around, the focal point of the loss of faith was halfway around the world. We were able to comfort ourselves – to find faith – in the idea that Western governments would never engage in such dangerous shenanigans.

Chart: Euro debt map
View Larger Chart

This time, the focal point is right here in the West. When one peruses such newspapers as the International Herald Tribune, one is treated to multicolored displays reveling in the sheer impossibility of genuinely solving Europe’s Gordian knot of debt.

Chart: U.S. treasury securities

Stateside, one cannot go a day without reading of the overwhelming weight of debt Washington has taken on. These figures are critical both as facts, and as ascending memes, ideas that are gathering power in the minds of more and more investors. As faith in sovereign debt and currency declines, investors (at least those who are not pondering a new dark age) are looking toward the usual safe harbors of gold and silver.

Critical Memes

As mentioned earlier, I have no particular faith in gold and silver’s inherent values. But I do note with much interest the relative increases in the rate of uptake of the “Gold” and “Silver” memes.

Gold has long been the obsessive’s dream, the stuff they make movies like “Treasure of the Sierra Madre” about. But silver does a heck of a lot more of the heavy lifting. As Nobel Laureate economist Milton Friedman is said to have told Jim Blanchard, “The major monetary metal in history is silver, not gold.” Think about it: Gold is kept in vaults around the world – but most every coin in your pocket right now is covered in silver.

Both gold and silver have been used to hedge against inflation driven crashes like we saw in 2007 (and like we are about to see again in 2010). In October of 2007 the S&P 100 was trading at 714.51, Gold futures were $745 an ounce, and silver was available for $13.89. (That’s a ratio of 53-to-1, an important figure we will come back to in a moment.)

Six months later, the stock market was down 18.32% (on its way to a total loss of 56.79%). Gold futures were up to $1033.9 an ounce (a gain of 38.78%) and silver was up to $18.85, a similar gain of roughly 36%. The relationship between gold and silver was still holding even at about 55-to-1.

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A Curious Gap – and 197% Gains

We are approaching a critical moment in the market very similar to the precipice we stepped off in 2007. Oil is skyrocketing again, and is spreading its inflationary poison throughout the system.

But investors are facing an extraordinary problem: Gold’s nonstop rise over the past year has already pushed futures to $1,166 – just a whisker away from its all-time high. Silver has also been rising. But its current price of $17.27 an ounce leaves it 18.46% shy of its March 2008 high of $21.18.

More importantly, there is a unique distortion in the ratio between gold and silver: Right now it takes almost 68 ounces of silver to buy an ounce of gold! This gap cannot last more than a moment or two, as investors looking to hedge against stocks rush in to take advantage of silver’s discount to gold.

With this closing gap in mind, I suggest to you that you expose yourself to silver’s pending upside. Since I retain the view that even silver’s value is in the end just as fictive as any five dollar bill, I suggest instead a vehicle such as iShares’ Silver Trust ETF (SLV:NYSEArca). My charts indicate a pending upside run that could easily add 30% to SLV’s current share price of $17.19.

Taking this idea another step, I have suggested to my WOW readers that they divorce themselves even further from physical silver, and involve themselves primarily in SLV’s upside motion via the purchase of select SLV calls, with the intent of harvesting gains ranging as high as 197%.

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