Weekender: Gold is a Credit Default Swap

December 5, 2010
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Gold is the ultimate Credit Default Swap. It’s meltdown insurance taken out against Federal Reserve Inc. and the global financial system at large. And the best part is, with this CDS you never have to worry about your counterparty.

That simple observation is a worthy retort to all those who yammer on about how “gold has no intrinsic value”… how gold is worthless because “it offers no yield, no return on investment” and so on.

When was the last time you heard someone complaining about the fire insurance policy on their house — the fact that it “offered no yield” etcetera?

When it comes to insurance, yield isn’t the point…

There is a speculative component too, of course. You can make a ton of money buying fire insurance on houses you don’t own. John Paulson taught us that, via his multi-billion-dollar CDS score when the housing bubble turned to bust.

The CDS analogy also applies in that you don’t need armageddon to turn a profit. A company (or a country for that matter) doesn’t need to implode for long CDS to pay off.

All we need to see is a rise in the perceived risk of default — an increase in the statistical probability, however small, that the worst-case scenario could occur.

And this of course explains why the financial establishment hates gold. Ben Bernanke is the CEO of Federal Reserve Inc., and gold is a CDS bet that the organization is flailing and management has lost control.

Let’s keep exploring this parallel. Apart from the recent cycle, when was the last big heyday for gold? The mid to late 1970s — no coincidence the Fed had lost control then too.

(By the way, did you know there was a massive housing bubble in the 1970s, on a scale to rival the latest one?)

Those who pooh-pooh gold do so on the basis of knee-jerk historical recency bias. They point to the extended doldrums of the post-1980 period as evidence of how worthless the yellow metal is.

Reaching into their memory banks and bringing forth the good times of the Reagan-Bush-Clinton years, they mistake a roughly 20-year historical time window for a permanent state of affairs.

Yet once again, the CDS analogy — gold as a bet against Federal Reserve Inc. — sheds light on this mistake.

Not to put too fine a point on it, Fed Chairman Paul Volcker was “the man.” He helped the Fed get its shit together in the late 70s / early 80s. His ability and willingness to do that laid the groundwork for the long period of increasingly leveraged prosperity that followed.

So it’s no wonder that gold went into dormancy after “Tall Paul” broke the back of inflation. Through the actions of an extraordinary leader, the financial system cleansed itself of excess and facilitated a path to healing — exactly the type of environment in which a CDS “meltdown” bet would peak out and decline.

But that was then and this is now. Today we’re on the far side of the leverage and debt supercycle, with unaddressed problems mounting and no competent leadership in sight.

Question: You see any “cleansing of excess” going on in 2010? I don’t. I see a bunch of theory-drunk gamblers (disguised as academics) hooked on double-down martingale strategy.

“If this desperation bet doesn’t work, we’ll just up the size of the next one…”

As a side note, it’s instructive to recall that Volcker was exactly what a Fed Chairman (and perhaps a CEO) should be. Gruff, hard-nosed, determined. A loner type, not a flesh-pressing people-pleaser. Someone who could stoically sit back and take it when outraged homebuilders, crushed by interest rate hikes, started sending 2×4 planks to Volcker’s office with hate notes attached. Someone with the testicular fortitude to do what needed to be done in the face of deafening public outcry.

Volcker, in other words, stands in direct and nearly absolute contrast to that lily-livered, mealy-mouthed, glad-handing cheerleader pantywaist, Alan Greenspan.

When “the Maestro” dared to utter the words “irrational exuberance” in the mid-1990s, the political fallout from a swooning stock market scared him so badly he might as well have had his spine surgically removed the very next day. Mr. “I just want to be loved” never again challenged the bullish orthodoxy after that. (Or at least, not until he retired and started craving missed attention…)

And now we have Ben Bernanke, a cowed academic after Greenspan’s own heart. We recently saw the full extent to which “the Ben Bernank” would go to please all manner of masters, and gold surged on the reveal.

The Fed’s solution — MOAR STIMULUS! MOAR PRINT! MOAR! — would be hilarious were it not so tragic. (Come to think of it, it’s darkly hilarious anyway.)

Thus gold, the ultimate CDS, remains a powerful insurance bet that Federal Reserve Inc., under Keystone Cops management, has screwed things up badly and is in danger of making things worse.

And of course, if you like gold, it’s hard not to like gold stocks

JS

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4 Responses to Weekender: Gold is a Credit Default Swap

  1. Alex on December 5, 2010 at 9:10 am

    "Through the actions of an extraordinary leader"

    You should get a job on CNBC, that's just the kind of talk they use there.

    Having said that, good article, sums up the mess very well. hard not to like Gold.

    • Jack Sparrow on December 5, 2010 at 4:11 pm

      "A job on CNBC?"

      I'd rather work in a meat processing plant, cutting the sphincters out of chickens with a pair of scissors.

  2. it's the pirate's life for me on December 5, 2010 at 10:38 am

    Thanks, I’ve been trying to get my head around the true value of gold (and away from the lunatic fringe goldbug theories) for a while.

    It’s telling that gold always goes up during threat of war. Its demand is almost entirely a function of fear. The ultra-rich put their money in gold so that when calamity occurs (revolution, natural disaster, war, depression, abrogation of human rights), they can carry their wealth in a very convertible form (unlike currencies or stocks) to a safer country and start over.

    I’ve read Reinhart & Rogoff, and it’s telling that we haven’t had a significant country default or outright financial collapse in one heck of a long time. But countries are **supposed** to default regularly, it’s expected, it’s all over the historical record as R&R demonstrate. Greece, Spain and France, for example, were serial defaulters for decades, and there are massive defaults that occurred in places like post-Kerensky Russia.

    But the financial plutocrats aren’t letting countries default anymore! No no no, we don’t care that your economy will be permanently crippled – you have to steal your people’s social security money to play back our debts!

    I’d wonder what Reinhart and Rogoff would say about the relative power of bondholders today, versus a time like the 19th century. Definitely bondholders then were at the whim of governments. Definitely now (as ZeroHedge love to point out) the bondholders are the true rulers, and heads of state are little more than their functionaries.

    So maybe the presently soaring price of gold, then, is resulting from the new fundamental tension between the bondholders who are trying to stave off national defaults, and the natural tendency of governments to default?

    The idea being this: taking Ireland as an example, the financial plutocrats aren’t letting Ireland default the way it necessarily needs to. (EMF plays a part in this too.) But ultimately, Ireland will still default. There’s no way that they can pay 6% on bailout money without their debt continuing to spiral out of control.

    Let me know your opinion on this, but to me, the gold market seems to be acting as if it feels that the unavoidable crashes to come will be even bigger and more explosive, because of the greater tension that has built up between the opposing forces.

    Multiply Ireland times all the other countries after a contagion hits and the financial plutocrats ultimately lose control. And they will: either someone else will pull an Iceland and demonstrate positive results that nobody can ignore, or the people will get fed up of their money being confiscated and elect nationalist governments that purposefully default, or (if the plutocrats get in the way of the latter two) you’ll start to see violent revolutions and a resurgence of communism. Seriously: if you have a nasty enough enemy you can get revolution, and “greedy bankers” have been the foil before, haven’t they?

    Maybe we really can see $5000 gold when the edifice finally cracks through wide enough? What was the price of gold in 1941? I think that’s the last time we had enough chaos in the world to compare with what might come when the bondholders finally lose their grip and all that built-up tension snaps.

  3. brett on October 2, 2011 at 9:24 pm

    What do we call it when politicians elongate the pain, rather than default? I'm sure JS/MM can come up with something pithy.

    More to the point: If you a money manager in the United States, how do you invest knowing that (european) "leaders" are avoiding default at all costs?

    BTW: I'm pretty sure that all the way back to the Bible, a year of jubilee was held ever seven years where debtors were forgiven. I don't k now the actual terms, but the anecdote supports the idea of default regularity.

    And finally: Do you think the guy who's alway the one dissenter from the Kansas City Fed might be tagged in the next administration?

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