Monetary Mess, the Dollar, Gold—and You, Part VI

(For previous parts in this series, scroll down and click on the links in the righthand column.)

At the end of last year, according to Robert F. Wilmers, chairman and CEO of M&T Bank Corporation, the total outstanding debt of Fannie and Freddie “either held directly on their balance sheets or as guarantees on mortgage securities they'd sold to investors, was $8.1 trillion. That compares to $7.8 trillion in total marketable debt outstanding for the U.S. government.” And it's going to get worse, because the government has directed them to lose money by modifying mortgages to prevent foreclosures. The banks have already repaid $136 billion of the $205 billion they received, and GM, Chrysler and AIG are working to make repayments, but Fannie and Freddie are designed to lose more money going forward. The Congressional Budget Office estimates the taxpayers' cost of keeping Fannie and Freddie operating will be $380 billion over the next ten years. But this is based on an assumption that the housing market will “normalize” as the recession ends, which may very well be overly optimistic.

The full cost of subsidizing mortgages remains hidden because it is off the official balance sheet, but the GSEs have already cost the taxpayers nearly $150 billion. When Treasury first bailed them out in September 2008, Congress put a limit of $200 billion ($100 billion each) on federal assistance. When that appeared insufficient, the limit was raised to $400 billion. Then on Christmas Eve 2009 the administration raised the limit...to infinity. No limit whatsoever, for the next three years. Christmas Eve was a time when the public and the media would give little attention to the matter, and something had to be done before December 31. Otherwise, congressional approval would be needed to raise the $400-billion limit. Without that approval, negative net worth for Fannie and Freddie would force them by law into receivership, which would wind them down. The administration was preparing for the possibility of Fannie and Freddie exceeding the CBO estimate of $380 and even the previous $400 billion limit, perhaps by a wide margin. Thus, despite the government's efforts to convince the public that it has handled the problems of Fannie and Freddie effectively, those two will continue to bleed red ink and erode confidence in the dollar.

In 2008, a Standard & Poor's study found the taxpayer risk from Fannie and Freddie, combined with other government-guaranteed agencies, “yields a potential fiscal cost to the government of up to 10% of GDP.” The Wall Street Journal April 4, 2008, wrote, “With total GDP at somewhat north of $14 trillion, that would put the Fan and Fred bailout cost at $1.4 trillion. Yowza. This 'fiscal burden' would be so large, in fact, that S&P figures it could even jeopardize the AAA credit rating of the U.S. government.”

Last year, French President Nicolas Sarkozy joined Russia, China and other emerging countries in calling for an end to the dollar's reign as the primary international currency. And the United Nations Conference on Trade and Development endorsed moving away from the central role of the dollar in the world monetary system.

The U.S. announcement in 1971 that it was ending the final link between gold and the dollar led to the collapse of the Bretton Woods system of fixed exchange rates in 1973. From 1976 to 1980 the International Monetary fund eliminated the use of gold as a common denominator, abolished the official price of gold, and ended the obligatory use of gold between the IMF and its member countries. Also, it sold approximately one-third (50 million ounces) of its gold holdings “following an agreement by its member countries to reduce the role of gold in the international monetary system,” says an IMF fact sheet.

Naive social reformers and politicians have long dreamed they could create a better world if political power could overcome the restraint gold-anchored money imposed on their good intentions, because it prevents runaway government spending. But their dream to reduce, or even ultimately eliminate, gold from the international monetary system suffered a rude awakening by what has been happening to the dollar cut lose from gold. France, which had been the largest seller of gold, now says it will sell no more gold. A report by the Austrian central bank last year said the rise in gold prices and “the concomitant depreciation of the U.S. dollar over the past few years have shown clearly how important gold is as an instrument for a central bank.” Germany's Bundesbank, the world's second largest official holder of gold with 3,417 tons has indicated it is now more willing to hold and buy gold than to sell. Russia has been buying regularly, bought about 100 tons in the past year, and says it intends to continue buying and increasing the percentage of its reserves in gold.

Ever since the IMF began selling its gold, that additional supply—or even the threat of it—has had a tendency to hold down the market price of gold. But the situation has now changed, because of demand. On September 18, 2009, the IMF approved the sale of 403 metric tons of gold (one-eighth of its holdings of 3,217 tons) to shore up its own finances and enable loans to poorer countries. The IMF sold 200 tons to India and the remainder to three smaller countries.

China has by far the world's largest holding of dollars, $2.45 trillion. Spokesman Cheng Siwei said Beijing is dismayed by the Fed's recourse to easy credit. He said China fears U.S. printing of money will lead to inflation and a hard fall of the dollar, which would seriously reduce the value of China's holding. So it has been diversifying into other investments. At the end of May 2010, China had reduced its holdings of U.S. Treasuries to $867 billion, down from $900.2 billion the previous month and the record $939.9 billion in July 2009. It has been buying commodities such as copper, iron, aluminum, lead, zinc and oil. It has been buying euros, other currencies and bonds of other countries and the ECB. It has been buying companies, factories, banks, and real estate all over the world. In 2009, China increased its gold holding by 76%, to 1,054 tons. It would love to buy much more, but as Siwei said, “When we buy, the price goes up. We have to do it carefully so as not to stimulate the markets.” China's Assets Supervision and Administration has set a goal of accumulating 10,000 metric tons of gold in the next ten years.

The chart below shows why China wants more gold. You can see that as of the end of last year, gold comprised only one and a half percent of its vast reserves. Notice, too, that India, Russia and Brazil, which are large countries with rapidly growing economies, also have very small percentages of their official reserves in gold.

Countries which are running current-account surpluses and don't have their own domestic production are the most logical future buyers. We have already noted the gold purchases by the central banks of India and Russia. According to the IMF, among the countries with the largest dollar surpluses behind China and Russia are Malaysia, Singapore, Kuwait, Saudi Arabia and Venezuela. 2009 was the first year since 1987 that central banks bought more gold than they sold. There are likely to be no shortages of buyers for future sales.

“You won't see major players be blatant about increasing their gold exposure, but it is a trend we've been witnessing in the past few months,” noted Kathy Lien, director of currency research at GTF Forex in New York on June 8, 2010. “For the most part, whether they openly admit it or not, central banks are increasingly worried about their exposure to euros.”

For Part VII of this series, click link