The St. Peter of Money Heaven Works Overtime
(Why the U.S. Banking System is Toast)

Years ago, I used to puzzle over the dynamics of deflation until my head ached.

The closer I thought about it, the more I found my concentration drifting as, for example, it tends to do when you think about particle physics and try to imagine a brane with two spatial dimensions that is rolled up so tightly that it becomes a string.

If you don’t know what I am talking about, the analogy was successful. Even with a good education, there is always a point where you reach an imaginative dead-end.

As I stubbornly slogged on, trying to trace the arch of wealth from creation to liquidation, I reminded myself of the plodding Oxford philosopher satirized by Tom Stoppard in his 1972 play Jumpers.

If you haven’t seen it, it’s a rowdy intellectual puzzle about philosophical gymnastics, morality and murder.

The main protagonist struggles to recall the crucial bits of a proof for the existence of God. As he flounders through that task, a disturbing discovery is made in his beautiful wife’s closet: the dead body of another philosopher.

It’s murder. But the audience is offered consolation from Wittgenstein: “He’s dead. It’s very sad, but it’s not as if the alternative were immortality.”

There was the hint I was looking for. Wealth brought into existence by an artificial credit boom will inevitably find its way to Money Heaven. The Grim Reaper of finance comes knocking no matter what.

You can’t necessarily foretell the details of the death that looms ahead. But you can be fairly confident that nature will figure it out.

Setting the Trap of Financial Collapse

As Lord William Rees-Mogg and I wrote in our 1993 book, The Great Reckoning: Protect Yourself in the Coming Depression (quoting from Emerson),

There is a “deep remedial force that underlies all facts.” At every point where something goes up, nature is constantly compensating by finding a way to bring it down.

That was as close as we could come to wisdom back in the day. Today, we see its impact reflected in the market cap of Citigroup, a bank that claims assets of $1 trillion but is worth just $13.95 billion (Feb. 19).

The collapse took longer to emerge than Lord Rees-Mogg and I anticipated when we wrote The Great Reckoning. And it still has a long way to go. But looking back now, it’s clear that the protraction of the boom - especially the rapid rebound in credit growth after the pricking of the dot-com bubble in 2000 - became an integral part of the “deep remedial force” conspiring to inform the current crisis.

It took many years for financial improvisations Wall Street adopted in the 1990s and early in this decade to set the spring on the trap of debt liquidation that was finally triggered with the subprime mortgage collapse. So it’s little wonder that 15 years ago neither Lord Rees-Mogg nor I (nor anyone else) could have foreseen the precise pathway that the credit collapse eventually took.

A decade and a half ago there were few subprime mortgages. And the trillions of dollars of off-balance-sheet derivative products that followed from the securitization of subprime mortgages, such as credit-default swaps, scarcely existed then. 

They had to be created.

And they had to prove so profitable in their early manifestations that the hydraulic pressures of competition could force their rapid adoption throughout the conservative field of banking. Of course, it also helped to spring the trap that these derivatives were innovations as obscure as particle physics.

Misregulating the Banking System

That such complex derivative products had never existed before contributed to the lack of coherent regulation of their risks - even in the highly regulated banking sector. (It’s certainly not true, as we now so often hear, that banking was unregulated; it was misregulated.)

For starters, it was federal policy to expand home ownership. The government pressured financial institutions (through the Community Reinvestment Act) to lend mortgage money to millions of borrowers who were high credit risks. (Hello, subprime!)

And it was only a short step from there for bankers, who were being bullied (and handsomely paid) to lend to high risk borrowers, to securitize those mortgage loans for re-sale around the globe.

You see, the artificially low interest rates the Fed set after the bursting of the dot-com bubble had left income investors begging for higher yields, which the sub-prime mortgage securities provided. So these loans were packaged up, sliced and diced according to perceived risk and covered by a new insurance scheme (credit-default swaps).

With the illusion that all risks were covered, it no longer seemed to matter if the loans defaulted because the default was “insured.”

Furthermore, apparently prudential regulation, such as that embodied in capital adequacy standards, was designed to account for familiar risks, not unfamiliar ones. The regulators and political authorities, whom we imagined to be all-knowing guardians of financial integrity, didn’t see the need to account for off-balance-sheet risks posed by derivatives such as credit-default swaps.

Therefore, to the extent the regulations were effective, they actually tended to compound systemic risk by encouraging commercial banks to deal more heavily in derivatives. That’s because these appeared, on a short track record at least, to afford the opportunity for big profits without the need of an equivalent capital provision to back them up.

Networked Economics

That these derivative products were designed by mathematicians and traded on electronic networks also contributed in at least two ways to their potential to trigger a global credit collapse.

Firstly, the derivatives were often so obscure that the executives and directors of the big banks and insurance companies that traded them had little grasp of what they actually entailed. They were the financial equivalent of the “hidden dimensions of the universe” postulated by particle physicists.  

As George Soros opined, “no one understands them.”  

So when the insurance giant AIG lent its balance sheet to trading of credit default swaps, the management of AIG had no track record to help gauge the risks entailed.

As The Washington Post reported, AIG tried to map the risks through computer simulations. These showed that the only worry for AIG would be another 1930s-style economic collapse. This was, naively, considered unlikely. So AIG plunged ahead with derivative transactions that would ultimately incur hundreds of billions of dollars in losses.

The second cause of the meltdown in these derivatives was a hidden feature of the network itself.

The greater the number of connections, or nodes, in any network, the greater the mathematical chance that changes in one part of the network will have negative effects. Therefore, as these networks became more popular with hedge funds, investment banks and insurance companies from around the world, the network became less stable.

The “Hair Trigger” Effect

You see, even though more participants superficially made the network more liquid, they introduced interdependencies that actually made it less viable. That’s because transactions across the network became interlinked to the extent that even small changes in one part led to cascading negative consequences.

For example, stop losses and other hair triggers for automated trades were pre-programmed into trading systems, so that relatively small price movements would be amplified by an avalanche of automated responses.

On September 18 2008, $550 billion had been withdrawn from money market funds by 11am in the morning. Later that day, the Fed announced it would guarantee money-market accounts up to $250,000 to stem this electronic run. According to the Fed, if it had not acted when it did, as much as $5.5 trillion would have likely been withdrawn from money-market funds. This would have precipitated a complete collapse of the economy.

Other interdependencies were also dangerously amplified by the multiplication of connections in the network.

For instance, when confidence in the reliability of counterparties failed for any reason, the velocity of electronic money plunged. This set the stage for a deflationary collapse of the world’s banking system.

Ironically, this collapse was amplified by the proliferation of the inscrutable electronically traded over-the-counter derivatives. In principle, they were meant to mitigate risk. In the event, their fantastic proliferation compounded systemic vulnerability.

A $600 Trillion Problem

By 2007, global derivatives, on a conservative estimate, totaled about $600 trillion – or roughly ten times the current annual output of all the world’s economies combined. And some knowledgeable estimates for the total of outstanding derivatives go as high as $1.2 quadrillion.

Another way of measuring this staggering number is in relation to the total wealth of the world. This was estimated at about $100 trillion as of December 2007. So a sum at least six times the total wealth of the world was put at risk.

More to the point, U.S. money center banks took on off-balance-sheet derivative liabilities that dwarf the U.S. national debt; unfunded Social Security and Medicare liabilities; and all known promises of profligate politicians throughout the whole of history!

JPMorgan Chase alone had exposure to off-balance-sheet derivatives of $90,408,468,778,000 (That’s $90 trillion, with a “t.”)

Little wonder the authorities choose JPMorgan to takeover Bear Stearns and the corpse of Lehman Brothers. JPMorgan desperately needed to add assets and pump some serious ballast into the hold in hope of stabilizing a potential shipwreck of the magnitude that sank Iceland.

As you surely know, Iceland went bankrupt after its three biggest banks got caught in a liquidity squeeze last fall. The government of Iceland tried to bail them out. But there was one small problem. As The Wall Street Journal explains:

At the root of Iceland’s troubles was an outsize banking system, which grew wildly overseas and built up foreign liabilities many times the size of Iceland’s economic output.

With the banking sector’s balance-sheet-to-annual-GDP ratio of about 900%, there was simply no way Iceland’s government could bailout the nation’s banks.

Of course, the then prime minister of Iceland made brave noises about standing behind the banks just days before they collapsed.

“The government will not hesitate in its determination to ensure with all means possible a stability of the financial system,” said the hapless Geir Haarde, “and sacrifice all that may be needed.”

But the promise of a bailout was a bluff.

The amounts required far exceeded the spare fiscal capacity of the country. And the further the crisis developed, the less plausible a successful bailout became.

The lesson, of course, in Iceland’s troubles is that other small countries may have a hard time sustaining outsized banking systems in a bankrupt world.

America’s Zero-Sum Game

The bigger question now is at what point, if any, could losses in the U.S. banking system compound beyond the capacity of the government to bail them out.

The U.S. obviously has considerable advantages over Iceland. Its economy is the largest in the world. And unlike Iceland, the U.S. borrows its own currency, which it retains the sovereign capacity to print in unlimited quantities.

Still, there can be political as well as technological obstacles to the transfer of wealth at the scale required on current estimates of U.S. banks’ exposure.

If the solvency gap in the U.S. banking system exceeds the unused fiscal capacity of the authorities, at some point the only choice will be between banking sector insolvency and sovereign insolvency.

In other words, the government may have to decide whether it will let the banks go broke or go broke itself.

As the sums required for a bailout rise, it’s completely predictable that taxpayers and the beneficiaries of public spending programs will object to devoting more resources to the problem. (Witness the deep unpopularity of both versions of the bungled Troubled Asset Relief Program.)

It will also become politically impossible in any semblance of democratic government to escalate the bailouts to ever higher levels. That’s because the costs of doing so could seem so steep that most non-bankers would be content to let the banks collapse and take their chances in the ensuing liquidation rather than pay the enormous fiscal and monetary costs of a bailout at the scale required.

That scale is already enormous. And it’s destined to go higher in the near future.

As of early 2008, JPMorgan Chase was exposed to an off-balance-sheet derivative liability of about $669,692 for each tax return filed in the U.S. (By contrast, Iceland’s total banking liabilities amounted to approximately $553,000 per capita.)

Bank of America and Citigroup followed JPMorgan Chase with off-balance-sheet derivative liabilities of $38 trillion each. Together, the three banks hold $166.6 trillion in these liabilities.

That equates to $1,229,630 for each of America’s 135 million tax returns - a mismatch of the sort that proved ruinous in Iceland.

Obviously, not all these derivatives could come due at once. But if even one-tenth did, I would judge that to be an impossibly large solvency hole to fill.

To meet it would require tacking more than $100,000 on to the average tax liability. Alternatively, it would require a monetary issue of hyper-inflationary proportions.

Both scenarios would mean a major hit to taxpayers and a sharp decline in the resources devoted to the beneficiaries of government spending. It is far from obvious to me that the political process would ratify bailouts at the scale that may be required. 

Iceland went bankrupt because its banks expanded their liabilities beyond the spare fiscal capacity of the Icelandic government.

The U.S. has magnitudes more fiscal and monetary capacity than Iceland. But U.S. banks have incurred liabilities and losses magnitudes higher than those of the Icelandic banks, too.

And unlike the Icelandic banks, which were only illiquid, the U.S. banking system is insolvent.

I say this advisedly, based on reasonable estimates of asset values and losses already incurred. But it has been confirmed by the behavior of the political authorities as they’ve scrambled to structure a bailout that will return the banking sector to functioning health.

Between the TARP and a Hard Place

A crucial reason why the Bush administration wavered in its determination to deploy TARP funds to remove toxic assets from the nation’s banks was that the $700 billion Congress reluctantly appropriated was far short of the amount required.

When the administration initially conceived the TARP, former Treasury secretary Hank Paulson argued for swift action to remove toxic assets from the balance sheets of banks. But as Paulson and his team tackled this task they came to an alarming realization: there was no “right answer” for fine-tuning the bailout. And almost any path to acquiring toxic assets posed a risk of cascading effects that would deepen the crisis.

The administration’s initial plan to find the market price of toxic assets through auctions was hastily dropped. Officials realized that paying a market price for the troubled assets of one bank would require that bank and others to write down similar assets on their books. This would precipitate a more general collapse of banks.

For example, knowledgeable observers report that Citigroup is holding a vault full of mortgage-backed securities it has written down to 50 cents on the dollar. But if these doubtful assets were sold at a market price, experts believe they would trade for only 22 cents on the dollar. (The FDIC has been realizing only between $0.05 and $0.10 on the dollar when it sells the loan portfolios of shuttered banks.) To realize the losses implied by more optimistic estimates of loan value would entail a writedown that would make Citigroup insolvent.

To avoid this unpalatable option, the Treasury considered paying a “premium” or inflated price for the troubled assets. But this idea was also rejected, because paying too much would destroy the government’s credibility with financial markets and anger the general public.

There was another, even more vexed question, facing the administration. Would paying a premium price for troubled assets shatter traders’ confidence that the markets were accurately pricing debt securities and assessing their risk?

If this was the case, an expensive intervention to artificially raise the prices of troubled assets would not only cost hundreds of billions - or indeed trillions - of dollars, it could also backfire. It could keep traders out of the markets for packaged loan securities until they were convinced the markets had returned to equilibrium after the massive government intervention.

That’s why the Bush administration eventually opted to invest billions directly into dodgy banks. The one thing they could not afford was to encourage a “wait and see” attitude about unfreezing the banking system.

U.S. Banks Are Broke

Unfortunately, the change of administration has not changed the arithmetic in a favorable way. To the contrary, it is rapidly getting worse.

Goldman Sachs recently forecast that the banks will record an additional $1.1 trillion in losses before the economy bottoms out. That is a low-ball estimate. NYU economics professor Nouriel Roubini, who broadly predicted this crisis, has forecast that total losses and writedowns could reach $3.6 trillion.

Senator Charles Schumer (D-NY), who closely follows the banking crisis, has also estimated the costs of the next stage of the bailout at between $3 and $4 trillion.

This arithmetic means U.S. banks are effectively insolvent.

The system’s capital base is just $1.4 trillion. If losses exceed $3 trillion - which amounts to just 1.8% of the derivative exposure of the three biggest money center banks - then the system is not just insolvent but deeply insolvent.

This is a primary reason that the credit freeze has not thawed despite the hundreds of billions of dollars the government has pumped into the big banks in recent months and the additional $1 trillion or more that the Fed has brought aboard its balance sheet.

In aggregate, U.S. banks are broke. And their biggest concern now is to rebuild their balance sheets – a preoccupation that doesn’t comport with liberalizing credit.

A Broader Crisis

The feedback effects from the insolvency of the banking system in accelerating deleveraging are profound and powerful. For one, the drying up of credit has resulted in a sharp deceleration of consumer spending.

New York State recently reported a 12% year-over-year decline in sales-tax revenue. This reflects a broad collapse in spending. Meanwhile, the drop in retail sales has fed on itself and been amplified by the credit freeze.

A prime example is the fate of one-time electronics retail giant Circuit City.

The company filed for bankruptcy protection in November. At the time, management expected to use the bankruptcy process to reorganize and re-launch the company. But two months later Circuit City was forced into liquidation. It will close all 567 stores and lay off its 34,000 employees.

Like other retailers that filed for bankruptcy protection in 2008, Circuit City found no protection. More to the point, it found it could not get debtor-in-possession (DIP) financing. This enables a bankrupt company to stay in business while it takes on the difficult task of renegotiating its debts.

The problem is banks that previously provided DIP financing are functionally bankrupt themselves. And the hedge funds and private equity firms that previously would have sought to acquire and restructure bankrupt firms also lack access to the financing that would enable them to do so.

Consequently, many big name retailers are joining Circuit City in liquidation. Among them are Sharper Image, Linens N Things, Whitehall Jewelers and Steve & Barry’s. Mervyns, the west coast department store franchise, is also closing down.

Less spectacular bankruptcies all along the retail spectrum fail to make the headlines but feature in the accelerating deleveraging of the consumer economy. On average, seven auto dealers close their doors every day in the U.S. News reports indicate that General Motors, hemorrhaging losses at the rate of $118,000 a minute, will soon terminate the Saturn brand and close all Saturn dealers.

Even retail chains owned by companies that could choose to keep them open have been given the axe. Expo, the home furnishing chain owned by Home Depot, had been dragging down the group’s total profits. Until January 26, that is, when Home Depot announced it would close all 34 Expo stores over the next two months. 

No Buyers for Troubled Competitors

Aggressive competitors who would have jumped in to acquire capacity at discount rates in the recent past are standing back now. They’ve been chastened by the credit freeze. Now that consumers can no longer pay for purchases with easy credit and home equity loans, many businesses fear that consumer spending will settle at a lower level for a long time to come.

The bottom line is there are no buyers for troubled competitors.

David Ross, an analyst for Stifel Nicholas, explains why mergers have dried up in the trucking field.

There are very few trucking mergers right now — essentially they are letting companies go out of business if they can’t make it – even though the prices for those companies are cheap.

A spokesman for chipmaker Intel voiced the sentiments of many companies currently in survival model when explaining a decision to shutter its last Silicon Valley plant and cut more than 5,000 jobs worldwide. The analysis wasn’t complicated.

“We think what’s happening now is the entire system is hitting the brakes very rapidly,” he told the press.

In mid-October, Intel forecast 4Q sales of $10.3 billion. Ten weeks later, more than $2 billion in anticipated revenue had vanished.

“Demand just fell off the cliff – unprecedented in the 40-year history of this company,” said the Intel spokesman.

Companies throughout the economy are responding to the tsunami of deleveraging in a similar fashion. They’re reducing capacity, slashing employment and trimming capital spending, foreshadowing an even severer retrenchment of the consumer economy.

The most recent data on economic growth reveal that the economy contracted at a 3.4% annual rate in the 4Q 2008. This was the worst result in a quarter of a century.

Be that as it may, the 4Q contraction is actually milder than the consensus estimate of 79 economists surveyed by Bloomberg. They forecast a 5.5% annual decline.

But look more closely.

The decline was less than forecast because a build-up of unsold inventories cushioned the blow in production. Without the inventory build-up, the decline would have been 5.1%.

Economic reports from Europe and Asia reveal that a worldwide inventory liquidation is underway. And as consumers and businesses reel in the wake of the greatest loss of wealth in history and wave after wave of layoffs and plant closings, I expect the contraction to accelerate in 2009.

First quarter GDP will probably decline by 7% or more at an annualized basis. That’s greater than the 6.4% contraction that followed the great crash of 1929.

Reaching Inflexion Point

The effects of the credit collapse not only threaten to ruin many retail and industrial businesses, but they also promise additional waves of credit impairment and bankruptcy as new tranches of dodgy debt reach the inflexion point of default.

Remember, subprime loans are not the only impaired asset class that Wall Street securitized and tied to credit-default swaps. There are also Alt A and Option ARM residential mortgages.

Alt A loans, also called “liars loans,” make up a higher total indebtedness than the now notorious subprime mortgages. Outstanding Alt-A mortgages total $1 trillion, compared with $855 billion of subprime loans, according to trade publication Inside Mortgage Finance.

Another major layer in the rapidly eroding mountain of bad debt is comprised of commercial real estate loans. According to the Real Estate Roundtable, the value of commercial real estate mortgages nearly tripled over the past decade to $3.4 trillion.

The problem is many of the commercial mortgages originated between 2005 and 2007. This was the heyday of the boom, when rates were low and terms were easy. Worse still, many were also interest only loans.

These loans, like subprime and Alt A residential mortgages, were packaged on Wall Street and sold to insurance companies, pension funds and other institutional investors. Now many of them have looming deadlines to be refinanced. But with the market for commercial mortgage-backed securities locked in a deep freeze, many of these loans will probably not be easily refunded.

A banker to whom I spoke about this told me that he would be surprised if half the maturing commercial real estate mortgages were refinanced. He expects commercial property values to sink by 10% or more.

As leading commercial developer Shelton Zuckerman puts it, “Getting money these days is like pulling an elephant through a key hole.”

This suggests another wave of foreclosures and an associated notch down of asset values looming ahead.

No Bottom in Sight

Those who assume the misery is bottoming out or coming to an early end are wrong. Remember, when it comes to writedowns, losses and raising fresh capital the crisis has only just begun for banks. Losses are expected to reach trillions – only a fraction of which has been uncovered.

And don’t forget that the very actions the Fed has taken to rescue the big banks will have the effect of undermining the profitability of more conservatively run U.S. banks. Slashing interest rates to practically zero means that sound banks will struggle to make a profit on a conservative gearing. Their income is based on interest rate spreads, which are now invisibly low.

This means we’re looking at the prospect of years of negative compound growth as deleveraging works its mysterious magic.

If, as many fear, the banks do not mobilize enough fresh capital, they will be forced to sell depreciating assets in a cyclical downturn. This could trigger a classic death spiral of asset prices. Sales of assets would put downward pressure on prices, which in turn would weaken banks’ balance sheets. This would trigger further sales. And so on. 

“Once again we have a mountain of distressed assets to sell, which is enormous in comparison with any conceivable demand [for those assets],” says hedge fund manager Ray Dalio.  
 
Exacerbating the situation is the fact that so-called “smart” investors bought large amounts of securitized loans last year and, as their prices plunged, trying to “catch a falling knife” in the hope of snapping up bargains.

If prices continue to drop, these investors will come under severe pressure, especially those who are using borrowed funds for their speculation.

This explains why Dalio, one of the world’s richest men, is so pessimistic.

The U.S. is stuck in a large debt-workout process. It’s a “classic deleveraging” that is much like the one Japan went through in the 1990s. It’s also frighteningly similar to the experience of countries during the Great Depression and of developing countries during various other debt crises.

Only this time everything is much more complex.

This is because of the enormous international interdependence of the financial services industry. And making things worse, U.S. consumers are overly indebted and their accustomed access to cheap money is now blocked.

The forgoing is a quick summary of the preconditions that paved the way for a “perfect financial storm.” It has triggered deleveraging sharp enough to have practically wiped out the world’s banking system, thereby precipitating global liquidation in the real economy.

Money Heaven

The issue is vexed. But we will be following it closely as it unfolds, even though it still gives me headaches to think about it.

In particular, I still find it difficult to imagine how the souring of a few hundred billion dollars worth of sub-prime mortgages could have had such catastrophic cascading effects as to have bankrupted the whole country of Iceland. It’s especially puzzling considering that the Icelandic banks didn’t even hold any sub-prime assets in their portfolios.

Another puzzle that will occupy historians is how what was initially just a few hundred billions of dollars of bad debt came to be sliced and diced into a multi-hundred-trillion-dollar orgy of derivative exposure.

And exposure to whom? Don’t you wonder?

Yet another puzzle is how a hefty fraction of the total wealth of the world could be gambled away – hemorrhaging losses throughout the world banking system as a result – with so little hint of anyone being on the winning side of these gambles. The money didn’t go to Mars. So where did it go?

The nearest approximation I can give you is that the missing trillions went to Money Heaven, where a version of St. Peter with a green eyeshade must be working overtime to process the new arrivals.

It seems impossible. But it was inevitable.

Perhaps it is only fitting that the compensation for decades of runaway credit creation would be as far out of proportion as the gaudy excess it brought to a close.

The Floyd Bostwick Odlum Memorial

Brainstorm of the Month

Strategies inspired by Floyd Bostwick Odlum (1892-1976), possibly the only man in the United States who made a great fortune out of the Great Depression.

Odlum’s key insight was that credit liquidations dramatically misprice assets.

We aim to follow this insight in Crisis Strategy Alert.

You see, you can be a victim of this mispricing. Or you can watch carefully, move boldly at the right moment and seize these mispricing opportunities to build wealth rather than lose it.

Odlum turned an initial $39,000 into $100,000,000.

Gold: The New Strategic Imperative

Floyd Bostwick Odlum made his big scores in sectors that are dead today: utilities, department stores, movie studios and airlines. If we are to follow his lead, we must not follow simple-mindedly in his footsteps, but blaze a new strategic direction calculated according to today’s lights.

I believe the new strategic imperative is to buy gold.

This conclusion, to be clear, is entirely strategic in nature. It is not based upon technical analysis of spot gold or stock price movements.

As I analyze elsewhere in this issue, the U.S. banking system is insolvent. And the promise and hope of a bailout may ultimately force a choice between insolvency of the banks and insolvency of the state.

As the example of Iceland shows, when that threshold is reached the likely result is bankruptcy for both.

Following in Brazil’s Footsteps

It’s important to remember that the recently passed ‘stimulus’ legislation, along with the trillions of dollars in bailouts (all spun out of an empty pocket) are not a new experiment, but an old one repeated.

My Brazilian wife reckons Americans are crazy if they think that printing money willy-nilly, as we are now doing, will have a different outcome than the one experienced by Brazil after it cranked up the printing presses in her youth.

From her birth in 1980 to her fifteenth birthday the price level in Brazil increased a trillion-fold, while real income stagnated. It was Inflation with a capital “H” – as in Hyperinflation.

As my wife says, if you mix a gallon of water into a glass of wine there is no mystery about what you will get. Perhaps some Americans would be tempted to disagree.

Presumably they would do so on grounds that runaway inflation is something that happens to other countries and that America can spend trillions of newly created fiat money without experiencing the usual consequences. (Maybe they think it was the diet heavy with “feijoada complete,” the skimpy attire of samba clubs during Carnaval and women parading the beaches at Ipanema half-naked that led to Brazil’s hyperinflation rather than the mere printing of money.)

All sorts of arguments can be advanced to confuse the obvious and deny the inevitable. But the way I see it is we’re doing just what Argentina and Brazil did during their lost decades: printing money to cover fiscal deficits that averaged 5% or more of GDP.

Sometimes, the deficits were much higher. But seldom, if ever, were they as high as those now in view in the U.S.

No Plausible Fiat Currency Left

Of course, those who propose a big difference between hyperinflation of the Brazilian cruzeiro (as the currency was then known) and hyperinflation of the dollar are right about one thing. The dollar is the world’s reserve currency, which means that dollar depreciation will have a much greater impact in lifting gold values than did the collapse of the cruzeiro.

When the cruzeiro and the Argentine peso were inflated to oblivion, people in South America responded by buying dollars. When the dollar is obliterated by inflation, people will buy gold, not Argentine pesos.

That’s because there will be no plausible fiat currency to buy in preference to gold when big money wants to move out of dollars. The euro, Swiss franc, British pound and Japanese yen are all hampered by some of the same draw-backs as the dollar.

And the invisibly low interest rates in most currencies lower the opportunity costs for holding gold. Hence, I expect interest in gold to compound rapidly as the costs of the bailout continue to rise.

The implication is that you should buy gold in some form or other now in anticipation of the inflationary effects from multi-trillion-dollar deficits in Washington (and similar stresses in London, Paris, Tokyo and Frankfurt.)

But what form?

Physical Demand Is Rising

The most basic and obvious step is to buy gold bars or bullion coins or ETFs.

We are already positioned in the DB Gold Double Long ETN (NYSE:DGP). This has already proven profitable. We are now holding a 22% gain in just a month.

Demand for bullion coins from small investors has soared.

The U.S. Mint sold 92,000 ounces of its American Eagle coin in January – more than it shipped during the first six months of 2008.

Demand from large investors is also soaring, as you would expect.

I lunched with a bank chairman the other day. And he told me something startling. He told me he had a request from a billionaire to rent vault space to house a tremendous amount of gold. The billionaire had placed 20% of his portfolio into gold and now needs a bank-sized vault to store it.

He is not the only one. Almost everyone I meet is reflecting an interest in gold.

And the upsurge in gold ETFs guarantees a large physical take-off.

Although a case can be made for taking profits, we should be careful not to outsmart ourselves. I recommend that you stay in and, indeed, that you expand your investment in gold in two other avenues.

Mr. Fleming’s Gold Mine

This month’s first addition to our plan to profit from the dynamic bull market in gold involves a famous name, Adam Fleming, chairman of Witwatersrand Consolidated Gold Resources (better known as Wits Gold).

Fleming is a nephew of James Bond creator Ian Fleming. He is also related to Peter Fleming, the famous adventurer and travel writer.

This all came with the territory for someone born into the venerable Robert Fleming & Co. banking fortune. Half a lifetime ago when I was at Oxford, “Flemings” (as Robert Fleming & Co. was commonly known) was a major player in the City of London, with a particularly strong outpost in Hong Kong. But this began to wind down in the late nineties.

By 2000 Robert Fleming & Co. had been sold for $7.7 billion to Chase Manhattan Bank. The family took their marbles and set up Fleming Family and Partners. The rump of Flemings continues to operate under the name JP Morgan Fleming. Meanwhile, Adam Fleming had taken his bit of the family money and de-camped part-time to South Africa to go into gold mining in a big way.

His collateral ancestor Ian Fleming may have written Goldfinger, but Adam is the Fleming with the real golden touch. He first became involved in the gold business through the major gold miner Harmony Gold Mining Ltd. More recently, he set up Wits Gold, which he now chairs.

Wits Gold trades in Johannesburg and on the Toronto Stock Exchange under the symbol WGR. As I write, the most recent closing price in Toronto was C$4.50.

A few points about Wits Gold:

• One third of all the gold ever produced in the world has come from the Witwatersrand Basin
• Wits Gold holds the fifth largest gold resource in the world (Canadian NI 43-101 compliant)
• It has exposure to gold and uranium
• It is currently evaluating six near mine projects
• It has indicated resources of 19.4 Moz gold (Canadian NI43-101 compliant)
• It has Inferred resources of 130.4 Moz of gold in the Southern Free State, Potchefstroom and Klerksdorp Goldfields (Canadian NI43-101 compliant). Additional in-fill drilling is in progress to further improve the classification of these resources
• It has initiated a positive scoping study of Bloemhoek Project (11.3 Moz indicated resources) – pre-feasibility study has commenced
• It has cash resources of R135 million (US$13.5m) as at 30 November 2008
• Its management team has  over 50 years experience in the Witwatersrand Basin
• It has upside uranium potential (Canadian NI43-101 compliant inferred resources of 54.3 Mlb U3O8) in the Southern Free State Goldfield.

Wits Gold’s massive land package in South Africa’s rich gold belt is divided into 15 projects. The foremost of these is the Bloemhoek Project, which the company is fast-tracking towards production.

The interesting thing about Wits Gold, and the reason I recommend it, is that the company holds a total of 159.7 million ounces of proven, indicated and inferred gold reserves under its ownership. And with only about 28 million shares issued, that means each share controls about 5.7 ounces of gold.

Another reason why Wits Gold is so promising is because it holds $12.3 million in cash. This allows the company to fund operations for the next three to five years and shelters it from the ongoing credit crisis.

Just like any smart exploration company would, Wits Gold stretches its cash reserves by splitting the costs, risks and production of new mines with major gold producers.

This is exactly the type of conservative business strategy you should look for in a gold exploration company, especially one that holds the fifth-largest resource of gold in the world.

Since you can buy the share for C$4.50 (US$3.65), you are effectively buying an upside option on gold for $0.64 a share. I recommend that you do it. You could make a lot of money as the gold price continues on its merry way upwards.

Action to take: Buy Witwatersrand Consolidated Gold Resources (WGR.TO). But don’t pay more than C$6.00 a share. Because this stock is traded on the Toronto Stock Exchange, you may have to call your broker and order it through them directly. Be sure to give them this CUSIP number: S98297104. Most major brokerages, like Scott Trade, Prudential, and Ameritrade, should all be able to acquire shares from the TSX.

Buy Gold Mines in General

The final recommendation for this installment of the Floyd Bostwick Odlum Memorial Brainstorm of the Month is to buy the Market Vectors Gold Miners (ETF) (NYSE:GDX).

This index seeks to provide equity results that correspond generally to the price and yield performance of publicly traded equity securities of gold and silver mining companies, as represented by the Amex Gold Miners Index (NYSE:GDM).

The Gold Miners Index is a composite of 32 small, mid-sized and large gold companies…

And as physical demand for gold accelerated in the wake of the crisis the GDX hit a multi-year low in October 2008. It has done little more than bounce off its bottom since.

Our new gold positions should put us in an excellent position to profit as gold rallies. Stay tuned.

Action to take: Buy Shares of Market Vectors Gold Miners Index (NYSE:GDX). But don’t chase them past $40 a share.

Published by Investor Media Group SRL, Gorriti 4949, Buenos Aires, Argentina 1007

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